Volume 7 • Issue 7 • August 2017
The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning, business succession planning and charitable planning issues. This month’s issue will be a discussion of step six of the exit planning process – business continuity planning. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.
This newsletter is the seventh in a continuing series of newsletters discussing the seven step exit and succession planning process used by Hallock & Hallock. In this month’s issue, we will take a closer look at step six – business continuity planning. In step one, we determined what your goals and objectives are; in step two, we addressed valuing the business; in step three, we determined how to build and preserve the business value; in step four, we addressed selling your company to a third-party; and in step five, we looked at transferring the business to an insider.
Business continuity planning allows for the protection of your interest when an owner dies, becomes disabled, divorces, or the occurrence of other triggering events such as retirement, bankruptcy, or termination. For owners of a closely held business such as an LLC, Partnership, or Corporation, there are few things more important in business continuity planning than the buy-sell agreement among the owners. The buy-sell agreement is an agreement among the owners designed to establish a predetermined and agreed-upon business value (or method of arriving at the value) at the occurrence of certain trigger events.
There are various types of buy-sell agreements, including stock redemption (equity purchase), cross purchase (surviving owners purchase), use of a partnership to hold insurance on the lives of multiple shareholders, and a hybrid or wait-and-see combination to give shareholders the right of first refusal. Each type has differing tax consequences, so it is important to thoughtfully consider the choice you are making to determine which will be right for you.
One of the most important features of the buy-sell agreement, of course, is its ability to set a value. A fixed price method is useful, but must be updated annually and should be supported by an appraisal to avoid disputes. A formula method can include book value, modified book value, capitalization of earnings, and discounted future cash flows. Under the appraisal method, a single appraiser can be used, or the buyer and seller can each have an appraiser with any disputes resolved by a third appraiser. A recommended hybrid would be to use a fixed price that defaults to an appraisal if it is not updated.
The 2011 case of Estate of Cohen v. Booth Computers provides an excellent example of the problems that can arise if the valuation question is not properly considered. In Estate of Cohen, the partnership agreement provided for the mandatory buy-out upon the death of a partner. One of the partners, Claudia Cohen, died in 2007. The company was valued at approximately $45,000,000.00 at the time of Claudia’s death. If the value of her interest had been defined by fair market value, her interest in the company would have been equal to $11,526,162.00. However, because of the way the valuation clause was written, Claudia’s heirs received only $178,000.00 – a loss of more than $11,000,000.00!
Under the Internal Revenue Code, the transfer tax value is determined without regard to any buy-sell agreements among family members unless: a) the buy-sell agreement is a bona fide business arrangement; b) it is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and c) its terms are comparable to similar arrangements entered into by persons in arm’s length transactions. This is a very difficult burden to overcome. As a practical matter, what is paid under almost all buy-sell agreements has no relationship to what the IRS determines to be the value transferred.
Funding the Buy-Sell Agreement
Failure to consider how an interest will be purchased can be devastating to both the company and the selling owner (or his/her family). Here are a few options to consider:
- Cash Fund – Keeping enough after-tax cash available to pay the purchase price. The problem is knowing in advance if you have enough time to build up the cash fund. We never know when the triggering event is going to happen. It is also difficult to tie-up that much cash at any time.
- Borrowing – Borrowing from a bank is pretty straight forward, but there is no real certainty as to whether a loan can be obtained at the time it is needed.
- Installment Payments – Installment payments can be a good alternative, but careful thought should be given to the term and interest rate. A longer term and lower interest rate is good for the business, but may be a hardship for the departing owner (or his/her family).
- Insurance – Insurance can present an excellent option to meet the needs of both the seller and the buyer. The downside, of course, is the immediate premium payout, but the ready source of funds is a big plus. Insurance is not available for all triggering events, but at a minimum it should be in place to fund in the event of a death or disability.
A Review Checklist
This brief review checklist will help assess potential deficiencies in a current buy-sell agreement and identify those areas that should be updated. If a buy-sell agreement doesn’t exist, this checklist can be used to ensure any new agreement includes important provisions. While it is not meant to be comprehensive or replace important advisors, the checklist should provide a jump start to the process.
|Does the agreement bind all owners and the business entity?|
|Have the spouses agreed to accept the terms of the agreement with regard to community property/marital interest?|
|Are there any provisions conditioning ownership or acquisition based on family relations or other factors?|
|Did you address non-competition, non-solicitation, and confidentiality?|
|Is there a provision for how the purchase price is determined (valuation)?|
|Is there a provision for how the purchase price will be paid?|
|Is your agreement adequately funded – i.e. how will a buy-out be paid?|
|Will the purchase be funded by life insurance?|
|Has life insurance been purchased?|
|Are appraiser qualifications specified?|
|Is the appraiser selection method specified?|
|Did you address the death of an owner?|
|Did you address the disability of an owner?|
|Did you address the divorce of an owner?|
|Did you address the bankruptcy of an owner?|
|Did you address the failure of an owner to perform expected duties?|
|Did you address the retirement or other voluntary withdrawal of an owner?|
|Did you address the right to sell to a third-party purchaser?|
|Did you specify the method of resolving disputes?|
|Did you address expulsion of an owner?|
|Did you address dissolution of the company?|
Often overlooked business continuity planning is a vital part of succession planning or exit planning process. Business continuity planning can provide peace of mind for the occurrence of those triggering events that can derail even the strongest business.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.