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If your business has multiple shareholders, read this article carefully. Chances are you have a buy-sell agreement in place. If you do not currently have a buy-sell agreement, I suggest you contact your corporate attorney immediately and get one drawn up.
In short, a buy-sell agreement is negotiated among a corporation’s shareholders to define in advance how the corporation and its surviving shareholders will address the shares owned by a deceased shareholder. Will the corporation redeem the shares of the deceased shareholder from his/her estate, and if so, under what terms? Will one or more of the other shareholders purchase the shares from his/her estate, and if so, under what terms?
As a mergers and acquisition advisor and business coach for 34 years, as president of CrossPointe Private Equity Advisors, I have witnessed the upset and chaos that results when a shareholder dies and there is no buy-sell agreement in place. Here are some of the challenges.
The remaining shareholders are now in an unplanned, unwilling partnership with the estate and/or the family of their deceased partner. Everyone is distraught, especially the family of the deceased. Family members may wish to get involved in the operation of the business. This usually does not sit well with the other shareholders and can be very disruptive. No methodology for valuing the shares has been established. Neither the corporation or the shareholders have the cash on hand to fund a redemption or purchase of the shares. The estate wants maximum value for the shares, and it wants the most cash possible. The remaining shareholders want a modest valuation, minimal cash outlay and favorable seller financing. The raw emotions of all involved make resolving these challenges extremely challenging. Relationships can be broken, and the controversy can be devastating to business operations. Too often, everything ends up in litigation and everyone loses — except the lawyers.
The solution, for as long as I can remember is for the buy-sell agreement to establish a valuation methodology to be followed in the event of a shareholder death, as well as establishing how the share redemption or purchase will be funded. One very common approach for funding the purchase price has historically been for the corporation to purchase a life insurance policy on each shareholder with the intent that if one died, the life insurance proceeds would fund the purchase of their shares in cash. The goal was that the corporation would pay the premiums, the insurance proceeds would be estate tax-free, and the operating profits of the company would be unaffected.
Although, as you might guess, the IRS has wanted to tax the decedent’s estate in the amount of the insurance proceeds, this life insurance approach to funding buy-sell agreements has been upheld judicially until now. For example, in the 2005 case of Estate of Blount v. Commissioner, a federal appeals court held that such a payout was excluded from a corporation’s value because it was offset by a liability — the obligation to repurchase the owner’s shares.
In a recent case, Connelly v. United States, the Connelly’s corporation, which had a market value of $3.86 million (excluding the insurance value) was deemed by the IRS to be worth $6.8 million when the founder died, and the $3 million policy payout occurred. This resulted in an unexpected additional $900,000 in estate taxes, based on the estate’s 77% ownership of the corporation. The case went to the Supreme Court.
Now, in a little-noticed decision, issued in June, the Supreme Court unanimously agreed with the IRS in Blount and reasoned that the requirement to repurchase a decedent’s shares wasn’t offset to the insurance payment because it wasn’t a liability like a debt. Instead, the exchange of shares for dollars provided something of value to the firm.
So, if your buy-sell agreement is funded by life insurance, it’s time to immediately revisit and validate or revise your strategy. Stu Malakoff, President of Bend Wealth Advisors, offers this guidance:
A cornerstone of a good financial plan is that it be reviewed and — if warranted — changed whenever life circumstances, financial objectives and regulations such as tax law have materially changed. Connelly v. United States is a ruling that has caused us to reach out to potentially impacted clients — those with i) closely held businesses, ii) family-owned businesses, or iii) other small business owners — and especially those businesses with life insurance policies in place to provide liquidity or to facilitate redemption agreements at the death of an owner.
Along with their advisor team (especially in tax and estate planning), we are helping our clients evaluate the right structure for any buy-sell arrangements and are encouraging them to determine fair market value of the business. Cross-purchase arrangements could be adopted instead of redemption agreements because, even though they can pose increased cost and complexity to owners, such agreements can help save even more money by avoiding additional estate tax…as much as a 40% tax at the federal level. A cross-purchase agreement would prevent the life insurance’s value from being added to the corporation’s valuation. In turn, the lower valuation lessens the likelihood that estate tax would apply at the death of a given owner. Alternatives to a cross-purchase agreement include a cross-endorsed Insurance LLC, as well as trust-owned life insurance.
The timing of the Supreme Court ruling coincides with another significant change to estate planning: the reduction of the estate tax exemption to $5.6mm per individual (adjusted for inflation from 2017) scheduled for the end of 2025. Therefore, revisiting your estate plan — which requires having a solid handle on the value of your taxable estate — is especially timely. I’ve seen these types of sweeping changes several times during my 22-year career as a financial advisor and life insurance producer; it seems that change is the one constant in federal tax law. Revisiting your estate plan from time to time has also become a constant.
You could find that estate taxes may not be a concern even with the sunset of current estate tax exemption levels, in which case — an entity-redemption plan may still be the right approach if you own a closely held business. But you need a current, accurate fair market valuation to make that determination. Leverage your advisor team to optimize the financial outcome for you, your business, and the important people and causes in your life.
Closing thoughts: Corporations with multiple shareholders should seriously consider having a buy-sell agreement. The company should be valued when the agreement is put in place and the methodology for future valuation should be established in writing in the agreement. Shareholder exit strategies should be established, not only to address untimely death but also to provide a planned exit path for shareholders during life. CrossPointe can help with these issues.
Bend Wealth Advisors, your CPA, and your estate and tax planning attorneys can help you design a redemption or repurchase plan to fund your buy-sell agreement in a manner that’s appropriate to your situation. Take the SCOTUS decision as a wake-up call. Meet with your professional advisors and act now to avoid the potential of chaos, business disruption, and a painful tax bill in the event of the death of a shareholder.
Michael Sipe is President of CrossPointe, Inc., a local mergers and acquisitions firm.
Stu Malakoff, CFP, CDFA, CPFA, CRPC is President of Bend Wealth Advisors, a financial planning and investment management practice.
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Any opinions are those of the author and not necessarily those Raymond James Financial Services, Inc., or of Raymond James. The information contained in this presentation does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
