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Firm news and client alerts that may be beneficial
Whenever a corporation is owned by more than one individual, there are always questions as to what will happen if an owner dies, becomes sick, stops showing up to work, or decides to sell his or her stock in the corporation to someone else. A great way to protect from the “what ifs” is by implementing a “Buy/Sell Agreement“.
The basic premise of a Buy/Sell Agreement is to set forth the terms and conditions of which:
(a) Voluntary Termination. If a shareholder voluntarily terminates his or her employment with the corporation, this may, depending on the circumstances, cause a hardship on the corporation and could affect the operation of the business. Options available in such an instance are to provide for vesting schedules and/or alternative payment provisions.
(b) Termination for Cause. If a shareholder is terminated “for cause”, certain limitations on the buy-out of the shareholder’s interest may be imposed.
(c) Retirement. The Buy/Sell Agreement may also define when a shareholder will be considered as having terminated employment as a result of “retirement” (i.e., notice requirements, etc.). This ensures that there are no surprises caused by sudden termination of employment.
The purchaser of a Terminated Shareholder’s shares may be the corporation (“redemption”) or the remaining shareholder(s) (“cross purchase”).
If the corporation redeems the stock of a Terminating Shareholder, the remaining shareholder(s)’ cost basis is unchanged. Gain on all subsequent sales by the remaining shareholder(s) will be measured by the difference between the original cost for their stock and the sale price. The Terminating Shareholder typically will have a capital transaction. If the corporation is a “C” corporation, there will be no step-up in basis for the remaining shareholder(s)’ stock if the corporation redeems the stock. If, however, the corporation is an “S” corporation, the Buy/Sell Agreement and the ownership of life insurance can be structured so as to provide for a step-up in basis of the remaining shareholder(s)’ stock.
If a cross purchase is used, the remaining shareholder(s) will have paid for the stock of the Terminated Shareholder. The purchasing shareholder’s basis would, therefore, increase upon the purchase of the stock. Any gain on a subsequent sale would be reduced. If the sale occurs by reason of death, typically there is no gain recognized by the Terminated Shareholder’s estate because the estate benefits from a “step up” of the deceased’s cost (or “basis”) to the fair market value as of the date of death.
The most difficult issue to overcome in any Buy/Sell Agreement is the purchase price of a Terminated Shareholder’s shares. There are numerous methods of valuing stock that include, but are not limited to: (i) a fixed price, which is periodically reviewed; (ii) book value; (ii) appraisals, or (iii) values set by a formula such as multiple of average earnings.
However, there are many factors to consider when determining which method is most appropriate to use for valuing the stock of a closely-held corporation. For example, some of the factors the shareholders should take into consideration include: (i) the nature of the business; (ii) the overall economic outlook; (iii) the corporation’s net worth; (iv) the corporation’s financial condition; and (v) the market price of similarly situated corporations.
There are a number of ways to pay for a Terminated Shareholder’s shares.
As you can see, Buy/Sell Agreements can become quite complex and this outline is only intended to be a preliminary overview. If you have any questions regarding any of the issues discussed, please do not hesitate to contact me.
To view a PDF copy of this article, please click here [Protecting Your Corporation From Outsiders].
Since 1979, the Syracuse-based law firm of SCOLARO FETTER GRIZANTI & McGOUGH, P.C. has provided sophisticated tax, business, litigation, employee benefits, estate and trust planning and administration services to its individual, business, entrepreneurial and professional clients throughout New York, Pennsylvania, Florida and other states in which its attorneys are admitted to practice.