Buy-sell agreements--an invaluable tool.

• Author: Jackson, George, III
• Position: Part 1

EXECUTIVE SUMMARY

* Generally, there are three types of buy-sell agreements--redemption agreements (also called entity agreements), cross-purchase agreements and combination agreements.

* Most buy-sell agreements are activated on the occurrence of a triggering event, such as a voluntary sale, shareholder bankruptcy, divorce, death or disability, irresolvable shareholder disagreement or shareholder retirement.

* Buy-sell agreements can be used to prevent stock ownership disputes, protect S status and otherwise protect shareholder interests.

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Buy-sell agreements can be valuable tools to closely held corporations that seek to protect shareholders' ownership interests and increase the probability of achieving a long and successful operating life. Part I of this two-part article describes the primary forms and common objectives of buy-sell agreements; it also discusses how the agreements operate, including how they are activated, priced and funded and how they affect the selling shareholder's taxes.

Small business owners can use buy-sell agreements to (1) ensure that their interests do not fall into the hands of those with a competing management philosophy; (2) encourage the retention of current employee-shareholders; and (3) create a market for their previously unmarketable stock. These increasingly popular restrictive agreements can be valuable tools to closely held corporations that seek to protect shareholder ownership interests and increase the probability of achieving a long and successful operating life.

Part I of this two-part article describes the primary forms and common objectives of buy-sell agreements; it also describes how they operate, including how they are activated, priced and funded and their effect on the selling shareholder. Part II, in the May 2003 issue, will describe the tax ramifications on the buyer and the remaining shareholders, then highlight the advantages and disadvantages of each type of agreement.

Definitions

Generally, there are three types of buy-sell agreements: redemption agreements (also called entity agreements), cross-purchase agreements and combination agreements. Each Type of stock-transfer agreement has its respective advantages and disadvantages; shareholders should decide the objectives they intend to achieve through the agreement before they choose the particular type to employ. Choosing the appropriate form of buy-sell agreement is critical to ensure shareholders' objectives are met.

The most common type of buy-sell agreement is the redemption agreement. A redemption agreement is an arrangement by which a corporation is obligated (or has the option) to purchase its own stock back from its shareholders on a triggering event (discussed below), such as a shareholder's death or retirement.

In a cross-purchase agreement, the remaining shareholders are obligated (or have the option) to purchase a departing shareholder's stock on the occurrence of a specified triggering event.

A combination agreement has characteristics of both a redemption agreement and a cross-purchase agreement. Specifically, on the occurrence of a triggering event, the corporation has the primary obligation or option to purchase the departing shareholder's stock; the remaining shareholders have the secondary obligation or option to purchase that stock.

Motivations

Before entering into a buy-sell agreement, the shareholders must identify the corporate and shareholder goals that they want to achieve. They should then weigh the costs and benefits of each type of stock-transfer agreement. While the type of agreement that the shareholders choose may be motivated by the tax treatment that each agreement receives, how the stock purchase will be funded is also a significant consideration.

Funding

Because each type of buy-sell agreement either requires or provides the corporation or the remaining shareholders with an opportunity to purchase a retiring shareholder's stock, the purchasing party (or parties) must have funding in place to finance the purchase. However, without adequate planning, most businesses and/or shareholders would not likely have sufficient liquid assets to make such a purchase. Consequently, insurance (most commonly, life insurance) is often used to fund both redemption and cross-purchase agreements.

When closely held corporation shareholders are trying to decide whichtype of buy-sell agreement to enter into, the funding issue can be the deciding factor. If they enter into a redemption agreement, the corporation, rather than the shareholders, will be responsible for purchasing the policy and paying the premiums. In a cross-purchase agreement, the shareholders must secure funding. Having the corporation provide the funding for the stock purchase is often the preferred choice; as a result, a redemption agreement is frequently used.

Objectives

There are many reasons for closely held business owners to want a buy-sell agreement. For example, the loss of one shareholder due to death or retirement can seriously jeopardize the...