The Importance of Buy-Sell Agreements for Closely Held Corporations

By Abatemarco, Michael J.; Cavallaro, Alfred | The CPA Journal, February 1992 | Go to article overview

The Importance of Buy-Sell Agreements for Closely Held Corporations


Abatemarco, Michael J., Cavallaro, Alfred, The CPA Journal


The corporate form of business enterprise has many advantages including limited liability of shareholders, continuity of existence, ease of transferring ownership interests, and an expanded ability to raise capital. Two disadvantages of incorporating, possible double taxation and strong governmental regulation, can be alleviated with proper planning.

The death of a stockholder in a closely held corporation has an immediate impact on its operations, the remaining stockholders, and the decedent's heirs, if any.

PROBLEMS FOR THE CORPORATION

Upon death of a shareholder, the corporation may suddenly be without the talents and skills of a key individual possessing management skills that are irreplaceable. The stewardship of the entity may be in jeopardy and the confidence of the clientele may be seriously weakened.

CONCERNS OF THE REMAINING STOCKHOLDERS

The surviving stockholders confront several issues. They may decide to continue the corporate enterprise with the heirs of the deceased shareholder as part of management.

On the other hand, the surviving shareholders may want to purchase the stock of the deceased. The price for such an acquisition may be high and the funds to accomplish this unavailable.

The remaining stockholders may consider selling their own interest. This strategy may have limited practical use, since an established market for such a sale may not exist and the selling price may not provide the shareholders with what they consider a reasonable return on their investment.

If the remaining shareholders expect to continue the operations of the company, they may have to deal with new co-owners who purchase the decedent's interest. Once again, the personal attributes, management techniques, and ownership goals of the new purchasers may clash with those of the remaining shareholders.

GOALS OF THE HEIRS OF THE DECEASED STOCKHOLDER

The heirs of the deceased stockholder may wish to dispose of the stock in order to enhance the liquidity of the decedent's estate. However, they may be surprised to learn that neither the corporation nor the remaining shareholders have the financial capability of engaging in such an undertaking. In addition, finding outsiders interested in buying the stock may prove to be time-consuming and unrealistic. In this scenario, the heirs will have no choice other than to retain the stock and play an active role in the business, while finding an alternate source of funds to pay estate taxes and administration expenses.

HOW TO AVOID THESE MULTIPLE PROBLEMS

The proven mechanism for dealing with these issues is the buy-sell agreement. A carefully drafted agreement is a valuable tool that can ensure the financial security of the corporate owners and their families. At the same time, the buy-sell agreement allows the business to continue in a normal manner with a qualified and motivated management group at the helm.

The specific provisions of the buy-sell agreement must be tailored to satisfy the needs and objectives of the individuals and the corporation. The general goals, however, are to provide the cash so that the decedent's interest in the company may be purchased and the mechanism so that the business may continue to operate smoothly.

VALUATION CONSIDERATIONS

Of paramount importance in drafting a buy-sell agreement is providing for the value of each shareholder's interest in the business and determining what price is to be paid for such interest. To be useful for estate tax valuation purposes, the agreement should contain a mechanism, to establish the value of the business which will apply to all dispositions of a shareholder's ownership interest.

The buy-sell agreement may fix the value of the business by consent of the parties at a predetermined price, approximating fair market value, or by formula. If the parties agree upon a specific value, then the agreement must further provide that the parties will periodically reexamine the corporation's value and certify any changes in such value. …

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