PROTECTING YOUR FAMILY BUSINESS WITH A BUY/SELL AGREEMENT DANIEL A. PALMER, LL.M., J.D.

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1 PROTECTING YOUR FAMILY BUSINESS WITH A BUY/SELL AGREEMENT presented by DANIEL A. PALMER, LL.M., J.D. Daniel A. Palmer Haley & Olson, P.C. 510 North Valley Mills Drive - Suite 600 Waco, Texas telephone fax dpalmer@haleyolson.com Copyright 2012, Daniel A. Palmer, All Rights Reserved.

2 BIOGRAPHY DANIEL A. PALMER, born in Lake Charles, Louisiana. Received both his undergraduate degree (B.S. (Accounting) 1982) and law degree (J.D. 1985) from LSU in Baton Rouge, Louisiana. Received a master's of law degree in taxation (LL.M ) from SMU Dedman School of Law. Danny is a shareholder and director with the law firm of HALEY OLSON, P.C. and is a Board Certified Tax Attorney by the Louisiana State Bar Association Specialization Board. Danny is AV Preeminent Peer Review rating, the highest rating by Martindale-Hubbell. Martindale-Hubbell is the largest and oldest peer review rating service for attorneys in the United States. Danny s primary areas of concentration are in the fields of mergers and acquisitions, estate planning, probate, business planning, employment contracts for physicians, creditor planning, taxation, financial planning for the elderly and employee benefits. Given numerous lectures to individuals and groups, both layman and professionals, on estate planning and taxation, including the following: Asset Preservation - Central Texas Society of CPA's (1992 and 1994), McLennan County Family Practice Residence Program (1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012), Fellowship Program (1993, 1994, 1995, 1998), Waco-McLennan County Bar Association (1992), McLennan County Medical Society (1994), PaineWebber Seminar Series, Corpus Christi (1994, 1995), PaineWebber Insurance Coordinator Regional Meeting (1994), PaineWebber Broker Series, Dallas, San Antonio (1996), Ft. Worth (1997), Waco Association of Life Underwriters (1996); Texas Society of Certified Public Accounts (Houston Chapter) (1998); Texas Medical Association and Texas Medical Liability Trust (Hillsboro, (2002), Waco (2002); Estate Planning for the Elderly - Waco Estate Planning Council (1993, 1999), United Bank of Waco "Over 55" Club (1988); Providence Hospital Foundation (1998); Why Do I Need A Will? - Texas National Bank Trust Department Seminar (1994), Veteran's Administration Seminar (1992); The State of Your Estate - PaineWebber Summer Series for Women (1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2004), Hillcrest Hospital Hospice Training Programming (1996, 1997), Austin Avenue Methodist Church Seminar (1996), PaineWebber Seminar Series, McAllen (1996, 1997), Waco Business Women's Club (1996), Catholic Diocese (1996); PaineWebber Forum Series, Dallas, Texas (1998) PaineWebber Seminar Series, Dallas, Texas (2000), Ft. Worth (2000); First United Methodist Church (2006); The Rules of OSHA for Physicians Regarding Blood-Borne Pathogens - Hillcrest Hospital (1991, 1992); Criteria in Selecting an Attorney - KWTX Noon Hour Interview for Waco-McLennan County Young Lawyers Association (1990); What is the 1986 Tax Act All About? - First National Bank of Mexia (1987), Farmers and Merchants Bank of Mart (1987), Waco-McLennan County Bar Association (1987), Haley, Davis, Wren, Bristow & Rasner, P.C. Firm Seminar (1986); Do I need a Living Trust? - Hillcrest Hospital Hospice Training Programming (1995), First United Methodist Church Senior's Seminar (1995); Advanced Estate Planning Techniques for the 90's - Central Texas Society of CPA's (1995), PaineWebber PaceSetters Series, Dallas (1997); PaineWebber Seminar, Waco (1999); Tax Treatment of Qualified Accelerated Death Benefits Under Life Insurance Contracts - PaineWebber Branch Manager/Insurance Coordinator Regional Meeting, Beaver Creek, Colorado, (1996); Why Haven't You Formed Your Family Limited Partnership - Central Texas Society of CPA's (1997), Baylor University Entrepreneur Program Morning Series (1998); Southern Methodist University Family Business Class, guest lecturer (2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012);

3 Practical Legal Considerations to be Considered by New Physicians - McLennan County Family Practice Residence Program (1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012); 1997 Taxpayer Act - Relief or Grief? - PaineWebber Insurance Training Seminar, Austin (1997); Taxpayer "Hoax" Act of PaineWebber Seminar, Ft. Worth (1997); McLennan County Medical Society Bridging the Gap Seminar (1997); "Beneficiary Designations and Beyond" - Waco Estate Planning Council (1997); PaineWebber Seminar, Dallas (1999); PaineWebber Pace Setters Seminar, Houston (2000); PaineWebber BOIC Meeting, Austin (2000); Estate Planning Strategies Using Life Insurance - Providence Hospital Foundation (1999); Midland College Foundation, Inc. and Midland Memorial Foundation Seminar (1999, 2004); Florida Estate Planning Council of the Emerald Coast, Inc. Symposium (2009); Protecting Your Family Business with a Buy/Sell Agreement Texas A&M Family & Owner- Managed Business Program (1999); Estate Planning Council of the Emerald Coast Dinner Meeting (2012); Estate Tax Repeal Providence Hospital Foundation Seminar Series (2000); PaineWebber BOIC Meeting, Dallas (2001); 2001 Tax Act PaineWebber Seminar, Waco (2001) Special Planning Concerns for the Disabled Client or Disabled Beneficiary National Alliance for the Mentally Ill - Waco (2003); Autism Support Group Waco (2006) Basic Estate Planning Strategies for Clients PaineWebber Seminar, Waco (2003, 2004) COMMUNITY INVOLVEMENT Fellow of the Texas Bar Foundation (2009-current); Ted Nash Long Life Foundation [President and Director (1998-current)]; Waco Symphony Orchestra [Board of Directors ( )]; Waco Estate Planning Council [Board of Directors ( ); President (1995)]; Greater Waco Chamber of Commerce [(Board of Advisors (2007-current) (Board of Directors ( , ); Leadership Waco Class (1990); Leadership Waco Alumni (1991-current); Leadership Waco Curriculum Committee (1994, 1995); Sports and Recreation Committee ( ); Golf Tournament Chairman ( ); Small Business Committee ( ) Starburst Texas-New Mexico Junior College Basketball Tournament Chairman (1997, 1998); Business Retention Committee ( ); Starburst Junior Golf Classic Committee ( )]; Keep Waco Beautiful Systems [Board of Directors ( )]; Midway Little League [Board of Directors ( ), Executive Committee and Player Agent (2001, 2002), Manager ( )]; Community Cancer Association [Director ( )]; Hillcrest Hospital Board of Visitors [Director ( )]; Co-Chairman Waco Cattle Baron's Ball for the American Cancer Society (1996); American Cancer Society-Texas Division-National Gala Task Force [Board of Directors ( ), Vice-President/President-Elect (2005), President (2006)]; Austin Avenue United Methodist Church [Board of Trustees ( ); Administrative Board ( ); Finance Chairman ( ); Chairman of Endowment Funds (1995)]; Austin Avenue Montessori School [Board of Directors ( )]; First United Methodist Church of Waco [Finance Committee ( ; ); Administrative Board ( )]; Greater Waco Rotary Club [Member ( )]; Midway Independent School Board Education Foundation [Board of Directors ( )]; Ridgewood Country Club [Board of Directors ( ) Vice-President/President-Elect (2005), President (2006), Past- President (2007); Finance Committee ( ), Golf Committee Chairman ( ); Men's Golf Association President ( )]. Danny and his wife, Laura, have three children, Drew (age 22), Grayson (age 20) and Caroline (age 18). Updated 7/5/2012

4 I. General A. Purpose. A Buy/Sell arrangement is highly recommended for all closely held businesses. Without such an agreement each owner or the owner s survivors will usually be unable to obtain a fair value for their interest, and the possibilities of disruption of the business and hostility among the owners and other interested parties are increased. A carefully structured Buy/Sell agreement can meet the specific objectives of the seller and buyer, promoting an orderly and economical transition of ownership while maintaining, to the extent possible, the value of the business. B. Business Dynamics. Because the owners of closely held businesses most often use Buy/Sell agreements, there is a need to consider carefully the special dynamics of these businesses. 1. Personality Issues. In planning a Buy/Sell agreement, careful consideration must be given to the people issues. Often, this will require an understanding of family relationships, active and non-active participants in the business, the philosophy of the controlling owner (e.g., parent or surviving parent), spousal relationships, key persons, and other peopleoriented factors. 2. Economic Issues. Although difficult to do, it is essential to assure that the business owners fully understand the economic consequences of their agreements -- to the business, its continuing owners, and the family or survivors of the selling shareholder. It is generally advisable to involve other professionals such as accountants, appraisers, and insurance professionals to assist in the understanding and planning of the economic aspects of the agreement. For example, disaster can result if economic assumptions are made regarding the business and its ability to produce revenues to fund directly the redemption of a business interest (or to fund through salary or other distributions - a cross-purchase arrangement). Therefore, an economic analysis of the funding requirements under a Buy/Sell agreement is a critical part of the buy/sell planning process. 3. Tax Factors. A Buy/Sell arrangement must also be analyzed carefully to determine the likely income, gift, estate and generation-skipping tax consequences. II. Objectives A. Seller's Objectives 1. Marketability. The agreement provides for a ready market for the stock of the seller, to the corporation or the other stockholders, upon certain specified events. 2. Fair Value. The agreement establishes a negotiated price for the stock while the parties generally are on parity, or at least are able to participate in bona fide negotiations to Page 1

5 arrive at the value or valuation approach. This can be contrasted with negotiations conducted by the continuing shareholders with an estate of a deceased shareholder, which may be in need of liquidity. 3. Orderly Disposition. The agreement provides for certainty and structure for the disposition of stock by the seller. Provisions should address valuation procedures, closing procedures, and method of purchase upon the occurrence of specified events. 4. Fixed Death Value. The agreement may establish the value of the business interest for federal estate tax purposes. 5. Income Tax Consequences of Distributions. The agreement can provide for a method of withdrawing funds from the business in a manner where the federal income tax consequences of the distributions, both for the business entity and the seller are predetermined. 6. Planned, Secure Funding. The process of arriving at a Buy/Sell agreement, and negotiating the provisions of the agreement, can promote an understanding of the finances of the business and future funding requirements so that the seller can obtain a planned funding of the Buy/Sell agreement using insurance, a sinking fund, or upon other agreed terms (with or without collateral) thus allowing the seller some comfort in knowing that the Buy/Sell agreement can and will be implemented. 7 Liquidity. The agreement can provide liquidity on a predetermined basis, both as to amount and timing. B. Buyer's Objectives 1. Unwanted Outsiders. The agreement can prevent or limit the transfer of shares to unwanted outsiders. 2. Orderly Disposition. The buyer is also generally interested in an orderly transfer of the business interests from seller to buyer so as to prevent unnecessary delay, confusion, and hostility. 3. Planned, Economical Funding. The buyer can predetermine the funding requirements under the agreement and negotiate the terms of purchase and/or determine whether insurance funding is necessary. Insurance funding can increase the liquidity of the buyer and reduce the out-of-pocket costs to the business and/or continuing owners. 4. S Corporation Status Preservation. The agreement may protect a corporation's S election for the continuing owners. Page 2

6 5. License Requirements. The agreement may allow the business entity to maintain its compliance with licensing requirements where, for example, a shareholder is required to be licensed in order to own shares of the corporation. 6. Third-party Relationships. The agreement, through its predetermined structure, avoids business interruption and therefore is designed to maintain and strengthen the corporation's relationship with valued employees and customers. In addition, such agreements are viewed favorably by bankers and other creditors as they evaluate their ongoing relationships with corporations who are likely to face changes in ownership and/or control. C. Family Objectives. Because a closely held business interest often represents the largest and least liquid asset of many business owners, the estate planning objectives of the family are often closely tied to a Buy/Sell agreement. With careful planning, family objectives such as security and harmony can be maintained and promoted through Buy/Sell planning. A Buy/Sell agreement can provide for continuity of the business, needed cash flow to survivors, and liquidity for the owners' estates. III. Types of Agreements A. Alternatives. Buy/Sell agreements generally follow three different formats: (i) stock redemption agreement; (ii) cross-purchase agreement; or (iii) a hybrid agreement (usually a combination of the foregoing two types of agreements). B. Stock Redemption Agreement. Under a stock redemption agreement the corporation agrees to purchase stock of a deceased or selling stockholder upon certain events. C. Cross-Purchase Agreement. Under a cross-purchase agreement, the continuing stockholders individually agree to purchase the stock of a deceased or selling stockholder upon certain events. D. Hybrid Agreement. A hybrid Buy/Sell agreement generally employs a partial stock redemption and a partial cross-purchase agreement to satisfy certain specific objectives or to avoid potential problems. For example, such an agreement is often used where (i) a corporation cannot buy all the shares of a selling shareholder due to limits on its capital or because of creditor-imposed limitations, or (ii) a redemption cannot be made without dividend consequences under Code Section 302 of the Internal Revenue Code ( Code ) due to continuing family ownership and attribution, but a partial redemption can be made pursuant to Section 303 of the Code. E. Selection. No hard and fast rules apply to the selection of the form of agreement. Each fact situation must be reviewed separately with proper weight being given to all relevant factors, including: (i) business dynamics and (ii) the tax considerations, before a determination can be made as to the best form of agreement. Page 3

7 IV. Drafting the Buy/Sell Agreement A. Overview. In this Section is an analysis of the provisions of a corporate redemption Buy/Sell agreement, including planning and drafting considerations designed to avoid business conflicts and potential tax problems. Although the analysis focuses on a corporate redemption Buy/Sell agreement, the considerations are applicable in most cases to cross-purchase and hybrid agreements. B. Parties 1. Stockholders. As a general rule all stockholders should be parties to the Buy/Sell agreement. For minority stockholders, you may want to consider a separate agreement between that stockholder and the corporation without subjecting the majority stockholder's stock to the terms of the agreement. 2. Corporation. Whether a redemption or cross-purchase stock purchase agreement is used, the corporation should join as a party to the agreement. 3. Stockholder's Spouse. If a stockholder's interest is owned as joint or community property, the spouse of the record owner should be included as a signatory to the agreement. For example, Texas law has held that the spouse's community interest in stock is not bound under a Buy/Sell agreement on the other spouse s death unless each spouse is a party to the agreement. The agreement should clearly specify that the stockholder's spouse's shares are subject to purchase at the stockholder's death and grant rights to the stockholder to acquire the stockholder s spouse's stock in the event of termination of their marriage. Spouses should have separate counsel for purposes of review of the agreement. C. Purpose 1. Delineation of Purposes. It is desirable to set forth the business purposes for which the agreement has been entered into, such as continuing the business, limiting ownership of the business, providing an orderly manner of transferring the shares, providing a market for the shares in the event of death, disability, termination of employment, or other events requiring purchase, securing continuity in the management of the business, and precluding dissension and conflict among the stockholders and their families upon stock disposition. Setting forth the purposes of the agreement can support the proposition that the agreement is not a device to effect a testamentary transfer at a price per share less than its fair market value, in which event the agreement will be disregarded in establishing the value of the securities. Careful attention must be given to stating the business purposes. Consider also, the use of corporate minutes, notices or other requirements from third parties (such as lenders, manufacturers, suppliers, creditors) with which the business operates in establishing non-testamentary purposes. Page 4

8 D. Stock Identification 1. Classification. The shares, which each stockholder owns at the effective date of the agreement as well as the par value of each of those shares, should be stated. If the agreement does not cover all outstanding shares, the agreement should so state. 2. Additional Shares. The agreement should also provide that any additional shares, which a stockholder subsequently acquires automatically, become subject to the terms of the agreement. E. General Restrictions on Transfers 1. Restriction on Transfer. The agreement should prohibit a stockholder from being able to transfer the stockholder s shares directly or indirectly without complying with the terms of the agreement or obtaining the consent of all or a specified percentage of the other stockholders who are parties to the agreement. 2. Permitted Transfers. The agreement may permit a transfer of stock to family members or to a trust for their primary benefit without approval of the corporation and the other stockholders. If such transfers are permitted, the transferee should be required to join the agreement. The agreement should specify whether the shares will continue to be subject to the terms of the agreement as if owned by the transferor stockholder, or if the transferee becomes a party stockholder in the transferee s own right. If the transfer is to a trust, consideration must be given to certain events causing purchase, such as death. Caveat. The Buy/Sell agreement must restrict the disposition of the decedent's stock during the stockholder s lifetime. If the decedent is free to sell or give away the stock during the stockholder s lifetime without regard to the agreement, then the agreement will not satisfy even the non-chapter 14 requirements to establish the value of the stock for estate tax purposes. Consider providing that consent must be obtained from the other stockholders before a transfer can be made to other family members where the transferee becomes a party to the agreement in the transferee s own right. 3. Transfer Without Compliance. The agreement should specifically state that transfer of securities without complying with the terms of the agreement will be null and void and that the corporation will not recognize the transfer on its books. 4. Limited Class of Transferees. The agreement may limit the permitted class of transferees to whom the stock may be transferred. In some cases these restrictions will be required by law as in the case of professional associations, professional corporations, and regular corporations whose license requires all of its stockholders to hold identical licenses, e.g., corporations licensed to sell insurance. Page 5

9 F. Encumbrances 1. Prohibition. Many stock purchase agreements provide an absolute prohibition on a stockholder's encumbering the shares. This is a simple, effective solution to addressing how to deal with a stockholder who wishes to encumber his/her shares. However, in many instances, it forecloses a substantial source of credit for a stockholder, particularly if a stockholder is later trying to buy out another stockholder pursuant to the terms of the agreement. 2. Permitted. A Buy/Sell agreement, which permits stock to be encumbered, should provide a mechanism for preventing the shares from falling into creditors' hands on foreclosure, without strictly curtailing the amount of security the creditor has for the loan. Consider conditioning the stockholder's right to pledge the stock on the creditor's agreement to give the corporation and then the other stockholders the right to purchase the stock in the event of default. Also consider limiting the amount that can be borrowed against the stock to a percentage of the stock value as determined pursuant to the Buy/Sell agreement. If the corporation's right to purchase is on terms, the lender may be hesitant to loan against the stock since it will be required to receive payment on the stock in accordance with the terms of the installment pay-out. G. Lifetime Transfer Restrictions 1. Purposes a. Third Parties. Restrict transfer to third parties. purposes. lifetime. b. Value. Establish maximum value of shares for sale and estate tax c. Parameters. Establish outer parameters for purchase terms during 2. Types of Restrictions. a. Option to Purchase. The corporation and then the other stockholders are given a right to purchase in the event a stockholder elects to sell or otherwise dispose of his/ her shares. The right of the continuing stockholders' to purchase shares not purchased by the corporation should be clearly specified. Continuing stockholders are customarily granted a pro rata right to purchase based on the stock interests of the stockholders who elect to purchase. b. Forced Buy/Sell. A forced buy/sell option provides a stockholder with the right to buy the other stockholders' shares if he/she tenders his/her shares and the other stockholders elect not to purchase his/her shares upon the terms offered. Maximum value of the Page 6

10 shares should not exceed the value of those shares determined by the agreement. This option is more advantageous for stockholders with deep pockets or with special expertise who can locate suitable financing. c. Absolute Prohibition. A provision allowing no transfer without consent of the corporation and the other stockholders or a percentage thereof is an example of an absolute prohibition. Restrictions absolutely prohibiting transfer may be deemed to be overreaching and unreasonable and can result in the agreement being rendered void or unenforceable. If such a covenant is desired, however, granting the stockholder the right to put his/her shares to the corporation under certain agreed terms may eliminate that argument. 3. Purchase Price. a. Notice. The purchase price for the option shares should be required to be stated in the notice of sale. Any documentation concerning the offer or proposed contract for purchase should also be required as an attachment to the notice of sale. b. Maximum Price. If one goal is to attempt to fix values for Federal estate tax purposes (subject to Chapter 14 considerations), the purchase price should be the lesser of the price provided for in the notice of sale or the price determined by the agreement. c. Effect on Estate Taxes. Unless restrictions are imposed on a stockholder during his/her lifetime which prohibit the stockholder from obtaining for his/her shares a price greater than the amount he/she would obtain at death, the purchase price determined by the agreement for the shares at death does not meet the non-chapter 14 requirements under existing law to establish the federal estate tax value of the shares. 4. Terms. forth in the offer. a. Cash/Offer. Cash, or, at the option of the purchaser, upon terms set b. Agreement/Offer. As set forth in the agreement, provided if the terms in the offer are more favorable to the purchaser than the terms in the offer control. c. Bona Fide Offer. Consideration can be given to restricting the type of third party offer, which must be received in order to trigger the right of first refusal provisions. Such a restriction might include (i) required percentage down payment; (ii) minimum or floor purchase price; or (iii) secured by letter of credit. Page 7

11 5. Miscellaneous Considerations. a. Shares Offered. If a stockholder elects to sell his/her shares during his/her life should he/she be required to offer to sell all of his/her shares? This requirement may be appropriate in any proposed sale by a non-family, minority stockholder, such as a key employee. Concern. If the corporation is given the option to purchase the offered shares, the partial redemption of part of a shareholder's shares may not meet the requirements of Section 302 of the Code to avoid sales proceeds being taxable to seller as dividends. b. Shares Purchased. The purchaser(s) in the aggregate should be required to purchase all of the shares offered or waive their right of purchase. Objective is to avoid reduction of the value of the stockholder's interest by reducing his/her percentage of ownership, thereby making a sale to a third party less attractive. c. If Stock Not Sold - Stock Remains Subject to Agreement. The agreement should give the selling stockholder a specified time period after the corporation and other stockholders waive their right of purchase to sell to the third party. If the shares are not sold during that time to the third party, the shares continue to be subject to the terms of the agreement. d. Designated Transferee. Require the selling stockholder to designate the name of the proposed transferee and limit any transfer to that designated transferee. Transferee should be required to enter into a Buy/Sell agreement as a condition to approving and/or recognizing the sale. e. Occurrence of Another Event of Purchase. If another event of purchase occurs prior to the consummation of the sale under a lifetime disposition, which event controls the purchase? f. Insurance. If stock is purchased during the lifetime of the stockholder, the corporation and/or other stockholders' rights with respect to any insurance on the selling stockholder's life at the time of the stock purchase should be determined and described in the agreement. Options include (i) voluntarily continuing the insurance during the purchase period to provide the purchase price in the event death occurs during the installment payment period, (ii) transferring the insurance immediately to the selling stockholder, after withdrawing and applying the cash value against the corporation's purchase price, (iii) making the insurance available to the terminating stockholder for its cash value, or (iv) requiring the insurance to be continued in force until all (or an agreed percentage) of the purchase price is paid, at which time the policy can be transferred to the selling stockholder, retained by the corporation, or split, with a portion being retained by the corporation (equal to the amount paid for the stock) and the balance being made available to the selling stockholder. Page 8

12 g. Percent Approving Transfer. The agreement should state the percentage of the shares which must approve the transfer of shares during the lifetime of a stockholder without having to comply with the first offer requirements of the agreement (such as a permitted gift to a family member). h. Limited Class. The agreement may limit the transfer of shares to a specified class of persons, e.g. those licensed to practice medicine, law, dentistry, sell insurance, etc. 6. Summary. The restrictions on transfer during lifetime should generally provide at least the outside parameters of the terms to be applied in the event a stockholder elects to terminate his/her interest in the corporation; and it is generally advisable to establish the exact terms of purchase to avoid controversy. H. Sale upon Disability 1. Purpose. A closely held corporation generally cannot afford to continue compensation to a disabled stockholder for an extended period of time, especially where the active participation of all key employee/shareholders is vital to the success of the business. 2. Benefits to Disabled Stockholder. Enables a disabled stockholder to receive cash for his/her stock at a time of need. 3. Key Person Replacement. The corporation will in all probability need to replace the disabled stockholder-employee on a permanent basis. 4. Definition of Disability. Inability to perform usual corporate duties. Inability to perform any meaningful duties. Definition of disability found in disability insurance policy, if any. Corporation determines existence of disability with its determination to be absolute and binding. Directors authorized to examine such medical evidence, as they deem appropriate. 5. Purchase Price. Disability value may be the same as or less than the death value. In making that determination, consider if death value is funded by insurance and if salary is continued to the disabled stockholder during a portion of the period of disability. a. Insurance. It may be difficult to fund the purchase price since life insurance is only payable in the event of a death; however, disability buy-out insurance may be used to fund the purchase price. Payments may be made either as a lump sum or in installments. Lump sum policies generally require at least 12 months before payment. Premiums for disability buy-out insurance are not deductible. Disability policies provided as employee benefits with the premiums deducted by the corporation should not be a part of the Buy/Sell agreement. Page 9

13 b. Payment to Disabled Stockholder. Disability income payments should be paid to the corporation with the corporation in turn applying those funds to the payment of the purchase price of the stock. If the insurer pays the disability insurance proceeds directly to the disabled stockholder, the agreement should clearly state that those proceeds are to be applied against the purchase price and shall be considered as payments by the corporation. It may be difficult to redirect payments to the corporation after the purchase price has been paid. State specifically that the corporation's obligations to make payments for the stock are offset if disability insurance subject to the agreement is paid directly to the disabled stockholder. I. Sale upon death 1. Purposes. To establish value of stock for estate tax purposes. Establish terms of purchase including form of note, security agreement, collateral, etc. Avoid controversy with deceased stockholder's estate, spouse, and children at time of emotional stress. 2. Purchase Price. The valuation method and purchase price are established by the agreement. Consider reduction of the purchase price in the event of suicide or false statements made to the insurance corporation in connection with issuance of the policy if the agreement is funded with insurance. Consider increase in purchase price to net insurance proceeds received on life of deceased stockholder (but only those which are scheduled and made subject to Buy/Sell agreement). 3. Insurance. Consider requiring all insurance subject to agreement to be mandatorily applied toward the purchase price. That portion of the purchase price not paid by insurance is paid in installments. It is important to specify which insurance is subject to the agreement and which insurance is key-man insurance not required to be applied toward the purchase price. 4. Simultaneous Death. If stockholders owning a stated percentage of the stock die within a specified period of time, the stock agreement and its obligations should be voided, or the agreement must specify the application and order of closings and payments. 5. Salary Continuation Payments at Death. In connection with the Buy/Sell arrangements, the parties may enter into salary continuation agreements which provide for continuing compensation payments following the death of a stockholder to his/her widow/widower or a named beneficiary. It is recommended that any salary continuation agreements be included in a separate document and not made a part of the Buy/Sell agreement. The objective of the salary continuation is to provide continuing income to a stockholder's surviving spouse or other family members on a deductible basis by the corporation. Deductibility of the salary continuation payments will be conditioned upon such payments being ordinary and necessary business expenses. Page 10

14 J. Other Events Requiring Disposition of Stock 1. Retirement. Usually provided when the corporation has some stockholders substantially older than others, especially in service oriented businesses. May elect not to provide in agreement and negotiate terms when and if a stockholder elects to retire. Usually paid over a period of time in conjunction with non-qualified retirement benefits to maintain standard of living. The disposition of the retiree's disability and life insurance policies owned by the corporation should be determined by the agreement. 2. Bankruptcy. The corporation should be given the option to purchase an insolvent stockholder's stock. Consider either (i) formula insolvency definition, (ii) final adjudication of bankruptcy, (iii) bankruptcy petition filed but not discharged within specified number of days, or (iv) specified acts indicating credit problems (e.g., personal deed in lieu of foreclosure, actual foreclosure, assignment for benefit of creditors, or levy on stock). Purchase price should be determined by the agreement. Validity of discounting the purchase price in the event of the bankruptcy of a stockholder is questionable. 3. Termination of Employment. Consider ability of majority stockholders to terminate minority stockholder's employment causing a mandatory buy-out of the minority stockholder's shares. Generally, this provision is not included when there are two stockholders, each owning 50% of the stock. A mandatory buy-out upon termination of employment essentially gives a terminating stockholder a put ; that is, if the corporation is required to purchase a terminating stockholder's shares, then, by voluntarily terminating his/her employment, a minority stockholder may be able to require the corporation to buy his/her shares when the corporation is having financial difficulty. 4. Tag along Provisions. Consider including provisions requiring that minority interests join in any sale approved by majority owners as long as sale is on same or similar terms. K. Valuation Methods. Choosing the appropriate valuation approach is one of the most difficult issues in buy/sell planning. It is not unusual to find that owners of the business have no real appreciation for the value of the business, their focus being primarily on the day-to-day operations. In many cases, the first indication that a business owner will have concerning valuation is a rough estimate of value provided by an insurance professional in the context of a sales call. The specific valuation approach adopted for any client should be molded to fit the business; and this is usually not possible without the assistance of an outside business appraiser and accountant. L. General Buy/Sell Payment Provisions. 1. Cash or Down Payment. The purchase price provisions may require a lump sum cash payment at closing. Page 11

15 2. Credit or Owner/Financed Purchase. If the purchase price is not to be paid in cash at the closing, then it is necessary to specify in the agreement the amount of the down payment, the timing of future payments, the rate of interest on the unpaid balance, and the security for the unpaid balance. The agreement could require a minimum down payment with the balance of the purchase price paid over a specified time at a specified interest rate; provided, any insurance proceeds subject to the agreement are paid forthwith in the event of the death or disability of a stockholder with only the balance of the purchase price being paid over terms. There should be minimum installment payments required under any note. a. Security. Security for a credit purchase might include a lien on the corporation's assets, a pledge of the stock being purchased (or all of the outstanding shares), the personal guarantee of the continuing stockholders, or restrictions on the future conduct of the business. Security and other restrictions should be set forth in the agreement and not left for negotiation when an event of purchase occurs. If interest is charged at less than the minimum required by IRS, interest will be imputed, converting a portion of the purchase price to interest for income tax purposes. b. Documents. Balance due, if any, should be evidenced by promissory note(s) and secured by a pledge of the transferred stock or other security. It is suggested that approved forms of notes, security agreements, and guaranties, if applicable, be annexed to the stock purchase agreement as exhibits. There is no limit on the amount that can be paid in the year of sale to qualify for installment sale treatment. At the death of a stockholder because his/her stock will have a new basis equal to the purchase price established by the agreement, all proceeds would be received by the estate of the deceased stockholder and his/her spouse income tax free. M. Disposition of Insurance. If a withdrawing stockholder has the right to purchase the insurance on his/her life owned by the corporation on his/her withdrawal, the IRS has taken the position that certain rights to purchase insurance are an incident of ownership requiring inclusion in the stockholder's estate. If the agreement grants the stockholder the right to purchase the insurance policy on his/her life from the corporation upon the sale of his/her stock, then the IRS may take the position that the stockholder had the right to cause the corporation to sell him his/her insurance policy immediately prior to death. The effect of such right is to cause the inclusion not only of the stock but also the proceeds of the insurance policy received by the corporation and applied toward the purchase price of the stock in the deceased stockholder's estate. N. Interest of Spouse. 1. Divorce. The stockholder should be given the right to acquire his/her spouse's interest, if any, in the stock at a price and upon terms determined by the agreement. Upon his/her failure to exercise that right, the corporation, followed by the other stockholders, should have the right to purchase the spouse's stock. Page 12

16 2. Death. If the stockholder's spouse predeceases the stockholder and leaves her interest in the stock to a beneficiary other than the stockholder or in a manner provided by the agreement, the stockholder should have the right to acquire the stock for the price and upon the terms set forth in the agreement, or, if he/she fails to exercise that right, the corporation and the remaining stockholders should have the right to acquire the stock. Stock left to a trust of which the stockholder is the trustee and/or beneficiary could be exempt from the purchase requirement. A mandatory purchase may be necessary if a Stockholder is required to be licensed and a non-licensed spouse of a stockholder is allocated shares pursuant to the divorce decree. 3. Signature of Spouse. The spouse should sign the agreement to acknowledge it (or as a party) and consent to his/her interest, if any, in the stock being subject to the terms of the agreement. 4. Revaluation. If the stock is to be revalued by the stockholders, state clearly if the spouse must sign the valuation statement. 5. Spouse s Interest Obligated. The agreement should specifically obligate the spouse of a stockholder to sell his/her interest in the shares upon the occurrence of an event requiring purchase of the stockholder's shares. The terms of the agreement, including the lifetime restriction, should extend to the spouse's interest in the shares. 6. Separate Attorney. Although a bona fide Buy/Sell agreement affecting community and/or marital property may, given the right circumstances, be effective even if the spouses are not separately represented, having separate counsel for each spouse in approving the agreement can substantially increase the likelihood that the agreement will be fully enforceable. O. Amendment. Specify if all or a specified percentage of the stockholders who are parties to the agreement must agree to any amendment. Avoid placing any stockholder who has minimal number of shares in a posture to control the amendment of the agreement. P. Termination. Events which may cause the Buy/Sell agreement to terminate: 1. Bankruptcy of Corporation. Consider survival of agreement as to installment purchases, which have begun but are not complete, and to events of purchase which have occurred. 2. Mutual Agreement. Specify percentage of stockholders who must agree to termination. The agreement should clearly state if a spouse has a right to participate in termination or amendment of the agreement. Page 13

17 3. One Stockholder. One Stockholder becoming owner of all the shares (but only after completion of all purchase obligations). 4. Simultaneous Death. Simultaneous death of all (or a percentage) of the stockholders within a specified period. The effective date of the termination should be the date preceding the date of the first stockholder to die. 5. Disposition of Shares. If the agreement requires consent of all stockholders for termination, provide that a stockholder ceases to be a party to the agreement in the event he/she disposes of his/her shares. Q. Other Drafting Considerations 1. Closing Date. The agreement should provide for a specific closing date upon the occurrence of an event requiring purchase. An extension of the closing date should be provided in the event the determination of value is not made by the scheduled closing date. 2. Offset. The corporation may be given the specific right to offset any obligations due it against the purchase price for the stock and/or any salary continuation arrangements. The agreement may state that the stockholders grant to the corporation a security interest in their shares to the extent of any outstanding indebtedness from time to time existing from them to the corporation. 3. Endorsement. Each certificate should bear conspicuous wording stating clearly on the front that the stock evidenced by the certificate is subject to restrictions and on the back that a copy of the agreement restricting the stock may be examined at the corporation's principal office. 4. Covenants of Stockholders. Stockholders should be required to covenant that no additional shares will be issued, no new classes of stock authorized, or any other action taken which would void or reduce the effectiveness of the agreement. 5. Warranties. Customary warranties, e.g., the stockholders are the owners of the shares, certification that there are no encumbrances on the shares, the stockholders have the full right to convey the shares and no knowledge of any matters which could prevent the agreement from being effective, should be contained in the agreement. A selling stockholder should also be required to deliver a compliance certificate upon sale certifying that those warranties continue in force at the time of closing. The compliance certificate should be attached to the agreement as an exhibit. 6. Liquidation. Consider granting the continuing stockholders the right to liquidate the corporation in lieu of effecting the purchase of shares. Page 14

18 7. Notice. Notice should be authorized by actual delivery or upon the date of (or specified number of days thereafter) deposit in the U.S. mail. R. Escrow or Trust Arrangements. The agreement can utilize a trust or escrow arrangement with a bank or other third party. For example, the escrow agent can hold all documents for closing, including insurance contracts, stock certificates with stock powers, resignations of officers, notes, and security agreements. The escrow agent collects the insurance proceeds as beneficiary and effects the transaction for all parties concerned. V. S Corporation Planning A. Generally. Over the past 20 years, the number of S corporations has increased dramatically (and certainly the amount of legal and tax analysis regarding S corporations has likewise increased). Due to the many qualification requirements and special tax rules which are applicable to S corporations, they create, by their very nature, a particular need for shareholder agreements. All of the standard reasons for doing buy/sell planning described in this outline are generally applicable to S corporations; however, there are special buy/sell considerations as well. This section addresses some of the more important ones. B. Purposes. Among the special purposes of an S corporation Buy/Sell agreement are the following: (i) preserving S corporation status; (ii) limiting the number of shareholders; (iii) restricting transfer to ineligible shareholders; (iv) avoiding violation of the one class of stock requirements; (v) allocations of income and loss items related to a terminating shareholder and in the event of termination of S status; (vi) providing for the amount of, and timing of, operating distributions; (vii) providing penalties or payment obligations in the event a shareholder violates the Buy/Sell agreement and eliminates the S status; and (viii) where more than one family is involved in the ownership of an S corporation, possibly allocating shareholder slots among the various families so that an equitable sharing of ownership positions is available under the 100 shareholder limitation. C. Special Drafting Considerations. Because of the need to restrict transferees to qualified S shareholders (whether they are permitted transferees or third parties who have offered to buy stock) the Buy/Sell agreement should provide for pre-transfer notification and approval with respect to transfers so there is not a violation of the S election. The transferee can be required to execute a copy of the Buy/Sell agreement and consent to the S corporation election (although this is not required, it would fully inform and bind the transferee). With respect to any indemnification clause to protect the remaining shareholders for loss of S corporation status, consider how damages will be measured. Perhaps the liquidated damages clause should reflect the lost cash flow benefit of the S corporation. It has been suggested that the period to be measured by such an indemnity clause should cover the five year waiting period for a new election of S status. The indemnity requirement should only be effective, however, after the remaining shareholders in the corporation have Page 15

19 attempted to mitigate any damages by obtaining a waiver from the IRS based on an inadvertent termination. C. Operating Distributions. Buy/Sell or shareholder agreements applicable to S corporations often contain provisions, which require or set out the circumstances under which operating distributions shall be made. This is of particular importance to minority stockholders or inactive stockholders who wish to receive some assurance that cash will be made available to them, at least in an amount necessary to pay the income taxes generated by the S corporation. D. One Class of Stock Requirement. In any Buy/Sell agreement for an S corporation care must be given to avoid creating more than one class of stock. Careful consideration must be given where different restrictions apply to different owners' stock, e.g., based upon whether the stock is owned by original shareholders or perhaps by key employees holding small minority interests. E. Revocation. The agreement may also address special voting requirements with respect to voluntary revocation of the S status, requiring under certain circumstances greater than 50% consent to revocation. F. Buy/Sell Valuation. In valuing an S corporation certain corporate attributes may need special consideration, especially that an S corporation shareholder is taxed currently on earnings whether distributed or not. The following issues should be considered: (i) the agreement should provide for shareholder consents and/or elections regarding income allocations for a terminating shareholder; and (ii) the determination must be made whether to reflect in the formula or stated price any additional value for the selling shareholder's allocable share of the Accumulated Adjustments Account or a credit for his/her share of accumulated pre-s earnings and profits. Both of these factors will affect the taxability of future distributions to the continuing shareholders. G. Special Corporate Level Taxes. Special price consideration may be necessary regarding the potential valuation impact of future corporate level taxes not yet recognized; for example, built in capital gains or taxes on passive income may require special adjustments. H. Loss of S Status. Perhaps a special valuation provision is required in the S Buy/Sell agreement in the event the S election is terminated at the time the buy/sell event is triggered. VI. Special Planning Considerations A. Loan Agreement Limitations. Insurance proceeds may not be permitted to be used to purchase stock under a loan agreement. If a corporation is restricted on its use of capital, a crosspurchase agreement may be required. Also, consider getting lender consent to the Buy/Sell agreement and implementation at the outset. Page 16