An accountant’s perspective and advice is very useful for a number of decisions made during the consideration of a buy/sell agreement. Buy/sell agreements can be appropriate for small, closely held companies to have in place to provide for the sale of the stock of the principals of the business upon the occurrence of certain events.

These agreements serve many purposes including, but not limited to, providing certainty as to the identity of the owners, matching the benefits of ownership with participation in a way that the owners think is fair and providing liquidity for a deceased owner’s estate.

The agreements may be called “cross-purchase agreements,” “buy/sell agreements” or “shareholder agreements” and accountants should be brought into the discussion concerning their terms. If you have a client with multiple owners that does not have such an agreement, you may want to broach the topic.

One example of an event that may trigger the purchase terms of a buy/sell agreement is when a principal retires or otherwise has his or her employment relationship terminated (whether by the entity or by that individual). The remaining principals may feel it is inequitable to have the departing principal own equity of the entity when he or she is not personally contributing to the growth and success of the entity. For that reason, owners sometimes desire a contract to compel the departing equity owner to sell his or her equity stake upon termination of his or her employment.

Other events upon which a buyout may occur can include: (1) the death of a principal; (2) the total and permanent disability of a principal; (3) any voluntary transfer of the equity interest by the principal; and (4) any involuntary transfer of the equity interest by the principal.

In all of the scenarios, one large issue to be addressed is how the purchase is to be funded. For this reason, sometimes the transaction is not mandatory, but is executable at the option of the remaining principals. They can then make a decision based upon available financial resources.

One triggering event, however, for which the obligation is often mandatory is the death of a principal; for one reason is it is the easiest scenario for which to provide the funding, in addition to the desire of each principal to know his or her estate will be well funded and in receipt of a liquid asset upon his or her death. The funding can most easily be provided for by the purchase of life insurance policies.

These life insurance policies present a tax issue, which an accountant should discuss with his or her clients. Upon the death of a principal, any policies owned by the deceased principal naming the other principals as the insureds and naming that deceased principal as the beneficiary are no longer needed, raising the question as to what the disposition of these policies should be. One solution would be to transfer or sell the policies to the individual who is named as the insured. As a result, each principal receives an additional policy for which he or she can name the beneficiary upon death.

Alternatively, the policies could be transferred to the surviving equity owners who have the purchase obligation under the agreement to fund the surviving equity owners’ obligations to buy-out the other survivors.

Transferring these policies raises issues with regard to the exclusion from income tax of the policy proceeds and transfer for value rules. In general, the proceeds of life insurance policies are taxable to the recipient when the policies are paid out. IRC § 61(a)(10).

There is an exception however for amounts paid under certain life insurance contracts if the amounts are paid by reason of the death of the insured. IRC § 101(a)(1). This exclusion does not extend to the situation where the beneficiary purchased the policy from a third party. In such case, the amount to be excluded from income is limited to the amount paid for the policy and any premiums paid by
the transferee.

There are certain exclusions from this exception including, but not limited to, if the transfer is to a partner of the insured party, to a partnership in which the insured is a partner or to a corporation in which the insured is a shareholder or officer. IRC § 101(a)(2)(B).

This, in a scenario of a corporation with multiple shareholders and one shareholder dies at a time during which he owns policies pursuant to which he is the beneficiary and each policy has one of the other shareholders as an insured, if those policies are sold to the other shareholders (who are not the insureds but are rather the “non-insured” shareholders who remain subject to the purchase obligations for the “insured’s” stock), the
receipt of those insurance proceeds will be taxable to
the beneficiaries.

These transfer for value rules are a trap for the unwary
if a closely-held corporation arranges for cross-purchase obligations to be imposed upon shareholders and is to
be funded by life insurance policies upon the death of
a shareholder.

Further, these transfer for value rules are a good reason for a small closely-held corporation with multiple shareholders
to impose the purchase obligations upon the entity rather than the shareholders. Because limited liability companies and their members are treated like partnerships and partners, this argument in favor of the entity being
saddled with the buy-out obligation does not apply to
limited liability companies.

When discussing buy/sell agreements funded by insurance policies with clients, if the client already has agreements and policies in place, it is a good idea to ask to review the documents. Unfortunately these arrangements are not always implemented correctly, and it is all too common to find insurance policies naming the company as the beneficiary whereas the agreement imposes the buy-out obligation on the other owners. A little due diligence at the start of representing a new client can avoid a lot of headaches later on.

This raises another issue about which the accountant’s opinion may be solicited: who should the purchaser be? The entity or the other equity owners?

The impact of income taxes is an important factor to discuss with clients concerning this issue. If the entity redeems the equity interest of the departing principal, it is not a tax-deductible expense and it depletes cash without a corresponding reduction in income.

However, redemption by the entity is a buy-out with pre-tax dollars, in contrast to the undesirable reality that any purchase by the other equity owners will be funded with post-tax dollars. Obviously situation-specific facts such as the marginal tax rates of the entity and the principals and whether the entity has pass-through taxation are needed to conclude this discussion with clients as to which is the tax-preferred purchaser.

A second tax issue related to the identity of the purchaser is the impact upon the equity owners’ tax basis in their equity interests. If the other equity owners are the purchasers, then each will have his or her respective basis increase by the amount of the purchase price. This may be important for reasons such as needing basis to recognize losses. Conversely, if the entity purchases the equity interest of the departing principal, none of the remaining principals will have their basis increased.

CPAs may also be called upon to assist in the valuation of the entity, either at the time the agreement is drafted or at the time of a buy-out. At the time of drafting the CPA may be consulted about the appropriate valuation formula. At the time of the transaction, the CPA may be consulted to obtain the data required by the formula.

One common method of valuation is a formula to calculate the price of the equity being purchased.

For example, the valuation formula may work off of financial information such as earnings before interest, taxes, depreciation and amortization. Some agreements delegate to the CPA the calculation of the entity’s value at the time of the transaction, but an accountant should be sure he or she is competent to render a valuation that will withstand a challenge before agreeing to undertake this obligation.

Many small businesses will benefit from having a buy/sell agreement in place. A CPA’s opinion or advice is indispensable for many decisions to be made by equity owners implementing a buy/sell agreement.

About the Author
Scott W. Ellison is a shareholder in the Business and Tax Planning Practice Group of Devine, Millimet & Branch, PA, where his practice focuses on assisting closely-held companies with their business, transactional and commercial related legal needs.

Article reprinted with permission from the New Hampshire Society of CPAs.

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