A BUY-SELL AGREEMENT INSTEAD OF DEFERRED COMPENSATION?
Tax legislation passed in the mid-1990s limited annual contributions to qualified retirement plans, restricting the ability of business owners, professionals, and key highly compensated employees (HCEs) to save for retirement on a tax-favored basis.
To help assure adequate retirement income, there are a number of nonqualified alternatives, including the traditional deferred compensation plan in which the company “promises” to pay a benefit at some point in the future.
While deferred compensation plans can be used effectively for key employees and the owners of many closely-held businesses, they may be of more limited value to owners of one type of closely-held business: the professional corporation (PC). While a professional corporation can be either a regular C corporation or an S corporation, it is unique in that the stock in a PC can only be owned by practitioners of the same profession (e.g., a group of lawyers, doctors, dentists, or engineers). Consequently, while a nonqualified deferred compensation plan might satisfy the retirement income problem, it would not address the issue of what to do about the withdrawing shareholder’s stock.
THE BUY-SELL AGREEMENT TO THE RESCUE?
A properly structured buy-sell agreement could solve both the retirement income and restricted ownership problems. In its simplest form, a buy-sell agreement is an arrangement between two or more parties, whereupon a triggering event (e.g., early death or retirement), one party has an obligation to buy and the other has an obligation to sell. Such an agreement could be structured as either a stock redemption or a cross-purchase agreement.
A stock redemption agreement is also known as an entity purchase agreement because an entity (the corporation) is the purchaser rather than the other shareholders individually. Redemption agreements are usually inappropriate where family attribution problems exist, but the very nature of a PC (ownership limited to members of the same licensed profession) eliminates the issue of family attribution.
Briefly, under “attribution-of-ownership” rules, a shareholder could be considered to own shares that are also owned by a spouse, children, parents, and grandchildren. The transaction could be subject to double taxation unless all of the shareholder’s stock is redeemed, thus terminating the shareholder’s interest in the corporation. This potential problem is avoided with a PC.
One disadvantage of a stock redemption plan is the lack of a “step-up” in basis for the remaining shareholders. The corporation would be buying the departing shareholder’s stock, but would not get a deduction for payments made to the deceased or retiring stockholder because it would be acquiring a capital asset.
The other alternative is a cross-purchase agreement, which is a buy-sell arrangement solely among shareholders. Upon the occurrence of some previously defined event, one shareholder (or the estate in the case of death) must sell, and the remaining shareholders, rather than the corporation, must buy, the stock. While a cross-purchase plan does provide for a “step-up” in basis for the remaining shareholders, its main disadvantage is that the purchase is accomplished with personal dollars.
FUNDING THE AGREEMENT
One of the most common funding vehicles is the use of life insurance. It helps ensure adequate liquidity will be available when a qualifying event brings about the sale of an ownership interest, thus avoiding a potentially adverse impact on working capital.
If a cross-purchase agreement is used, each shareholder owns an insurance policy on the life of every other shareholder. If the agreement is structured as a redemption (entity purchase), the corporation usually carries a policy on the life of each owner. The party obligated to buy the business interest should be both owner and beneficiary of the policy.
If the early death of one owner is the triggering event, the death benefit proceeds would fund the buy-out; if retirement by one of the owners is the triggering event, the policy cash values would fund the buy-out, providing retirement income to the withdrawing shareholder.
Buy-sell agreements have a broad range of business applications, and are integral to many business succession plans. With respect to professional corporations, a properly structured stock redemption or cross-purchase agreement can address both retirement income needs and problems of restricted ownership. For a PC, such a dual purpose strategy may be more advantageous than a traditional deferred compensation plan.