Employment-Related Restrictions

Something that is frequently over looked in the review of buy-sell agreements is the effect of employment-related restrictions with respect to the body of law, regulations, and tax provisions concerned with employment status. Employment law and regulations are a state concern. That is one reason why it is important to identify a state jurisdiction when drafting a buy-sell agreement. From the federal tax aspect, § 83(a) of the Internal Revenue Code provides that an employee who receives substantially vested stock “in connection with the performance of services” must recognize as ordinary income the difference between the value of and the amount paid for the stock received.

In an effort to create shareholders, sometimes stock is transferred to employees under conditions or at a lesser price than might otherwise be charged. This can bring certain tax consequences that may not be anticipated. Chapter 15 of Business Succession Planning discusses the effect of § 83 and related regulations on buy-sell agreement arrangements.

Funding the Buy-Sell Arrangement

Funding is critical to the essential value received and the enforcement of the buy-sell agreement. Where funds are immediately available, such as with life insurance proceeds, the price can be paid immediately rather than over time. Where funding is available, it is much more likely the buy-sell agreement will be implemented.

There are a number of different methods to fund a buy-sell agreement, and Chapter 14 of Business Succession Planning reviews these methods. The method can be determined by the trigger causing the transfer. There can be differing tax implications for each funding method. Most importantly the funding cannot drive the value determination, it must the value that is then appropriately funded.

Value

At the heart of the buy-sell agreement is the value used for the transactions provided for by the agreement. Critical to the appropriate functioning of the buy-sell agreement is the understanding that the value and terms of sale will vary depending upon the trigger causing the sale.

Another common misunderstanding is that value will not be the same for one owner buying from another owner as it will be for an outside (non-owner) buyer. The outside buyer will pay for intangible knowledge not possessed by a non-owner. The inside (owner) buying an additional ownership interest should not have to pay for these intangibles. This is the difference between “fair value” and “fair market value.”

These concepts as well as the test for value involved with the funding of the purchase are contained in Chapter 13 of Business Succession Planning.