Can you answer ‘What If?’

by Andrew Scott

One of the more overlooked, or misused corporate documents, is the Buy-Sell Agreement. This document is also commonly referred to as a Shareholders’ Agreement and has been mistaken for a Stock Purchase Agreement more than once.

To clarify, a Buy-Sell Agreement differs from a Stock Purchase Agreement in that the Stock Purchase Agreement documents a contemplated, actual, pending sale of stock. The Buy-Sell Agreement, in contrast, attempts to provide answers to the ‘what if ’ questions: What if my business partner dies? What if he wants to sell his stock to someone else? What if he retires? What if he divorces and his wife wants the company stock? What if he files for bankruptcy? The Buy-Sell Agreement is a document executed by the individual shareholders, and sometimes the company, to provide an answer to the endless list of ‘what ifs’ that might otherwise keep business owners awake at night.

Misconception #1
"You only need a Buy-Sell Agreement if the partners are not related."

Truth:
Every company with multiple owners should have a buy-sell agreement in place.

Intro facts:
XYZ, Inc. has been owned by the Jones family for three generations. Five years ago, Frank began transferring shares of the C corporation stock to his son, Steve, as part of Steve’s executive compensation package until they each own 50% of the company. Frank’s Last Will and Testament provides for his remaining XYZ stock to go to Steve. Steve, 37, has not executed any estate planning documents, figuring he has plenty of time to put his affairs in order.

Worst case scenario:
Steve, driving home after another late night at XYZ, perishes in a car accident. He never executed any estate planning documents. Final distribution of the probate estate happens 18 months later, and his state’s intestacy law provides that his wife and 19-year-old son share equally in Steve’s estate, including his stock in XYZ, Inc.

Frank, who had intended to transfer ownership in XYZ, Inc. to Steve now finds himself partners with Steve’s widow and teenage son, neither of whom have previously shown any interest in the company. While Frank got along with his son’s wife and child, he never thought he would be in business with them. They refuse to sell their stock and now simple transactions, like electing to be taxed as an S Corporation, need the approval and consent of otherwise disinterested business partners.

How a Buy-Sell could have helped:
One of the most common triggering events covered in a Buy-Sell Agreement is the death of a partner. Had there been an Agreement between Frank and Steve, Frank could have had the right to purchase Steve’s shares upon his untimely death. The stock would not have been tied up in the probate process for more than a year because this transaction could have been affected with the executor of the estate. Additionally, business operations would not be slowed due to disinterested or incapable owners.

Misconception #2
"We have a Buy-Sell Agreement in place in case one of us dies. We’re covered."

Truth:
While death and a bona fide purchase offer are the most common triggering events that Buy-Sell Agreements cover, they can contemplate a wider range of issues, including divorce, disability, retirement and termination.

Intro facts:
When Bill and Bob began 2B’s Corp. five years ago—a furniture business—they went to their local attorney and had a Buy-Sell Agreement drafted. It provided that when Bill or Bob dies, the other shall purchase the decedent’s interest for $500,000, to be paid with life insurance proceeds that they would maintain on each other’s lives. The Agreement also provided that if Bill or Bob wanted to sell their stock, the remaining partner would have a right to match the price the selling partner received from a third party. Satisfied that this would cover them, they executed the document, put it aside and didn’t think about it again.

Worst case scenario:
After several years of non-stop fighting, coupled with minor corporate losses, Bill decides he will not work with Bob anymore. He cleans out his office on a Wednesday afternoon and quits. Purely out of spite, Bill refuses to sell his stock to Bob for less than $5 million, which is a couple million dollars more than he knows Bob can raise. The best offer Bob has received for his interest is far less than he’s invested in the company and Bill has been able, and willing, to match every offer Bob’s received. Bob cannot force Bill to sell his stock for a reasonable price, and he cannot afford to take the loss that he would realize if he sold his interest in the company to Bill or another investor.

How a better Buy-Sell could have helped:
In addition to covering the death of a partner and a bona fide offer to purchase, Bob and Bill’s Buy-Sell Agreement could have also been triggered by Bill’s resignation. Realizing that an active shareholder is better for the operations of the business, the Agreement could have covered resignation, termination, retirement and disability, to name only a few options. When Bill quit, the Buy-Sell Agreement could have required that he sell his stock to Bob, or to the company for its fair market value, as determined by an independent business valuation firm.

Misconception #3
"It doesn’t matter how we come up with the purchase price as long as we have one."

Truth:
An agreed-upon purchase price may not hold up to IRS scrutiny, resulting in the imposition of additional taxes and penalties.

Intro Facts:
When siblings Dave and Tom Smith formed their company, Smith Brothers, Inc., one year ago, they had a corporate attorney draft their Buy-Sell Agreement. The Agreement’s triggering events included death, bona fide purchase offer, retirement, disability (physical or mental), divorce, bankruptcy and a few others. It also provided that Dave and Tom would agree between themselves what the company was worth within three months of the close of each tax year.

Worst case scenario:
Tom is diagnosed with heart disease and is given less than one year to live. At their annual meeting to determine the value of the company three months later, they agree that the company is worth $500,000. An independent determination of fair market value would have shown a value of between $2,500,000 and $3,000,000. Although they’re not so foolish as to document this in their minutes, the reason for the low number was to reduce Tom’s estate tax liability. When Tom passes away, Dave pays his estate $250,000 for Tom’s Smith Brothers, Inc. stock, in accordance with the terms of the Buy-Sell Agreement.

The IRS, in their review of Tom’s estate tax return, determines that Tom’s Smith Brothers, Inc. stock should have been worth $1,750,000, which results in $690,000 in increased estate tax liability. Tom’s estate would have to prove that the IRS value is unreasonably high. This is a difficult, and almost impossible, standard to meet. If his estate cannot meet that burden, the IRS’s determination will stand, the additional tax will be assessed and they may incur penalties and interest charges.

How a better Buy-Sell Agreement could have helped:
By tying the purchase price to an independent, third-party valuation, the burden of proving unreasonableness shifts to the IRS. Although this may result in a higher pershare value than the shareholders would like, the valuation will stand up to IRS scrutiny.

The importance of a properly-drafted Buy-Sell Agreement cannot be overstated when there are multiple owners in a company. Make sure that yours is properly structured to meet all of your what-if ’s. A Buy-Sell Agreement is an invaluable tool in defining corporate and shareholder obligations on the happening of unforeseen and unforeseeable occurrences. It can provide the peace of mind that the ‘what-if ’s’ seek to undermine.