Shareholder Agreements (Buy-Sell Agreements)
INTRODUCTION
A shareholder agreement is a written contract among the shareholders of a corporation. While a shareholder agreement can be used to address a number of different potential issues, the most common use of the shareholder agreement is to provide restrictions on the sale of a shareholder's ownership interest to third parties and to provide for the transfer of the ownership interest upon the death of a shareholder.
General Objectives of a Shareholder Agreement
Provide protection from being locked into a business, by creating a market for the business.
Prohibit a shareholder from selling an ownership interest without the consent of the other shareholders.
Insure continuation of the business by providing a means for orderly transfer of an ownership interest.
Establish a price for the ownership interest, or a method of determining the price.
Provide a method of funding the purchase upon the death of a shareholder.
Provide a means of transferring funds to the heirs of a deceased shareholder, without adverse tax consequences.
If the corporation is a Sub-chapter S corporation, protect the S corporation status by prohibiting a transfer that would disqualify the corporation from being a Sub-chapter S corporation.
Typical Types of Shareholder Agreements
The most common types of shareholder agreements are the redemption agreement and the cross purchase agreement. Each type of agreement has its advantages and disadvantages which must be taken into consideration in order to determine which approach works best in a given situation. With a redemption agreement (sometimes referred to as an entity purchase) it is the corporation itself that buys the deceased shareholder=s ownership interest. Typically, following the purchase of the ownership interest, the purchased shares are cancelled, with the effect being that the remaining owner(s)' percentage of the outstanding shares increases. For example, if there are three equal shareholders and the deceased shareholder's shares are redeemed and then cancelled, the surviving two shareholders' ownership interests will increase from 1/3 to 1/ 2. With a cross purchase agreement, the surviving shareholders buy the ownership interest of the deceased shareholder. As a result, the number of shares owned by the surviving shareholders actually increases, since they are buying additional shares.
Advantages and Disadvantages of a Stock Redemption Agreement
ADVANTAGES
Each shareholder's interest in the corporation is automatically increased in proportion to their prior interest.
Assuming life insurance will be used to fund the purchase from the heirs of a deceased shareholder, only one life insurance policy is necessary for each shareholder.
The transfer for value problem in avoided since there is no deemed transfer of the insurance policies.
The corporation owns the life insurance policies and pays the premiums, avoiding the necessity of all of the shareholders having to make the payments.
There is an equalization of the insurance premium cost (for instance the younger shareholders are not required to directly pay higher premiums for the older stockholders).
DISADVANTAGES
The surviving shareholders do not receive a step-up in basis in their shares, since the corporation is the buyer. (This can be a very significant disadvantage.)
Life insurance policy cash values and proceeds are corporate assets, and therefore are subject to the claims of creditors.
The corporation may be required to obtain the consent of a lender in order to redeem the shares of a shareholder.
The Florida statutes may limit the ability of the corporation to redeem its stock.
There are additional tax issues that must be considered, such as possible reclassification as dividends and possible alternative minimum tax exposure.
Advantages and Disadvantages of a Cross Purchase Agreement
ADVANTAGES
Florida law restrictions on redemptions do not apply.
The cash value and insurance proceeds are not subject to the claims of the entity creditors, (although they could be subject the owner's creditors).
The surviving shareholders who buy the interest of the deceased shareholder would receive an increase in his basis for the stock acquired.
The transaction cannot be reclassified as a dividend.
The alternative minimum tax does not apply.
DISADVANTAGES
If there are more than two or three shareholders, the number of insurance policies required can become very cumbersome, as each shareholder would purchase and own a policy on the life of each other shareholder.
The cash value increase and insurance proceeds are subject to the claims of the shareholder's creditors.
Transferring the life insurance policies could cause a portion of the proceeds to be taxable to the beneficiary.
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