Special Buy-Sell Provisions for Limited Liability Companies Special Buy-Sell Provisions for S Corporations... 47

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1 TABLE OF CONTENTS Purposes of the Buy-Sell Agreement... 1 For the entity... 1 For the patriarch of the family... 1 For the children of the patriarch For the grandchildren of the patriarch For unrelated owners of the business For the patriarch in anticipation of his retirement or potential incapacitation For the surviving owners of the business... 3 Types of Buy-Sell Agreements... 3 The number of owners of the business... 3 The age of the owners Credit considerations The relative income tax brackets of a C corporation and its shareholders Transfer for value considerations Alternative minimum tax... 5 Accumulated earnings tax... 5 Capital gains tax treatment of the sale proceeds... 6 Section 318 attribution rules... 7 Family attribution rules... 7 Estate and trust attribution rules... 7 Is this redemption a sale or a dividend

2 ... 8 Exceptions under Code Section The redemption is substantially disproportionate... 8 Waiver of attribution rules when a shareholder retires Waiver of attribution rules when a shareholder dies Exception for redemptions by a C corporation to pay an estate s taxes and expenses of administration Basis considerations The deductibility of interest paid on deferred sale proceeds Excessive life insurance If the entity is owned by several families or by several family groups The hybrid buy-sell agreement Transfer Restrictions Permitted transferees Triggering Events...0 Death 20 Permanent disability Termination of employment or engaging in competition Retirement Bankruptcy Divorce Pledges of an ownership interest Any attempted sale to an outsider

3 Setting the Purchase Price...5 What is fair market value Periodic agreement of the owners The formula approach The appraisal approach Setting a special cut throat price Valuation discounts Fixing the Transfer Tax Value of the Ownership Interest Grandfathered buy-sell agreements The present rules Exceptions to the general rule The exception for unrelated owners Meeting the requirements of Code Section 2703 does not guarantee the result What if the price set in the agreement is not binding on the IRS Some concluding thoughts on pricing options Funding the Buy-Sell Agreement The entity s ability to pay for the ownership interest The credit purchase of the ownership interest Using life insurance to fund the Agreement Special Buy-Sell Provisions for Partnerships...5

4 Special Buy-Sell Provisions for Limited Liability Companies...5 Special Buy-Sell Provisions for S Corporations...7 Outline of Key Issues for Agreements Among Equity Owners AGREEMENT CONCERNING STOCK Rights of First Refusal and Co-Sale (Tag-Along) Rights Registration Rights Provisions Agreement To Be Bound By Buy-Sell Agreement Cross Purchase vs. Redemption and Type of Entity LLC Operating Agreement Some Common Mistakes in Buy-Sell Agreements Buy-Sell Agreements By Eric A. Manterfield A well drafted buy-sell agreement is a critical tool for planning the successful succession of a family business. It can keep ownership of the business in the family, avoid unintentional termination of an S corporation election and can provide a market for the sale of an ownership interest in the event of certain triggering events.

5 The provisions of a buy-sell agreement can be contained within a separate document executed by the shareholders and a corporation, within an LLC operating agreement or within the partnership agreement for a family limited partnership. While the planning considerations are typically identical whether the entity is a corporation, LLC or family limited partnership, there can be significant differences. Except as otherwise specifically noted in this paper, all references to the agreement will mean and refer to the transfer restrictions relating to each of those entities. Purposes of the Buy-Sell Agreement For the entity. The Agreement can be used to keep ownership of the entity within a family or a limited group of owners by restricting gifts or sales to outsiders. It can void any transfer which would terminate an S corporation election or would terminate a partnership. If the entity is a professional corporation, the agreement can void the transfer of an ownership interest with would disqualify the entity for that purpose. For the patriarch of the family. The Agreement can provide the assurance that ownership interests will not be transferred to non-family members, including in-laws. While many of my clients employ sons-in-law and daughters-in-law in the family business, several are concerned about letting ownership pass outside of the blood family. Once ownership gets into the hands of in-laws, they fear that it will later pass to even more distant, unknown owners. The Agreement can lead the patriarch to consider the future management of the family business after he is no longer the manager. How will the business continue after the retirement, incapacitation or death of the patriarch? How will the surviving children manage the business in the absence of a strong-willed entrepreneur? The Agreement can provide a mechanism for the patriarch to sell control to one or more business children, with payment to be made over time, so as to treat fairly other non-business children with the sales proceeds. The Agreement can provide a forum for the resolution of family business disputes. The Agreement can require the business children to purchase over time any ownership interest which is given to non-business children, either with or without the consent of the non-business children. The Agreement can provide a market for the redemption or sale of the patriarch s unmarketable ownership interest with a predetermined mechanism to determine the price to be paid. The business owner s personal representative need not negotiate the purchase of the ownership interest from a weak position, which easily could be the case with the owner of a minority interest in the business.

6 For the children of the patriarch. The second generation of owners looks to the agreement s continued restriction on the transfer of ownership outside of the immediate family. While the transfer of outright ownership to the spouses of the second generation is typically prohibited, tax planning strategies can be permitted, including gifts to a QTIP trust. Because transfer of ownership to members of the third generation (or to trusts for their benefit) is permitted, the opportunity exists to shift future appreciation to subsequent generations. Some agreements among the children of the patriarch may require that all owners be employees of the business, with the ownership interest of any non-employee child to be purchased by the business or the other owners. Provisions of this type may minimize the conflict which can exist when the employee owners take some portion of the earnings out in the form of compensation (with the remaining earnings to be reinvested in the business), while the non-employee owners want to minimize salaries and maximize dividends and distributions to all the owners. For the grandchildren of the patriarch. As cousins become owners, having a mechanism to keep the business in the family, to resolve family disputes and to elect successor managers becomes even more critical. As grandchildren seek to withdraw from the business, the agreement can provide a market for their ownership interests; further, it can give the business itself or the other owners the right to match any offer made by a non-family member. For unrelated owners of the business. Unrelated business owners typically do not want to do business with spouses of the current owners and, perhaps, even their children. A mandatory sale upon the death of each owner is not unusual. Nevertheless, consideration should be given to deferring tax to the death of the survivor between the owner and his wife through use of a QTIP trust and to passing appreciation to trusts for the children (whose stock must be sold upon the death of the donor owner in accordance with the agreement). For the patriarch in anticipation of his retirement or potential incapacitation. The patriarch who is willing to retire (rather than work until he dies!) can establish an agreement which will provide a source of cash payments for his ownership interest, hopefully with favorable capital gains tax treatment. The patriarch s recovery of cost basis is tax free, of course. Gain on the amount by which the sale proceeds exceed basis is now taxed at 15%, which is more favorable than the ordinary income tax which must be paid if the payments were styled as compensation for consulting services. The patriarch who becomes incapacitated can also have an assured flow of cash, in the form of payment for his ownership interest, at a time when his cash needs may increase. The sale of all the ownership interest of either a retired or a disabled patriarch will also go a long way towards eliminating any continued real or imagined interference with the new owners of the