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Business Buy-Sell Agreements Legal Tax Angles: How to Save Taxes Without Going to Jail One of the biggest hazards for the heirs of a taxpayer who owns an interest in a business is that the IRS will attempt to assert a value on the business that will greatly increase the amount of estate taxes due. Without some way to determine what the value of the business will be at the time of the owner’s death, it’s not even practical to use life insurance to provide the cash needed to pay the estate taxes - because you have no practical way to know how much life insurance will be needed. Where there are non family members who own significant shares of the business, a buy/sell agreement that sets a value for the business will generally be effective in setting the value for estate tax purposes. The agreement can provide for a formula method of valuation or for a set price that must be re-negotiated every few years. To the extent that there are non family members who are parties to the agreement, the IRS is not likely to prevail in attempting to set a higher value after the estate tax return is filed. The agreement can be funded with life insurance, with cash savings or can be unfunded. An unfunded agreement makes it necessary for the heirs to rely on the ability of the remaining owners of the business to be able to generate enough after tax cash flow to pay for the decedent’s interest in the business over a reasonable time. Although many business owners don’t like to have money tied up in cash value life insurance, term insurance is often a minimum method of funding until each owner can demonstrate an ability to satisfy the payment obligation to the heirs or estate of the other owners. The details of any specific buy/sell agreement will vary depending on how many owners there are, the legal form of the business and the method selected to fund the agreement. Generally, a buy/sell agreement can provide for the purchase of the interest of the deceased owner by the other owners or by the enterprise. In the case where each owner buys a proportional share of the deceased owner’s interest, it’s referred to as a cross purchase buy/sell agreement. Where the entity buys the interests of the deceased owner, it’s referred to as a redemption. Where there are only two owners, or where a business is a partnership, a cross purchase buy/sell agreement is usually preferred. With a taxable “C” corporation, a redemption is often preferred by the owners, but it may entail some complex tax planning to overcome some significant tax problems that are common in the case of a corporate stock redemption. Suitability While a buy/sell agreement can be adopted by members of a family who are also owners of a family enterprise, the IRS and the courts are often inclined to ignore the values arrived at by the agreement because of a presumption that the family will want to set an unreasonably low value for the enterprise in order to minimize estate taxes. Thus, in family owned businesses, other methods of estate tax minimization may be more effective. Income Taxes The funds to purchase the business interests of a co-owner from his estate or heirs is usually derived from after tax savings, after tax loan payments or from life insurance purchased with after tax income. The proceeds of life insurance policies are not subject to income taxes so long as the owner of the policy has an insurable interest in the life of the insured. Generally, this includes a spouse, children, parents, a corporation in which the deceased is an officer or key person, or a partnership in which the deceased is a partner. In the case of a corporate redemption that is funded with life insurance, there may some alternative minimum tax implications at the time the proceeds are received. Although the proceeds are exempt from tax under the regular corporate tax, they are not exempt from tax under the alternative minimum tax. Under a worst case (with respect to taxes) example, the corporation might have no income or loss under the regular tax, but it has received a $1 million life insurance benefit from the death of an owner. Under current rules, 75% of that may be subject to an alternative minimum tax rate of 20%. Thus, there could be a tax of up to $150,000 on the life insurance proceeds. The most common solution to this kind of problem is to buy enough extra insurance to offset that tax. In the example just given, this would require an extra $176,000 of insurance. Capital Gains Tax If the buy/sell agreement is between unrelated parties, and imposes a binding obligation on the surviving owners of the business to buy the interest of the deceased at the amount stipulated, that will usually set the value for estate tax purposes. Thus, there should be no gain or loss due to a difference between the valuation price in the agreement and the fair market value in the estate. This will usually be true even if the market value of the assets owned by the business is greater the value of the business set forth in the buy/sell agreement at the time of the death of an owner. The buy/sell agreement will impose restrictions on the transfer of the interests in the business so as to reduce the value to the amount set forth in the agreement. Gifting and Income Splitting In some cases, owners of interests in a business may want to reduce their estate through a process of lifetime gifting to their children or grandchildren. To the extent that the shares are subject to a bone fide buy/sell agreement that permits inter-family transfers by the co-owners, the child or grandchild who receives the interests (usually corporate stock) will be bound by the terms of the buy/sell agreement. Thus, it may also be necessary to provide the child or grandchild with the funds to satisfy the agreement or to buy the insurance needed to satisfy the agreement. Estate Taxes The primary advantage of a buy/sell agreement is that it will fix the value of the business for estate tax purposes for all of the owners of the business. That then permits the owners to make plans to obtain life insurance or to implement other funding arrangements based on a measurable or known value. Implementation The co-owners of a business must first decide on some method for setting the value to be used for the purchase of any shares of a deceased owner. The value can be based on an agreed upon amount that must be revised or renegotiated every few years or it can be based on some mutually acceptable valuation formula that can be computed at any time. The co-owners must then agree on whether the buy-out will be an entity redemption of the interest of the deceased co-owner or whether it will be a cross purchase arrangement where the deceased owner’s interest is purchased by the other owners. In some cases, a cross purchase plan is accomplished with an insurance trust where the funds are provided to the trust by the business, on behalf of the respective owners. Another critical decision will be to select some method of funding the agreement so that the heirs of the various owners can be sure they will get the cash needed to pay any estate taxes on the value of the business in the estate of each co-owner. The most common method is to use life insurance. With a redemption plan, the life insurance is owned by the entity. With a cross purchase plan, the life insurance is owned by the other owners on the life of each co-owner. With two co-owners, this is not a complicated arrangement because it only involves two insurance policies. With three co-owners, each owner must buy two policies, resulting a total of six policies. With four co-owners, there will be 12 separate policies. If a cross purchase arrangement is still desired, the use of an insurance trust will become a practical arrangement. In the event of an entity buy-out, the corporation or the partnership will own a policy on the life of each co-owner. In many cases, the agreement also provides for buying out an owner who is disabled or who wants to retire. These ancillary (but desirable) elements will add some complications to the questions of funding. Generally, the use of disability insurance on each owner will have an affect similar to life insurance, but will entail additional policies. The method selected for a retirement buy out will often be funded at the time of retirement rather than being pre-funded. An agreement must be drafted and executed by all the co-owners of the business. Tax Risk The greatest tax risk arises when there is a family relationship among
the owners and the value of the business has been depressed by the buy/sell
agreement compared to what the value would be if it were negotiated between
unrelated owners. Citations IRC Sec. 1019(a)(1)
Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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