Buy-sell agreements: an invaluable tool.

• Author: Jackson, George, III
• Position: Part 2

Shareholders of closely held corporations should collectively decide which type of buy-sell agreement is appropriate to meet their goals. Part II of this article summarizes the tax effects of common types of agreements on the corporation, the buyer and continuing shareholders and the advantages and disadvantages of each type of agreement. It also identifies some common problems that arise in drafting buy-sell agreements, and how to avoid them.

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Owners of closely held corporations need to decide which type of buy-sell agreement is appropriate to meet their goals. In so doing, shareholders must consider both tax and nontax consequences and other features, such as who will be responsible for financing the stock purchases. Part I of this two-part article described the primary forms and common objectives of buy-sell agreements. Part II, below, considers the tax ramifications of each type of agreement on the corporation, the buyer and the remaining shareholders, as well as advantages and disadvantages. It also shows how to handle some common problems associated with buy-sell agreements, such as Sec. 302 sale and exchange requirements, constructive dividends and valuation problems.

Tax Effect on Buyers and Continuing Shareholders

Although the effect of a buy-sell agreement on a selling shareholder receives a great deal of attention, stock-transfer agreements also affect the corporation and the remaining shareholders. For this reason, shareholders of a closely held corporation must collectively decide which type of buy-sell agreement meets their needs, and analyze the likely results of choosing a particular agreement.

Redemption Agreements

Sec. 311 provides that if a corporation distributes the proceeds of a redemption agreement to its shareholders in a form other than appreciated property, it will not recognize gain or loss, regardless of whether the redeeming shareholder receives dividend or sale or exchange treatment. However, if it distributes appreciated property in exchange for an individual shareholder's stock, the corporation must recognize gain to the extent that the distributed property's fair market value (FMV) exceeds its adjusted basis.

When a corporation distributes either money or property in exchange for its stock, its earnings and profits (E&P) account is reduced by the amount of cash and the property's FMV, under Sec. 312(a) and (b). If the basis of property distributed exceeds its FMV, the corporation's E&P is reduced by the property's adjusted basis. However, if the redeeming shareholder treats the distribution as a sale or exchange under Sec. 302 or 303, the E&P reduction is subject to Sec. 312(n)(7) limits.

In spite of the corporation's treatment resulting from a redemption agreement distribution, the only affect the transaction has on the continuing...