Business Succession Planning: Strategies for California Estate Planners and Business Attorneys,

Transcription

Business Succession Planning: Strategies for California Estate Planners and Business Attorneys,
Reprinted from Business Succession Planning: Strategies for California Estate Planners
and Business Attorneys, copyright 2012 by the Regents of the University of California.
Reproduced with permission of Continuing Education of the Bar - California (CEB). All
rights reserved. (For information about CEB publications, telephone toll free 1-800-CEB3444 or visit our web site, CEB.com).
6
Buy-Sell Agreements
Louis A. Mezzullo
I. INTRODUCTION TO BUY-SELL AGREEMENTS
A. Scope of Chapter §6.1
B. Definition of Buy-Sell Agreement §6.2
C. Types of Buy-Sell Agreements §6.3
D. Mandatory or Optional Buy-Out §6.4
E. Identifying Seller’s Property Interest and Limiting Marital Claims
1. Importance of Characterization §6.5
2. Documents Needed or Recommended for Limiting Marital Claims §6.6
II. OBJECTIVES OF BUY-SELL AGREEMENT
A. Maintaining Continuity of Business §6.7
B. Preventing Outsiders From Obtaining Control §6.8
C. Providing Orderly Liquidation of Departing Owner’s Interest §6.9
D. Providing Capital Gains Treatment for Retired or Disabled Owner §6.10
E. Preserving Legal Status of Business §6.11
1. Preserving S Corporation Status §6.12
2. Preserving Professional Business Status §6.13
3. Avoiding Partnership and LLC Termination §6.14
F. Estate Planning Objectives
1. Fix Business Value for Estate Tax Purposes §6.15
a. Applicable Law as Determined by Date of Agreement or Recipient of Business §6.16
b. Agreements Made Before October 9, 1990 §6.17
(1) Requirements for Fixing Value for Agreements Entered Into Before October 9, 1990
§6.18
(2) Substantial Modification of Agreements Entered Into Before October 9, 1990 §6.19
c. Agreements Among Family Members On or After October 9, 1990 §6.20
(1) Bona Fide Business Arrangement §6.21
(2) Not Device to Transfer Property to Family Members for Inadequate Consideration
(a) Definition of “Family Members” and “Natural Objects of Transferor’s Bounty” §6.22
(b) Possible Testamentary Substitute §6.23
(c) Full and Adequate Consideration §6.24
(3) Evidence of Comparable Arm’s-Length Arrangements §6.25
(4) Restrictions Applicable During Life and On Death §6.26
(5) Obligation of Estate to Sell §6.27
(6) Determinable Selling Price §6.28
d. Agreements Among Unrelated Parties §6.29
2. Create Market for Shares §6.30
3. Provide Liquidity for Owner’s Estate §6.31
4. Meet Marital Deduction Requirements §6.32
III. PLANNING CONSIDERATIONS §6.33
A. Special Considerations Depending on Type of Entity
1. Corporation §6.34
a. Evaluating Corporate Redemption Agreement §6.35
(1) Corporate Law Redemption Issues §6.36
(a) Statutory Financial Tests §6.37
(b) Exception for Insurance-Funded Distributions §6.38
(c) When Funds Must Be Present §6.39
(2) Transfer Restrictions §6.40
(3) California Securities Law Requirements on Creation if Buy-Sell Agreement Is Part of
Articles or Bylaws §6.41
(4) California Securities Law and Other Regulatory Requirements on Purchase §6.42
(5) Income Tax Consequences of Corporate Redemption §6.43
b. Evaluating Corporate Cross-Purchase Agreement §6.44
2. General Partnership §6.45
a. Income Tax Considerations §6.46
b. License Requirements §6.47
3. Limited Partnership
a. General Partners §6.48
b. Limited Partner §6.49
4. Limited Liability Company §6.50
B. Additional Considerations
1. Basis for Income Tax Purposes §6.51
2. Deductibility of Interest Under Installment Note §6.52
C. Credit Considerations §6.53
D. Determining Value of Business §6.54
E. Planning Issues Concerning Owners
1. Family Relationships Among Owners §6.55
2. Working Relationships Among Owners §6.56
3. Relative Ownership Interests §6.57
4. Ages of Owners §6.58
5. Financial Condition of Owners §6.59
6. Health and Insurability of Owners §6.60
7. Commitment of Owners to Business and Importance of Participation in Business §6.61
F. Funding Buy-Sell Agreement §6.62
1. Borrowing §6.63
2. Using Employee Stock Ownership Plan (ESOP) §6.64
3. Purchasing Insurance §6.65
a. Using Life and Disability Insurance §6.66
b. Insurance Funding of Cross-Purchase Agreement
(1) Difficult if Many Owners §6.67
(2) Transfer-for-Value Issue §6.68
4. Corporate Sinking Fund §6.69
G. Integrating Agreement With Other Estate Planning Documents §6.70
IV. SUGGESTED TERMS OF BUY-SELL AGREEMENT §6.71
1. Triggering Events §6.72
a. Death §6.73
b. Disability §6.74
c. Termination of Employment §6.75
d. Bankruptcy §6.76
e. Encumbrance or Default on Personal Loan §6.77
2. Setting Purchase Price §6.78
a. Fixed Price Method §6.79
b. Book Value and Adjusted Book Value §6.80
c. Appraisal §6.81
d. Capitalization of Earnings §6.82
e. Other Valuation Methods §6.83
3. Payment Terms §6.84
4. Restrictions on Voluntary Transfers §6.85
5. Drag-Along, Tag-Along, and Other Rights §6.86
V. CHECKLIST: BUY-SELL AGREEMENT PROVISIONS §6.87
I. INTRODUCTION TO BUY-SELL AGREEMENTS
§6.1
A. Scope of Chapter
This chapter is intended to provide practitioners who are doing business succession planning for small,
closely held businesses—whether in the form of a corporation, partnership (limited or general), or limited
liability company (LLC)—with an overview of the uses and purposes of a buy-sell agreement. While
most of the considerations are the same whether the business operates as a corporation (either a C or an S
corporation), a partnership, or a limited liability company, there are some important differences among
them. On the nature of different entities, see chap 14. This chapter covers the following:
• Types of a buy-sell agreements and whether to make the purchase and sale mandatory or optional (see
§§6.3–6.4);
• Business and estate planning objectives of a buy-sell agreement, particularly whether a buy-sell
agreement can and should be used to freeze the business value for estate tax purposes (see §§6.7–
6.31);
• Planning considerations specific to the type of entity (see §§6.34–6.52) and planning considerations
applicable regardless of type of entity, such as considerations concerning the owners or how to fund
the buy-sell agreement (see §§6.53–6.70);
• Suggested terms of a buy-sell agreement, such as the triggering events, setting the purchase price, and
payment terms (see §§6.71–6.86); and
• A checklist of buy-sell agreement provisions (see §6.87).
The buy-sell agreement will embody the owners’ decisions about their objectives by planning for the
succession of interests, training employees or family members to enter the business, agreeing to restrict
sales and other transfers of business interests to a designated group of potential transferees, agreeing on
the value of their interests or on how the value should be determined, deciding what will happen if the
entire business is sold, providing the mechanism for the acceptable transfer of interests in the business,
and providing how the purchase of those interests will be funded so that the business is not damaged by
the repurchase of an interest.
Due to the complexity of the issues, this chapter is unable to cover all of the business law, estate
planning, and tax considerations affecting buy-sell agreements. It is recommended that the practitioner
consult Business Buy-Sell Agreements (Cal CEB 1991) or Mezzullo, An Estate Planner’s Guide to BuySell Agreements for the Closely Held Business (2d ed 2007) to review all of these issues in detail.
Complete forms for buy-sell agreements can be found in Business Buy-Sell Agreements (Cal CEB
1991). For a corporate buy-sell agreement, see Buy-Sell Agreements, chap 3; for partnership (general and
limited) and LLC buy-sell agreements, see Buy-Sell Agreements, chap 4. For a checklist on provisions to
consider when drafting a buy-sell agreement, see §6.87.
§6.2
B. Definition of Buy-Sell Agreement
A buy-sell agreement is an agreement between the owners of a business, or among the owners of the
business and the entity, to purchase and sell interests of the business at a price determined under the
agreement on the occurrence of certain future events. These so-called triggering events generally include
death, disability, bankruptcy, divorce, retirement, an offer to purchase an owner’s interest from an outside
party, and termination of employment.
The buy-sell agreement can be drafted as a stand-alone agreement or can be incorporated in the entity’s
operating agreement (e.g., as covenants within a shareholder agreement or as part of a partnership
agreement). Obviously, great care must be taken to make sure that the entity’s operating agreement and
the terms of the buy-sell agreement do not create a conflict.
Basic contract law and drafting principles apply to buy-sell agreements. A buy-sell agreement that fails
to reflect adequately or accurately a transaction or to describe and protect the client’s rights fails in one of
its essential purposes. An imprecise or badly drafted buy-sell agreement may result in either a dispute
regarding an ambiguous or incomplete contractual provision or a malpractice claim based on an
inadequate buy-sell agreement that worked to the client’s disadvantage.
For a review of California law on drafting contracts in general, see Drafting Business Contracts:
Principles, Techniques & Forms (Cal CEB 1994); on principles of contract law, see California Law of
Contracts (Cal CEB 2007).
§6.3
C. Types of Buy-Sell Agreements
There are three types of buy-sell agreements, depending on who has the obligation or right to purchase
the interest of a withdrawing or deceased owner.
(1) Cross-purchase agreement. This may also be referred to as a shareholders’ or partners’
agreement, which requires, or gives an option to, the remaining owners to purchase on a pro rata or other
basis the ownership interest of a withdrawing or deceased owner.
(2) Redemption agreement. This is also called an “entity purchase agreement,” under which the entity
is obligated or has an option to purchase the ownership interest of the withdrawing or deceased owner.
(3) Hybrid or combination agreement. Under this arrangement (also sometimes known as a “waitand-see” clause), the entity has either an option or an obligation to purchase the ownership interest of the
withdrawing or deceased owner, but to the extent the ownership interest is not purchased by the entity
because of legal restrictions, lack of sufficient funds, or for other reasons, the option or the obligation to
purchase passes to the remaining owners.
How to decide which type of agreement is most appropriate for a particular client depends on factors
such as the flexibility desired (a hybrid agreement likely provides the most flexibility), the solvency of the
entity or the shareholders and members, the income tax consequences, and the sources of funding.
§6.4
D. Mandatory or Optional Buy-Out
The business owner must decide whether the purchase or sale specified in the buy-sell agreement will
be mandatory or whether the entity or remaining owners will only have an option (the right to buy) or
right of first refusal (the right to meet the terms of a third party’s offer). As a general rule, a right of first
refusal alone is not sufficient to protect the original owners’ preferred succession of interests. If
unrestricted transfers (either within the “preferred” group or outside it) are allowed, the remaining owners
may have insufficient funds or otherwise be unable to exercise a right of first refusal at the time a transfer
is proposed.
In most situations the withdrawing owner or the deceased owner’s estate should be obligated to sell if
one of the goals of the buy-sell agreement is to limit owners to persons active in the business.
From the viewpoint of the withdrawing owner or the deceased owner’s estate, the entity or remaining
owners should be obligated to purchase the interest. Absent an obligation to purchase, the entity or
remaining owners may decide that there is no practical reason to purchase the interest of the withdrawing
owner or the deceased owner’s estate if the interest is a minority one. It is unlikely that the withdrawing
owner or the deceased owner’s estate will find a ready market for a minority interest in a closely held
business. A minority owner in a closely held business typically derives little or no current economic
benefit as a result of owning the interest because he or she cannot require the business to make him or her
an employee, officer, managing partner, or director of the business. Absent such an employment
arrangement, the minority owner may have no voice in the affairs of the business and thus is unlikely to
receive any distributions in respect of its ownership interest. For example, a closely held C corporation is
unlikely to pay substantial dividends, because the dividends are not deductible for tax purposes, while
reasonable compensation is deductible and will likely be maximized in favor of those in control of the
corporation. Similarly, in an S corporation, partnership, or LLC, the owners of the majority interest, or the
general partners or member-managers, will likely draw compensation from the entity for services
rendered and use their control position to minimize the distribution of profits to the owners, unless
otherwise agreed.
NOTE™ Mandatory purchase obligations held by a corporation are risky because creditors may set aside
the transaction and impose personal liability on the directors. See Corp C §§316, 500. Mandatory
repurchase is often provided only on the shareholder’s death if there is life insurance in place to fund
all or part of the repurchase (which is an exception to Corp C §500; see Corp C §503). See §§6.35–
6.37.
The estate tax consequences to the deceased owner’s estate must be considered if the entity or other
owners have only a right of first refusal and the price at which the interest will be purchased is to be the
price established under the agreement or the price contained in a good faith offer from a third party,
whichever is higher. In such a situation, the purchase price established under the agreement is not likely
to be accepted by the IRS for estate tax valuation purposes, because the actual price paid for the interest
could be higher. However, if the entity or remaining owners have the right or obligation to purchase the
interest at a price no higher than the price determined under the agreement, the buy-sell agreement should
establish the estate tax value of the interest, provided the requirements of IRC §2703 are met or are not
applicable. See §§6.15–6.29. If the entity or remaining owners are not obligated to purchase the interest,
the potential financial impact on the withdrawing owner or the deceased owner’s estate must be
considered, particularly the need for sources of cash to pay estate taxes.
E. Identifying Seller’s Property Interest and Limiting Marital Claims
§6.5
1. Importance of Characterization
If community property, separate property, and quasi-community property interests of shareholders,
partners, or members are properly defined when the buy-sell agreement is negotiated, the estate planning
goals of the individual parties can be considered. On necessary and recommended forms and form
provisions, see §6.6. The nature of the interests of owners with former or deceased spouses or registered
domestic partners should also be clearly established. Establishing the property nature of a business
interest subject to a buy-sell agreement allows all parties to anticipate family claims after the death or in
the event of the dissolution of the marriage or registered domestic partnership of the parties to the
agreement. This may be particularly important to the other owner-parties, who want to ensure that the
agreement is enforceable when the triggering event occurs.
The attorney should check the share certificates, partnership agreement, certificate of limited
partnership, or LLC operating agreement to learn how title is held. Appropriate provisions relating to the
sale of the stock or other business interest should be included in the party’s will and, if he or she has a
spouse or registered domestic partner, in the spouse or domestic partner’s will. On integrating buy-sell
agreements with other estate planning documents, see §6.70; chap 20. It is especially important to check
stock certificates to ensure that they are not held in the names of the party and his or her spouse or
registered domestic partner as joint tenants, because this form of title could present a conflict on the
party’s death between the claim of the surviving joint tenant to the respective property interest free of any
creditors of the deceased tenant and the purchaser’s claim of the right to purchase the property under the
buy-sell agreement. See CC §§682–683.
NOTE™ The possibility of litigation over this conflict can be avoided before the buy-sell agreement is
signed, either by placing title in the party’s name alone or by transferring title to the trustee of a
revocable trust. Transferring joint tenancy property to a revocable trust ordinarily severs the joint
tenancy because the trust distribution provisions are usually inconsistent with the survivorship right
of the joint tenant. Estate of Powell (2000) 83 CA4th 1434, 100 CR2d 501. Severance of the joint
tenancy raises questions about the character of the property after severance. The initial joint tenancy
title created a presumption that the property was owned as equal shares of separate property. CC
§683 (but see Prob C §5305). The Fam C §2581 presumption that joint tenancy property acquired
during the marriage is community property does not apply if there is no dissolution of marriage
proceeding. Some practitioners believe it is better practice not to rely completely on the trust
instrument to characterize or transmute property but instead to use a separate transmutation
agreement. See §6.6.
§6.6
2. Documents Needed or Recommended for Limiting Marital Claims
Provisions in the buy-sell agreement that confirm property interests are not a total safeguard against
later claims or attacks on the agreement, but their absence may encourage later challenges. For example,
there may be circumstances in which the characterization of a property interest in a buy-sell agreement
could be overridden (e.g., a different characterization in a will or revocable trust would be given great
weight under Prob C §§21102–21103, 21120–21122).
Possible additional documents that may be needed or helpful are as follows:
• A separate transmutation agreement;
• Provisions in the buy-sell agreement characterizing the property and a statement by the nonparty
spouse confirming the characterization of the property to be added to the buy-sell agreement;
• Consent to buy-sell agreement signed by the nonparty spouse.
Some practitioners believe it is better not to rely completely on the buy-sell agreement to characterize
property and instead draft a separate transmutation agreement or statement to be added to the buy-sell
agreement, signed by the nonparty spouse or registered domestic partner. Fam C §852(a). (“Nonparty”
refers to the spouse or registered domestic partner who is not a party to a buy-sell agreement.) In addition,
it may be necessary to have the contributing party execute a written waiver of the Fam C §2640(b) right
to reimbursement (for separate property contributions to the community property; applicable on
dissolution but not on death) in a document separate from the transmutation document (for separate
property contributions to the other spouse’s or domestic partner’s separate property, the transmutation
agreement alone is sufficient; see Fam C §2640(c)). If the nonparty spouse or domestic partner is waiving
property rights that he or she would otherwise have as a surviving spouse or domestic partner, the
nonparty spouse or domestic partner must be represented by independent counsel, the property interest
and the effect of the change must be disclosed, and the nonparty spouse or domestic partner must agree in
writing. For detailed discussion of transmutation and reimbursement issues, see §§20.6–20.24.
Further, it might be prudent to have the nonparty spouse or registered domestic partner execute a
consent to the buy-sell agreement to preempt any challenges under Fam C §1100(d), which requires the
managerial spouse or partner to give prior written notice of any “sale, lease, exchange, encumbrance, or
other disposition of all or substantially all of the personal property used in the operation of the business”
regardless of whether the property is held in the name of only one spouse, and under Fam C §721(b)(3),
which requires an accounting if any benefit or profit is obtained by one spouse or domestic partner from a
transaction that affects community property without the consent of the other. On Fam C §§721 and 1100,
see §20.21. For a form of statement by the nonparty spouse or registered domestic partner confirming the
characterization in a separate document to be added to the buy-sell agreement, see §20.24.
For a spousal or registered domestic partner consent form and for form clauses confirming the property
character in the buy-sell agreement, see Business Buy-Sell Agreements (Cal CEB 1991).
II. OBJECTIVES OF BUY-SELL AGREEMENT
§6.7
A. Maintaining Continuity of Business
A primary goal in planning for the disposition of the interests of shareholders, partners, and members
of LLCs is to ensure to the highest degree possible the continuation of the business after the death or
withdrawal of the original owner or owners. For some businesses, a buy-sell agreement is all the business
succession planning that is needed. See chaps 1, 5.
In buy-sell agreements, business owners can provide for the smooth transition of management and
operations in a manner acceptable to all the owners (and, possibly, key employees and lenders), whether
among members of a defined class (such as within the group of current owners or the same family) or
from one generation to another. A carefully crafted buy-sell agreement permits the owner to plan for the
transfer of control and ownership to the next generation without fear of losing control over the business
before he or she is ready.
Continuity is ensured only if each owner’s right to sell, give away, or otherwise transfer an interest in
the business is restricted. Normally, buy-sell agreements give the other owners rights of first refusal or
impose an obligation to purchase on certain transfers; buy-sell agreements may authorize certain other
transfers that would not jeopardize operation of the business but would further the owners’ individual
estate planning goals. For example, transfers to revocable trusts (for probate-avoidance purposes) might
be expressly authorized; in family businesses, owners might agree to allow gifts within the family in order
to take advantage of the annual gift tax exclusion. For a sample form clause permitting such transfers in a
corporate buy-sell agreement, see Business Buy-Sell Agreements §3.54 (Cal CEB 1991).
§6.8
B. Preventing Outsiders From Obtaining Control
Another major objective of a buy-sell agreement is to prevent outsiders, whose interests may conflict
with those of the entity or the remaining owners, from obtaining an ownership interest. See Tu Vu DriveIn Corp. v Ashkins (1964) 61 C2d 283, 38 CR 348, in which the court upheld a bylaw that company
shares could be transferred to an outsider only after the other shareholders declined to purchase the shares
at the price and under the same terms as offered to the outsider. Some owners may choose to prohibit such
transfers absolutely, while others may be satisfied with only a right of first refusal. Another tool in
handling these issues is to incorporate “tag-along” provisions in the buy-sell agreement, which essentially
allow any owner to join a sale by any other owner to a third party, typically on a prorata basis. See §6.82.
This type of provision can have the effect of discouraging sales to outsiders and adds a level of protection
to minority interest holders to prevent them from having their ownership interests “orphaned” with an
unknown third party in control of the entity. Of course, the owners are always free to agree outside of the
buy-sell agreement to a sale to a particular third party, if desired.
In addition to protecting the business from outsiders, the buy-sell agreement can prevent other
unwanted third parties, such as a retired owner or the former spouse of an owner (as the result of a
divorce) from maintaining or acquiring an ownership interest in the entity. Without a buy-sell agreement
to force the withdrawal of a retired owner in exchange for a fair share of his or her prior contribution to
the entity, he or she would be able to continue to exercise his or her voting rights, if any, and to receive
distributions on the same terms as that of the active owners. Given that a passive owner’s goals and
knowledge often differ from those of more involved owners, his or her continued ability to vote and
receive distributions could cause conflict and resentment.
§6.9
C. Providing Orderly Liquidation of Departing Owner’s Interest
The buy-sell agreement can deter disputes by providing independent mechanisms for determining the
purchase price of a withdrawing or deceased owner’s interest and requiring arbitration to settle disputes
between owners. On setting the purchase price, see §§6.78–6.83. A change in an owner’s status is almost
always accompanied by a change in goals and priorities. Both disabled owners and retired owners
typically have more need for cash distributions as a source of income, and therefore they may begin to
push for investment and distribution policies that favor short-term growth and return on investment over
those policies more conducive to the entity’s long-term health. A buy-sell agreement can also decrease the
chance of disputes when an owner wishes to withdraw from the entity to enter into competition.
The respective rights among the remaining owners to purchase the interest of a departing owner should
also be fixed in the buy-sell agreement. Owners may wish to provide for either prorata or equal purchase
rights, or any combination of rights. It is also not uncommon for owners to give preference to other
owners who are members of the departing owner’s immediate family before opening up the right to
purchase to all owners. It is simpler for all concerned to negotiate payment terms before the fact, when
presumably no party is operating from a position of weakness, and to peg the interest rate to be charged
the purchaser to an independent source such as the federal government, The Wall Street Journal, or a
bank.
The buy-sell agreement can provide a source of long-term financing for the purchase of a departing
owner’s interest, allowing payments to be made out of the business’s cash flow by purchasing insurance
or otherwise. If the manner of payment is left for negotiation at the moment of departure, a departing
owner and the remaining owners could differ greatly in their preferences. The departing owner will prefer
to receive as much of the purchase price as possible in cash immediately; if the amount involved is large,
such a lump-sum payment could place a strain on the entity’s cash reserves and short-term financing
sources. It may also cause an issue of illiquidity for a corporation in violation of Corp C §§500–511. See
§6.36. A buy-sell agreement therefore typically provides for a portion of the purchase price, such as 10
percent, to be paid to the departing owner immediately, with the remaining portion, together with a
reasonable rate of interest, to be paid over the course of several years pursuant to a promissory note. On
payment terms, see §6.84.
§6.10
D. Providing Capital Gains Treatment for Retired or Disabled Owner
A buy-sell agreement can provide a source of cash, either in a lump sum or over a period of time,
usually with favorable capital gains treatment. There are at least four reasons why capital gains treatment
is desirable:
(1) In 2012, the tax rate on capital gain for property held for more than 12 months was 15 percent, as
opposed to a 35-percent maximum rate on ordinary income. See IRC §1(h).
(2) Capital losses in excess of capital gain may only offset $3000 of ordinary income each year. See
IRC §1211(b)(1).
(3) In a capital gains transaction, the owner is taxed only on the amount by which the sale price
exceeds his or her basis in the interest, thus allowing the owner to recover his or her basis tax-free. See
IRC §1001(a).
(4) Installment sale treatment is not available for certain transactions that are not treated as sales or
exchanges, such as dividend distributions. See generally IRC §453(b)(1) (referring to a “disposition of
property”).
§6.11
E. Preserving Legal Status of Business
The buy-sell agreement can include provisions to void transfers that would result in the termination of
an entity’s S election (see §6.12); status under state law as a professional corporation, professional limited
liability partnership (LLP), or LLC (see §6.13); or status as a partnership for tax purposes (see §6.14).
§6.12
1. Preserving S Corporation Status
With the exception of another S corporation that is the sole shareholder of a qualified Subchapter S
subsidiary, IRC §1361 prohibits any type of entity other than an estate, certain trusts, or certain exempt
organizations from owning shares in an S corporation. Nonresident aliens are also prohibited from being
S corporation shareholders. If a share is transferred to a prohibited shareholder, the corporation’s S
election is terminated and it will be taxed as a C corporation until permitted to reelect S corporation
treatment. IRC §1362(d)(2). For example, a buy-sell agreement dealing with an interest in an S
corporation might provide for the redemption or purchase of shares that, in the hands of certain
shareholders, might cause the corporation to lose its S corporation tax status.
For a sample form clause preserving the S corporation election, see Business Buy-Sell Agreements
§3.68 (Cal CEB 1991). On S corporations generally, see chap 16. See also Organizing Corporations in
California (3d ed Cal CEB 2001).
§6.13
2. Preserving Professional Business Status
Ownership in professional corporations or professional limited liability partnerships (LLPs) is
generally restricted by state law to members of the particular profession. For example, a law partnership is
prohibited from continuing to practice law if one of the partners ceases to be licensed to practice law. Cal
Rules of Prof Cond 1–310. Loss of a professional license by a shareholder or partner of a professional
corporation or partnership usually triggers a mandatory buy-sell obligation to ensure continued
compliance with professional corporation and licensing statutes. Similarly, the death of a licensee or any
other triggering event that may result in transfer of an interest to an unlicensed party should trigger a
mandatory buy-sell obligation.
For further discussion of professional practice succession, see chap 17.
§6.14
3. Avoiding Partnership and LLC Termination
NOTE™ The following discussion of IRC §708 applies to LLCs that have elected to be treated as
partnerships for federal income tax purposes. See Treas Reg §§301.7701–1—301.7701–3. See also
§14.55. Thus, in this section, the term “partnership” includes both partnerships and LLCs.
A buy-sell agreement can be drafted to prevent the inadvertent termination of the partnership for
federal income tax purposes. Internal Revenue Code §708(b)(1)(B) provides that a partnership will
terminate if there is a sale or exchange of 50 percent or more of the total partnership interests within a 12month period. In such an event, the terminated partnership’s tax year will close, and it will be treated as
having contributed all its assets and liabilities to a newly formed partnership in exchange for a partnership
interest and, immediately thereafter, distributing interests in the new partnership to the incoming partner
and the remaining partners, either for the continuation of the business by the new partnership or for its
dissolution and winding up. Treas Reg §1.708–1(b)(4). Accordingly, termination does not cause
recognition of gain by the remaining partners (see IRC §§731–737) but may have other tax consequences
such as bunching of income due to the closing of the partnership’s taxable year. See Treas Reg §1.706–
1(c)(1).
In contrast, a disposition of a partnership interest by gift (including assignment to a successor in
interest), bequest, or inheritance or the liquidation of a partnership interest is not a sale or exchange for
purposes of IRC §708(b). Treas Reg §1.708–1(b)(2).
For a clause that prohibits transfers that would result in termination of a partnership, see Business BuySell Agreements §4.48 (Cal CEB 1991).
PRACTICE TIP™ A sale of a partnership interest that would otherwise terminate the partnership can be
divided into two sales that are more than 12 months apart. In the alternative, the selling member’s
interest in capital and profits could be reduced before the contemplated sale. For example, the
partnership’s operating agreement could be amended to reduce the selling member’s profits interest.
Unless the reduction is bona fide, however, the IRS may disregard it. Alternatively, the partnership
could reduce the selling member’s capital interest through a distribution. Furthermore, IRC
§708(b)(1)(B) does not apply to a transfer of a partnership interest by liquidation. Treas Reg
§1.708–1(b)(2). Thus, a buy-out by the partnership itself, even a large buy-out, will not result in a
tax termination.
NOTE™ The death of a partner in a general partnership does not terminate the partnership for federal
income tax purposes (unless no partner remains to carry on the business; see IRC §§706(c)(1),
708(b)(1)(A)) nor under the California Corporations Code (see Uniform Partnership Act of 1994
(RUPA) (Corp C §§16100–16962), especially Corp C §16601). This is also true with regard to the
death of a limited partner. See Corp C §15906.01(b)(6). However, termination for tax purposes
needs to be distinguished from termination for state corporate law purposes. For further discussion
of dissociation (defined under RUPA as voluntary or involuntary withdrawal of a partner) under
state law, see Advising California Partnerships, chap 16 (3d ed Cal CEB 1999). For further
discussion of dissolution of partnership under state law, see Advising Partners, chap 17.
F. Estate Planning Objectives
§6.15
1. Fix Business Value for Estate Tax Purposes
One of the most important tax-related issues is whether a buy-sell agreement can and should be used to
attempt to fix the value of a deceased shareholder’s, partner’s, or member’s interest for federal estate tax
purposes. The value of an asset for federal estate tax purposes is its fair market value at the time of death.
IRC §2031; Treas Reg §20.2031–1(b). “Fair market value” is defined as the price a willing buyer would
pay a willing seller for the property or interest in property, both with reasonable knowledge of the
relevant facts and neither under a compulsion to sell or to buy. Treas Reg §20.2031–1(b). The general rule
is that restrictions on an owner’s ability to acquire, sell, or use the property are disregarded for federal
transfer tax purposes (IRC §2703(a)) unless the requirements of IRC §2703(b) are met. If those
requirements are not met, the business interest will be valued at its fair market value. IRC §§2031, 2512,
2621–2624, 2703; Treas Reg §§20.2031–2—20.2031–3, 25.2512–2—25.2512–3, 25.2703–1.
PRACTICE TIP™ If the business owner’s estate is not large enough to cause concern about estate tax
matters, or if the agreement is between an owner and his or her spouse, so that a transfer for fair
market value will be exempt from tax because of the marital deduction, the effect of a buy-sell
agreement allowing the interest to be valued at less than fair market value may be undesirable
because the income tax basis of the business interest in the hands of the decedent’s heirs will be the
value accepted for estate tax purposes (IRC §1014), resulting in increased gain when the business is
eventually sold. If this is the case, and if the business is entirely family-owned, it may be preferable
to allow the decedent’s interest in the business to pass under the decedent’s will or revocable trust
rather than by purchase.
§6.16
a. Applicable Law as Determined by Date of Agreement or Recipient of
Business
For a buy-sell agreement to determine the value of the business interest for estate tax purposes,
different sets of rules must be followed depending on the recipient of the business on the business
owner’s death or the date of the agreement:
• Agreements made before October 9, 1990. Before the IRC Chapter 14 (IRC §§2701–2704; see
§§18.80–18.99) rules were enacted, less stringent rules applied to set the value of a business for estate
tax purposes. See §§6.17–6.18.
• Agreements among persons who are family members or the natural objects of each others’
bounty (for definitions, see §6.22), made on or after October 9, 1990, and agreements made before
October 9, 1990, but substantially modified later. See §§6.19–6.28.
• Agreements among persons who are not family members and are not the natural objects of
each others’ bounty. See §6.29.
§6.17
b. Agreements Made Before October 9, 1990
Buy-sell agreements made before October 9, 1990, are subject to the requirements of Treas Reg
§§20.2031–2—20.2031–4 and rulings and cases construing those regulations, not to the requirements of
IRC §2703, unless they are substantially modified after October 8, 1990 (in which case IRC §2703
applies). Treas Reg §25.2703–2. See Estate of True v Commissioner (10th Cir 2004) 390 F3d 1210. On
substantial modification, see §6.19.
WARNING™ Because the requirements of IRC §2703 and Treas Reg §25.2703–1 will probably be more
difficult to meet for parties who are related to each other than were the requirements of Treas Reg
§§20.2031–2—20.2031–3 alone, buy-sell agreements among family members that were entered into
before October 9, 1990, and that continue to meet the needs of the parties should not be amended
without careful consideration of the consequences of a proposed amendment.
§6.18
(1) Requirements for Fixing Value for Agreements Entered Into Before
October 9, 1990
Under agreements entered into before October 9, 1990, the purchase price determined under a buy-sell
agreement can fix the value of an interest in a closely held business if the following four requirements are
satisfied (see Treas Reg §20.2031–2(h)):
(1) The price must either be fixed or determinable under a formula contained in the agreement.
(2) The decedent’s estate must be obligated to sell at death at the fixed price. This can be accomplished
either by giving the entity or the other owners an option to buy the deceased owner’s interest or by using a
mandatory buy-sell arrangement.
(3) The transfer restriction must apply during the deceased owner’s lifetime. At a minimum, the other
owners must have a right of first refusal to buy the interest at the fixed or determinable price before the
owner can sell the interest to a third party. Estate of Lionel Weil (1954) 22 TC 1267, acq 1955–2 Cum
Bull 10. This requirement may not be satisfied if the owners may transfer their interests to relatives or
other owners by gift during life unless the donees become subject to the same restrictions.
(4) The agreement must be a bona fide business arrangement and not a device to pass the interest to the
natural objects of the deceased owner’s bounty without full and adequate consideration in money or
money’s worth. Rev Rul 59–60, §8, 1959–1 Cum Bull 237. Historically, this requirement was satisfied if
the price under the agreement was equal to the fair market value of the interest at the time the agreement
was originally executed.
In Rudolph v U.S. (SD Ind 1993) 93–1 USTC ¶60,130, 71 AFTR2d 2169, which dealt with a buy-sell
agreement predating the effective date of IRC §2703, the district court reviewed the fourth requirement in
some detail. In holding that the purchase price under the agreement controlled the estate tax value of the
shares in a family-owned business, the court rejected the government’s position that because the price
under the agreement was below fair market value, the agreement was a device to transfer the shares to the
objects of the decedent’s bounty without full and adequate consideration.
The court held that “the reasonableness of the price set forth in a restrictive agreement should be
evaluated based on the facts in existence at the date the agreement is reached unless unusual intervening
circumstances occur.” In addition, intent to use the agreement as a testamentary disposition must be
present before the agreement is held invalid.
§6.19
(2) Substantial Modification of Agreements Entered Into Before October
9, 1990
The regulations provide some guidance as to what will be considered a substantial modification (see
Treas Reg §25.2703–1(c)(1); Treas Reg §25.2703–1(d), Example 2):
• Any discretionary modification of a right or restriction, whether or not authorized by the terms of the
agreement, that results in other than a de minimis change to the quality, value, or timing of the rights
of any party with respect to property that is subject to the right or restriction.
• If the terms of the right or restriction require periodic updating, the failure to update is presumed to
substantially modify the right or restriction unless it can be shown that updating would not have
resulted in a substantial modification.
• The addition of any family member as a party to a right or restriction (including by reason of a
transfer of property that subjects the transferee family member to a right or restriction with respect to
the transferred property) is considered a substantial modification unless
• The addition is mandatory under the terms of the right or restriction; or
• The added family member is assigned to a generation (determined under the generation-skipping
transfer tax rules (IRC §2651)) no lower than the lowest generation occupied by individuals
already party to the right or restriction.
The following are not considered substantial modifications (Treas Reg §25.2703–1(c)(2)):
• A modification required by the terms of a right or restriction;
• A discretionary modification of the agreement containing the right or restriction if the modification
does not change the right or restriction (e.g., an amendment to change the company’s name or
registered agent’s address) (Treas Reg §25.2703–1(d), Example 3);
• A modification of a capitalization rate used with respect to a right or restriction if the rate is modified
in a manner that bears a fixed relationship to a specified market interest rate; and
• A modification that results in an option price that more closely approximates fair market value.
In IRS Letter Ruling 200625011, the IRS ruled that an amendment to a pre-1990 buy-sell agreement
involving S corporation stock, which clarified that the agreement applied only to nonvoting stock owned
by shareholders, was not a substantial modification of the agreement.
§6.20
c. Agreements Among Family Members On or After October 9, 1990
To effectively fix the value of a business interest for transfer tax purposes, a buy-sell agreement
between or among family members must comply with the following six requirements (the first three are
contained in IRC §2703(b) and Treas Reg §25.2703–1; the next three are found in Treas Reg §§20.2031–
2(h) and 20.2031–3(c) and in case law):
(1) The agreement must be a bona fide business arrangement (IRC §2703(b)(1); Treas Reg §25.2703–
1(b)(1)(i)). See §6.21.
(2) The agreement must not be a device to transfer property to members of the decedent’s family or the
natural objects of the decedent’s bounty for less than full and adequate consideration in money or
money’s worth (IRC §2703(b)(2); Treas Reg §25.2703–1(b)(1)(ii)). See §6.22–6.24.
(3) The agreement’s terms must be comparable to similar agreements entered into by persons in arm’slength transactions (IRC §2703(b)(3); Treas Reg §25.2703–1(b)(1)(iii)). See §6.25.
(4) The agreement must restrict transfer of the business interest both during the decedent’s life and on
his or her death (Treas Reg §§20.2031–2(h), 20.2031–3(c)). See §6.26.
(5) The decedent’s estate must be bound by the agreement to sell the business interest at the price fixed
in the agreement (Treas Reg §§20.2031–2(h), 20.2031–3(c)). See §6.27.
(6) The selling price must be fixed or calculable according to a formula or another reasonable method
(Treas Reg §§20.2031–2(h), 20.2031–3(c)). See §6.28.
Some of the significant differences between the requirements for buy-sell agreements as they existed
before IRC §2703 was enacted (see §6.18) and the requirements under §2703 are as follows:
• Each requirement under IRC §2703 is a separate test (Treas Reg §25.2703–1(b)(2));
• In addition to meeting all pre-section 2703 requirements, the agreement among related parties must be
comparable to similar agreements entered into by persons in arm’s-length transactions; and
• Agreements among unrelated persons who are not the natural objects of each others’ bounty are
subject to fewer requirements than agreements among related parties (see §6.29).
NOTE™ The practical effect of the section 2703 requirements is that prices under buy-sell agreements
among related parties are likely to be close to the fair market value and cannot be artificially
depressed. On the use of minority and lack-of-marketability discounts, see §§18.67–18.73.
§6.21
(1) Bona Fide Business Arrangement
Internal Revenue Code §2703(b)(1) and Treas Reg §25.2703–1(b)(1)(i) require the option, agreement,
right, or restriction to be a “bona fide business arrangement.” Because neither the Code nor the
regulations define the term, guidance is found in case law. (Note that pre-1990 case law is still good
because the bona fide business requirement predates the enactment of IRC §2703.)
Courts have found the following agreements to constitute bona fide business arrangements:
• Agreements whose purpose is to provide continuity of management and preservation of family
control. Slocum v U.S. (SD NY 1966) 256 F Supp 753; Estate of Joyce C. Hall (1989) 92 TC 312;
Estate of Pearl Gibbons Reynolds (1970) 55 TC 172, acq 1971–2 Cum Bull 3.
• Agreements necessary to retain the services of a family employee. Edith M. Bensel (1937) 36 BTA
246, 253, nonacq 1937–2 Cum Bull 36, aff’d (3d Cir 1938) 100 F2d 639 (bona fide arrangement
between father and son-employee, who had an “unfriendly” relationship, when son was “the most
able man in the employ of the company”); Citizens Fid. Bank & Trust Co. v U.S. (WD Ky 1962) 209
F Supp 254 (option granted to family employee to secure continued services).
• Agreements meeting the desire of the decedent’s conservator to mitigate the risks of a minority
interest and to plan for future liquidity needs of the decedent’s estate. Estate of Pearl I. Amlie, TC
Memo 2006–76.
On the other hand, restrictions included in a limited partnership agreement were not a bona fide
business arrangement, but rather, were predominantly for purposes of estate planning, tax reduction,
wealth transference, protection against dissipation by the children, and education for the children. Thomas
H. Holman (2008) 130 TC 170, aff’d (8th Cir 2010) 601 F3d 763.
The general rule is that an arrangement must have a business purpose at the time the agreement is made
as opposed to the date of the decedent’s death. See St. Louis County Bank v U.S. (8th Cir 1982) 674 F2d
1207; Slocum v U.S., supra.
(2) Not Device to Transfer Property to Family Members for Inadequate
Consideration
§6.22
(a) Definition of “Family Members” and “Natural Objects of Transferor’s
Bounty”
For purposes of transfer restrictions, “members of the transferor’s family” include the persons
described in Treas Reg §25.2701–1(d), i.e., transferor’s spouse, any lineal descendant of the transferor or
the transferor’s spouse, the spouse of any such lineal descendant, and “any other individual who is a
natural object of the transferor’s bounty.” IRC §2703(b)(2); Treas Reg §25.2703–1(b)(1)(ii). (Note that
the regulation refers to “natural objects of the transferor’s bounty” rather than “members of the decedent’s
family.”)
Thus, although an intended beneficiary need not be a “relative” in the commonly understood sense of
the word to qualify as a natural object of the decedent’s bounty, the beneficiary must have enjoyed a
relationship with the decedent in which the beneficiary was considered as though he or she were in some
manner related to the decedent. A “business relationship” with a “friend” is insufficient. Estate of
Gloeckner v Commissioner (2d Cir 1998) 152 F3d 208, 215 (employee was not object of decedent’s
bounty despite being named beneficiary in decedent’s will and receiving several loans from him during
decedent’s lifetime, one interest-free).
§6.23
(b) Possible Testamentary Substitute
The issue of whether a buy-sell agreement is a testamentary substitute and not a contract for the sale of
a business interest is a question of fact that examines the parties’ intent at the time they entered into the
agreement. Rudolph v U.S. (SD Ind 1993) 93–1 USTC ¶60,130, 71 AFTR2d 2169. Applying Treas Reg
§20.2031–2(h), the Tax Court has expressed the issue as whether the parties “knew at that time the
agreements would or would not be enforced as an element of testamentary intent to pass ownership of the
enterprise to the normal objects of [the decedent’s] bounty under artificial and arbitrary advantage.”
Estate of Joseph H. Lauder, TC Memo 1990–530.
Indications that a buy-sell agreement is a testamentary substitute are as follows. (This list is based on
Estate of True v Commissioner (10th Cir 2004) 390 F3d 1210, 1220, in which the court summarized
relevant case law.)
• The health or age of the decedent when entering into the buy-sell agreement. See, e.g., Slocum v
U.S. (SD NY 1966) 256 F Supp 753 (party’s ill health indicates testamentary intent); St. Louis County
Bank v U.S. (8th Cir 1982) 674 F2d 1207. But see Orville B. Littick (1958) 31 TC 181, withdrawal
acq in part, acq in part 1984–2 Cum Bull 1 (agreement between brothers established estate tax value
even though one brother suffered from incurable disease when agreement was made).
• The lack of regular enforcement of the agreement.
• The exclusion of significant assets from the agreement.
• The arbitrary manner in which the price term was selected, including the failure to obtain
appraisals or seek professional advice. See, e.g., Estate of True v Commissioner (10th Cir 2004) 390
F3d 1210 (agreement reached in arbitrary manner, not based on appraisal, and accomplished without
professional guidance; no negotiations among parties, and earlier buy-out of one of decedent’s
children pursuant to agreement treated as substitute for her receiving share of decedent’s estate);
Cameron W. Bommer Revocable Trust, TC Memo 1997–380 (overly generous payment terms, lack of
bona fide negotiations in setting price, lack of attention to formalities in drafting agreement, and fact
that decedent had reported significantly higher values per share on previous taxable gifts of stock).
• The lack of negotiation between the parties in reaching the agreement terms. See, e.g., Estate of
Pearl I. Amlie, TC Memo 2006–76 (fact that buy-sell agreement was reached by family members
with adverse interests after negotiations is evidence that agreement was not testamentary device).
• Whether the agreement allowed for adjustments or revaluation of its price terms. See, e.g.,
Cameron W. Bommer Revocable Trust, TC Memo 1997–380.
• Whether all the parties to the agreement were equally bound to its terms.
• Any other testimony or evidence highlighting that the agreement supported the decedent’s
testamentary plan.
Some courts have rejected the IRS argument that if, in the normal course of events, children might
acquire business interests from their parents on their deaths at below fair market value, an impermissible
testamentary substitute would exist, but only if the buy-sell agreement was equally applicable to parents
and children alike. Orville B. Littick (1958) 31 TC 181, 188, withdrawal acq in part, acq in part 1984–2
Cum Bull 1.
§6.24
(c) Full and Adequate Consideration
The buy-sell agreement must also be supported by full and adequate consideration. Treas Reg
§§20.2031–2—20.2031–3; Rev Rul 59–60, 1959–1 Cum Bull 237; Rev Rul 80–213, 1980–2 Cum Bull
101; Rev Rul 83–120, 1983–2 Cum Bull 170. The reciprocal obligations of the parties under the
agreement usually constitute sufficient consideration, regardless of the relationship between the parties.
See Orville B. Littick (1958) 31 TC 181, withdrawal acq in part, acq in part 1984–2 Cum Bull 1. But see
Estate of True v Commissioner (10th Cir 2004) 390 F3d 1210, 1226 (reciprocal agreement may be
considered testamentary substitute). Although in the Littick decision life expectancies were found
irrelevant in determining whether adequate consideration was present to support the estate tax validity of
a buy-sell agreement, the IRS has announced that a substantial disparity in life expectancies between
parties to a buy-sell agreement may result in an immediate gift to the party with the greater life
expectancy. Action on Decision 1985–008 (Dec. 24, 1984). See also GCM 37958 (May 8, 1979). The IRS
will be more likely to assert this position if the agreement is exclusively between family members, if the
buy-out price is set below the interest’s fair market value, and if there are significant age differences
between the parties.
A unilateral option granted gratuitously to a family member to purchase the decedent’s interest at death
will not fix the value of the interest for estate tax purposes. Claire Giannini Hoffman (1943) 2 TC 1160,
aff’d (9th Cir 1945) 148 F2d 285.
§6.25
(3) Evidence of Comparable Arm’s-Length Arrangements
The buy-sell agreement must be comparable to similar agreements resulting from arm’s-length
negotiations at the time the right or restriction is created. IRC §2703(b)(3); Treas Reg §25.2703–
1(b)(1)(iii).
Treasury Regulation §25.2703–1(b)(4) states that a right or restriction is comparable to similar
arrangements entered into by persons in an arm’s-length transaction if the right or restriction could have
been obtained in a fair bargain among unrelated parties in the same business. The determination will
generally entail consideration of such factors as the expected term of the agreement, the current fair
market value of the property, anticipated changes in value during the term of the arrangement, and the
adequacy of any consideration given in exchange for the rights granted. Treas Reg §25.2703–1(b)(4)(i).
A right or restriction will be considered a fair bargain if it conforms to the general practice of unrelated
parties under negotiated agreements in the same business. Treas Reg §25.2703–1(b)(4)(i). Although it is
not necessary that the terms of a right or restriction parallel the terms of any particular agreement, isolated
parallels do not constitute evidence of general business practice. The selection of one recognized
valuation method, when two or more methods are commonly used in a business, will not constitute a
failure to show a general business practice. In unusual cases, when comparables are difficult to find
because the business is unique, comparables from similar businesses may be used. Treas Reg §25.2703–
1(b)(4)(ii).
NOTE™ Planners are becoming concerned that it may be difficult to prove that terms of a specific
agreement are comparable to similar arrangements entered into by persons in arm’s-length
transactions. In Estate of George C. Blount, TC Memo 2004–116, aff’d in part and rev’d in part on
other grounds in Estate of Blount v Commissioner (11th Cir 2005) 428 F3d 1338, the court
suggested that it is necessary to produce evidence of actual agreements negotiated by persons at
arm’s length under similar circumstances and in similar businesses. Because such agreements are
usually private, the evidence could be difficult to obtain. In Smith III v U.S. (WD Pa 2004) 2004–2
USTC ¶60,488, 94 AFTR2d 5283, the court ruled that two affidavits signed by attorneys stating that
the provisions were comparable to those used in arm’s-length transactions were too conclusory to
“constitute evidence sufficient to dispel any genuine issue of material fact.”
PRACTICE TIP™ According to the legislative history of IRC §2703, expert testimony may also be used to
show that the “fair bargain” and “similar arrangement” tests have been met. Senate Finance
Committee Report S Rep No. 3209, 101st Cong, 2d Sess (1990), Small Business Incentives. Thus, in
drafting the agreement for a family-owned business, the attorney should be guided by terms that
have been negotiated in buy-sell agreements for similar businesses owned by unrelated parties and
should consider retaining an expert for this purpose. See, e.g., Estate of Pearl I. Amlie, TC Memo
2006–76 (decedent’s conservator obtained advice of valuation specialist in negotiating restrictive
agreement with decedent’s prospective heirs regarding price of closely held bank stock; court held
that terms of agreement were comparable to similar arrangements entered into by persons at arm’s
length).
§6.26
(4) Restrictions Applicable During Life and On Death
The value of a business interest will not be fixed for federal transfer tax purposes by an agreement
unless the agreement restricts the transfer of the business interest to the agreement price, both during the
party’s lifetime and on his or her death. Treas Reg §§20.2031–2(h), 20.2031–3(c); Rev Rul 59–60, 1959–
1 Cum Bull 237; Rev Rul 80–213, 1980–2 Cum Bull 101; Rev Rul 83–120, 1983–2 Cum Bull 170.
Consequently, price restrictions that take effect only on the death of the shareholder or the partner are not
effective for that purpose. See, e.g., St. Louis County Bank v U.S. (8th Cir 1982) 674 F2d 1207; Brodrick
v Gore (10th Cir 1955) 224 F2d 892, overruled on other grounds in Estate of True v Commissioner (10th
Cir 2004) 390 F3d 1210, 1226; Estate of Lionel Weil (1954) 22 TC 1267, acq 1955–2 Cum Bull 10. See
also U.S. v Land (5th Cir 1962) 303 F2d 170, cert denied (1962) 371 US 862 (lifetime restriction expiring
at death does not fix value). But see Estate of McClatchy v Commissioner (9th Cir 1998) 147 F3d 1089
(value of stock held by decedent was limited because decedent was “affiliate” under securities laws;
decedent’s estate was not affiliate, so stock had greater value, but lower value applied for estate tax
purposes).
A right of first refusal, exercisable during life, in a buy-sell agreement meets this requirement if the
price under the right does not exceed the exercise price at death. Brodrick v Gore, supra; May v
McGowan (2d Cir 1952) 194 F2d 396; Wilson v Bowers (2d Cir 1932) 57 F2d 682; Estate of Lionel Weil,
supra.
A provision prohibiting a partner from transferring his or her interest without the consent of the other
partners has been held to be an adequate lifetime restriction. Estate of Robert R. Gannon (1954) 21 TC
1073, acq 1954–2 Cum Bull 4; Estate of Angela Fiorito (1959) 33 TC 440, acq 1960–1 Cum Bull 4
(transfer restriction adequate, although partner could have unilaterally withdrawn before death and
realized more than amount fixed in agreement); Estate of Lionel Weil, supra (partner could not dissolve
partnership; restriction adequate despite partner’s ability to unilaterally withdraw and realize more than
amount in agreement). See also Estate of Pearl I. Amlie, TC Memo 2006–76 (restrictive agreement
between decedent’s conservator and decedent’s prospective heirs prohibited conservator and decedent
from transferring closely held stock without consent of one of heirs and his family).
A lifetime transfer restriction will not fix the estate tax value if exceptions to the price restriction are
made for specific potential transferees. For example, a right of first refusal does not meet this requirement
if transfers to lineal descendants can be made without restrictions (Mathews v U.S. (ED NY 1964) 226 F
Supp 1003) or if sales to company employees can be made without restrictions (IRS Letter Ruling
8710004). In Estate of Pearl I. Amlie, supra, under an earlier agreement with the majority shareholder,
the stock could be transferred only to the decedent’s lineal descendants and their spouses, who were also
bound by the agreement.
§6.27
(5) Obligation of Estate to Sell
The decedent’s estate must be bound by the agreement to sell the stock or partnership interest at the
price fixed in the agreement. Treas Reg §§20.2031–2(h), 20.2031–3(c). Either a mandatory buy-sell
agreement or an option to purchase, combined with an obligation to sell if the option is exercised, suffices
to meet this requirement because in either case the seller’s estate has no choice in whether to sell the stock
or the partnership interest. See Brodrick v Gore (10th Cir 1955) 224 F2d 892, overruled on other grounds
in Estate of True v Commissioner (10th Cir 2004) 390 F3d 1210, 1226; Lomb v Sugden (2d Cir 1936) 82
F2d 166 (stock option); Estate of Henry A. Maddock (1951) 16 TC 324, acq 1951–2 Cum Bull 3
(partnership); Orville B. Littick (1958) 31 TC 181, withdrawal acq in part, acq in part 1984–2 Cum Bull 1
(mandatory corporate agreement); Estate of Pearl I. Amlie, TC Memo 2006–76 (put-call option to
purchase decedent’s stock at agreement price on decedent’s death).
It is not necessary that the surviving parties have an obligation to buy the business interest if the sale
may be enforced against the shareholder’s, partner’s, or member’s estate. For example, an agreement that
provides for a right of first refusal during life and an option to buy that is exercisable against the
decedent’s estate meets this requirement. See Wilson v Bowers (2d Cir 1932) 57 F2d 682. See also Lomb
v Sugden, supra. A mere right of first refusal exercisable by the surviving parties to an agreement,
however, does not obligate the decedent’s estate to sell and, without more, will not effectively fix the
estate tax value of a business interest. Estate of Pearl Gibbons Reynolds (1970) 55 TC 172, acq 1971–2
Cum Bull 3. If the decedent’s estate has a choice, the option or agreement price will not be controlling.
See Estate of Samuel H. Strauss (1949) 13 TC 159, nonacq 1949–2 Cum Bull 4, rev’d on other grounds
sub nom Commissioner v Treganowan (2d Cir 1950) 183 F2d 288.
§6.28
(6) Determinable Selling Price
The agreement among shareholders, partners, or members must specify either a sales price for the
business interest or a formula or other method for determining the price. Treas Reg §§20.2031–2(h),
20.2031–3(c). If this and the other requirements listed in §§6.21–6.27 are met, then the price specified in
the buy-sell agreement will be accepted for federal estate tax valuation purposes, even if the price is less
than the fair market value of the stock or business interest at the relevant date for fixing that value. See
Brodrick v Gore (10th Cir 1955) 224 F2d 892, overruled on other grounds in Estate of True v
Commissioner (10th Cir 2004) 390 F3d 1210, 1226 (book value partnership interest); Lomb v Sugden (2d
Cir 1936) 82 F2d 166 (stock price by formula); Wilson v Bowers (2d Cir 1932) 57 F2d 682 (fixed stock
price); Estate of Angela Fiorito (1959) 33 TC 440, acq 1960–1 Cum Bull 4 (book value partnership
interest); Orville B. Littick (1958) 31 TC 181, withdrawal acq in part, acq in part 1984–2 Cum Bull 1
(fixed stock price); Estate of Pearl I. Amlie, TC Memo 2006–76 (fixed stock price; higher price obtained
on resale during alternate valuation period disregarded).
To be effective for estate tax purposes, the price fixed by the agreement must have been reasonable
when the agreement was signed; later appreciation that results in increased value at the time of the
shareholder’s, partner’s, or member’s death is irrelevant. Later changes in the nature of the business
without corresponding changes in the manner in which the price is fixed under a buy-sell agreement (if
changes are warranted) may render the agreement price ineffective. See St. Louis County Bank v U.S. (8th
Cir 1982) 674 F2d 1207.
NOTE™ Provisions dealing with the valuation of partnership interests must include interest for the period
between the date of termination of a partnership interest and the date of payment under a buy-sell
agreement. Corp C §16701(b).
§6.29
d. Agreements Among Unrelated Parties
The requirements of IRC §2703 are intended to apply to transfers between related parties. Treasury
Regulation §25.2703–1(b)(3) provides that a right or a restriction under an agreement is presumed to meet
each requirement of IRC §2703(b) (i.e., it is a bona fide business arrangement, not a device to transfer
property to family members for inadequate consideration) if more than 50 percent by value of the interests
subject to the right or restriction is owned, directly or indirectly, by persons who are not members of the
transferor’s family and if the interests owned by the unrelated parties are subject to the right or restriction
to the same extent as the property owned by the transferor.
Presumably, even though IRC §2703 would not apply, the requirements of Treas Reg §20.2031–2(h)
that were not codified in IRC §2703 would have to be met. See §6.18. Thus, to be effective for estate tax
purposes, an agreement between unrelated parties who are not the natural objects of each others’ bounty
must contain lifetime restrictions on sales, impose an obligation to sell the interest, and contain a
determinable price. These agreements will be presumed to constitute bona fide business arrangements that
are comparable to similar arrangements entered in arm’s-length transactions. See IRC §2703(b)(1), (b)(3).
Agreements between unrelated parties are, of course, not devices to transfer an interest within a family for
less than adequate consideration under IRC §2703(b)(2).
In the situation of unrelated owners, who may still succeed in depressing the value of an interest
through a buy-sell agreement, the difference between the price of the interest under the agreement and the
fair market value of the interest can be made up through the use of group term life insurance under IRC
§79, split-dollar insurance arrangements, and death benefit only plans. See chap 7. The benefits under
these plans may be arranged so that they are not included in the deceased owner’s estate, generally
through the use of irrevocable trusts in the case of insurance arrangements. Nevertheless, there are
problems with using an artificially low price to reduce the estate tax value of the interest:
• The buy-sell agreement may not qualify as a bona fide business arrangement, although under the
regulatory exception to IRC §2703, it is not necessary that the agreement be a bona fide business
arrangement.
• Because dispositions during lifetime must be made at the lower price set out in the agreement if the
agreement is to be effective for establishing the estate tax value, such a plan may not be acceptable to
owners who may wish to sell their interests before death.
• As a result of the reduced value of the interest, the estate may fail to qualify under IRC §303
(providing for sale or exchange treatment for certain redemptions), §2032A (special use valuation for
real property used in a farming or other closely held business), and §6166 (installment payments for
the estate tax on the value of the estate attributable to closely held business interests).
§6.30
2. Create Market for Shares
Because interests in small businesses are usually difficult to value and difficult to sell, buy-sell
agreements can provide a market for the estate of a shareholder’s, partner’s, or member’s interest and a
way to value that interest. Without a buy-sell agreement to address this issue, the shareholder, partner, or
member would be forced to either hold an illiquid asset against his or her better judgment or sell the
interest to the remaining owners for less than its fair market value.
§6.31
3. Provide Liquidity for Owner’s Estate
The buy-sell agreement can provide much-needed liquidity to a deceased business owner’s estate.
Because of the limited market for closely held business interests, without a buy-out provision the estate is
likely to find it difficult to sell such an interest, and extremely difficult when the estate holds a minority
interest. In addition, liquidity is often needed to raise cash to pay debts and administration expenses. It
should be remembered, however, that a minority discount (a lower value assigned to a noncontrolling
interest) might be available to the estate, perhaps providing for a greater benefit for estate tax purposes
than would a buy-sell agreement. On minority interest discounts, see §§18.67–18.69.
The buy-out agreement can also help owners avoid the moral dilemma that could arise in negotiating
price and terms with the spouse and children of a deceased owner or with an incapacitated owner (often a
longtime friend, partner, or business associate). While personal feelings might cause many of the
remaining owners to want to be generous, their fiduciary duty to any other not-so-generous owners, as
well as their obligations to creditors, will prevent them from doing so. This fact may be difficult for the
grieving family or incapacitated friend to accept, and hard feelings could result unless the price and terms
are fixed in advance.
§6.32
4. Meet Marital Deduction Requirements
On the definition of and requirements for a marital deduction trust, possible conflicts between the
marital deduction trust and the buy-sell agreement, and how to avoid such conflicts, see §§20.28–20.29.
§6.33
III. PLANNING CONSIDERATIONS
Selecting the appropriate agreement for the buy-out requires consideration of complex legal and tax
factors in addition to the individual circumstances and goals of the parties to the agreement. The most
important factors are as follows.
• The type of entity will drive much of the planning because the underlying laws and tax
considerations are significantly different depending on whether the business owner’s business is a
corporation, partnership, or LLC. These factors are discussed in §§6.34–6.52. On the nature of the
entity and the impact on the succession plan generally, see chap 14.
EXAMPLE™ For S corporations, unrestricted transfers to impermissible shareholders may lead to
loss of S corporation status. See §6.12. For professional corporations, it may be important to restrict
the transfer of interests to nonprofessionals. See §6.13. Tax differences between corporations and
LLCs taxed as partnerships also may affect a buy-sell agreement. The sale of shares in a corporation
results in capital gains treatment, but the sale of an LLC membership interest, like a partnership
interest, requires complex analysis under IRC §§741 and 751, which may result in capital gains or
ordinary income treatment. See §6.46.
• The business owner’s factual situation, including his or her age, relationship with the other owners,
and a host of related issues discussed in §§6.55–6.61, must be considered.
• The means that will be used to fund the purchase when the triggering event occurs. See §§6.62–
6.69.
PRACTICE TIP™ As discussed in chap 2, ethical issues often arise during the business succession
planning process. It is important to remember who the attorney represents and his or her ethical
responsibilities throughout this process. This is particularly important when reviewing the planning
factors. A potential for conflict of interest is involved in representing or advising more than one
owner and the entity. As the adviser to the entity, the attorney has a duty to protect all of the owners’
interests equally. The ability to do so may be compromised if he or she offers advice to one owner
without making that information available to the others. The likelihood of ethical problems also
increases when the attorney has dealt previously with one or more, but not all, of the owners or has
not advised each owner to seek independent counsel.
A. Special Considerations Depending on Type of Entity
§6.34
1. Corporation
When selecting the appropriate corporate buy-sell agreement, the advantages and disadvantages of
each type of agreement have to be weighed. The main advantage of a corporate redemption is that it is
simpler to administer than a cross-purchase agreement because it involves only the corporation and the
estate or withdrawing shareholder. In the past, redemptions generally were preferred for corporations
because of their simplicity and because corporate rather than personal funds or credit were used to
complete the purchase. However, cross-purchases have become more popular because of the potential
adverse income tax consequences of a corporate redemption, particularly when insurance funding is used.
See §6.66. A hybrid agreement has the advantage of flexibility.
NOTE™ For a C corporation, the corporation should have the initial obligation to purchase the shares
under a hybrid agreement. (For the definition of hybrid agreement, see §6.3.) Otherwise, if the
corporation purchases shares that the shareholders are obligated under the agreement to purchase,
the shareholders will be deemed to be receiving dividends taxable as ordinary income to the extent
that the corporation has earnings and profits. See Rev Rul 69–608, 1969–2 Cum Bull 42.
§6.35
a. Evaluating Corporate Redemption Agreement
Major disadvantages that arise with a corporate redemption agreement include the following:
• Corporate law redemption issues. A corporation cannot redeem its shares unless it meets certain
statutory financial tests that it will not become insolvent. Corp C §§166, 500–501. Thus, when the
buy-sell agreement is entered into, it remains uncertain whether a corporation’s purchase obligation is
enforceable when a triggering event occurs. See §§6.36–6.39. These statutory financial tests do not
apply to a cross-purchase.
• Income tax issues.
• Potential unfavorable income tax treatment. A corporation’s acquisition of its own shares from a
shareholder in exchange for property (defined as money, securities, and any property other than
shares of the distributing corporation or rights to acquire such shares) is treated as a redemption for
tax purposes and generally has little tax effect on the corporation if it qualifies as an “exchange.” IRC
§§302, 311(a), 317(b). Care must be taken, however, not to trigger inadvertent negative tax
consequences of the redemption, e.g., if the corporation distributes appreciated property to redeem the
stock. IRC §311(b). Further, capital gains treatment for the selling shareholder is not automatic. IRC
§302. See §6.43.
• No stepped-up basis for remaining shareholders. Following a redemption, the remaining
shareholders in a C corporation increase their equity interests but not their basis in their shares for
income tax purposes. See §6.51.
NOTE™ A “redemption” for tax purposes has a somewhat different meaning in the California
Corporations Code. See 1 Ballantine & Sterling, California Corporation Laws §144 (4th ed 1962).
• Regulatory issues on creation and execution of buy-sell agreement. See §§6.41–6.42.
A significant benefit of a corporate redemption agreement that is to be funded with insurance proceeds
is that it requires the purchase of only one policy for each shareholder. A cross-purchase requires each
shareholder to purchase a policy on the life of every other shareholder, which can be excessively
burdensome and expensive. See §6.44.
§6.36
(1) Corporate Law Redemption Issues
The corporation’s redemption or purchase of its own shares is subject to the Corp C §§500–501
restrictions on corporate distributions to shareholders. Corp C §166. These sections prohibit a corporation
from making a redemptive distribution to a shareholder if doing so will leave it unable to pay its debts
when due in the usual course of business or will result in its assets’ becoming less than the total of its
liabilities plus any amounts needed to satisfy any preferential distribution rights held by shareholders that
are superior to those of the distributee if the corporation were to be then dissolved.
Generally, distributions are permitted only to the extent of retained earnings unless the corporation
meets two specific balance sheet ratio tests (Corp C §500):
(1) Solvency test. Distributions are prohibited if the corporation is or would likely be unable to meet
its liabilities as they mature. Corp C §501. The solvency test must be met even if the corporation can
satisfy the retained earnings or assets-to-liabilities test. For further discussion of solvency test, see
Business Buy-Sell Agreements §3.6 (Cal CEB 1991).
(2) No impairment of priorities of outstanding senior shares. A corporation may not make
distributions that impair the liquidation or dividend priorities of outstanding senior shares. Corp C §§502–
503. For further discussion of this restriction, see Buy-Sell Agreements §3.7.
However, net proceeds of disability or life insurance used by the corporation to redeem the shares of a
disabled or deceased shareholder are exempt from these “sources of funding” rules. Corp C §503. See
§6.38.
Additional restrictions on a corporation’s right to purchase its shares may be imposed by its articles,
bylaws, or any indenture or other agreement made by the corporation. Corp C §505. For example, a
lender may require the corporation to enter into an agreement that prohibits distributions until a loan is
repaid. On corporate distributions generally, see Counseling California Corporations, chap 5 (3d ed Cal
CEB 2008).
§6.37
(a) Statutory Financial Tests
Retained earnings test. A corporation may purchase its own shares if retained earnings, immediately
before the distribution, equal or exceed the amount of the proposed distribution. Corp C §500(a)(1). The
term “retained earnings” refers to the balance of net profits, after deducting distributions to shareholders
and transfers to capital accounts under generally accepted accounting principles (GAAP). See Corp C
§114. For further discussion, see Business Buy-Sell Agreements §3.4 (Cal CEB 1991).
Assets-to-liabilities test. A corporation with insufficient retained earnings may still purchase its own
shares if, after the distribution (Corp C §500(a)(2)) total assets equal its total liabilities plus the
preferential dividends in arrears amount. For further discussion, see Buy-Sell Agreements §3.5.
§6.38
(b) Exception for Insurance-Funded Distributions
Agreements that are fully funded by life or disability insurance need not meet the retained earnings,
balance sheet, or solvency requirements for corporate distributions and need not meet the restrictions on
distributions that impair the liquidation or dividend priorities of outstanding senior shares. Corp C §503.
If the insurance proceeds in excess of the total premiums paid by the corporation for the insurance are
insufficient, the repurchase of the remaining shares must satisfy the distribution requirements of Corp C
§§500–503. Because the proceeds attributable to the recovery of premiums increase retained earnings,
they too should be available for distribution unless the corporation is already operating at a deficit or
cannot meet the solvency requirement.
NOTE™ It is unclear whether the corporation must meet the distribution requirements at the time the
premiums are paid. See 1 Ballantine & Sterling, California Corporation Laws §63.03[2][b][ii] (4th
ed 1962).
§6.39
(c) When Funds Must Be Present
The time of any distribution for the purchase of shares is the date the corporation transfers cash or
property, whether or not under a contract dated earlier. Corp C §166. Thus, a buy-sell agreement may
provide for a purchase of shares by the corporation even if it does not either have sufficient retained
earnings or meet the balance sheet ratio test when the agreement is signed.
If a negotiable debt security is issued in exchange for shares, the time of the distribution is the date the
corporation acquires the shares in the exchange, not when payments are made on the debt. Corp C §166.
For this purpose, a “negotiable debt security” is defined as securities issued in bearer or registered form of
a type commonly traded in the public securities markets. Com C §8102(a)(2), (13), (15)–(16). It does not
include simple promissory notes for which the date of distribution is deemed to be the time of payment,
not of issuance. For simple promissory notes, the tests under Corp C §500 are applied each time a note
payment is made.
For sinking fund payments (see §6.69), the date of distribution is the date cash or property is delivered
to a trustee or physically segregated by the corporation, not the date the fund is used to complete the buyout. Corp C §166.
The retained earnings test must be met immediately before the distribution (Corp C §500(a)), the
assets-to-liabilities tests must be met immediately after the distribution (Corp C §500(b)), and the
solvency test must be met at the time of and immediately after the distribution (Corp C §501).
§6.40
(2) Transfer Restrictions
For the rights and obligations imposed by the agreement to be meaningful, the buy-sell agreement
should provide that the shares covered by the agreement may not be transferred except under the terms of
the agreement. Shareholders are permitted to enter into such agreements. See Corp C §§204(a), 706(d).
See Counseling California Corporations §4.20 (3d ed Cal CEB 2008). For sample form clauses, see
Business Buy-Sell Agreements §§3.52–3.54 (Cal CEB 1991).
The corporation’s articles or bylaws may reasonably restrict the right to transfer or hypothecate
(pledge) shares. Corp C §§204(b), 212(b)(1). Shares issued before the adoption of restrictions are exempt
unless the holders of those shares voted for the restrictions. Corp C §204(b).
§6.41
(3) California Securities Law Requirements on Creation if Buy-Sell
Agreement Is Part of Articles or Bylaws
Under Corp C §25103(e), any imposition, change, or deletion of restrictions on the transfer of
outstanding shares in the articles of incorporation or bylaws that would materially and adversely affect
any class of shareholders is excluded from the general exemption for changes in the restriction of
outstanding shares and must be qualified with the Commissioner of Corporations. (Under Corp C
§25120(a)(1), an offer or sale of securities, including any change in the rights, preferences, privileges, or
restrictions on outstanding securities (see Corp C §25017(a)), must be qualified unless exempt.) Thus, if
the buy-sell agreement is part of the corporation’s articles or bylaws, the restrictions must be qualified
with the Commissioner of Corporations because they “materially and adversely” affect shareholders.
NOTE™ Such restrictions need not be qualified if they are adopted in a separate buy-sell agreement. See
Dep’t of Corps. Release No. 55-C (May 19, 1978).
A corporation whose shareholders have entered into or intend to enter into a buy-sell arrangement must
be careful if it plans to rely on the Corp C §25102(h) small offering exemption. Section 25102(h) exempts
an issuer from the qualification requirements of Corp C §25110 for offers or sales of securities if,
immediately after the proposed sale and issuance, the corporation has no more than 35 owners and only
one class of stock outstanding. Corp C §25102(h). However, if a shareholders’ agreement or other
arrangement exists or is intended at the time the shares are issued that gives some shares rights,
preferences, privileges, or restrictions as described in Corp C §25103(e) that are not given to other shares,
the corporation is considered to have more than one class of stock. 10 Cal Code Regs §260.102.4(b).
If the effect of the agreement is to divide the stock into more than one class, then the Corp C §25102(h)
small offering exemption is unavailable. The limited private offering exemption in Corp C §25102(f)
should be considered as an alternative to the Corp C §25102(h) small offering exemption. The limited
private offering requires that sales are not made to more than 35 persons and that all purchasers either
have a preexisiting relationship (in the case of an LLC) or have the business and financial expertise to
reasonably protect their own interests (in the case of a corporation). Corp C §25102(f).
On federal securities law considerations, see §§13.79–13.81, 14.23.
§6.42
(4) California Securities Law and Other Regulatory Requirements on
Purchase
A corporation must comply with the notice or consent requirements of a variety of governmental
agencies when it purchases its own shares. The filings discussed below (except for IRS Form 966) should
be completed before the purchase occurs.
• California securities law requirements. Qualification with the Commissioner of Corporations under
California securities laws of a sale of shares by a shareholder to either the corporation or to the other
shareholders under a shareholders’ agreement is seldom required, because of the exemption from
qualification in Corp C §25104(a). The sale of shares by a shareholder is a nonissuer transaction
subject to the qualification requirements of Corp C §25130 unless an exemption applies to the
transaction. Section 25104(a) exempts from the qualification requirements of Corp C §25130 any
offer or sale of a security by the bona fide owner for his or her own account if the sale (1) is not
accompanied by the publication of any advertisement and (2) is not effected by or through a brokerdealer in a public offering. Title 10 Cal Code Regs §260.102.2 provides that, for purposes of Corp C
§25104(a), an offer or sale does not involve any public offering if (1) offers are not made to more
than 25 persons, (2) sales are not consummated to more than ten of such persons, and (3) all of the
offerees either (a) have a preexisting personal or business relationship with the offeror or its partners,
officers, directors, or controlling persons or (b) by reason of their business or financial experience,
could be reasonably assumed to have the capacity to protect their own interests in connection with the
transaction. On federal securities law issues, see §§13.79–13.81, 14.23.
• Consent of licensing authorities. Corporations engaged in more highly regulated businesses (e.g.,
banks, insurance companies, public utilities, or corporations holding alcoholic beverage licenses) may
be required to obtain the approval of the appropriate regulatory agency, particularly if control of the
corporation is affected by the transaction.
• Filing information return with IRS if liquidation results. If the purchase will result in the
corporation’s liquidation, in whole or in part, the corporation must file IRS Form 966 (Corporate
Dissolution or Liquidation) with the IRS within 30 days after the corporation adopts a plan of
dissolution or liquidation. IRC §6043; Treas Reg §1.6043–1.
§6.43
(5) Income Tax Consequences of Corporate Redemption
For corporation. A corporate redemption may also have significant unfavorable tax consequences,
including the following:
• Recognition of income by the corporation if it distributes property to redeem the stock and the
property’s fair market value exceeds its basis (i.e., it is appreciated property). IRC §311(b).
• Recapture of investment tax credits (IRC §§47(b), 50(a)) and depreciation deductions if the
corporation distributes appreciated property to redeem a shareholder’s interest (IRC §311(b)).
• Imposition of an accumulated earnings tax on funds accumulated beyond the reasonable needs of the
business. IRC §§531, 533. Savings for IRC §303 corporate stock redemption needs in the year of the
shareholder’s death are considered accumulations for reasonable business needs and are not subject to
the tax, but accumulations for redemptions triggered by events other than death do not qualify for the
section 303 exception. IRC §537(a)(2), (b)(1). (IRC §303 distributions in redemption of stock to pay
death taxes and expenses do not incur any income tax liability.) Key employee life insurance is
frequently employed to avoid these issues in closely held corporations. See §§7.43–7.50. The
accumulated earnings tax is not imposed on partnerships or LLCs.
• A corporate alternative minimum tax imposed on a C corporation on the receipt of insurance
proceeds, or inclusion of the proceeds (less premiums and other amounts paid for the policy) in gross
income unless the notice and consent requirements of IRC §101(j) are met. On the use of life
insurance in buy-sell agreements and its tax effects, see §§6.65–6.68.
For selling shareholder. The general rule under the Internal Revenue Code is treatment of the
redemption distribution as a dividend unless there is an applicable exception under IRC §302(b), taking
into account the attribution rules of IRC §318:
• “Complete termination of interest” test under IRC §302(b)(3): A corporate buy-out is most often
structured as a complete redemption of all stock of the corporation owned by the shareholder, which
should qualify as a termination of the shareholder’s interest.
• “Not essentially equivalent to a dividend” test under IRC §302(b)(1): This test is difficult to meet
because whether a distribution is essentially equivalent to a dividend depends on the facts and
circumstances of each case. Treas Reg §1.302–2(b).
• “Substantially disproportionate” rule of IRC §302(b)(2): This is a mechanical test to determine
whether there has been a substantial reduction in ownership. The redemption will qualify for this safe
harbor if these criteria are met:
• Immediately after the redemption the shareholder owns less than 50 percent of the total combined
voting power of the total of all classes of stock entitled to vote;
• After the redemption the shareholder owns less than 80 percent of the percentage of voting stock
owned before the redemption; and
• After the redemption the shareholder owns less than 80 percent of the percentage of the value of all
common stock (voting or nonvoting) owned before the redemption.
NOTE™ If the transaction fails to qualify for sale or exchange treatment under IRC §302, the entire
distribution may be taxed as a dividend. IRC §§301(c), 316(a).
Full discussion of the tax consequences of a corporate redemption is beyond the scope of this book. On
tax consequences to corporation, see Business Buy-Sell Agreements §§3.23–3.25 (Cal CEB 1991); on tax
consequences to selling shareholder, see Buy-Sell Agreements §§3.26–3.39. See also Counseling
California Corporations, chap 5 (3d ed Cal CEB 2008).
§6.44
b. Evaluating Corporate Cross-Purchase Agreement
A corporate cross-purchase agreement has the following benefits compared to a corporate redemption
agreement:
• A cross-purchase agreement avoids the adverse tax consequences of a redemption agreement
discussed in §6.43. See also the Note in §6.34.
• A cross-purchase agreement benefits the remaining shareholders because they receive a basis in the
purchased shares equal to their purchase price, which can be especially useful to an S corporation if
there are losses that can be passed through to the shareholders. IRC §1012. In a corporate redemption,
the basis of the shares of the remaining shareholders is not affected, even though the value of those
shares may be increased by the corporate redemption. See IRC §1060(a).
• A cross-purchase permits the relative power between groups of shareholders to remain the same by
allowing them to structure the buy-out so that the departing shareholder’s interest is purchased by
members of the same group.
• When insurance funding is used, a cross-purchase is more equitable than a corporate redemption
when there are differences in the ages or shareholdings of the owners.
For most shareholders, the primary disadvantage of a cross-purchase is that each shareholder must use
his or her own funds to finance the buy-out. If the shareholders have to withdraw dividend income from
the corporation to fund the buy-out, the funds will be subject to double taxation: once as income to the
corporation and again when the funds are received by the shareholders. On the other hand, if the entity’s
anticipated liquidity will be insufficient to meet the demands of a purchase obligation under a buy-sell
agreement, it may be advisable to draft the agreement so as to provide for a cross-purchase by the
remaining owners in some form. Affecting this decision, of course, will be the owners’ own liquidity and
the relative future availability of credit to the entity and to the individual owners. On credit
considerations, see §6.53.
Another disadvantage of cross-purchase agreements is increased complexity when insurance funding is
used. Not only are additional policies required, but the shareholders also must be able to monitor the
policies to ensure that the polices do not lapse. In addition, insurance proceeds may be subject to taxation
under the transfer-for-value rule. IRC §101(a). See §6.68.
NOTE™ A cross-purchase agreement may have to be rewritten after a triggering event occurs in order to
redefine the responsibilities of the remaining shareholders. It is also possible to provide in the
original buy-sell agreement for this occurrence, e.g., by imposing the original obligations on the
transferee. For a sample clause to this effect, see Business Buy-Sell Agreements §3.55 (Cal CEB
1991).
§6.45
2. General Partnership
The buy-out of a partner’s interest can be structured as a cross-purchase (i.e., a sale to the other
partners) or as a liquidation to the partnership itself. Although the practical differences between a crosspurchase and a liquidation may be minimal, the structure of the buy-out can result in significant
differences in tax treatment. For summary discussion of some of the more important tax considerations,
see §6.46. For discussion of the risks of termination of the partnership for federal income tax purposes,
see §6.14.
For full discussion, see Business Buy-Sell Agreements §§4.18–4.45 (Cal CEB 1991).
§6.46
a. Income Tax Considerations
For partnership. Tax consequences will usually be the decisive factor in structuring the buy-sell
agreement as a liquidation rather than as a cross-purchase agreement. If capital is not a material incomeproducing factor for the partnership, and the retiring or deceased partner was a general partnership, a
liquidation may be more tax advantageous because it permits the partners to decide whether certain
payments to a retiring partner or to a deceased partner’s successor in interest will be treated as any of the
following:
• Distribution of income that reduces the distributive shares of the remaining partners (IRC §736(a)(1);
Treas Reg §1.736–1(a)(4));
• Guaranteed payment that is deductible by the partnership and is ordinary income to the withdrawing
partner (IRC §736(a)(2); Treas Reg §1.736–1(a)(4)); or
• Nondeductible payment for a partnership interest that is taxed at capital gains rates to the withdrawing
partner (IRC §736(b)).
This ability to pay part of the liquidation price with pretax dollars can be accomplished at little or no
cost to the partner whose interest is being liquidated, even with more favorable capital gains tax rates. See
2 Willis, Pennell & Postlewaite, Partnership Taxation ¶¶15.06[3]-15.06[4] (6th ed 1997).
NOTE™ A partner with capital losses may prefer capital gains treatment because, although capital losses
can be completely offset against capital gain, they may be deducted against only $3000 of ordinary
income ($1500 in the case of a married individual filing a separate return). IRC §1211. In addition, a
deceased partner’s successor will prefer capital gains treatment because the IRC §1014 basis step-up
rules generally do not cause the successor to recognize gain, while IRC §736(a) payments cause the
successor to recognize ordinary income in the amount of the entire payment. This preference may
have little practical effect on the structure of the buy-sell agreement when the business succession
plan contemplates the disposal of partnership interests before the business owner dies (and therefore
the basis step-up rules will be of less concern), but it will be important if the plan considers
disposing of the partnership agreement after death.
The discussion above should be qualified by taking into account the special treatment of redemption or
liquidation payments made to general partners for goodwill and unrealized receivables with respect to
partnerships in which capital is not a material income-producing factor—that is, when substantially all the
gross income of the business consists of fees, commissions, or other compensation for personal services
performed by an individual. Under IRC §736(b)(2)–(3), such payments are treated as a distributive share
or guaranteed payment under IRC §736(a) that could give rise to a deduction or its equivalent to the
partnership.
For selling partner. The death of a partner or any other disposition of the entire interest closes the
taxable year of the partnership with respect to the deceased or withdrawing partner. IRC §706(c)(2)(A).
WARNING™ The decision on how to proceed should not be made without the advice of experienced
partnership tax counsel. The sale of a partnership interest requires complex analysis under IRC
§§741 and 751. See Business Buy-Sell Agreements, chap 4 (Cal CEB 1991).
§6.47
b. License Requirements
Businesses with license requirements will require additional planning. More than 150 businesses in
California require a license (see Bus & P C §§5080–11352), not all of them transferable. If such a license
is required, the attorney should be familiar with the specific requirements of the business being planned
for. The primary concern is whether there are limitations on who may obtain an interest in the licensed
business. The following are some examples of licensing requirements:
• A new partner may not be admitted to a general partnership conducting a business holding an
alcoholic beverage license (see Bus & P C §24071) without complying with the transfer requirements
of Bus & P C §24073. See Bus & P C §§23405.1–23405.2 for limited partnership and limited liability
company requirements. See also Carmichael, Transferring Retail Liquor Licenses in California, 15
CEB Cal Bus L Prac 65 (Summer 2000).
• In many kinds of businesses, at least one partner who holds a license or other form of qualification
must remain a partner if the partnership is to continue to be licensed, e.g., contractors (Bus & P C
§7068.2) and landscape architects (Bus & P C §5642).
• Each partner must be licensed or meet certain other criteria in many professional partnerships, e.g.,
physicians, surgeons, and doctors of podiatric medicine (Bus & P C §§2052, 2415–2417), certified
public accountants (Bus & P C §5072), and attorneys (Bus & P C §6125; Cal Rules of Prof Cond 1–
310). If a transfer makes it unlawful for the partners to carry on the business as a partnership, the
partnership must be dissolved unless otherwise cured within 90 days. Corp C §16801(4).
On business succession issues for law practices and medical practices, see chap 17.
3. Limited Partnership
§6.48
a. General Partners
Restrictions on the transferability of general partners’ interests are essential in a limited partnership to
ensure that no unqualified or otherwise unacceptable outsider obtains the general partner’s interest, with
all the obligations and powers that go with it. The interest of the general partner, as general partner,
should not be transferable without the consent of all or a substantial majority of the limited partners’
interests. Because the general partner’s rights, duties, and responsibilities are so broad and their
performance so fundamental to the business, free transferability of the position is generally not allowed.
If there is only one general partner, transfer of his or her entire interest will cause dissolution of the
partnership and winding up of the business, unless a majority in interest of the limited partners (or the
greater interest provided in the partnership agreement) agree in writing to continue the business and admit
one or more general partners within 90 days. Corp C §15908.01(c).
For a sample form clause that prohibits transfer of general partners’ interests without unanimous
written consent of limited partners, see Business Buy-Sell Agreements §4.66 (Cal CEB 1991). On the
risks of termination of a limited partnership for federal income tax purposes, see §6.14. On family limited
partnerships in general, see chap 14. For more thorough discussion of transfers of limited partnership
interests, see Advising California Partnerships chaps 7, 14 (3d ed Cal CEB 1999).
§6.49
b. Limited Partner
A limited partner’s interest is much different in character from a general partner’s interest. Limited
partners must be excluded from control to remain protected from personal liability for partnership debts.
Corp C §§15903.02–15903.03. However, a closely held business that operates in the form of a limited
partnership generally will place restrictions not only on the transfer of the general partners’ interests (see
§6.48) but also on the transfer of the limited partners’ interests for the same reasons and objectives that
recommend a buy-sell agreement for corporations and for general partnerships. See §§6.7–6.31. (If the
limited partners are unrelated investors in the business, there may be no compelling reason that they
should not be able to transfer their interests to outsiders without triggering a buy-out.)
For a sample form clause that gives general partners a right of first refusal on the transfer of a limited
partner’s interest, see Business Buy-Sell Agreements §4.67 (Cal CEB 1991).
A general partner may also be a limited partner. Corp C §15901.13. To facilitate estate planning gifts
of interests in a family limited partnership, it may be advisable to arrange for senior family members who
are the general partners to own substantial limited partnership interests as well. For discussion of
fiduciary duties of general partners to limited partners, see Everest Investors 8 v McNeil Partners (2003)
114 CA4th 411, 8 CR3d 31. On valuation issues, see chap 18.
Note that restrictions on the transferability of partnership interests for tax purposes are unnecessary
except (1) to avoid termination of the partnership for income tax purposes (see §6.14) and (2) to avoid
classification as a publicly traded partnership (see IRC §7704; Treas Reg §§301.7701–1—301.7701–3).
For entities whose interests are sold to the public in SEC-registered offerings, this is a real concern. (This
is not a concern for general partnership interests, because those interests generally are not considered to
be securities under the California Corporate Securities Law of 1968 (Corp C §§25000–25707) or the
federal Securities Act of 1933 (15 USC §§77a–77aa). See Advising California Partnerships, chap 14 (3d
ed Cal CEB 1999).)
In addition, exemptions under federal and state securities laws may also require the partners to
maintain control over transfers. See Advising Partners, chap 16.
§6.50
4. Limited Liability Company
The Beverly-Killea Limited Liability Company Act (Corp C §§17000–17656) governs the formation
and operation of limited liability companies (LLCs) in California. The LLC is a form of entity that
combines the limited liability available in the corporate form with the favorable tax treatment of a
partnership (see Treas Reg §§301.7701–1—301.7701–3) and allows for simple or complex organization
at the discretion of the LLC’s founders.
As with a partnership buy-sell agreement, a fundamental question in the buy-out of an LLC member is
whether the withdrawing member’s interest is to be purchased by the remaining members (crosspurchase) or by the LLC itself in a liquidation of the member’s interest. Although it is procedurally
simpler for the LLC to liquidate the member’s interest, tax consequences will usually be the decisive
factor in structuring the transaction. The sale of shares in a corporation results in capital gains treatment,
but the sale of an LLC membership interest, like a partnership interest, requires complex analysis under
IRC §§741 and 751, which may result in capital gains or ordinary income treatment. See §6.46. See also
Business Buy-Sell Agreements, chap 4 (Cal CEB 1991).
An LLC, like a partnership, may terminate for tax purposes under IRC §708(b)(1)(B). See §6.14.
For further discussion of LLCs, see §§14.78–14.90. See also Forming and Operating California
Limited Liability Companies (2d ed Cal CEB 2007).
B. Additional Considerations
§6.51
1. Basis for Income Tax Purposes
For a C corporation, under a redemption agreement the basis of the shares owned by the remaining
shareholders is not increased as a result of the corporation’s purchase of the shares of the withdrawing or
deceased shareholder, while under a cross-purchase agreement each remaining shareholder obtains a basis
in the newly purchased shares equal to the purchase price he or she pays. If it is anticipated that the
remaining shareholders will continue to own the shares until death, the basis issue will not be important.
As each shareholder dies, the basis of his or her stock will be adjusted to the fair market value at the date
of death or at the alternate valuation date. See IRC §1014(a).
Despite the basis increase, the amount of potential gain in some cases may not decrease as a result of
the use of a cross-purchase agreement when the purchase is not funded by life insurance.
EXAMPLE™ Assume that A and B each owns 50 percent of the shares of Acme Corporation, that each
has a basis of $100 in the shares, and that the value of the corporation is $300. If B dies and the
corporation redeems its shares for $150, the corporation will presumably be worth $150. If A sells
his or her shares immediately after the redemption for $150, the fair market value of the corporation,
A will have a $50 gain ($150 minus $100 basis). Instead, if A had purchased B’s shares for $150, A
would have a basis afterward in all of his or her shares of $250. If A sold his or her shares
immediately after the purchase for $300, the fair market value of the corporation, A would still have
a gain of $50 ($300 minus $250 basis). This result assumes that the value of the corporation is based
on the value of its assets and not on its going-concern value.
This issue may not be relevant in the case of an S corporation, partnership, or LLC, because the
remaining shareholders, partners, or members will receive an increase in the basis of their ownership
interests regardless of the type of buy-sell arrangement. The life insurance proceeds or the profits used by
the entity to purchase the withdrawing or deceased owner’s interest represent entity income that will have
already been passed through to the remaining shareholders, partners, or members, thereby increasing their
basis in the same manner as if they had purchased the interest directly from the withdrawing or deceased
owner with their own after-tax income. See IRC §§705(a)(1), 1367(a)(1)(A). However, in the case of an
accrual-basis S corporation, some of the proceeds will be allocated to the shares of the deceased
shareholder.
§6.52
2. Deductibility of Interest Under Installment Note
In a C corporation, the interest paid by the shareholders under an installment note under a crosspurchase agreement will be investment interest and will only be deductible to the extent the shareholder
has investment income. IRC §163(d). Note that to the extent a taxpayer does not elect out of the 15percent tax rate on dividends, the investment interest deduction is reduced. IRC §163(d)(4)(B). If a C
corporation redeems a shareholder’s shares, any interest paid will be deductible because the general
limitation on the deductibility of interest only applies to individuals. IRC §163(d).
In an S corporation, partnership, or LLC, interest paid by purchasing owners will be classified as either
deductible business interest, passive interest, or investment interest. If all the assets of the entity are used
in the conduct of a trade or business and the purchasing owner materially participates in the business, the
interest paid will be business interest and fully deductible. See IRC §§163(a), (h)(2)(A), 469(c)(1). If all
the assets of the entity are used in the conduct of a trade or business and the purchasing owner does not
materially participate, the interest paid will be passive interest and deductible only to the extent of passive
income. See IRC §§163(d)(4)(D), 469(c)(1). To the extent that the assets of the entity are investment-type
assets, a portion of the interest paid will be treated as investment interest and only deductible against the
investment income of the purchasing owner. See IRC §163(d). See also Treas Reg §1.163–8T for rules
governing allocation of interest expense. In the redemption context, if the entity is an S corporation,
partnership, or LLC, the interest deduction passed through to the individual owners will probably be
characterized in the same manner as if the individual owners had purchased the interest themselves. See
IRS Notice 89–35, 1989–1 Cum Bull 675.
§6.53
C. Credit Considerations
Credit considerations may dictate whether the entity or the owners should have the primary obligation
to purchase the interest of the withdrawing or deceased owner. The entity may be prevented by restrictive
covenants in loan agreements from redeeming its own shares or partnership interests. The obligation to
redeem the interest of a deceased owner may affect the entity’s ability to borrow in the future. The choice
may depend on the relative financial condition of the entity and the owners. The creditors of either may
have a prior claim to insurance proceeds or other assets designated for the purchase of the interest when
the triggering event occurs.
§6.54
D. Determining Value of Business
Given the differing nature of businesses, the appropriate valuation method for an interest may vary on
a case-by-case basis. For a business engaged primarily in the manufacture and distribution of goods, the
liquidation value of its tools, equipment, and inventory will be a truer indicator of the business’s value
than the depreciated book value of such items. For a professional services business, the inverse will
frequently be true because its assets will generally be concentrated in its accounts receivable and works in
progress. It is usually necessary to obtain the services of experts on the valuation of business interests. On
hiring a business valuation expert and valuation methods, see chap 18. In some situations, consideration
should be given to using a defined-value clause as an alternative to an agreed purchase price or option
price provision. Defined-value clauses are of two types; such a clause may either (1) retroactively adjust
the purchase price in response to a subsequent valuation determination (adjustment clause) or (2) define
the purchase price with reference to the value of a larger identified property interest (value-definition
clause). For further discussion of defined-value clauses, see Business Buy-Sell Agreements §§2.66–2.81
(Cal CEB 1991). On setting the purchase price, see §§6.78–6.83.
E. Planning Issues Concerning Owners
§6.55
1. Family Relationships Among Owners
Family relationships among the existing owners will have an impact on planning suggestions. For
example, if the shareholders of a C corporation are related, the entity’s redemption of a departing
shareholder’s interest may trigger the realization of ordinary income instead of the more desirable capital
gains treatment under IRC §302. See §6.43. Also, the family relationships among owners may dictate
whether one or more of them will have preferential purchase rights or whether unilateral transfers to
spouses or children will be permitted.
Further, family relationships among owners are a factor in the applicability of the special valuation
rules contained in Chapter 14 of the Internal Revenue Code (IRC §§2701–2704). See §§18.80–18.99.
On family dynamics generally, see chap 4.
§6.56
2. Working Relationships Among Owners
One or more owners may be more likely to withdraw to pursue their own interests in the future, or an
antagonistic relationship between owners may ultimately lead to a management deadlock curable only by
one owner’s leaving. In either event, special attention should be paid to the price and payment terms in
order to minimize future conflict.
§6.57
3. Relative Ownership Interests
If the owners do not hold equal ownership interests in the entity, having the entity purchase a departing
owner’s interest could disproportionately affect majority owners, whereas having the remaining owners
purchase the interest could disadvantage minority owners. Also, if the owners wish to maintain their
existing ownership ratio, the buy-sell agreement should provide either for the purchase of the departing
owner’s interest by the entity itself or a prorata purchase by the remaining owners based on their
ownership interests. In other cases, owners may desire to grant preferential purchase rights to certain
owners such as family members so as to preserve an owner group’s overall ownership percentage intact.
§6.58
4. Ages of Owners
If an owner is near retirement age, special provisions may be desired to address specifically the manner
of his or her withdrawal. Also, in many instances, an older generation of owners may wish to transfer
control or value to members of the next generation for operational or estate planning reasons. In this
situation, little will be accomplished by granting the older owners purchase rights equal to those of the
younger owners. Conversely, if very young persons own interests as a result of gifts or an inheritance, it
may not be part of the overall family estate plan to grant them additional control; therefore, they may be
relegated to junior priority with regard to purchase rights. Finally, if a number of the owners are older,
acquiring life insurance on their lives to fund the purchase of their interests at their deaths may not be
equitable or even financially feasible for younger owners.
§6.59
5. Financial Condition of Owners
If there is reason to believe certain owners will not be able to purchase their shares of the departing
owner’s interest because of cash flow or net worth issues, the buy-sell agreement may be drafted to
require the entity to purchase the interest (if its financial condition is expected to be secure), to provide
for funding by way of insurance proceeds in the case of a deceased owner’s interest, or to permit the
purchase by the other owners with greater financial means. On credit considerations, see §6.53; on
funding the buy-sell agreement, see §§6.62–6.69.
§6.60
6. Health and Insurability of Owners
An owner’s poor health will necessarily have an impact on the decision of how to structure future
purchases under the buy-sell agreement. For example, if the cash demands of acquiring insurance on an ill
owner to fund a cross-purchase obligation could exceed the financial means of some owners, they may
prefer to place the purchase obligation on the entity. Also, the owners’ relative rights to purchase a
departing owner’s interest may be structured differently if it is anticipated that one particular owner may
predecease the others.
§6.61
7. Commitment of Owners to Business and Importance of Participation
in Business
The relative purchase rights of the remaining owners often differ if some of them actively participate in
the business or are considered key to the business while others are viewed as passive owners. The more
active owners may feel they are entitled to purchase a larger portion of a departing passive owner’s
interest in order to permit them to consolidate control of “their” business. The more active participants
may also wish to place more stringent restrictions on the less active owners’ ability to transfer their
interests to third parties out of a belief that without a high degree of commitment, such owners would be
more likely to disregard the welfare of the business when transferring their interests. Also, the owners
may wish to provide more favorable purchase terms for those who continue to participate in the business
until death over those who may choose to leave to pursue other interests or to compete with the entity.
§6.62
F. Funding Buy-Sell Agreement
A crucial issue for a closely held business that wishes to buy out one of its principal owners is whether
it will have the funds to do so. Because few businesses have sufficient cash or other resources to fund a
buy-out, the seller usually must accept an installment payout and continue to share the risks of the future
profitability of the business, unless the business has provided for a fund to buy out a major owner. There
are essentially four methods for funding a buy-out:
(1) Borrowing (see §6.63);
(2) Using an employee stock ownership plan (ESOP) (see §6.64);
(3) Acquiring insurance (see §§6.65–6.68); or
(4) Setting up a sinking fund or reserve (see §6.69).
§6.63
1. Borrowing
The business entity could borrow money to buy the interests of deceased or withdrawing owners. The
obligation to purchase could put the entity at a disadvantage in negotiating with banks or other financing
sources. Also, banks may be reluctant to make loans to a business for payment to a withdrawing owner or
the estate of a deceased owner unless the loan is well collateralized or guaranteed by persons with
significant net worth. Recent experience has shown that relying on borrowing capacity at the time of the
death or withdrawal of an owner is a risky strategy if the withdrawing owner or his or her estate needs
liquidity.
§6.64
2. Using Employee Stock Ownership Plan (ESOP)
Employee stock ownership plans (ESOPs), arguably just another form of borrowing (albeit by an
employee group rather than the company itself), may be used to fund the buy-sell agreement. Under this
approach, the corporation creates the ESOP and makes deductible contributions to it, subject to statutory
limits and restrictions. See IRC §§404(a)(9), 415(c)(6). The trust is tax-exempt, as are the earnings on
contributions to it. The trust uses contributions to purchase stock from the corporation or from the
shareholder and might also purchase the stock of a retiring or deceased owner. Interests in the stock
acquired are allocated to the ESOP accounts of employees who are eligible to participate in it.
ESOPs are not available to partnerships and LLCs but are available to S corporations and C
corporations. See Small Business Job Protection Act of 1996 §1316 (Pub L 104–188, 110 Stats 1755).
For detailed discussion of ESOPs, see §§13.15–13.57.
§6.65
3. Purchasing Insurance
Whether life insurance should be used to fund a buy-out depends on the nature of the business, the
owners’ objectives, the buy-sell prices for the owners’ interests, and the cost of life insurance, including
taxes. These factors differ according to the type of buy-sell agreement used. Sections 6.66–6.68 briefly
discuss the advantages and disadvantages of using insurance to fund a buy-out versus borrowing or using
cash reserves.
For more detailed discussion of using life insurance to fund a buy-sell agreement, see chap 7. See also
Business Buy-Sell Agreements, chap 6 (Cal CEB 1991).
§6.66
a. Using Life and Disability Insurance
In many closely held businesses, life insurance proceeds will be used to fund the purchase of the
interest of a deceased owner. While term life insurance may be used, it is usually more cost-effective to
use some type of permanent life insurance because it is likely that the insurance coverage will be needed
for many years. On the different types of insurance, see chap 7. Although whole life insurance will
provide predictable annual premium payments, universal life insurance or some variation could be used.
Another alternative would be to use a first-to-die policy, particularly when there are only two or three
owners. When the first owner dies, the insurance proceeds would be paid to the entity. On the occurrence
of triggering events other than death, the policy’s cash value is used to fund all or part of a buy-out.
NOTE™ Life insurance, like other buy-sell funding, may subject the corporation to the accumulated
earnings tax, which is equal to 15 percent of the accumulated taxable income of a C corporation.
IRC §531. See §6.43. The corporation’s ownership of life insurance policies that include large cash
surrender values should be planned with this risk in mind.
Disability insurance proceeds can be used to fund the buy-out of an owner who has become disabled.
Usually, disability buy-out policies require a minimum period of disability before the benefits will be
paid, typically 1 to 2 years, and may not provide enough cash to cover the entire purchase price. A
disability policy designed to fund the buy-out of a shareholder may not pay disability benefits if the
shareholder owns more than a certain percentage (e.g., 80 percent) of the stock.
The entity usually owns the policies under a redemption or hybrid agreement. The owners usually own
the policies under a cross-purchase agreement. A life insurance trust may own the policies under any of
the three types of agreements. The use of a trust may avoid the transfer-for-value rule of IRC §101(a)(2)
(which provides that the proceeds of life insurance policies transferred for valuable consideration are
taxable as income to the beneficiary). On the transfer-for-value issue, see §6.68. The trust would own one
policy on each owner’s life. When an owner dies, the proceeds would be paid to the trustee, who would
pay the proceeds to the deceased owner’s estate in exchange for the decedent’s interest, which would then
be distributed to the remaining owners. However, on the death of a shareholder, the transfer-for-value rule
may still apply because each of the remaining shareholders obtains an additional interest in the policy
insuring the other remaining owners in exchange for the obligation to pay premiums. See Monroe v
Patterson (ND Ala 1961) 197 F Supp 146. Finally, a separate partnership of the shareholders could own
the policies under a cross-purchase agreement for a corporation. The partnership would allow for sales to
other partners of life insurance policies owned by the deceased partner, because the transfer of a policy
for valuable consideration to a partner of the insured (or to a partnership in which the insured is a partner)
is an exception to the transfer-for-value rule. See IRC §101(a)(2)(B). See also §6.68.
b. Insurance Funding of Cross-Purchase Agreement
§6.67
(1) Difficult if Many Owners
Cross-purchase agreements are entered into between two or more business owners and provide for the
surviving business owners to purchase the decedent’s shares directly from a deceased business owner’s
estate. If life insurance is used to fund a cross-purchase agreement, each business owner must obtain a life
insurance policy on the life of every other business owner in amounts sufficient to fund his or her prorata
obligation to purchase shares from the decedent’s estate.
This approach can be disadvantageous when there are many business owners, because a large number
of insurance policies will be required. For example, if there are five owners, 20 policies would be
required: five (the number of owners) times four (the number of owners minus one). When there is a large
number of owners and a cross-purchase agreement is desired, the owners may create a separate trust or
partnership to purchase the necessary policies and hold the proceeds to be used to carry out the purchase
of the departing owner’s interest.
§6.68
(2) Transfer-for-Value Issue
Generally, life insurance proceeds are not subject to income tax unless the policy has been transferred
to another person for valuable consideration. IRC §101(a)(1). Consideration is not limited to a cash
purchase; it includes an assignment of the policy in exchange for an agreement to purchase the insured’s
shares at a specified price or agreeing to use the proceeds under a buy-sell agreement. Monroe v Patterson
(ND Ala 1961) 197 F Supp 146.
Such a transfer for value subjects the proceeds payable on the death of the insured to income tax to the
extent they exceeded the purchase price and post-transfer premiums paid by the transferee. The transferfor-value rule does not apply to a transfer to the insured (which should be avoided because the insured
should not have “incidents of ownership” in policies on his or her own life—otherwise, the value of the
proceeds will be included in his or her gross estate under IRC §2042(2)), a partner of the insured, a
partnership in which the insured is a partner, or a corporation in which the insured is an officer or
shareholder. IRC §101(a)(2). In a corporate cross-purchase agreement, when one of the shareholders dies,
the policies he or she owns on the lives of the other shareholders cannot be sold by his or her estate to any
remaining shareholder without triggering the transfer-for-value rule, unless one of the exceptions applies.
For example, a partnership among the shareholders will avoid the transfer-for-value problem; however,
the partnership must have a purpose other than tax avoidance. Swanson v Commissioner (8th Cir 1975)
518 F2d 59.
EXAMPLE™ Assume that the corporation has three shareholders, A, B, and C, with a cross-purchase
agreement, and A dies first. A’s estate would then own policies on the lives of B and C, who may
want to purchase the policies on each other’s lives from A’s estate to continue the life insurance
funding of the cross-purchase arrangement. If either surviving shareholder does, in fact, purchase
the policy on the other shareholder’s life from A’s estate, the proceeds from that policy would be
taxable as ordinary income when paid to the purchaser (whether B or C), to the extent that the
proceeds exceed the consideration and any premiums paid by the purchaser for the policy. IRC
§101(a)(2).
To avoid the transfer-for-value problem, surviving shareholders B and C should purchase new
insurance instead of the decedent’s policies if they want additional coverage. If either surviving
shareholder has become uninsurable, the corporation can purchase the insurance from the decedent’s
estate and enter into a new entity buy-sell agreement with the surviving shareholders, under which
the corporation will purchase their shares when a triggering event occurs. The insurance acquired by
the corporation from the decedent’s estate is not subject to the transfer-for-value rule. Or, if the
shareholders are also partners, they can transfer the policies to each other without running afoul of
the transfer-for-value rule, provided the partnership has purpose other than tax avoidance. IRC
§101(a)(2)(B).
NOTE™ If statutory requirements are met, the transfer-for-value rule does not apply to disability
insurance. See IRC §104(a)(3).
§6.69
4. Corporate Sinking Fund
If a partner or shareholder or member of an LLC is totally uninsurable and no method is found to
obtain life insurance to fund the buy-out, the entity could consider establishing a sinking fund or other
reserve in which specified amounts of cash or liquid investments are set aside from the business over a
period of years to provide for the purchase of the interests of the deceased or withdrawing owners under a
redemption agreement. This approach may create a valuation problem, however, because the reserve
increases the value of the business and may increase the amount to be paid in the buy-out. Moreover, the
inability of the business to use the money in the reserve may handicap its day-to-day operations, the fund
may be reachable by its creditors, and there is the risk that the accumulated earnings tax under IRC §531
will be imposed if the business is a corporation. On the accumulated earnings tax, see §6.43.
§6.70
G. Integrating Agreement With Other Estate Planning Documents
The selling shareholder’s, partner’s, or member’s will, existing trusts, and any other estate planning
documents should be reviewed to ensure that the terms of the agreement are consistent with the seller’s
estate plan. Will and trust provisions, for example, should be drafted to preserve the S corporation
election. If the election was made after a will or revocable trust was made or created, these documents
should be reviewed to make sure that their terms would not jeopardize the S corporation’s status. For
further discussion of integrating the agreement into the estate plan, see chap 20.
§6.71
IV. SUGGESTED TERMS OF BUY-SELL AGREEMENT
As with any contract, the attorney preparing a buy-sell agreement should strive to have the document
state the terms and conditions of the parties’ agreement clearly and completely. The drafter advances the
agreement’s clarity and completeness by following basic drafting principles:
• The parties must understand the document if they are to use it. Thus, the attorney should prepare a
complete, readable working document rather than an eloquent example of impressive but difficult-tounderstand legal prose.
• Laypersons should be able to understand the wording of the agreement because a jury of laypersons
may have the ultimate say on what the agreement means.
• The attorney must understand the details of a transaction to draft the proper instrument for the
transaction. The time spent in learning the details of the transaction and structuring the agreement will
make the document more accurate, effective, and complete.
The document should accomplish the following:
• Transform the parties’ imperfectly formed ideas into a fully formed, legally binding agreement; i.e.,
the agreement should contain all legally essential and material elements.
• Establish policies and procedures for the continuing relationship between the parties.
• Establish and protect the rights of the parties.
• Anticipate risks and problems so that the parties can allocate risks by agreement and thus reduce the
possibility of future litigation.
§6.72
1. Triggering Events
The events triggering a purchase may include the death, retirement, or disability of an owner, an
attempted sale to a third party, the owner’s personal bankruptcy, and the termination of employment of an
owner for reasons other than death, retirement, or disability. In many cases it may be advisable to add
divorce as a triggering event to ensure that an interest in the entity will not be transferred to a former
spouse of an owner in a divorce proceeding, even though such a transfer should arguably be covered
under a general restriction on transferability contained in the agreement. For each triggering event, the
agreement must determine whether the event forces the shareholder or member to sell and the entity to
purchase or whether it is more advantageous to make the buy-out optional.
§6.73
a. Death
Death of a shareholder or member may be the event most likely to trigger a buy-out. The agreement
can provide for mandatory purchase of the decedent’s interest, first by the entity, then if it is legally or
financially unable to do so, by the remaining shareholders or members. On corporate law redemption
issues, see §§6.36–6.39.
Certain tax risks should be considered when using a mandatory purchase provision in a corporate buysell agreement. The clause must not effectively give the corporation the option to redeem as many shares
as it wishes and then require the shareholders to buy the remaining offered shares. In that situation, the
corporation may be held to have satisfied the shareholders’ obligation to the extent that it redeems shares,
and the redemption distributions will be taxed to the remaining shareholders as dividends. See the Note in
§6.34. The estate should be obligated to sell all the shares to make the valuation fixed by the agreement
acceptable for estate tax purposes. See §6.27.
For a sample form clause in a corporate buy-sell agreement, see Business Buy-Sell Agreements §3.57
(Cal CEB 1991).
In a general partnership agreement, often the deceased partner’s interest in the partnership will be
liquidated by the partnership rather than purchased by the remaining partners, because this approach will
usually lower the overall taxes on the buy-out. Counsel should evaluate the circumstances of the
individual partners for each buy-sell agreement, however, because the tax savings to the partnership for
an IRC §736(a) distributive share or guaranteed payments may be less than the increased tax cost to the
partners, who would pay little or no tax on the sale of a partnership interest after the IRC §1014 basis
adjustment has been made. See §6.51. Tax treatment of payments made on the purchase or liquidation of
a deceased partner’s interest is discussed in §6.46.
For a sample form clause in a general partnership buy-sell agreement, see Buy-Sell Agreements §4.56.
§6.74
b. Disability
How to arrive at a disability determination must be carefully defined in the buy-sell agreement to avoid
disputes when an alleged disability arises. For example, if arbitrators rather than physicians are designated
to determine disability, there is no need for the release of medical information. Disability is often included
as a triggering event in service or other businesses in which the members must be active. It is fairly
common for either the entity in a redemption agreement or the shareholder or members in a crosspurchase agreement to purchase disability buy-out insurance. This insurance typically provides for a
lump-sum payment after a certain number of months of disability. For a sample form clause in a corporate
buy-sell agreement, see Business Buy-Sell Agreements §3.59 (Cal CEB 1991).
§6.75
c. Termination of Employment
The triggering termination of employment may be voluntary (e.g., to enter into competition with the
entity, to move to another geographic location, or to work for another employer) or involuntary (e.g.,
termination by the company, whether for “cause” or not; termination as a result of the loss of the owner’s
professional license to practice the profession for which the entity is organized; or the owner’s permanent
disability). The reason for the termination of employment may dictate the purchase price for the
withdrawing owner’s interest. For example, a higher price may be paid to the estate of a deceased owner
than to an owner withdrawing to enter into competition with the entity.
For a sample form clause in a corporate buy-sell agreement, see Business Buy-Sell Agreements §3.58
(Cal CEB 1991).
§6.76
d. Bankruptcy
Bankruptcy or insolvency of an owner may also trigger an option or obligation to purchase. Such a
provision ensures that the remaining owners can avoid the bankruptcy trustee’s participation in the
entity’s management.
PRACTICE TIP™ Because execution of a buy-sell agreement in bankruptcy may run afoul of the
automatic stay or 11 USC §362, the drafter should consider requiring owners who face bankruptcy
to notify other co-owners before filing and making that a triggering event.
For example, a partnership buy-sell agreement may permit the nonbankrupt partners to continue the
business by deeming a partner’s bankruptcy to be an offer to sell under the agreement; the agreement may
also provide that filing a voluntary petition, even without an adjudication of bankruptcy, constitutes an
offer for purposes of the agreement, to prevent the possibility of the partnership and the solvent partners
from becoming involved in a voluntary bankruptcy proceeding. While the enforceability of these
provisions may be questionable due to bankruptcy law considerations, it is generally considered good
practice to include them in the documents. Another approach, though not foolproof, is to create triggering
events based on financial covenants, which will force the distressed owner to sell before bankruptcy
becomes a possibility. While these types of provisions can be difficult to negotiate, they can provide a
resolution with respect to the business well before the eve of any individual owner’s bankruptcy. For a
sample form clause in a partnership buy-sell agreement, see Business Buy-Sell Agreements §4.57 (Cal
CEB 1991). For a sample form clause in a corporate buy-sell agreement, see Buy-Sell Agreements
§3.56A.
However, such a provision may not be enforceable under the Bankruptcy Code if the purchase price
does not reflect the fair market value of the interest. See 11 USC §548. In this regard, an interest in an
LLC or general or limited partnership may be subject to less disruption because a creditor is only entitled
to a charging order in most cases. A charging order usually entitles the holder to whatever distributions
the debtor would have received but not to participate in the management of the entity. See Corp C
§§15672, 16503, 17301(a). On the effect of charging orders, see Debt Collection Practice in California
§§11.7–11.11 (2d ed Cal CEB 1999).
§6.77
e. Encumbrance or Default on Personal Loan
Whether the buy-out should be triggered by an encumbrance (e.g., a pledge) of shares is an important
question that must be decided when the agreement is being drafted. Although many buy-sell agreements
contain an outright prohibition on the right to encumber shares, this prohibition prevents the shareholders
from tapping a valuable source of credit before a real threat of default and foreclosure has materialized.
Therefore, consideration should be given to permitting owners of interests to borrow against their shares,
with a buy-out triggered only by a default on the encumbrance. For a sample form clause in a corporate
buy-sell agreement, see Business Buy-Sell Agreements §3.53 (Cal CEB 1991).
California permits partners and LLC members to encumber or assign the economic attributes of their
partnership or LLC membership interests. See Corp C §§15672, 16502, 17301. Those laws generally do
not permit partners or LLC members to assign their entire partner or membership interests without
consent of the other partners or members. See Corp C §§15674(a), 16503, 17301. Therefore, if the
partner’s or member’s identity is important (which is usually true for a general partner or managing
member), the bankruptcy trustee of such partner or member probably will not be permitted to become a
full partner or LLC member without consent of the other partners or members. For a sample form clause
in a general partnership buy-sell agreement, see Buy-Sell Agreements §4.57. On bankruptcy as a
triggering event, see §6.76.
§6.78
2. Setting Purchase Price
One of the most important features of the buy-sell agreement is the mechanism for determining the
purchase price of the ownership interest. In many situations it may be advisable to use the services of a
certified public accountant or a professional business appraiser. If all the owners agree on the method
used by the appraiser in determining the value of the business, the same method could be used for
purposes of determining the purchase price in the buy-sell agreement. On determining the value of the
business, see §6.54. On selecting a valuation expert, valuation methods, valuation discounts, and the IRC
valuation rules, see chap 18.
If there is little goodwill associated with the business, the owners may wish to have a choice between
purchasing the departing owner’s interest and liquidating the entity. Conversely, if a large amount of
goodwill is associated with the business, the buy-sell agreement’s pricing formula should take it into
consideration.
§6.79
a. Fixed Price Method
One of the simplest methods is to use a fixed price, redetermined periodically by the owners. For
example, the owners could agree to meet each year after the financial statements for the entity have been
prepared to discuss adjusting the purchase price for purposes of the buy-sell agreement. If this method is
used, consideration should be given to employ some other method to determine the price if the fixed price
has not been redetermined within a specified period. It may be to the advantage of a younger or healthier
owner to refuse to agree to an upward adjustment of the purchase price when the other owner or owners
are older or in bad health. By requiring an automatic adjustment if the price is not readjusted by
agreement, the older or less healthy owners are protected. For example, the buy-sell agreement may be
drafted to provide that if the owners fail to agree to a new purchase price after a certain period of time,
such as 2 years, and one of the owners dies, the last purchase price determined will be adjusted upward or
downward on the basis of the increase or decrease in either the book value of the business or the average
earnings of the business over the period of time from the last redetermination of the purchase price to the
occurrence of that owner’s death.
§6.80
b. Book Value and Adjusted Book Value
The book value of the business may be used to set the purchase price, although in most situations the
book value will not reflect the real value of the business. The book value uses the historical cost of assets
less depreciation, which in many closely held businesses is determined under the same depreciation
method used for tax purposes. Liabilities are usually shown at face value. Although book value is
superficially the easiest way to determine the value of an entity and its outstanding stock or membership
shares, the concept is difficult and should be used with caution. Failure to use fair market value may cause
the agreement to be disregarded for estate tax purposes under IRC §2703. See §§6.15–6.29. Thus, an
adjusted book value may be more appropriate because it can take into account the following factors:
• Any assets not appearing on the balance sheet, such as goodwill and work in progress;
• Any accrued income or expenses not appearing on a balance sheet prepared under the cash or hybrid
method of accounting;
• Any contingent liabilities;
• The appraised value of certain assets such as real estate and large machinery;
• The market value of securities of other companies held as investments that are listed on a recognized
exchange;
• The loss of the deceased owner’s services to the business; and
• Insurance proceeds.
There are three ways to account for life insurance proceeds. First, the cash value of the policy on the
deceased owner’s life before his or her death, which should be reflected in the balance sheet, can be used
in place of the proceeds. Second, the excess of premiums paid by the entity over the cash value before
death can be added to the book value. Third, the proceeds can be substituted for the cash value of the
policy.
In addition, the agreement may provide for revaluation of assets from book value to a fair market
valuation, on the basis of accounting practices and principles that are reasonable in the circumstances, as
needed to create sufficient value if the corporation is prohibited from purchasing shares under Corp C
§§500–501 (see §6.36) or restrictive agreements.
For a sample form clause in a corporate buy-sell agreement, see Business Buy-Sell Agreements §3.60A
(Cal CEB 1991).
§6.81
c. Appraisal
The buy-sell agreement may require that an appraisal be made at the time the interest of the
withdrawing or deceased owner is to be purchased. Sometimes specific instructions will be given on what
factors should be considered and the relative weight to be given to such factors. The cost of an appraisal
of a closely held business may vary between $10,000 and $20,000, depending on the type of business and
the area of the country in which the business is located. The agreement should also provide the method by
which an appraiser is selected. Many buy-sell agreements provide that the entity or remaining owners will
choose and pay for the initial appraiser. If the selling owner disputes the first appraisal, he or she is
allowed to pick a second appraiser (typically at his or her expense). If the appraisals are within a certain
percentage of one another, then the purchase price is the average of the two. Otherwise, the two appraisers
pick a third appraiser, whose expense is split evenly and whose appraisal becomes binding. The use of the
appraisal method gives the owners the assurance that the purchase price will reflect the conditions
existing at the time the interest is to be purchased. The agreement should require that the appraiser have
experience in valuing businesses of the type in which the entity engages.
For a sample form clause in a corporate buy-sell agreement, see Business Buy-Sell Agreements §3.60C
(Cal CEB 1991). On selecting the appraiser, see §§18.4–18.16.
§6.82
d. Capitalization of Earnings
The buy-sell agreement may provide for a formula price based on the capitalization of average
earnings over a specified number of years. The earnings may be weighted in arriving at the average,
giving more weight to the earnings over the last several years. The capitalization rate should be set forth
in the agreement or should be based on some objective standard. Under this method, the capitalization
rate times the average earnings would produce the value of the business.
In a closely held C corporation, the earnings would have to be defined because the after-tax earnings
may not be indicative of the true earning capacity of the corporation. Often the shareholders of a closely
held C corporation will receive either higher compensation than would be normal (to reduce the taxable
income of the corporation) or lower compensation than would be normal (in order to provide for the
current cash needs of the corporation). Consequently, a fair market value rate of compensation for the
positions that the shareholders hold in the corporation should be substituted for the compensation actually
paid to the shareholders. Similar adjustments may be required for other types of closely held entities.
For a sample form clause in a corporate buy-sell agreement, see Business Buy-Sell Agreements §3.60B
(Cal CEB 1991).
§6.83
e. Other Valuation Methods
“Put and take” method/Dutch auction/”half a slice” method. The owners may adopt a “put and
take” method. Under this method, one party or group makes an offer to buy or sell its interest in the entity
at a price specified in the offer. The other party or group is then required to choose whether to buy the
offering party or group’s interest or to sell its own interest to the offering party or group at the price stated
in the offer. This type of pricing mechanism is often referred to as a “Dutch auction,” or sometimes as the
“half a slice” method. The party making the first offer to buy or sell may be required to post sufficient
collateral to finance the purchase. This is usually an unsatisfactory method for a disabled owner or a
deceased owner’s estate that may not be in a position to continue to run the business or have the necessary
collateral.
Purchase price based on estate tax value. Another method bases the purchase price on the estate tax
value of the deceased owner’s interest. However, such a method will not provide any certainty to the
owners about the purchase price until the death of one of them, and it will not provide a price for purposes
other than a purchase at death. Such a method may also give an estate an incentive to agree to a higher
value for estate tax purposes because any additional estate tax will be less than the increased purchase
price.
The price may be based on a percentage of gross receipts or some other objective factor or related to
the sales of interests of comparable companies. Or the price may be set to equal a prorata share of the
proceeds of a forced sale of the entity’s assets unless the remaining owners and the withdrawing owner or
deceased owner’s estate can agree on another price. Finally, a “blend” of several of the valuation methods
may be used. For example, the formula may be based on a combination of average earnings over a period,
average gross receipts over a period, and either the book value or the adjusted book value of the business
at the date the interest is to be purchased, each factor to be weighted depending on the type of business.
For example, a business engaged in rental real estate may weigh the appraised value of the assets higher
than average earnings.
§6.84
3. Payment Terms
The buy-sell agreement should specify how the purchase price will be paid.
Cash. The agreement may require the payment to be made entirely in cash. This probably will be
unacceptable to the remaining owners if they or the entity have insufficient funds and would be forced to
borrow money to finance the purchase. On credit considerations, see §6.53; on borrowing, see §6.63.
Installment sale and note. Most buy-sell agreements will permit a portion of the purchase price to be
paid in installments, with the selling owner or the estate of the deceased owner taking back an installment
note of the entity (or notes of the remaining owners under a cross-purchase agreement). If the installments
are payable over an extended term, the purchase may be funded out of the entity’s or remaining owners’
cash flow. Consequently, the need for life or disability insurance funding will be reduced. In the case of a
corporation, the note would usually be secured by a pledge of the shares held by the other shareholders. In
the case of a corporate redemption, the shares of the other shareholders, rather than the redeemed shares,
should be pledged to secure the payment of the note. (Redeemed shares of the corporation may be treated
as authorized but unissued shares and therefore may not have any value as collateral; see Corp C
§510(a).) On installment sales, see chap 9.
Period of payment of outstanding balance dependent on profitability of entity. The purchase price
may be paid over a period of time based on the profitability of the entity, so that the more profits the
entity has in a given year, the more it will pay on the outstanding balance. Because the price itself would
not be dependent on the profits (only the period over which the purchase price would be paid), this
method is not analogous to an “earn-out” in the business acquisition context, in which the purchase price
may increase or decrease on the basis of post-acquisition performance.
Annuity. In some situations, a private annuity may be an appropriate way to pay for the interest of the
withdrawing owner when all the owners are related or objects of one another’s bounty. The use of a
private annuity can result in significant estate tax savings if the annuitant dies prematurely. However, a
proposed regulation would require the immediate recognition of any gain on the transfer of the stock for
the private annuity. See Prop Treas Reg §§1.72–6, 1.1001–1. On annuities, see §§9.57–9.62.
Entity’s property. The entity may use property to pay for the interest, including real property that the
entity currently uses in the business. The selling owner would then lease the property back to the entity,
thus providing additional income to the seller and a deduction to the entity. However, a corporation will
recognize gain on any appreciation in the property as a result of the exchange of the property for its own
shares. See IRC §311(b). See §6.43. This gain will be measured as of the date of the exchange. Another
approach would be to exchange preferred stock or other securities of a corporation for the common stock
of the corporation. Under this approach, applicable securities laws should be reviewed to confirm that an
exemption from securities registration is available. On securities transfers and exemptions, see §§6.41–
6.42. See also §§13.79–13.84, 14.23.
Serial redemption-purchase. The entity may redeem a portion of the ownership interest each year
over a period of years. The use of a serial redemption-purchase will mean that the withdrawing owner will
continue to have a voice in the affairs of the entity, unless the continued ownership interest is a nonvoting
one. If the formula for determining the price is adjusted as the earnings of the entity go up or down, the
entity and the remaining owners may not be certain of the total price that will be paid for the withdrawing
owner’s interest. In addition, the remaining owners may object to this method because it in effect
penalizes them for making the entity more profitable.
§6.85
4. Restrictions on Voluntary Transfers
The buy-sell agreement usually should contain restrictions on the owners’ voluntary transfers of
interests in the business. Transfers may be permitted to an owner’s spouse or children, or to trusts created
for their benefit, to allow the owners to engage in estate planning transactions. Such a right may reduce
the effectiveness of the agreement in establishing the estate tax value unless the transferees are subject to
the same restrictions.
Transfers to third parties may be permitted after first offering the interest to the entity or the other
owners, either at the price determined under the agreement or the price offered by a third party, whichever
is lower. If instead the owners must purchase at the higher of the price determined under the agreement
and the price offered by a third party, the buy-sell agreement may not be effective for establishing the
value of the interest for estate tax purposes, because the decedent could have sold his or her interest at a
higher price during life. See IRC §2703, discussed in §§6.20–6.29.
For sample form clause in corporate buy-sell agreement, see Business Buy-Sell Agreements §3.60C
(Cal CEB 1991).
§6.86
5. Drag-Along, Tag-Along, and Other Rights
Drag-along. The buy-sell agreement may provide that if a certain percentage of the equity interests are
being sold to a third party, the selling equity owners have a right to require the remaining equity owners
to join in the sale at the same price and on the same terms that apply to the selling equity owners.
Tag-along. The agreement may also provide that if the equity owners of more than a certain
percentage of the equity interests have agreed to sell their equity interests to a third party, the other equity
owners have the right to join in the sale at the same price and on the same terms that apply to the selling
equity owners, provided that if the other equity owners are not permitted to join in the sale, they have the
right to purchase the equity interests of the selling equity owners at a purchase price equal to the price
determined under the buy-sell agreement or that offered by the third party, whichever is lower, and on the
terms described in the buy-sell agreement or contained in the offer by the third party, whichever are more
favorable to the other equity owners.
Other rights. The agreement may provide for an adjustment in the purchase price if either a certain
percentage of the equity interests or a certain percentage of the assets of the entity are sold within a
certain period of time. The adjustment would give the equity owners who have recently sold their
interests (either to the entity or to the other equity owners) the advantage of the increased value of the
entity, as determined by the subsequent sale.
§6.87
V. CHECKLIST: BUY-SELL AGREEMENT PROVISIONS
BUY-SELL AGREEMENT PROVISIONS
Agreement between shareholders and corporation or among shareholders (LLC members or
partners). Corporation is a necessary party if corporation has option to purchase shares.
⎯ Transferees required to execute agreement.
⎯ Agreement may be amended to include transferees.
Encumbrances (alternative provisions)
⎯ No encumbrance without consent of corporation and other shareholders (or other LLC members and
partners).
⎯ Pledge, hypothecation, or other encumbrance of shares as security for debt permitted. Corporation
and shareholders (or other LLC members and partners) have the right to cure defaults and take
possession of encumbered shares.
Legend required on share certificates if shares are represented by certificates
Option: Restriction on additional shareholders (shareholder consent required)
Right of First Refusal for lifetime transfers and other triggers (e.g., disability, retirement, bankruptcy,
termination of employment, breach of agreement, criminal conviction or willful misconduct, and death if no
mandatory purchase)
⎯ Corporation option to purchase shares for specified time (e.g., 45 days).
⎯ Purchase approved by board of directors.
⎯ Purchase approved by majority of remaining shareholders.
⎯ Shareholders may purchase shares if corporation does not exercise (LLC members or partners may
purchase). Must purchase all shares offered.
⎯ Shares transferred to prospective transferee on specified offer terms (not more favorable to
purchaser), and transferee holds shares subject to agreement.
Permitted transferees (e.g., spouses, family members, revocable trust or trust for family members,
limited partnership or other entity controlled by shareholder and family members)
Mandatory purchase on death
⎯ Estate must sell and corporation or shareholders must purchase. LLC members or partners must
purchase. (For optional purchase on death, see Right of First Refusal, above.)
⎯ Corporation must purchase, and shareholders must purchase if not legally possible for corporation to
purchase (LLC members or partners must purchase).
⎯ Option: Corporation may elect to dissolve and liquidate in lieu of purchase.
⎯ Cross-purchase by remaining shareholders (LLC members or partners).
Purchase price (alternative provisions)
⎯ Agreed price. Periodic review (e.g., annual) with arbitration.
⎯ Option: Use book value if no agreed price.
⎯ Book value (or percentage of book value, e.g., 115 percent).
⎯ Value adjusted (e.g., includes cash surrender value of life insurance policies on shareholders
owned by corporation).
⎯ Option: Revaluation of assets. Book value adjusted to fair market value on basis of reasonable
accounting practices if corporation not permitted to purchase shares under state law (or loan
agreement or restrictive agreement).
⎯ Capitalized earnings (average net profit over, e.g., 5 years).
⎯ Other appraisal (e.g., seller’s and buyer’s appraisers choose third appraiser and agree to abide by
whatever that appraiser decides; seller’s and buyer’s appraisers take the average of their two closest
appraisals).
Purchase terms
⎯ Settlement date within, e.g., 60 days; assignment of title free and clear of all liens, encumbrances,
and security interests; corporate secretary to effect transfer of shares.
⎯ Option: Purchase price adjusted if stock dividends or other shares issued.
⎯ Portion of purchase price (e.g., 10 percent or all insurance proceeds) paid in cash.
⎯ Deferred portion represented by promissory note of corporation or shareholders (LLC members or
partners) with specified terms secured by shares purchased.
Life insurance funding (alternative provisions)
⎯ Corporation required to obtain policies on shareholders to fund purchase (redemption agreement).
⎯ Shareholders (LLC members or partners) required to obtain policies on each other (cross-purchase
agreement).
⎯ Trustee may be named to hold policies and receive insurance proceeds.
⎯ Option: Surviving shareholders (LLC members or partners) may purchase policies on their lives
owned by decedent or after lifetime transfer of shares (interests).
Corporation agrees to apply for administrative approvals required to purchase shares
Shareholders (LLC members or partners) agree that wills and revocable trusts authorize executor
or trustee to comply with agreement and sell shares (interests)
S corporation provisions
⎯ Corporation and shareholders agree to take necessary actions to allow corporation to elect S
corporation status and not to make transfers to trusts or partnerships that terminate election without
consent of other shareholders.
⎯ Option: Corporation must make cash distributions to shareholders needed to pay income taxes on S
corporation income.
⎯ Additional provisions:
⎯ Shareholders agree not to cause corporation to operate as S corporation or to consent to
revocation of S corporation status without consent of other shareholders.
⎯ Shareholders agree not to take or permit other actions that would result in revocation or
termination of S status and agree to consent to adjustments required by IRS to waive tax effect of
terminating events.
⎯ Shareholders agree to take appropriate action on request of shareholder to make an election to
close corporation’s books if S corporation status terminated.
Spousal consent form
Comment: This checklist provides an overview of the topics to consider when drafting a buy-sell
agreement. For complete sample forms of buy-sell agreements for corporations and for general and
limited partnerships and LLCs, see Business Buy-Sell Agreements, chaps 3–4 (Cal CEB 1991).