Use of Buy-Sell Agreements -- Selling An Equity Interest In An Existing Veterinary Practice Upon An Owner's Retirement, Permanent Disability or Death
I. GENERAL OVERVIEW
A. Principal objectives of Buy-Sell Agreements.
1. Restrict transferability of ownership interests.
2. Give either the entity of the other owner an option or duty to purchase the ownership interest upon the occurrence of certain specified events (e.g., retirement, permanent disability or death).
3. Covenant not to compete.
4. Estate liquidity.
B. Reasons to use Buy-Sell Agreements.
1. Control access to ownership interest.
2. Provide for orderly, preplanned sale of equity interest by retired, disabled or deceased veterinarian.
3. Provide financial support for deceased veterinarian's spouse.
4. Estate liquidity.
C. When should the use of Buy-Sell Agreements be recommended?
1. Formation of entity.
2. Change of entity structure.
3. Change in ownership.
4. When reviewing an owner's estate plan.
II. PRACTICAL PROBLEMS REGARDING BUY-SELL AGREEMENTS
A. Valuation.
1. Four valuation techniques are commonly used in Buy-Sell Agreements.
(a) Mutual agreement.
(b). Formula (e.g., book value of assets and/or a percentage of gross receipts and collection of veterinary fees).
(c) Appraisal by independent appraiser specializing in the sale of veterinary practices.
(d)Fixes price subject to periodic review.
2. When should a particular valuation technique be used?
3. What types of adjustments should be considered when a formula technique is utilized?
4. Properly drafted Buy-Sell Agreements will "peg" the value of the ownership interest for federal estate tax purposes.
(a) While the unlimited marital deduction and the increased unified credit may reduce the impact of the federal estate taxes, it is likely that a deceased owner's estate will continue to bear significant estate tax burdens.
(b) The obligation to sell must be binding upon the deceased owner during his or her lifetime at the price set forth in the Buy-Sell Agreement. (The price must be specifically determinable under the Agreement, either by a formula or by reference to a specific price.)
B. Funding .
1. Unfunded . Buy-Sell Agreements rely on the ability of the entity or the other owner to obtain the case to make the purchase. (Use of installment promissory note where the terms of payments, interest rate and collateral used to secure note payments are set forth in the Buy-Sell Agreement).
(a) Often an entity Buy-Sell will be wholly or partially funded because of the anticipated cash-flow of the entity.
(b) Wholly unfunded entity Buy-Sell could create cash flow problems and jeopardize the ability to pay the terminated owner.
2. Life Insurance Funded . Life insurance funding is a common source of funding a Buy-Sell. The insurance can be owned by the entity or other owner(s) depending who is obligated to purchase the deceased owner's interest.
(a) Advantages of life insurance funding.
(i) It can help assure continuity of business avoiding disruptive partial liquidations or burdensome bank loans to purchase business interests.
(ii) It can compensate business for loss of key person.
(iii)It can assure liquidity of estate of deceased owner.
(b) Disadvantages of life insurance funding.
(i) Cost (premiums on policies insuring lives of owners are not deductible.)
(ii) Not all parties may be insurable.
(iii)Differences in ages, particularly in cross-purchase agreements, will cause younger owner to bear large premium burdens on life of older owner.
(iv) Effect on valuation.
3. Disability Insurance Funded.
(a) Disability salary continuation payments should be considered.
(b) The advantages and disadvantages are substan-tially the same as those relating to life insurance discussed above.
(c) Disability insurance policy may provide for a lump sum payment upon determination of permanent disability to facilitate payment of purchase price to disabled owner.
C. Community Property Considerations.
1. Buy-Sell Agreements often overlook community property considerations. Mere spousal consent is inadequate.
2. Provisions to consider for all Buy-Sell Agreements in community property jurisdictions:
(a) In the event of dissolution of an owner's marriage, the Buy-Sell Agreement should require the active spouse to obtain full control of the business interest; and if not done, then other owner should have an enforceable option to purchase the non-active spouse's interest.
(b) All restrictions on lifetime transfers apply to the interest of spouses of parties to the Buy-Sell Agreement.
(c) In the event of death of the active spouse, the community property interest of the non-active spouse should specifically be included in the Buy-Sell rights.
III. CORPORATE BUY-SELL AGREEMENTS
A. Types of Agreements.
1. Corporate Redemption Agreements-Corporation purchases the selling shareholder's stock.
2. Shareholder Cross-Purchase Agreements-Remaining Shareholder(s) buys the terminating shareholder's stock and the corporation is not a party to the transaction.
3. Hybrid Agreements-Usually in the form of the corporation having an option to purchase all or part of a shareholder's stock and the other shareholder(s) then have an option to purchase the balance.
B. Income tax consequences resulting from Corporate Redemption Agreements.
1. Corporation
(a) Generally, the corporation's payments for the selling shareholder's stock will not be deductible. For "C" corporations, such payments may be subject to a corporate level tax at 35%; for "S" corporation, such payments result in "phantom" income to the remaining shareholder(s) creating an individual level tax which may exceed 39% (i.e., the remaining shareholder may be taxed on income he or she never receives.)
(i) Exception: Payments to the retiring shareholder allocated to a covenant not to compete are deductible over 15 years, regardless of the term of the covenant.
(ii) Exception: Payments to the retiring shareholder allocated to consulting fees are deductible when paid.
(iii) Exception: Payments to the retiring shareholder allocated to salary continuation (i.e., deferred compensation) are deductible when paid.
(iv) Exception: "Rent premium" payments to the retiring shareholder (assuming he or she owns the real property where the practice is located and leases it to the corporation) are deductible when paid.
(v) Exception: Promissory note interest payments are deductible when paid.
(b) If the corporation is the beneficiary of a life insurance policy on the life of a shareholder, the corporation will receive no deduction for any premiums paid. Although the corporation will not recognize taxable income upon receipt of the insurance proceeds, a portion of the insurance proceeds may be subject to the alternative minimum tax.
2. Selling Shareholder
(a) Generally, if the selling shareholder completely terminates his or her interest in the corporation, the payments made to the selling shareholder in exchange for stock constitutes capital gains. Such payments are not deductible by the corporation.
(i) Exception: Payments allocated to covenant not to compete, consulting fees or deferred compensation constitute ordinary income to the selling shareholder and are deductible by the corporation. The selling shareholder recognizes gain in the year of sale measured by the fair market value of property received (usually cash and a promissory note), less his or her adjusted basis in the stock. Exception: If the purchase price is paid over a number of years, the gain will be recognized ratably over the period of the installment payments.
(b) The selling shareholder recognizes gain in the year of the sale measured by the fair market value of property received (usually cash and a promissory note), less his or her adjusted basis in the stock.
(i) Exception: If purchase price is paid over a number of years, the gain will be recognized ratably over the period of the installment payments.
(c) In the event of the selling shareholder's death, his or her estate should recognize no gain because the stock receives a "stepped-up" basis equal to the date of death value.
3. Remaining Shareholder .
(a) The distribution of the corporation's assets in exchange for the selling shareholder's stock will not constitute income to the remaining shareholder unless the redemption is in satisfaction of his or her primary and unconditional obligation to purchase that stock.
(b) In a "C" corporation, the basis of the stock held by the remaining shareholder is unaffected by a corporate redemption.
(c) In an "S" corporation, the basis of the stock held by the remaining shareholder is usually increased by the amount of the "phantom" income.
C. Income tax consequences resulting from shareholder Cross-Purchase Agreements.
1. Corporation
(a) Generally, there is no income tax consequences to the corporation since it is not a party to the transaction.
2. Selling Shareholder
(a) Since selling shareholder is selling a capital asset any gain will be taxed as a captial gain at favorable income tax rates.
(i) Exception: Payments allocated to a covenant not to compete constitute ordinary income.
(ii) Exception: Consulting fees or deferred compensation payments paid by the corporation constitute ordinary income.
(iii) Exception: "Rent Premium" payments to the selling shareholder (assuming he or she owns the real property where the practice is located and leases it to the corporation) constitute ordinary income.
(b) The selling shareholder recognizes gain in the year of the sale measured by the fair market value of property received (usually cash and a promissory note), less his or her adjusted basis in the stock.
(i) Exception: If the purchase price is paid over a number of years, the gain will be recognized ratably over the period of the installment payments.
(c) In the event of the selling shareholder's death, his or her estate should recognize no gain because the stock receives a "stepped-up" basis equal to the date of death value.
3. Buying Shareholder
(a) Generally, the payments made to the selling shareholder are not deductible; therefore, the buying shareholder is required to use after-tax dollars to effect the purchase.
(i) Exception: Payments allocated to a covenant not to compete (if the selling shareholder's retirement triggers the Buy-Sell) are deductible over 15 years, regardless of the term of the covenant.
(ii) Exception: If any portion of the purchase price is represented by a promissory note, the interest paid by the buying shareholder is fully deductible as business interest if the corporation is an "S" corporation and the buying shareholder materially participates in the business. Interest on debt incurred to purchase "C" corporation stock is investment interest which may be deducted each year only to the extent of net investment income.
(b) The buying shareholder will have a basis in the stock acquired equal to the purchase price allocated to the stock. Compare with Section III.B.3.(b) above.
(c) With respect to any cross-owned life insurance used to fund a Buy-Sell Agreement, the premium payments are not deductible. The insurance proceeds are not taxable income to the recipient and are not subject to the alternative minimum tax. The buying shareholder will have a basis in the stock acquired equal to the purchase price.
D. Income tax consequences of Hybrid Agreements.
1. The selling shareholder and the buying shareholder generally follow the pattern set forth for the other types of Buy-Sell Agreements regarding corporate stock.
2. Beware of "constructive dividend" if the corporation buys the selling shareholder's stock that would otherwise be subject to a binding purchase obligation on the other shareholder(s).
IV. PARTNERSHIP BUY-SELL AGREEMENTS
A. Types of Agreements.
1. Partnership Redemption Agreements: Partnership purchases the selling partner's interest in the partnership. (Applies only to payments in complete liquidation of the interest of a "retiring partner or a deceased partner." The term "retiring partner" includes those who are expelled and any other partner who ceases to be a partner under local partnership law.)
2. Partner Cross-Purchase Agreements: Partner buys terminating owner's partnership interest, and the partnership is not a party to the transaction.
3. Hybrid Agreements: Usually in the form of the partnership having an option to purchase all or part of the terminating owner's partnership interest, and the other partner then having an option to purchase the remaining partnership interest.
B. Income Tax Consequences Resulting From Partnership Redemption Agreements.
1. Partnership
(a) Generally, the partnership recognizes no gain or loss on distribution of property (including money) to the liquidating partner.
2. Liquidating Partner
(a) Generally, the liquidating partner recognizes gain only to the extent money exceeds the adjusted basis of his or her partnership interest, and recognizes loss under certain circumstances.
(b) Nature of payments to the liquidating partner are governed by I.R.C. Sections 736, 707(c) and 731.
(i) Payments may be considered as a "distributive share of partnership income" or as a "guaranteed payment" (i.e., ordinary income).
(ii) Exception: Payments made in exchange for the liquidating partner's interest in partnership property are treated as a "distribution by the partnership" (i.e., capital gain).
(c) Liquidating distribution may be in the form of cash, an installment promissory note and/or partnership property.
(d) Liquidating partner recognizes gain measured by the amount received (cash, fair market value of property plus relief of pro rata share of partnership's liabilities), less the liquidating partner's adjusted basis in his or her partnership interest.
(e) Liquidation of a partner's interest provides flexibility in structuring the tax consequences since it allows the partners to determine, among themselves, the tax treatment to be accorded to the distribution.
3. Continuing Partner
(a) If the liquidating payments are treated as either a "distributive share of partnership income" or as a "guaranteed payment," such payments are immediately deductible to the partnership (and as a result to the continuing partner).
(b) If the liquidating payments are treated as a payment for the selling partner's interest in the partnership's goodwill, such payments may be deductible by the partnership (and as a result to the continuing partner) over 15 years.
(c) The continuing partner would prefer an allocation to ordinary income items to receive an immediate deduction, whereas the selling partner will desire capital gain treatment.
C. Income Tax Consequences Resulting From Partner Cross-Purchase Agreements .
1. Partnership
(a) Generally, the sale results in no gain to the partnership.
(b) Partnership's basis in its property is not affected by the sale, unless an I.R.C. Section 754 election is in effect.
2. Selling Partner
(a) Generally, the sale results in no gain to the partnership.
(i) Exception: Depreciation recapture will result in ordinary income.
(ii) Exception: Payments relating to unrealized receivables and substantially appreciated inventory will result in ordinary income.
(b) The selling partner may receive purchase price in the form of cash, an installment promissory note and/or partnership property.
(c) The selling partner recognizes gain measured by the amount received (cash, fair market value of property plus relief of the selling partner's pro rata share of partnership's liabilities), less the selling partner's adjusted basis in his or her partnership interest.
(d) If the purchase price is paid over a number of years, the gain will be recognized ratably over the period of the installment payments.
(i) Exception: Depreciation recapture.
(ii) Exception: Liabilities in excess of basis.
3. Continuing Partner
(a) Generally, the tax treatment is the same as on the initial acquisition of the partnership interest.
(b) The continuing partner's basis in his or her partnership interest is increased by such partner's pro rata share of the purchase price, plus his or her additional share of partnership's liabilities.
(c) The continuing partner is allowed no deduction for any part of the purchase price. Compare with the deduction allowed under I.R.C. Sections 736(a) and 707(c), as discussed in Section IV.2.C.(2) above.
(i) Exception : Payments allocated to a covenant not to compete (if partner's retirement triggers the buyout) are deductible over 15 years, regardless of the term of the covenant.
(ii) Exception : Payments allocated to the selling partner's interest in the partnership's goodwill are deductible over 15 years.
(iii) Exception : If available, " rent premium " payments could create a deductible expense.
(iv) Exception : If any portion of the purchase price is represented by a promissory note, the interest paid is fully deductible as business expense interest provided the continuing partner materially participates in the business. Otherwise, the interest is deemed to be investment interest, the deductibility of which is subject to the net investment income limitations .
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