What happens to your company if you or your business partner unexpectedly dies, becomes incapacitated, or goes through a divorce? At death, shares of a business form part of an estate and may be left to one's spouse, children, or other heirs through the owner's last will and testament. With divorce, shares form marital property that could be divided such that an ex-spouse might become a shareholder.
Other types of disruptions such as medical incapacity or financial circumstances may force a shareholder to transfer shares to third parties. In addition, general disagreements between business partners may cause one or more of the owners to separate from the business and transfer or sell their ownership interests.
All of these circumstances could result in an “outsider” being a legal shareholder of the business and having the rights that go with ownership. That will not likely be comfortable or workable for existing shareholders.
On the other side of the coin, as the shareholders work hard to build a successful family business, their family's financial well-being is tied up in the fortunes of the business. Sooner or later they will want to retire and benefit from their years of hard work and effort invested in the business. So, it is in the best interest of the shareholders to make provisions to look after each other and their dependents. But, what tool is there to help solve these diverse and conflicting goals?
The answer is a shareholder agreement. Typically, the shareholders should agree in writing that in certain circumstances, such as death of a shareholder, the corporation will buy back the deceased's shares. Rather than have the business keep cash on hand “just in case,” it is common to have the business own life insurance on the shareholders. Upon the death of a shareholder, the business collects the proceeds and uses the funds to buy the shares from the estate.
For corporations established as C corporations, it is often more advantageous from a tax standpoint to have the agreement set up as a “cross-purchase” agreement whereby each shareholder agrees to purchase the shares of the other shareholders. In a cross-purchase agreement, each shareholder would own life insurance on the lives of the other shareholders.
For situations like divorce or disagreement, a shareholder agreement could provide that if a shareholder wishes to sell shares, they must first offer to sell their shares to the other shareholders. In other words, the existing shareholders have the first option to acquire shares that a shareholder wishes to sell. This is typically referred to as a “right of first refusal” provision in a buy-sell agreement.
The price at which shares will be bought and sold is always difficult in non-publicly traded businesses. Buy-sell agreements typically contain provisions that specify the price at which the business interest will be sold for and may include a formula, a stated price per share, or state that the price will be determined by certified valuation appraisers when a triggering event occurs.
The taxing authority will likely have an interest in the price the shares are sold for to ensure that capital gain is not under-reported by unusually low pricing. The IRS will also take a close look at valuation methods when a business is being passed between family members (i.e. parent selling business to children). It is highly recommended to have regular business valuations done in order to establish a price for a buy-sell agreement and for regular gifting of shares.
If you would like more information about shareholder agreements or information on the “Shotgun Clause” contact me.
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