This article outlines issues to be considered in structuring a buy-out agreement. It also addresses 2006 changes to the Internal Revenue Code affecting how company owned life insurance is taxed.
What is a buy-out agreement?
A buy-out agreement is a contract among the owners of a business. The business can be in the form of a corporation, partnership, or limited liability company. The purpose is to set forth the agreement of the owners as to what happens in the event one of them leaves the business or wishes to sell his or her ownership interest. It may provide for a buy-out of an owner on death, disability, retirement, or some other termination of employment.
Why are buy-out agreements important?
If the owner of an interest in a closely held business dies, is disabled, or otherwise leaves the business, whether voluntarily or involuntarily, there is an advantage to having an agreement in place to buy his or her interest. There is usually little market for the interest of one owner in a closely held business. If there is no mechanism in place to purchase the interest of the departing owner, he or she (or his or her heirs) may be stuck with an interest which carries no income benefits; in addition, the other owners may be stuck with a “partner” who is not participating in the business but attempts to use whatever leverage he or she might have to force the others to pay “dividends” to owners as such. An unhappy outside owner can be a distraction for those trying to run the business.
Who does a buy-out agreement protect?
A buy-out agreement protects the company in that it allows for a mechanism for peaceful termination of the departing owners interest without having to go through unpleasant negotiations at what may already be a stressful time. It protects the departing owner or his heirs by giving them a market for the interest which may not otherwise be marketable. It protects the remaining owners by providing a mechanism to protect themselves from an unwanted “partner,” be that the departed owner, his heirs or someone to whom he or they might try to sell the interest.
How is a buy-out agreement structured?
It can be structured to provide for a purchase by the company or a purchase by the other owners. There are practical and tax advantages and disadvantages to either approach. Those advantages and disadvantages should be reviewed with your attorney, accountant and life underwriter (if the buy-out will be funded with insurance).
How do the owners decide on a price?
This is sometimes the most difficult part of structuring a buy-out agreement, especially if the business is new and the owners have no real idea of how the business might grow. Formulas based on book value, appraisal, or annual agreement of the owners should be considered. It is advisable for the owners to give the valuation issue some thought before they meet with the attorney who will be drafting the agreement, and to then discuss alternatives with the attorney.
How will the buy-out be funded and paid?
Funding and payment terms can take a number of different forms, often as alternatives in the same agreement. A buy-out on death is often funded by life insurance owned by the company or the other owners. Income tax treatment of company owned life insurance is discussed below. Since death of an owner is often unexpected and disruptive to the business, life insurance can provide a welcome source of funds without putting undo financial pressure on the company or the other owners. It also allows the heirs to be paid largely, if not entirely, in cash. A buy-out on disability is sometimes funded by insurance as well, although this is less common. Your life underwriter, as well as your attorney and accountant, can help you evaluate your choices here.
A life time buy-out will often be structured as an installment sale. The interest would be sold in return for a down payment plus a note providing for payment of the balance of the purchase price at interest and over an agreed upon period of time. The note may or may not be secured or guaranteed. This mechanism allows for an immediate purchase of the entire interest without putting a substantial up front cash drain on the company or the other owners.
How is company owned life insurance taxed?
Prior to August 18, 2006, life insurance proceeds from a company owned policy on the life of an employee were not taxable to the company that was the owner and beneficiary of the policy. However, the Pension Protection Act of 2006 added provisions to the Internal Revenue Code which eliminate favorable income tax treatment for proceeds from certain “employer owned” life insurance issued or “materially changed” after August 17, 2006. As a result, such proceeds may be taxed to the company. There are exceptions, but those exceptions require the satisfaction of certain notice and consent requirements before the policy is issued or materially changed. The added Internal Revenue Code provisions also require that the company file a form with its income tax return annually listing information relating to the company, its employees and the policies in force.
There are a number of alternatives to be considered in structuring a buy-out agreement. They include alternatives relating to who is the purchaser, what triggers the buy-out, what is the purchase price, and how is the price to be funded and paid. Please contact us if we can be of assistance in structuring and preparing a buy-out agreement for your business.