By: Randall A. Denha, J.D., LL.M.
Contrary to popular belief, buy-sell agreements are not about buying and selling companies. Instead, they are binding contracts between co-owners of a business that govern what will happen when an owner wants to leave or a new owner wants to join. Because of this confusion over terminology, we will use the term “buyout agreement” from here on.
A buyout agreement controls the following business decisions:
- Can a departing member force the other members or the LLC to buy him or her out?
- Who can buy a departing member’s share of the business? (This may include outsiders or be limited to other LLC members.)
- What is the price for a member’s interest in the LLC?
- What other events can trigger a buyout?
A buyout agreement is a sort of “prenuptial agreement” between you and your co-owners: If your happy union doesn’t last, the buyout agreement spells out, in advance, what will happen to the business you own together.
What are typical buyout triggers? The typical events that trigger the obligation to sell or buy an ownership interest are known as buyout triggers. These typically are retirement, death, divorce, disability, bankruptcy, outside third party offer, the foreclosure of a debt secured by a membership interest and, in some situations, a breach of obligations under a major agreement with the entity, such as a failure to make an agreed-upon capital contribution.
But in some situations, certain triggers may not be the right choice. If the entity owns an investment asset such as an apartment building that has a professional manager, the death, divorce, or disability of an owner may not be important to the ongoing operation of the asset. It might be just fine if the ownership interest passed to a surviving spouse or children at death.
Another issue: what does the trigger trigger? A trigger normally triggers one of three rights—an option of a buying owner to buy out the selling owner’s interest, an option of the selling owner to force the buying owner to buy out the interest of the selling owner (also known as a “put right”), or a mutual obligation on both the buying owner to buy and the selling owner to sell the ownership interest. Of course, the owner who retires, becomes disabled, or dies wants to know that his ownership interest will be purchased. On the other hand, the potential buying shareholder wants to make sure that she is not forced to purchase an ownership interest that she cannot afford.
For many business owners, the business itself is their primary source of income both during working years and in retirement. Thus, buy-sell planning is critical for not only death planning but also disability and retirement planning during lifetime.
It’s a huge mistake to ignore the fact that sooner or later your circumstances will change. Here’s how the buyout agreement can help in several situations.
A member leaves. The odds are good that a member will want to leave the company before the other members are ready to sell or close the business down. Without a buyout agreement, the LLC might be automatically dissolved when one member leaves, forcing the assets to be sold and divided among the LLC members. If the other members wish to continue the business, there are no rules determining in advance whether and how departing members will be bought out, or for how much. This can lead to serious personal and business discord — perhaps even court battles and the loss of the business.
A new member wants to join. A buyout agreement also places controls on who can buy a membership interest in the company and how new members can join your ranks. Without this provision, another member could sell his or her share to someone you would rather not be in business with. Most tax surprises occur when using a corporation, however since an LLC can elect to be taxed as an S-Corporation, the following is important. For an S corporation, interests can be held only in certain types of trusts. Shares can never be owned by a nonresident alien or by a corporation, limited liability company, or partnership. An S corporation buyout agreement should generally be structured as a buyout by the buying shareholder directly and not by the corporation. This structure creates a higher basis in the buying shareholder. This not only will reduce gain if the stock is ever sold, but will also provide a basis that allows tax losses to pass through to the shareholder in bad years.
Encourages a discussion of expectations. In addition to avoiding potential problems in the future, writing a buyout agreement has a very real immediate benefit: It will force you and the other members of your ownership team to talk about the expectations for the business and those involved.
Unfortunately, the two traditional types of buy-sell agreements, entity purchase and cross-purchase agreements, have significant limitations and disadvantages that often prevent business owners from adequately preparing for many business succession issues. The wait-and-see, or hybrid approach, blends the flexibility of both an entity purchase and cross-purchase.
With a redemption arrangement, the entity owns the life insurance and agrees to redeem the interest of a deceased owner at that owner’s death. The owner in turn agrees that his or her estate will transfer the interest in the entity back to the entity for an agreed-upon price.
The advantages of this arrangement are:
- The simplicity of only one life insurance policy per owner;
- The owners allocate all premium costs according to their percentage ownership in the entity; and
- This arrangement ensures compliance with the terms of the buy-sell agreement.
The disadvantages of redemption arrangements are many:
- There is no change to the surviving owners’ basis at the owner’s death so the surviving owners will incur larger capital gains tax upon a lifetime disposition;
- The insurance policies are subject to attachment by the corporation’s creditors;
- If the corporation is a C corporation, the death proceeds may also be subject to the alternative minimum tax (AMT);
- If corporate-owned buy-sell policies are over-funded to provide non-qualified retirement benefits to the owners, the benefits are generally subject to income tax; and
- Potential taxation on redemption of the stock to the extent of earnings and profits where the attribution rules of IRC Sec. 318 apply.
If the LLC is taxed as an S corporation, the results of a membership interest redemption arrangement are better, because the AMT and attribution rules do not apply where the business has always been taxed as an S corporation. Also, the life insurance cash value and death proceeds give the member some membership interest basis adjustment, reducing the amount of capital gain tax that may be triggered on a sale during life or at death.
Planning Tip: Membership interest redemption arrangements require only one policy per member and thus cost less to implement, but have significant disadvantages as compared to cross-purchase arrangements.
Under a cross-purchase arrangement, each owner/member owns a policy on every other owner, and each surviving owner agrees to buy the deceased owner’s interest directly from the deceased owner’s estate.
The advantages of this structure are:
- The survivors use income-tax-free death benefit to buy membership interests directly from the decedent’s estate, thereby increasing their average membership interest basis;
- Use of the “wait and see” approach allows surviving members to keep the insurance proceeds for themselves to the extent that retained company earnings are available to effectuate a redemption; and
- Policies are protected from the company’s creditors.
The disadvantages of cross-purchase arrangements are:
- The number of policies required to accomplish funding (each owner must own a policy on each other owner) quickly becomes unwieldy as the number of members increases;
- Policies are subject to attachment by the owner’s creditors;
- An owner may fail to pay premiums or refuse to pay death benefits pursuant to the buy-sell agreement;
- The premium burden is allocated based on the cost of insurance of each other owner; and
- Application of the transfer-for-value rule (when surviving owners purchase from the deceased owner’s estate the policies on the other survivors) or need to buy new policies to cover increased values.
Planning Tip: Cross-purchase arrangements also have significant disadvantages. For many owners, the number of policies required for funding and the unequal cost burden are simply too big of a hurdle for implementation.
Use of LLCs to Structure and Fund Buy-Sell Agreements
In a recent Private Letter Ruling, PLR 200747002, the IRS accepted a strategy that has the advantages of both cross-purchase and redemption agreements without the disadvantages of either. With this structure, the members sign a cross-purchase agreement and form an LLC, taxed as a partnership, to own the life insurance. The cross-purchase agreement and LLC operating agreement have provisions that reference each other.
Special provisions of the LLC include:
- The LLC manager is a corporate trustee, and any replacement must be a corporate trustee;
- Members cannot vote on life insurance matters;
- The manager must use life insurance proceeds as required in the buy-sell agreement; and
- The LLC must maintain a capital account for each member, with special allocations of premiums and proceeds.
Upon examination of this structure, the IRS ruled that the life insurance death proceeds would not be includible in the estate of the deceased LLC member. Thus, this structure contains the advantage of the traditional buy-sell structures without the disadvantages.
Planning Tip: Using an LLC to own life insurance for buy-sell funding purposes accomplishes the buy-sell objectives without causing many of the adverse income tax consequences and without causing estate tax inclusion.