1. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company1 An arrangement for the disposition of a business interest in the event of the owner’s: –Death, –Disability, –Retirement, or –Earlier withdrawal from the business What Is A Buy-Sell (Business Continuation) Agreement?

2. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company2 Business continuation agreements can take different forms: –Entity Plan A stock redemption agreement between the corporation and individual owners, or A partnership liquidation agreement –Cross-Purchase (criss-cross) Agreement between the individual owners –3 rd Party Buy-Out Agreement between individual owners and a key person, family member or outside individual –Hybrid What Is A Buy-Sell (Business Continuation) Agreement?

3. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company3 A guaranteed market must be created for the sale of the business in the event of death, disability or retirement + It is necessary or desirable to peg the value of the business for death tax purposes A shareholder or partner would be unable or unwilling to continue running the business with the family of the deceased co-owner The business involves a high amount of financial risk for the family of the deceased owner and it is desirable to convert the business interest to cash at the owner’s death When Is Use Of A Buy-Sell Appropriate?

4. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company4 When it is necessary or desirable to prevent all or part of the business from falling into the hands of “outsiders” –Including through divorce or insolvency of an owner + When it is desirable to lend certainty to the disposition of a closely-held family business –The buy-sell agreement can be used as a substitute for a will with regard to the business interest When a state law restricts the parties who can own an interest in the entity, such as a professional corporation or association When Is Use Of A Buy-Sell Appropriate?

5. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company5 A written agreement stating the –Parties –Purchase price, either a set dollar amount or formula –Terms, including triggering events –Funding arrangements, insurance or a note payable Agreement obligates retiring (disabled) owner or owner’s estate to sell the business either to –Business itself (entity/redemption) –Surviving owners (cross-purchase) –3 rd party non-owner –Combination of the parties What Are The Requirements?

6. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company6 How Is It Done? Entity / Stock RedemptionCross-Purchase Business FMV $5,000,000 Owner 1 Dies Owner 2 Business FMV $5,000,000 Owner 1 Dies Owner 2 Business owns and is beneficiary of a $2.5M life policy on each owner’s life Business uses $2.5M of life proceeds to purchase stock from owner’s estate Estate transfers title to stock Owner 2 now owns all outstanding shares of business stock Owner 1 owns and is beneficiary of a $2.5M life policy on Owner 2 Owner 2 owns and is beneficiary of a $2.5M life policy on Owner 1 Note: Owner 1’s estate now owns a life policy on Owner 2. The estate can get additional cash by selling the policy to Owner 2 to increase his insurance coverage at the locked in rates that Owner 1 was paying. This transaction may subject the proceeds to the transfer for value rule unless it falls within an exception. Owner 2 pays estate $2.5M from proceeds Estate transfers title to stock

7. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company7 Example Stock Redemption: –Herb and Steve are equal owners of a business worth $5,000,000 –The business purchases $2,500,000 of life insurance on both men –At Herb’s death His stock passes to his estate The company purchases Herb’s stock from the executor of his estate with the insurance proceeds The executor transfers title to the stock to the company Steve ends up with ownership of all outstanding voting stock Herb’s estate has liquid funds to pay administrative costs and death taxes How Is It Done?

8. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company8 Example Stock Redemption: –At Herb’s disability Herb will continue to receive his salary for a pre-determined period of time, perhaps 6 months or 1 year Herb’s interest will be sold to the business The business will pay Herb a down payment, say 10% of $2,500,000 and issue a 10 year note payable at a reasonable interest rate for the balance, secured by Herb’s stock in an escrow account To help pay off the note, the business prior to Herb’s disability, would have applied for, paid for and named itself beneficiary of a disability income insurance policy on Herb How Is It Done?

9. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company9 Example Stock Redemption: –At Herb’s retirement Herb will sell his interest to the business The business will pay Herb a down payment of at least 10% of $2,500,000 and issue a 10 year note payable at a reasonable interest rate for the balance, secured by Herb’s stock in an escrow account To help finance the down payment on the note, the cash value from the life policy on Herb could be used How Is It Done?

10. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company10 Example Cross-Purchase: –Herb and Steve are equal owners of a business worth $5,000,000 –Herb purchases a $2,500,000 life insurance policy on Steve and a disability income policy on Steve –Steve purchases a $2,500,000 life insurance policy on Herb and a disability income policy on Herb How Is It Done?

11. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company11 Example Cross-Purchase: –At Herb’s death His stock passes to his estate Steve purchases Herb’s stock from the executor of Herb’s estate with the insurance proceeds The executor transfers title to the stock to Steve Herb’s estate has liquid funds to pay administrative costs and death taxes How Is It Done?

12. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company12 Example Cross-Purchase: –At Herb’s disability Herb will continue to receive his salary for a pre-determined period of time, perhaps 6 months or 1 year Herb must sell his business interest to Steve Steve will pay Herb a down payment of at least 10% of $2,500,000 and issue a 10 year note payable at a reasonable interest rate for the balance, secured by his stock To help pay off the note, Steve prior to Herb’s disability, would have applied for, paid for and named himself beneficiary of a disability income insurance policy on Herb How Is It Done?

13. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company13 Example Cross-Purchase: –At Herb’s retirement Herb will sell his stock to Steve Steve will pay Herb a down payment of at least 10% of $2,500,000 and issue a 10 year note payable at a reasonable interest rate for the balance, secured by Herb’s stock in an escrow account To help finance the down payment on the note, the cash value from the life policy on Herb could be used How Is It Done?

14. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company14 Stock Redemption Agreements –Assuming the corporation is the owner and beneficiary of the policy, the value of the life insurance on the decedent’s life will not be includable in decedent’s estate for federal estate tax purposes –Insurance proceeds will be considered in valuing the decedent’s interest in the business, unless there is a valid arm’s length agreement with terms fixing the price and excluding the proceeds from the purchase price –Life insurance or disability income premiums paid to fund the agreement are not deductible by the corporation Tax Implications

15. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company15 Stock Redemption Agreements –A properly drawn agreement will help to establish the value of the business for federal estate tax purposes providing: Estate is obligated to sell at the decedent shareholder’s death, or offer the decedent’s shares at his death at the agreement price There is a lifetime “first offer” provision prohibiting a shareholder from disposing of his stock interest without first offering it to the corporation at no more that the contract price The price was fair and adequate when made and resulted in a bona fide arm’s length transaction, and The price is fixed by the agreement as a set dollar amount or formula for determining the price Tax Implications

16. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company16 Stock Redemption Agreements –Biggest potential problem is the possibility that the redemption will be treated as a dividend distribution –A common exception to dividend treatment includes a complete termination of a shareholder’s interest through redemption of all of the shareholder’s stock –Be careful of constructive ownership and attribution rules triggering dividend treatment Estate is still considered stockholder because it is deemed to own stock actually owned by the beneficiary An individual is still deemed to own the stock owned directly or indirectly (through a trust or corporation) for the individual’s spouse, children, grandchildren, or parents, unless there is a waiver of constructive ownership Tax Implications

17. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company17 Stock Redemption Agreements –Life insurance proceeds received on a policy owned by a corporation that does not qualify as a small corporation are subject to AMT tax Purchase enough insurance net AMT to cover the need –Most family-owned and closely-held corporations will be “small corporations” and thus exempt from AMT –No AMT is imposed until the corporate exemption is used up Tax Implications

18. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company18 Cross-Purchase Agreements –Value of life insurance the decedent owned at the time of death on the lives of co-shareholders will be includable in decedent’s estate for federal estate tax purposes The includable amount is usually equal to the policy’s interpolated terminal reserve plus unearned premiums –Life insurance or disability income premiums paid to fund the agreement are not deductible by the co-shareholders –Death proceeds or disability benefits will be received by the respective co-shareholders income tax free Tax Implications

19. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company19 Cross-Purchase Agreements –A properly drawn agreement will help to establish the value of the business for federal estate tax purposes providing: Estate is obligated to sell at the decedent shareholder’s death, or offer the decedent’s shares at his death at the agreement price There is a lifetime “first offer” provision prohibiting a shareholder from disposing of his stock interest without first offering it to other shareholders at no more than the contract price The price was fair and adequate when made and resulted in a bona fide arm’s length transaction, and The price is fixed by the agreement as a set dollar amount or formula for determining the price Tax Implications

20. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company20 Cross-Purchase Agreements –Assuming the corporation does not take over directly or indirectly the buying shareholder’s liability once it becomes fixed, there is no possibility redemptions will be treated as dividends –If the price paid for the stock is more than its cost basis in the selling shareholder’s hands, the difference is usually taxable at capital gain rates –The surviving shareholder has the opportunity to increase his basis in the company for income tax purposes by the amount of money he pays for the stock –Where more than one shareholder is involved, the implications of the transfer for value rule must be analyzed if there are life insurance policies transferred among the shareholders or from the corporation to the shareholders Tax Implications

21. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company21 S Corporations –Cross-purchase preferred –Stock redemption may result in a second class of stock and disqualify the corporation for S election –Unclear the impact on shareholders’ income tax basis of life insurance premiums and proceeds on policies owned by the corporation –Life insurance does not trigger AMT problems in an S Corporation Buy-Sell Tax Implications

22. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company22 S Corporations –Agreement should spell out how to allocate the income and loss to the shareholders in the event of sale or death This will impact the shareholder’s basis and the gain or loss realized upon disposition –Agreement should bar sales to disqualifying shareholders and be structured so the sale is complete prior to such disqualifying transfers Buy-Sell Tax Implications

23. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company23 Partnerships –If more than 50% of the total partnership capital and profits are sold within a 12-month period, the partnership is dissolved under IRC Section 708 –If the buyout terminates the partnership, it is treated as having made a pro rata liquidating distribution of all assets to the partners, which are then treated as re-contributed to the partnership, generally tax-free –Any gain or loss realized by a selling partner is treated as gain from a sale or exchange of a capital asset, except for amounts attributable to hot assets In the case of a deceased partner’s interest, the stepped up basis will eliminate most of the gain, except IRD items Buy-Sell Tax Implications

24. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company24 Partnerships –The purchaser acquires the cost basis in the partnership interest under IRC Section 742, and may seek to adjust the basis of the partnership assets to reflect the purchase price –If the interest of a partner is liquidated rather than sold, there is no dissolution –Use of a liquidation plan that meets the requirements of IRC Section 736 permits part of the payment to take the form of a tax-deductible guaranteed payment that can be spread over several years Buy-Sell Tax Implications

25. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company25 Partnerships –Section 736(b) payments are made in exchange for a deceased partner’s interest in partnership property (e.g. goodwill) and will result in taxable gain to the selling partner to the extent cash received exceeds the basis of the partner’s interest in the partnership –Section 736(a) payments (e.g. receivables) made to successors of a deceased partner are classified as guaranteed payments or represent an interest in future partnership income, taxable to the recipient and tax- deductible to the partnership Essentially limited to service partnerships for partnership agreements entered into after January 4, 1993 Buy-Sell Tax Implications

26. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company26 Partnerships –Under a liquidation plan, receipt of life insurance proceeds on a policy owned by the partnership increases the income tax basis of the partnership interests of all partners, including the interest owned by the deceased –Under a cross-purchase plan, policies may be transferred between the partnership and partners without fear of the transfer for value rule Buy-Sell Tax Implications

27. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company27 Family Business Enterprises –IRC Section 2703 provides that any restrictions that result from options or agreements permitting any person to acquire any property at less than FMV, or any such restriction on the right to sell or use the property, are disregarded in valuing the property –An exception exists for agreements and options that meet the following three tests: They are bona fide business arrangements They are not devices to transfer property to the decedent’s family or natural objects of the transferor’s bounty for less than full and adequate consideration, and The terms are comparable to similar arrangements entered into by persons in arm’s length transactions Buy-Sell Tax Implications

28. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company28 Family Business Enterprises –Four factors in determining an arm’s length transaction Present FMV of property or business Expected value at the date of exercise of rights under the agreement Adequacy of any consideration offered for the option or agreement, and The expected terms of the agreement –Agreements in place before the effective date of IRC Section 2703 are not covered unless substantially modified thereafter Buy-Sell Tax Implications

29. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company29 Careful planning is required to protect –Against the risk that the shareholder’s spouse may predecease the seller and leave the spouse’s community property interest in stock to 3 rd parties –Against attachment by creditor’s of the stockholder’s spouse, and –Against attachment by the stockholder’s spouse if the spouse survives the stockholder and seeks to claim their community interest in the stock free of the agreement Appropriate written consents should be obtained Issues In Community Property States

30. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company30 The buy-sell agreement should contemplate the impact of a shareholder’s divorce property settlement granting stock or a partnership interest to a non-active spouse If all the stock is community property –The community property interest of the stockholder’s spouse will be included in the spouse’s estate if the spouse predeceases the stockholder, and –Will be excluded from the stockholder’s estate if the stockholder dies first If all stock is separate property of the stockholder –It will be included in the stockholder’s estate only Issues In Community Property States

31. Buy-Sell Business Continuation Agreement Chapter 40 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company31 The exact nature of stock ownership and spouses’ respective proportions should be identified and agreed upon in writing –It may be advisable to incorporate the property agreement into the buy-sell agreement Generally, the basis of property acquired from a decedent is FMV of property at date of death or alternate valuation date –For community property, the surviving spouse is given a stepped-up basis in her ½ of the community property as well, even though it was not included or taxed in the decedent spouse’s estate Issues In Community Property States