Buy-sell agreements are among the most important yet most often overlooked business agreements. If you are a business owner or partner and are suddenly unable to work, what would happen to your business? If the business has an effective buy-sell agreement, then you should not have to worry.
What is an effective buy-sell agreement? It is an agreement that is clearly written and yields results that are fair to the buyer and the seller. In working with closely held business owners as an advisor, and in working with attorneys as a business valuation professional and expert witness, I have seen the best and the worst of buy-sell agreements, and the results that they bring.
A bad but all too frequently used buy-sell provision calls for the buyer and seller to each have a valuation of the business interest performed, and if the two valuations do not agree, a third appraiser is agreed upon and hired to perform a binding valuation. Are you surprised to know that the first two valuations never agree, and it is always necessary to have a third one done? And for this process, you have paid for three appraisals, when only one was necessary. Furthermore, if the process is at all contentious, agreement on the third business appraiser is also very difficult. I was involved in a three appraiser dispute, and the legal and professional fees paid were more than two times the amount paid for the retiring partner's interest. What is the solution to these problems? Change the agreement now to require only one appraisal, and specify in the agreement who (or what firm) will perform that appraisal.
Another buy-sell provision that will often produce disastrous results is one that values the business based on a formula, such as a multiple of something such as sales, net income, or book value. Although the formula may have made sense when it was written, business conditions change, and the formula result may no longer be fair.
We recently helped a client where one of the owners became ill and passed away within one year of diagnosis. Although I had tried to get the business owners to address buy-sell issues for a number of years, they refused to focus on it until the illness was diagnosed. In this case, the owners were fair minded and reached an agreement that was equitable to all the parties. But this is the exception rather than the rule. If you wait until a triggering event such as disability or death to start negotiating the buy-sell agreement, it is very difficult to reach an agreement.
A fair buy-sell agreement is one in which no one is overpaid and no one is underpaid, and the payment structure does not place an unfair burden on the business. Although buy-sell agreements are frequently funded with life insurance, what is the funding mechanism if the seller is disabled and does not pass away? Can the business afford to make the required payments without the benefit of life insurance proceeds?
Do yourself a favor. Get out your buy-sell agreement and read it. If the price specified by the agreement is formula based, ask your CPA to use the formula to calculate the price for the business? Keeping in mind that you don't know if you will be a buyer or a seller, are you happy with the result? Is the agreement structured in a way that will minimize income taxes for both parties? If the answer to either question is no, it is time for a new agreement.
As always, we welcome your comments and thoughts, requests for additional information, and suggestions for new topics.
January 26, 2012
January 17, 2012
Why the Millionaires' Tax is Unfair
Over the past few months, there has been talk in Congress about increasing federal income taxes on "millionaires." Many people, including members of Congress, are concerned that such an increase will be counterproductive because tax increases will take away the millionaires' incentive to work. In fact, I heard a Congressman make that statement in a recent radio interview. This reason could not be further from the truth.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
In 1987, tax laws were changed to encourage businesses operating in the corporate form to elect S corporation status. At that time, most closely held businesses that were not already S corporations elected S status. The main difference between a C corp and an S corp is that a C corp pays tax on its income, and an S corp does not. The S corp passes its income through to its shareholders, who include it on their personal income tax returns and pay personal income tax on the income, whether or not the income is distributed to them.
Why is this important? It is important because a person that has ownership in an S corporation, partnership, or limited liability company may report income high enough to throw them into the "millionaire" tax bracket, when they receive little or none of the income that they are required to report on their tax returns. The problem is compounded by other tax rules, which require many businesses to report taxable income on the accrual basis of accounting, that is, recognizing taxable income when the income is earned rather than when it is received. So now imagine this reality; the S corp shareholder is not only paying tax on income that he has not received, but is paying tax on income not even received by his corporation! And if any tax rate increase is enacted, it may very well be this phantom income that causes the shareholder to be subject to the millionaires' tax.
So if the S corp shareholders must pay tax on income that they have not received, where do they get the money to pay this tax? Sometimes it comes from the shareholders' personal funds, but most often it is distributed to the shareholders from the corporation. The theory is that if the business was a C corp, it would be required to pay its own income taxes, so it distributes an equivalent amount to reimburse the shareholders for the tax liability arising from reporting the S corp income. And if there is a tax increase, it is likely that this policy will continue, but the additional distribution will reduce the amount of money available to the business to create jobs, purchase equipment, and finance growth. This is the reason why business owners object to the proposed milionaires' tax. It is not because it takes away their incentive to work, but because it reduces their ability to reinvest in their business. The most troubling part of this whole story is that members of the United States Congress do not grasp this concept.
Can this problem be solved without upsetting our entire pass through entity tax structure? I think it can, and the solution is relatively simple. If any proposed millionaires' tax is enacted, the only pass through entity income that should be considered in calculating income subject to the tax should be the amount actually distributed by the S corp, partnership, or limited liability company. Furthermore, distributions used to pay federal or state income taxes on the pass through entity income should be excluded from the calculation and the increased tax rates. This will prevent business owners who report phantom income from being subject to increased taxes on income not received.
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