Every limited liability company or closely held corporation with multiple members or shareholders should have a Restrictive Stock Transfer Agreement (Buy-Sell Agreement). These agreements protect both the owners and the company, and provide for a smooth transition upon the happening of several contingencies, including the death, disability, termination of employment, retirement, voluntary desire to sell and bankruptcy of an individual owner of the company. Although this is a standard list, each company should apply its own set of facts and some creativity of its own in approaching these issues. Advance planning and discussion is critical to developing a Buy-Sell Agreement that will serve the needs of the company’s owners throughout the life cycle of the business. Planning for these transitions in advance through the use of a Buy-Sell Agreement saves relationships, time and significant cost in legal and accounting fees when fashioning an owner’s exit from a company.
As indicated above, the use of a Buy-Sell Agreement allows companies to identify different approaches for different contingencies affecting a person’s ownership in the company. For some transitions, a mandatory purchase by the company may be appropriate. For others, it may be useful for the company and the remaining owners to acquire departing owner’s interest.
One of the most important features of a Buy-Sell Agreement, aside from governing the transfer of ownership in the company, is setting forth ways to fund an owner’s buyout. There are many different ways to fund an owner’s buyout. Often companies like to use a low buy in, low buyout approach to valuation as it makes the most sense. Sometimes, payment of the buyout can be made from cash flow and retained earnings, and some companies use valuation methods that involve complex formulas and appraisals. Again, there is no limit on the creativity that can be applied to the funding issue. Of course, the transitioning owner faces an element of credit risk by agreeing to other than a full cash buyout. This may be of particular concern if the owner is relying on these funds for retirement cash flow or payment to a spouse or family upon death.
Another very important issue is the tax implications of the transfer. This often drives whether the company or the remaining owners (or some combination thereof) acquire the shares of a departing owner. Analysis of capital gains and dividend treatment is important for the selling owner. The cash position and cash projections for the company must also be evaluated.
The use of life insurance products can be helpful in funding owner transitions upon death and disability. Either funding the down payment or the full buyout price can ease the burden on the company and the remaining shareholders upon such a transition. It is common for the company to purchase life insurance on each of the owners to cover at least a portion, if not all, of the buyout obligation. This pre-funds some or all of the repurchase obligation. Although the insurance premiums on policies owned by the company are generally not deductible, with some planning, insurance proceeds are often received tax-free by the company.
In a two-owner company, it is possible for the company to purchase a policy on each owner, or each owner purchase a policy on the other as a means of funding all or a portion of a buyout. Cross purchasing insurance policies are more difficult with multiple owners but it can be done. These complexities also exist where there are several related companies with overlapping or even identical owners or owner entities.
The complexities and tax issues involved in utilizing insurance products for buy-sell purposes is beyond the scope of this article, however we would be happy to discuss these issues, or any of the topics in this article with you in more detail. Buy-Sell Agreements are critical to the long-term financial and organizational stability of any company that has more than one owner. These documents should be planned for, drafted and executed at the time the company is formed and reviewed and modified as necessary as the company adds owners over time. It is generally far more expensive to address transition issues when they occur than it is to negotiate them in advance.
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