Academic journal article Journal of Accountancy

Redemptions versus Cross-Purchase Agreements

Academic journal article Journal of Accountancy

Redemptions versus Cross-Purchase Agreements

Article excerpt

The death of one of the owners of a closely held corporation can cause special problems for the owner's estate, especially those dealing with the value of the corporation's stock. One way to avoid many of these problems is through the use of a buy-sell agreement.

BUY-SELL AGREEMENTS

A buy-sell agreement is one that provides that remaining stockholders or the corporation itself will buy a stockholder's interest when he or she dies.

A principal advantage to using a buy-sell agreement is it fLxes the estate tax value of the decedent's stock interest. Without such an agreement, determining an acceptable value for stock not readily traded can be difficult (if not impossible).

In order to fLx the stock's value for estate tax purposes, the agreement's purchase price must have been reasonable when the agreement was made, the estate must be obligated to sell the decedent's interest and the interest must not have been sold during the decedent's lifetime without first being offered to the purchasers (the corporation or the other shareholders). In addition, the agreement must be a bona fide business arrangement; it must not be a device to transfer property to members of the decedent's family at a reduced value; and it must be comparable to similar arm's-length transactions.

REDEMPTION

If the decedent's stock is to be purchased by the issuing corporation, the agreement is a redemption. The major advantage of a redemption is its simplicity; only the corporation and the deceased stockholder are involved. This is especially true if there are numerous shareholders and if the agreement is funded by life insurance (as is often the case).

In addition, a corporation may be in a better financial position to pay the purchase price (or if funded with life insurance, the premium payments). Economically, a redemption agreement may be a better strategy if the purchase price (or premium payments) will not be taxable to the other shareholders as dividends.

Redemption agreements also may be disadvantageous. Some states have requirements that redemptions may be made only from specifically designated types of surplus or only if certain balance sheet ratios are maintained. (Funding the agreement through insurance usually alleviates this problem.) Some lenders have restrictions on the use of redemptions in loan agreements, to ensure the corporation's funds will go to paying its debt service. …

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