Advanced Underwriting Consultants

Question of the Day – October 11

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Here’s the question of the day.

Question:  What’s the biggest mistake you typically see in a client’s business buy-sell agreement?

Answer:  The biggest mistake that business owners can make is to not have a written buy-sell agreement!

If the owners of a business do have a written buy-sell agreement, one of our pet peeves is when the valuation provisions don’t yield a predictable business buyout price.  For example, we often see valuation clauses that look like this:

The fair market value of a deceased owner’s interest shall be the percentage of the owner’s ownership interest in the Company multiplied by the fair market value of the Company, which will be determined as follows:  within 15 days after receiving notice of the death of a Member, each of the Company and the legal representative of the deceased Member will select an accountant, business appraiser, or investment banker (each an Initial Appraiser) to determine the fair market value of the Company.  The two Initial Appraisers will determine the fair market value of the Company as of the last day of the month immediately preceding the month in which the deceased Member dies and will make such determination within 30 days after the expiration of such 15-day period (such 30-day period is hereinafter referred to as the Initial Appraisal Period).  If the two Appraisers cannot agree on the fair market value of the Company within the Initial Appraisal Period, then the two Initial Appraisers shall select an accountant, business appraiser, or investment banker (the Third Appraiser) within 15 days after the expiration of the Initial Appraisal Period. A majority of the Initial Appraisers and the Third Appraiser will determine the fair market value of the Company within 30 days following the appointment of the Third Appraiser and shall notify the Company, the surviving Member, and the estate of the deceased Member of the fair market value of the Company. 

While such a valuation method can work, it feels unnecessarily cumbersome and unpredictable for most businesses and their owners.  We usually recommend that the owners use a formula, based on easily ascertainable business metrics, to value the business for buy-sell purposes.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – August 17

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question:  I have a business owner client who is in the process of entering into a buy-sell agreement with his business partner.  Should they include divorce as one of the triggering events in the agreement?

Answer:  They should certainly consider divorce as a triggering event.

The divorce or legal separation of a business owner can create financial heartaches for the divorcing owner, and can put incredible emotional, organizational and financial stress on the business.  Usually divorcing spouses—or those who otherwise separate from committed long-term relationships—make financial claims on one another.  For those whose valuable assets include an interest in a closely held business, the parties may argue about

  • the value of the business interest,
  • how to divide the business asset between the parties, and
  • how to preserve the value of each parties’ interests and the overall business.

Those business owners who are working with co-owners should consider having a buy-sell agreement that has language dealing with the possibility of the divorce of one of the owners.  In the absence of an agreement, a divorce fight can tie up not only the business owner going through the divorce, it can also handcuff the non-divorcing owner or owners.

The parties need to consider how to define “divorce” if they include it as a trigger in a buy-sell agreement.  For example, is the filing of a divorce action a trigger for the buyout?  What about if one of the owners becomes legally separated from a spouse?  Should an owner in a long-term non-spousal relationship be included in the scope of the trigger?

Often business owners opt to include some type of buyout or contingency plan in the buy-sell agreement in the event of the divorce of an owner.  Making divorce—or separation—a buyout trigger can make it easier on the non-divorcing owners of the business.  It may not be so good for the divorcing owner, who may prefer to remain in the ownership instead of being forced out.

The potential for hard feelings when a divorce is occurring is one important reason the parties should evaluate whether a divorce trigger is warranted when the business (and the relationship) is running smoothly.

Insurance that pays off in the event of divorce is not available.  Therefore, the parties to a buy-sell agreement with a divorce trigger must plan to provide funds for purchase in the event of divorce.  Usually the parties choose to fund a buyout from the business’s cash flow through some type of installment (with interest) arrangement.   The parties may also decide that the buyout price triggered by divorce should be different—usually lower—than the one triggered by death.

To make sure a divorce trigger in a buy-sell agreement is effective, the best practice is for the owners of the company to have their spouses consent to the agreement—before there is any trouble in paradise.  The courts won’t always enforce an agreement for a divorce buyout if the non-owner spouse hasn’t signed on to the arrangement in advance.

In Barton v. Barton, 639 SE 2d 481 (Ga. 2007), for example, the husband owned half the stock in a closely held corporation.  He entered into a buy-sell agreement with the other owner of the company.  The buy-sell agreement provided that in the event of divorce of either owner, the non-divorcing shareholder would have the right to purchase the divorcing owner’s stock.

The wife did not consent to the agreement.

In its Barton decision, the Georgia Supreme Court ruled that the agreement did not bind the wife to the valuation in the buy-sell agreement.  The court reasoned that because the wife did not consent to the buy-sell agreement, she could not be bound by the valuation in it.  Thus, the original divorce court’s decision to use an arbitrator’s 50% higher value in dividing the marital assets was upheld.

The Barton decision reminds us that where possible, the spouses of parties to a buy-sell agreement should formally consent to the agreement’s terms.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day. 

Question of the Day – August 8

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Here’s the question of the day.

Question: Does a business owner’s spouse need to sign the business buy-sell agreement?

Answer: Given a choice, most attorneys would have the owners’ spouses consent to a buy-sell agreement for the business.

Each state has its own rules about whether a spousal consent is required to enforce a buy-sell agreement against that spouse.  Here’s an example of the Texas case of Mandell v. Mandell, 2010 WL 1006406, (2d Dist. TX 2010).

Susan and Lance Mandell, both doctors, were married in 1989.  While married, Lance became an employee and minority owner of a medical practice (the “practice”) organized as a corporation.  Lance held 22,000 shares.

Lance entered into a shareholders agreement with the practice that included buy-sell provisions.  The terms of the agreement dictated how shares could be transferred voluntarily in the event of withdrawal or retirement.  The agreement also included language requiring an involuntary transfer of shares in the event of the divorce of an owner.

The agreement provided that if a shareholder divorced from his spouse, the divorcing shareholder had the obligation to buy out his ex-spouse’s interest in the practice at 50 cents a share.  If the divorcing shareholder failed to perform the buyout, the right and obligation to purchase the shares would shift to the practice.

The 50 cent a share valuation was consistent for all the triggering events described in the buy-sell agreement.

Susan sued the practice and her ex-husband, arguing that the $11,000 value for Lance’s interest in the practice was unfairly low.  Her main argument was that since she did not sign the shareholders agreement, she was not bound by its terms valuing the stock in the event of a divorce.  Susan and her valuation experts believed the fair value of Lance’s interest in the practice to be about $1 million.

The court held that the buy-sell valuation was binding on Susan, even though she did not sign the agreement.  In so finding, the court noted that the agreement and buyout price would also be binding on Lance; that Lance would never be entitled to sell his shares himself for anything other than 50 cents a share.

Since the shares were only worth $11,000 to Lance, the court reasoned that it would be unfair to assign them a higher value for Susan’s benefit.

The result in the Mandell case can be contrasted with Barton v. Barton, 639 SE 2d 481 (Ga. 2007).  In Barton, the husband owned half the stock in a closely held corporation.  He entered into a buy-sell agreement with the other owner of the company.  The buy-sell agreement provided that in the event of divorce of either owner, the non-divorcing shareholder would have the right to purchase the divorcing owner’s stock.

As was the case in Mandell, the wife did not consent to the agreement.

In its Barton decision, the Georgia Supreme Court ruled that the agreement did not bind the wife to the valuation in the buy-sell agreement.  The court reasoned that because the wife did not consent to the buy-sell agreement, she could not be bound by the valuation in it.  Thus, the original divorce court’s decision to use an arbitrator’s 50% higher value in dividing the marital assets was upheld.

The Barton decision reminds us that where possible, the spouses of parties to a buy-sell agreement should formally consent to the agreement’s terms.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – June 4

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The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My clients have sold their business.  What happens to their buy-sell agreement and its funding?

Answer: There’s no general abstract answer to that question.  The clients should consult with their business attorney to decide what to do about the buy-sell agreement and its funding.  If they fail to do so, they may run into the kind of problem from Parduhn v. Bennett, 2002 UT 93, 61 P.3d 982 (2002).

In 1979, Brad Buchi and Glade Parduhn formed the University Texaco Company partnership to operate a service station business.  After the business was formed, the parties entered into a cross purchase buy-sell agreement funded with life insurance.  Insurance in the amount of $250,000 was purchased on Buchi’s life, and $300,000 of coverage on Parduhn.

Buchi and Parduhn sold their service station business’s assets in July, 1997.  Buchi subsequently died in August, 1997.  Parduhn, as beneficiary, received the $300,000 death proceeds from the life insurance policy originally intended to fund the buy-sell agreement.

Buchi’s heirs sued to have Parduhn turn over the death benefit to them.  They argued that Parduhn was always intended as a conduit for transferring the death benefit to Buchi’s family.  In support of their argument, they maintained that the buy-sell agreement remained in effect after the business’s assets were sold.

The Supreme Court of Utah ruled that the buy-sell agreement was no longer in effect because the underlying partnership—because of the business transfer—had been effectively dissolved.

The dissenting judges observed that while the service station may have been sold, the partnership itself was never formally terminated.  In the absence of a termination, they argued, there was still a partnership interest that could be transferred by the buy-sell agreement.

Here are some lessons from Parduhn:

  • Add language about disposition of policies in the event a business is terminated, or the coverage is no longer needed for buy-sell funding.
  • Make clear in the buy-sell agreement what constitutes termination of a business, and what consequences it has for the buy-sell obligaton.
  • As a professional agent, seek to be included in situations where your business owner clients are selling their businesses.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.

Question of the Day – November 29

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: I have two clients who own an S corporation.  They want to change their buy-sell agreement from redemption to cross-purchase, and need to switch ownership and beneficiaries of their life policies at the same time.  What tax issues do they need to be concerned about?

Answer: Since the transfer of the policies is related to business, the transaction will be treated as a sale and purchase.  There are three potential tax issues:

  • The transfer will be treated as a surrender of the policies by the business for income tax purposes,
  • The transfer to the non-insured shareholder will be treated as compensation or a dividend for tax purposes, and
  • The transaction may violate the transfer for value rules.

The business will be treated as surrendering the life policy at the time it makes the transfer.  Any cash value in excess of the company’s basis will be taxed as gain.

When the company transfers the policy to the owner, the policy’s value is either taxable compensation (if the owner is an employee) or taxed as an owner’s distribution.  If the business is a corporation, an owner’s distribution is generally a dividend.

The third issue—the transfer for value problem—is the biggest potential downside for the transaction.

Internal Revenue Code Section 101 (a) (1) says that life insurance death proceeds are usually income tax free.  Code Section 101 (a) (2) creates the so-called transfer for value rule.  The rule says the death benefit of a life policy will be income taxable to the extent it exceeds basis if the contract is transferred for valuable consideration—for example, money or loan forgiveness.

The transfer for value rule itself has exceptions.  If the transfer of a life policy is made to one of the following, the transfer for value rule does not apply.

  • The insured
  • A partner of the insured
  • A partnership including the insured
  • A corporation of which the insured is an officer or shareholder

The problem of the transfer for value rule comes up often in the context of buy-sell planning.  For example, say that Dusty and Lucky are the owners of Western Enterprises, Inc., a C corporation.  Say also that they have a buy-sell agreement in place structured as a redemption arrangement.  To fund the death-time buyout of the deceased owner’s shares, the company owns and is beneficiary of insurance on the lives of Dusty and Lucky.

After talking to their tax advisors, Dusty and Lucky decide to change their buy-sell arrangement from redemption to cross-purchase.  They also decide to transfer each of the existing corporate-owned insurance policies to the non-insured shareholder.

A transfer to a co-shareholder of the insured is not an exception to the transfer for value rule.  That change in policy ownership would cause the death benefit of the policy to be income taxable.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.