A buy-sell agreement is a legal contract common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement. When carefully drafted, your buy-sell agreement may be used to set the taxable value of your business interest.
The IRS tends to scrutinize transactions between related parties, so almost any business transaction between you and a family member could be subject to the attention of the IRS. There are rules in effect that can make the sale of an interest in a family business seem more difficult. However, you can take steps to ensure that your related party buy-sell agreement stands up to an IRS examination.
When setting the valuation method to be used under the buy-sell agreement, make sure that the transaction will represent fair market value (FMV). There are serious tax consequences that may result from using a price that the IRS determines to be higher or lower than FMV. To ensure that the IRS accepts your sale price, your buy-sell agreement must meet three requirements: 1) It must reflect a bona fide business arrangement; 2) It must not be a device to transfer your interest to family members for less than full and adequate consideration; 3) Its terms must compare with those of agreements between parties in an arms-length transaction. A professional appraisal should be conducted to establish the FMV of your business interest.
If your buy-sell agreement is between you and the business entity itself (entity purchase buy-sell agreement), if shareholders are related to each other, and if your business is a corporation, the attribution rules of Section 318 must be considered and can affect the tax treatment of a shareholder’s stock redemption.
Depending upon the circumstances and the way the buy-sell is structured, the proceeds the seller receives from the redemption of the business interest may be classified as a sale or exchange of the seller’s interest or as a dividend distribution. There remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution, despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. In the case of dividend treatment, the entire amount paid to the shareholder is subject to tax. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. In a family corporation, the sale of stock to the business under a stock redemption plan usually results in dividend treatment to the redeeming shareholder.
Buy-sell agreements let you arrange the terms for a current sale – or for a sale at some point in the future. You can lay all the groundwork in advance when there is no pressure to sell.
Craig Rumbaugh is an ING Financial Partners investment advisor representative and can be reached at 760.341.5010.
The above information is for informational purposes only and is not affiliated with nor controlled by ING Financial Partners. The opinions/views expressed within do not necessarily reflect those of ING Financial Partners or its representatives. In addition, ING Financial Partners is not responsible for the accuracy of the information provided which was edited for length by Desert Health®. The full article is available upon request to 760.341.5010.
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