Corporate Buy-Sell Agreements

Transcription

1 Reprinted from Business Buy-Sell Agreements, 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 CEB-3444 or visit our web site, CEB.com). 3 Corporate Buy-Sell Agreements Doron M. Tisser Whitney M. Skala I. INTRODUCTION A. Scope of Chapter 3.1 B. Corporate Redemption Versus Shareholders Cross-Purchase 3.2 II. PRELIMINARY CONSIDERATIONS: CORPORATION S PURCHASE OF ITS SHARES A. Limitations on Corporate Purchase Retained Earnings Test Assets-Over-Liabilities Test Solvency Test Scope of Board s Valuation Authority; Other Restrictions Exception for Insurance-Funded Distributions When Funds Must Be Present Administrative Requirements Curbs on Transfer Restrictions 3.11 B. Changes in Capital Structure Related to Stock Purchase 1. Authorized But Unissued Shares Accounting Treatment of Reacquired Shares 3.13 C. Liability for Improper Distributions Director Liability a. Violations of State Law 3.15 b. Misrepresentations 3.16 c. Breach of Fiduciary Relationship Shareholder Liability a. Selling Shareholder 3.18 b. Remaining Shareholders 3.19 c. Liability of Professional Advisers Liability of Corporation and Insiders Under Federal Securities Laws 3.21 D. Purchase of Shares From Donee or Estate 3.22 E. Tax Considerations for Corporation Corporation s Gain or Loss on Redemption Distribution of Property Effect of Redemption on IRC 312(a) Earnings and Profits 3.25

2 F. Tax Considerations for Selling Shareholder Dividend or Capital Gains Treatment of Redemption Distributions 3.27 a. Safe Harbors for Redemption Distributions 3.28 (1) Termination of Shareholder s Interest Under IRC 302(b)(3) 3.29 (a) Constructive Stock Ownership Rules Under IRC (b) Waiver of Constructive Ownership Rules 3.31 (2) Substantially Disproportionate Redemptions Under IRC 302(b)(2) 3.32 (3) Redemptions Not Equivalent to Dividends Under IRC 302(b)(1) 3.33 (4) Distributions in Redemption of Stock to Pay Death Taxes and Expenses Under IRC b. Section 306 Stock Delaying Tax Payment by Installment Sale Qualified Small Business Stock a. Partial Exclusion of 50 Percent of Gain From Sale of Qualified Small Business Stock 3.36A b. Rollover of Gain From Sale of Qualified Small Business Stock 3.36B 4. Deferring Payment of Estate Tax Estate Tax Deduction for Qualified Family-Owned Business Interests [Deleted] 3.37A 6. California Estate Tax 3.38 G. Tax Considerations for Remaining Shareholders 3.39 III. PRELIMINARY CONSIDERATIONS: CROSS-PURCHASE OF SHARES BY OTHER SHAREHOLDERS A. Business Law Considerations 3.40 B. Tax Considerations 1. Selling Shareholder: Ordinary Income Versus Capital Gain 3.41 a. Collapsible Corporations [Deleted] 3.42 b. Section 306 Stock Tax Considerations for Remaining Shareholders Combination Stock Redemption and Cross-Purchase 3.45 IV. ENTERING INTO BUY-SELL AGREEMENT A. Checklist: Buy-Sell Procedures 3.46 B. Form: Board of Directors Resolution Authorizing Execution of Buy-Sell Agreement 3.47 V. FORM: BUY-SELL AGREEMENT FOR CORPORATION AND SHAREHOLDERS A. Form: Table of Contents 3.48 B. Form: Preamble 3.49 C. Form: Share Certificate Requirement 3.50 D. Form: Legend on Share Certificates 3.51 E. Form: Right of First Refusal 3.52 F. Form: Pledge, Hypothecation, or Other Encumbrance 3.53 G. Form: Permitted Transfers; Prior Rights of Original Transferor 3.54 H. Form: Obligations of Transferees 3.55 I. Purchase on Other Events Optional Purchase on Bankruptcy 3.56A 2. Optional Purchase on Breach of Agreement 3.56B 3. Optional Purchase on Criminal Conviction or Willful Misconduct 3.56C J. Form: Purchase on Death 3.57

3 K. Form: Optional Purchase on Termination of Employment 3.58 L. Form: Purchase on Disability 3.59 M. Valuation Form: Book Value 3.60A 2. Form: Capitalized Earnings Formula 3.60B 3. Form: Appraisal Using Baseball Arbitration 3.60C 4. Form: Agreed Price With Arbitration 3.60D N. Form: Insurance Policies 3.61 O. Form: Payment and Transfer of Shares 3.62 P. Form: Notes and Security 3.63 Q. Form: Administrative Approvals 3.64 R. Form: Unneeded Insurance Policies 3.65 S. Form: Mandatory Dissolution of Corporation 3.66 T. Form: Termination of Agreement 3.67 U. Form: Preserving S Corporation Election 3.68 V. Form: Shareholder Wills and Revocable Trusts 3.69 W. Form: Insurance Company or Trustee Provisions 3.70 X. Form: Miscellaneous Matters 3.71 Y. Form: Signatures 3.72 Z. Form: Consent of Spouse or Registered Domestic Partner 3.73 VI. CHECKLIST OF PROCEDURES AND FORMS OF DIRECTORS RESOLUTIONS AUTHORIZING PURCHASE A. Checklist: Procedures for Purchase 3.74 B. Form: Board of Directors Resolutions Authorizing Purchase From Retained Earnings 3.75 C. Purchase Based on Assets-Over-Liabilities Test 3.76 D. Form: Board of Directors Resolution Authorizing Purchase of Shares Based on Assets-Over- Liabilities Test 3.77 E. Purchase Funded by Insurance Proceeds 3.78 F. Form: Board of Directors Resolution Authorizing Purchase of Shares From Insurance Proceeds 3.79 I. INTRODUCTION 3.1 A. Scope of Chapter This chapter covers buy-sell (or buy-out ) agreements for small, closely held corporations. The heart of this chapter is an agreement form (see ) for the purchase of the shares of a withdrawing shareholder by either the corporation (a corporate redemption ) or the remaining shareholders (a crosspurchase ). Such a buy-out may be triggered by a variety of events, e.g., death, disability, retirement, expulsion from the business, or a desire to sell an interest in the business. Alternative provisions are included in the form to provide flexibility in tailoring the agreement to the client s needs. The complex considerations that must be kept in mind when the agreement is being planned and executed are discussed in , 3.40 (business law) and , (tax).

4 3.2 B. Corporate Redemption Versus Shareholders Cross-Purchase Buy-sell agreements usually take the form of either a corporate redemption, in which the corporation purchases its own shares from the selling shareholder, or a cross-purchase, in which the other shareholders purchase the shares of the selling shareholder. In the past, a corporate redemption generally was preferred to a cross-purchase because of its simplicity and because corporate rather than personal funds or credit are used to complete the purchase. However, cross-purchases have become more popular because of the potential adverse tax consequences of a corporate redemption, particularly when insurance funding is used. See Dondershine, Planning For the Transfer of a Successful Closely Held Business, 29 Est Plan 335 (2002); Tannenbaum, What Every Business Lawyer and Business Owner Should Know About Buy-Sell Agreements (Part 1, 2), 45 Prac Law 55 (Oct./Dec. 1999); Sugar, Cross-Purchase Agreements Now Are Often More Beneficial Than Redemption Agreements, 18 Tax n for Law 370 (1990). See also 2.39, 6.29, 6.29A. The main advantage of a corporate redemption is that it is simpler to administer than a cross-purchase because it involves only the corporation and the estate or withdrawing shareholder. A cross-purchase agreement may have to be rewritten after a triggering event occurs in order to redefine the responsibilities of the remaining shareholders. Also, while a corporate redemption funded with insurance 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, or a schedule of premium payments must be calculated. See A major disadvantage of a corporate redemption is uncertainty concerning the enforceability of a corporation s purchase obligation when a triggering event occurs. A corporation cannot redeem its shares unless it meets certain statutory financial tests (Corp C 166, ). See ; Counseling California Corporations, chap 5 (3d ed Cal CEB 2008). These statutory financial tests do not apply to a cross-purchase. A corporate redemption may also have significant unfavorable tax consequences, including: (1) Recognition of income by the corporation if it distributes property to redeem the stock and the property s fair market value exceeds its basis (IRC 311(b)); (2) Imposition of an accumulated earnings tax on funds accumulated beyond the reasonable needs of the business (IRC 533; see 2.40, 6.30); (3) Imposition of a corporate alternative minimum tax 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 (see 6.29, 6.29A); (4) 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); see 3.24); or (5) Treatment of the redemption distribution as a dividend unless the distribution is substantially disproportionate, in complete termination of the selling shareholder s interest, or not essentially equivalent to a dividend (IRC 302(b)), taking into account the attribution rules of IRC 318 (see ). Besides avoiding these adverse tax consequences, a cross-purchase agreement can also benefit 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 See In a corporate redemption, the basis of the shares of the remaining

5 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. Finally, 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. See For most shareholders, the primary drawback 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. See 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-forvalue rule. IRC 101(a); see Selecting the appropriate form 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 form of agreement in this chapter permits the parties to delay the decision until the triggering event occurs, when the financial and tax situations of the parties can be better evaluated. For further discussion, see Zuckerman & Krall, Corporate Buy-Sell Agreements as Estate and Business Planning Tools, 28 Est Plan 599 (2001). II. PRELIMINARY CONSIDERATIONS: CORPORATION S PURCHASE OF ITS SHARES 3.3 A. Limitations on Corporate Purchase The corporation s redemption or purchase of its own shares is subject to the Corp C restrictions on corporate distributions to shareholders. Corp C 166. NOTE Corporations Code were substantially amended in 2011, effective January 1, Practitioners analyzing distributions made before that date should review the former language of those code sections. Under former Corp C , distributions were permitted only to the extent of retained earnings unless the corporation met at least one of two specific balance sheet ratio tests (see 3.5). Former Corp C 500. Distributions that resulted in corporate insolvency (former Corp C 501) or that impaired the liquidation or dividend priorities of any outstanding senior shares (former Corp C ) were prohibited. However, net proceeds of disability or life insurance used by the corporation to redeem the shares of a disabled or deceased shareholder were exempt from these sources of funding rules. Former Corp C See 3.8. The 2011 amendments (see Stats 2011, ch 203) have substantially simplified these tests, which are now consistent with the distribution statutes that apply to California and quasi-california limited liability companies and limited partnerships, and with the Model Business Corporation Act promulgated by the American Bar Association. For explanation of the new tests and other restrictions, see See also Counseling California Corporations, chap 5 (3d ed Cal CEB 2008).

6 Retained Earnings Test Although Corp C 500 was simplified by amendments effective January 1, 2012 (see Stats 2011, ch 203, 2), the substance of the retained earnings test from the previous statute remains intact. Under current California law, a corporation may purchase its own shares if retained earnings, immediately before the distribution, equal or exceed the sum of the amount of the proposed distribution plus the preferential dividends arrears amount. Corp C 500(a)(1). Before Corp C 500(a) was amended, there was no requirement to add a preferential dividends arrears amount in calculating the amount available for distribution. See former Corp C 500. 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. (Corporations Code 114 was not affected by the January 1, 2012, amendments.) Preferential dividends arrears amount means the amount, if any, of cumulative dividends in arrears on all shares having a preference with respect to payment of dividends over the class or series to which the applicable distribution is being made. Corp C 500(b). However, if the corporation s articles provide that a distribution can be made without regard to any preferential dividends arrears amount, then the preferential dividends arrears amount may be deemed to be zero and thus omitted from the equation. Corp C 500(b). Before Corp C 500 was amended, the amount of any distribution in property was required to be determined on the basis of the value at which the property was carried on the corporation s books in accordance with GAAP. Former Corp C 500(c). Therefore, a corporation could distribute property depreciated on its books that had a fair market value in excess of retained earnings as long as the corporation could satisfy the solvency test set forth in Corp C 501 and the additional restrictions on distributions by the corporation set forth in former Corp C , 505. Corporations should have even more flexibility to distribute appreciated property under Corp C 500(c) as amended. As amended, subsection (c) permits the board of directors to base a determination that a distribution is allowed on (1) financial statements prepared on the basis of reasonable accounting practices and principles, (2) a fair valuation, or (3) any other reasonable method. See 3.7. A special rule in Corp C 500 applies to the corporation s obligation to repurchase its shares if the corporation deducted reserves from retained earnings and added to liabilities at the time the obligation was incurred. If so, the deductions from retained earnings are added back and the additions to liabilities are deducted to the extent of the unpaid obligation. See Corp C 500(b) (former Corp C 500(d)) Assets-Over-Liabilities Test Amended Corp C 500(a)(2) allows a corporation that cannot satisfy the retained earnings test to repurchase its shares if, immediately after the distribution, the value of the corporation s assets would equal or exceed the sum of its total liabilities plus its preferential rights amount. Corp C 500(a)(2). Preferential rights amount means the amount that would be needed if the corporation were dissolved at the time of the distribution to satisfy the preferential rights (including accrued but unpaid dividends) of other shareholders on dissolution that are superior to the rights of the shareholders receiving the distribution. As in the case of the retained earnings test (see 3.4), if the corporation s articles provide that a distribution can be made without regard to any preferential rights, then the preferential rights amount may be deemed to be zero. Corp C 500(b).

7 Before the 2011 amendments to Corp C 500 (see Stats 2011, ch 203, 2), a corporation with insufficient retained earnings could purchase its own shares if it could satisfy a complicated assets-overliabilities test, which contained several deviations from GAAP. See former Corp C 500(b), (d). A corporation with insufficient retained earnings could purchase its own shares if, after the distribution, (1) total assets equaled at least 125 percent of total liabilities and (2) current assets were at least equal to current liabilities. If, however, for the two preceding fiscal years the average earnings before income taxes and interest expenses were less than the average interest expenses, then current assets were required to equal at least 125 percent of current liabilities. Former Corp C 500(b). The current-assets-to-liabilities test did not apply to corporations not required to classify their assets into current and fixed under generally accepted accounting principles (GAAP). Former Corp C 500(b)(2). The GAAP deviations in former Corp C 500(b) and (d), which had to be followed in applying the assets-over-liabilities test in former Corp C 500(b), were as follows: First, profits derived from an exchange of assets were not to be included as assets unless the received assets were currently realizable in cash. Former Corp C 500(b)(2). Second, for purposes of the total-assets-over-liabilities test, assets did not include goodwill, capitalized research and development expenses, or deferred charges, and liabilities did not include deferred taxes, deferred income, or other deferred credits. Former Corp C 500(b)(1). Third, current assets could include 1 year s projected receipts if the board of directors determined in good faith that they were reasonably expected to be received over the next 12-month period under an existing contract requiring fixed or periodic payments during the term of the contract. Former Corp C 500(b)(2). Future costs that were reasonably expected to be incurred in performing these contracts that were not included in current liabilities had to be subtracted from current assets. Former Corp C 500(b)(2). Finally, any amount added to liabilities at the time the corporation incurred the obligation to repurchase its shares had to be deducted from liabilities, but not in excess of the principal of the obligation that remained unpaid after the distribution. Former Corp C 500(d). Under former Corp C 502 (repealed by the 2011 amendments), a corporation was not permitted to make distributions that impaired the liquidation or dividend priorities of outstanding senior shares. Distributions to junior shareholders that would reduce the excess of the corporation s assets (excluding goodwill, capitalized research and development expenses, and deferred charges) over its liabilities (excluding deferred taxes, deferred income, and other deferred credits) to less than the liquidation preference of all senior shares were prohibited. Former Corp C 502. Also prohibited were distributions that would reduce retained earnings to an amount insufficient to cover all cumulative dividends in arrears on preferred shares. Former Corp C Solvency Test Under both former and current Corp C 501, distributions are prohibited if the corporation is or would be likely to be unable to meet its liabilities as they mature. Corp C 501. A liability that has been otherwise adequately provided for is exempt from this solvency test. Corp C 501. The solvency test must be met even if the corporation can satisfy the retained earnings or assets-over-liabilities test. Whether a corporation satisfies the solvency test is a question of fact. Flynn v California Casket Co. (1951) 105 CA2d 196, 233 P2d 131.

8 Scope of Board s Valuation Authority; Other Restrictions In addition to simplifying the assets-over-liabilities test and the financial accounting issues it raised, the 2011 amendments to the Corporations Code grant broad authority to the corporation s board of directors in the valuations required to determine the corporation s ability to purchase its shares. The board may now base its determination of sufficient retained earnings as well as adequate solvency on any of the following: (1) financial statements prepared on the basis of accounting principles that are reasonable under the circumstances; (2) a fair valuation; or (3) any other method that is reasonable under the circumstances. Corp C 500(c). See also 3.9. 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 Exception for Insurance-Funded Distributions Agreements for the purchase or redemption of shares of a deceased or disabled shareholder that are fully funded by the proceeds of life or disability insurance (as the case may be) in excess of the total amount of premiums paid by the corporation need not meet the retained earnings, balance sheet, or solvency requirements for corporate distributions in Corp C Corp C 503(a) (b). 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 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 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. 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 sinking fund payments, 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 buy-out. Corp C 166. The 2011 amendments further insulate the board of directors by providing that the effect of a distribution under the retained earnings test and the assets-to-liabilities test is to be measured on the date of the board s approval of the distribution, provided the distribution is made within 120 days of its

9 authorization. Corp C 500(d). Boards are still required to exercise good faith in authorizing any dividend, so caution should be exercised if a board is considering repurchasing shares at a time when a declining corporate financial condition that would otherwise disqualify a later repurchase is anticipated. Corp C 500(a) Administrative Requirements 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. 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 unless an exemption applies to the transaction. Section 25104(a) exempts from the qualification requirements of Corp C 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 broker-dealer in a public offering. Title 10 Cal Code Regs provides that, for purposes of Corp C 25104(a), an offer or sale does not involve any public offering if (i) offers are not made to more than 25 persons, (ii) sales are not consummated to more than 10 of such persons, and (iii) all of the offerees either have a preexisting personal or business relationship with the offeror or its partners, officers, directors, or controlling persons or 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. 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. 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 (a) Curbs on Transfer Restrictions The buy-sell agreement should provide that the shares covered by the agreement may not be transferred except under the terms of the agreement for the rights and obligations imposed by the agreement to be meaningful. See Transfer restrictions are circumscribed by common law and by statutory prohibitions against absolute restraints on alienation. Shareholders, however, are permitted to enter into any lawful agreement not otherwise contrary to public policy (Corp C 204(a)). Corp C 706(d). See Counseling California Corporations 4.20 (3d ed Cal CEB 2008). Courts have enforced agreements that were arguably unreasonable (see, e.g., Cutter Labs., Inc. v Twining (1963) 221 CA2d 302, 34 CR 317 (concerning price terms)). 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).

10 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 are excluded from the general exemption for changes in the restriction of outstanding shares (Corp C 25103(e)) and must be qualified with the Commissioner of Corporations. (Under Corp C 25120, 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.) However, 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 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). If a shareholders agreement or other arrangement exists or is intended at the time the shares are issued, however, 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 (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.