Buy-sell agreements: how to do them correctly

Do you have a buy-sell agreement or are you thinking of signing one? Most buy-sell agreements (B/S/A) happen like this: You meet with a lawyer and have a short discussion (or probably a long discussion about how to price the stock); the lawyer drafts the B/S/A; the parties (shareholders/partners) sign it; and it goes into the safe or a drawer. This is a big mistake! However, you never want to be a

Do you have a buy-sell agreement or are you thinking of signing one?

Most buy-sell agreements (B/S/A) happen like this: You meet with a lawyer and have a short discussion (or probably a long discussion about how to price the stock); the lawyer drafts the B/S/A; the parties (shareholders/partners) sign it; and it goes into the safe or a drawer. This is a big mistake!

However, you never want to be a member of “the No-B/S/A Club.”

For simplicity, let's assume the rest of this column is talking about a B/S/A for a corporation (this applies equally to an S corporation or a C corporation). The identical principles also apply to a partnership or limited liability company.

The easiest way to learn what to do and what not to do with your B/S/A is with the following real-life example. Joe (a reader of this column) and his brother Sam each own 50% of Success Co., an S corporation. Joe (age 51) has two sons who are both finishing grad school and will never go into the business. Sam (age 45) has three young kids (10 or younger), and it is too early to tell if any will go into the business.

Now, here is a bit more about Success Co. It is worth about $10 million and continues to grow in value as profits increase almost every year. The brothers built a little family business, which they bought from their dad, into a solid and growing moneymaker.

And, of course, they have a B/S/A. The price of stock rises as the company's value rises, as does the insurance funding (now at $5 million each on Joe and Sam). Both are prohibited from selling or transferring (in any way) all or any part of their stock … except to each other or to Success Co.

This typical B/S/A (which you will soon see is far from a winner) is way better than being a member of the No-B/S/A Club.

Unfortunately, a typical B/S/A enriches the IRS more than your family (remember the estate tax returns to a high of 55% in 2011). So let's follow the numbers if Joe dies. Because of the B/S/A, Joe's estate must sell his stock to Success Co. for $5 million (the amount of the insurance proceeds). A trust set up for Mary (Joe's wife) winds up with the $5 million. No estate tax is due now (because of the marital deduction). But when Mary dies, the IRS will get 55% of the $5 million (probably more because that $5 million — and other assets left to Mary — will throw off more income than Mary can spend). If you are single, you get nailed for the estate tax when you die. If you are married like Joe, the IRS's payday is deferred until your spouse dies.

What can you do to avoid this problem with a B/S/A? The following two ways will save you thousands or millions (depending on the value of your business).

First, take advantage of the legal discounts available when valuing any business for tax purposes. The law, regulations and accepted practice (by the IRS) allow you two specific discounts: a discount for general lack of marketability (35% is the most common number) and a discount for minority interest (10%). Remember, because Joe and Sam each own only 50% of Success Co., they automatically are entitled to a minority discount.

Success Co. is worth $10 million ($5 million each for Joe and Sam). Typically, the two discounts total 40% (or $2 million). So, using the discounts allowed by the tax law makes Joe's interest in Success Co. worth only $3 million, the fair market value (FMV) after discounts for tax purposes. The B/S/A should be worded so that Joe (and Sam) gets the higher of the FMV or the amount of insurance on his life. Now, Mary will only get $3 million from the insurance-funded B/S/A.

What about the other $2 million? Success Co. simply makes tax-free S corporation dividend distributions to Sam and Joe, which are used to buy another $2 million each in insurance coverage. Joe's policy is owned by an irrevocable life insurance trust (ILIT), so Joe's $2 million in insurance proceeds goes — tax-free — to his ILIT for Mary's benefit. Sam's policy is set up the same way. The result is an estate tax savings of $1.1 million ($2 million times 55%) for Joe (and Sam).

Second, reduce the amount of stock Joe and Sam own by gifting nonvoting stock (say 10,000 shares each) to their kids. Joe and Sam keep control of Success Co. by retaining the voting stock (say 100 shares each). An intentionally defective trust (IDT) is used to accomplish this tax trick. If Joe or Sam needs the funds represented by the value of stock to maintain their lifestyle, the stock is sold to the IDT instead of via a gift. The sale to the IDT is tax-free to Joe and his kids, saving $816,000 in income and capital gains taxes per each $1 million in FMV of the family business stock. Either way — gift or sale — the IDT makes the transfer tax-free.

An IDT is a surefire way to enrich your family, instead of the IRS. If you intend to transfer all or part of your family business to your kids, don't implement the transfer until you find out how an IDT might work for you, your business and your family.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at www.estatetaxsecrets.com.

MSCA adds 2 STAR contractors

ROCKVILLE, MD. — The Mechanical Service Contractors of America has announced that GHS Mechanical Inc., Elk Grove, Ill., and Ruthrauff Service LLC, Pittsburgh, recently achieved MSCA STAR status, bringing the total number of STAR contractors nationally to 89. MSCA STAR is a qualification program that recognizes contractors who exceed operating and training standards set by MSCA.

STAR contractors complete an application covering a range of criteria, including maintaining a superior safety record, offering outstanding customer service and remaining focused on continuing education and training for all of their employees. At least 25% of the contractor's technicians must be UA STAR certified to ensure they employ a qualified workforce.

TAGS: Taxes