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Presenting a live 90-minute webinar with interactive Q&A

Buy-Sell Agreements for Corporations and LLCs:

Drafting Stock Redemption, Cross-Purchase

and Mixed Agreements Navigating Complex Corporate, Tax, Estate Planning and Insurance

Law Issues When Planning for a Business Transition

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JULY 12, 2017

Brian E. Hammell, Esq., Sullivan & Worcester, Boston

Martin B. Robins, Partner, FisherBroyles, Chicago

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Buy-Sell Agreements for Corporations and LLCs: Tax Issues Brian E. Hammell [email protected] (617) 338-2462

Redemption vs. Cross-Purchase

Redemption

› Agreement between entity and its owners

› Company agrees to purchase shares/interests upon certain triggering events

Cross-Purchase

› Agreement among owners of the entity

› Other owner(s) agree to purchase shares/interests upon certain triggering events

20 © 2017 Sullivan & Worcester LLP


Hypothetical

› Corporation with two shareholders

› Value of the Company = $2,000,000

› Shareholder A's Basis = $10,000

› Shareholder B's Basis = $10,000



Lifetime Transfer – Tax Consequences to the Transferor

› Shareholder A shares purchased for $1,000,000

› Gain on transfer = $990,000

Amount realized ($1,000,000) minus basis ($10,000)

Capital gain (generally)

Federal Income Tax = $198,000 (assuming 20% long-term capital gains rate)



Lifetime Transfer – Tax Consequences to the Remaining Owner upon a future sale


Redemption Cross-Purchase

Company worth $2,000,000 Company worth $2,000,000

Shareholder B Basis = $10,000 Shareholder B Basis = $1,010,000

Gain = $1,990,000 Gain = $990,000

Tax = $398,000 Tax = $198,000

*Assumes a 20% long-term capital gains rate

Deemed Dividend in Case of Redemption

The above example presumes that the redemption is treated as a sale or exchange under Section 1001 of the Code

› This is the general result for a complete termination of the retiring owner's interest

However, a potential trap exists under Section 302(b) of the Code

› A redemption payment to a retiring shareholder is treated as a distribution to the retiring shareholder with respect to his or her shares (and not in exchange for the shares) if the redemption does not satisfy any of the Section 302(b) tests (e.g., the retiring shareholder continues to own too many shares, actually or by attribution, after the redemption)

› Family attribution rules under Section 318 apply



Family Attribution Example

› Father owns 60% of stock in corporation

› Son owns 30%

› Mother owns 10%

› Father's stock is redeemed by the corporation

› Son and Mother's stock is attributed to Father, thus redemption is not a complete redemption and proceeds may be taxed as a dividend



Exception to Family Attribution Rules

› Family attribution rules do not apply where:

Immediately after the distribution, the distributee has no interest in the corporation including an interest as an officer, director or employee, other than an interest as a creditor

The distributee does not acquire any such interest other than stock acquired by bequest or inheritance within ten years from the date of such distribution

The distributee files an agreement to notify the IRS of any acquisition described above


Insurance Funded Buy-Sell Agreements

Redemption Agreements

› Entity buys insurance on the lives of its shareholder

Entity is the owner and the beneficiary

› At death, the entity receives life insurance proceeds

› Proceeds are used to purchase shares/interests of the deceased owner



Issues Related to Insurance Owned by the Entity

› Premiums are non-deductible – Section 264(a)(1)

› Proceeds are income tax free – Section 101(a)(1)

Exception for a C Corporation which is subject to the Alternative Minimum Tax

› Proceeds are not includable in the Estate of the Decedent – Treas. Reg. 20.2042-1(c)(6)



Issues Related to Insurance Owned by the Entity

› COLI Best Practices Act

› Section 101(j)

› Applies to employer-owned polices issued after August 17, 2006 and previously issued policies in the event of material change

› IRS Form 8925: Provides notice of (a) number of policies held and (b) the total face amount of said policies

› Death benefits of employer-owned policies will generally not be taxable if:


Employer gives employee written NOTICE and gets written CONSENT from

employee before policy is issued

AND

Insured employee fits SPECIFIED EXCEPTIONS

OR

Death benefits fit SPECIFIED

EXCEPTIONS


Cross-Purchase Agreement

› Each owner purchases life insurance on the lives of each other owner

› Shareholders/members are owners and beneficiaries of the policy

› At death, surviving owner(s) receive life insurance proceeds from policy insuring life of deceased owner

› Surviving owners buy shares/interests from estate of deceased shareholder



Cross-Purchase Agreement

› Premiums must be paid by the owners and not the entity

Potential equity problem due to cost differences in underwriting

Payments from company are regarded as taxable compensation or distribution of S corporation profits

Split dollar still an option to consider

› Premiums are non-deductible – Section 264

› Proceeds are income tax free

› Purchase of interests increases cost basis of surviving owners, reducing capital gains at time of future sale



Transfer at Death – Tax Consequences to the Estate

› Assume company had $1,000,000 life insurance policy

› Shareholder A Shares purchased for $1,000,000

› No capital gain due to step up to fair market value at death – Section 1014



Lifetime Transfer – Tax Consequences to the Remaining Owner upon a future sale


Redemption Cross-Purchase

Company worth $2,000,000 Company worth $2,000,000

Shareholder B Basis = $10,000 Shareholder B Basis = $1,010,000

Gain = $1,990,000 Gain = $990,000

Tax = $398,000 Tax = $198,000

*Assumes a 20% long-term capital gains rate


Transfer for Value Issues

› Conversions from Redemption to Cross-Purchase Agreements could result in negative income tax consequences

› Proceeds may be taxable income – Section 101


Fixing the Value of the Estate

Special Valuation Rules – Section 2703

Buy-Sell Agreement must satisfy the following rules:

› Be a bona fide business arrangement – Section 2703(b)(1)

› Not be a device to transfer business interest to family members for less than full and adequate consideration – Section 2703(b)(2)

› Be comparable to similar arrangements entered into by unrelated parties bargaining at arm's length – Section 2703(b)(3)


Fixing the Value of the Estate

Cannot fix price between family members

Bottom Line: Purchase price needs to be Fair Market Value or based upon a formula which approximates Fair Market Value

Whipsaw Potential

› State law will likely declare a sale for less than Fair Market Value to be binding on the parties


Other Drafting Points

Transfer restrictions to avoid adverse tax consequences

› e.g., prohibit transfers of S corporation stock to ineligible S corporation shareholders

Purchase price allocation for S corporations and partnerships

Tax indemnification obligations

› Impact of new partnership audit procedures

Deferred compensation arrangements


Buy-Sell Agreements for Corporations and LLCs: Tax Issues Brian E. Hammell [email protected] (617) 338-2462

Documents

Buy-Sell Agreements for Corporations and LLCs: …media.straffordpub.com/products/buy-sell-agreements-for... · Buy-Sell Agreements for Corporations and LLCs: Drafting Stock Redemption,