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Have a plan in case a shareholder dies

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The death of a shareholder in a closely held corporation can cause financial problems for the surviving shareholders and their business.

Among concerns may be whether the corporation or its shareholders have sufficient financial resources to redeem the deceased shareholder’s interest in the corporation. Other concerns may be whether the deceased shareholder’s family retains an interest in the corporation and whether the surviving owners can avoid interference with the deceased shareholder’s family. Proper planning is the key to avoiding problems such as these.

Preventing complications and financial distress on surviving shareholders requires a buy-sell agreement. Basically, a buy-sell agreement is an agreement that addresses how the surviving shareholders are to fund the purchase of the deceased shareholder’s corporate stock and provides for the transfer of the deceased’s economic interest in the business to the survivors. Generally there are two common forms of a buy-sell agreement. These two forms are a cross-purchase agreement and a stock redemption agreement.

A cross-purchase agreement requires each shareholder to purchase a life insurance policy on the other shareholders. Upon the death of a shareholder, the surviving shareholders receive the proceeds of the life insurance which provides the financial means to purchase the deceased’s stock.

The advantage to the cross-purchase agreement is that the value of the deceased’s stock generally receives a tax basis equal to the fair market value of his stock on the date of death. This is advantageous because the stepped up basis reduces income taxes if the survivors sell their stock in the future.

Another advantage is that life insurance proceeds received by the surviving shareholders are generally not subject to income tax. The cross-purchase form may also benefit the deceased shareholder’s estate because the absence of the agreement likely will subject the decedent’s estate to income and estate taxes on the sale of the shareholder’s stock.

A disadvantage to the cross-purchase agreement is that it may require the purchase of a large number of life insurance policies if there are numerous shareholders as each shareholder is required to purchase a policy on all other shareholders. Secondly, there can be a wide disparity in the cost of the premiums among shareholders depending on the age and health of each shareholder, which may make the cost to purchase life insurance policies among shareholders inequitable.

A second commonly used buy-sell agreement is a stock-redemption whereby the corporation owns a life insurance policy on each of the shareholders. Under this scheme the corporation purchases the stock of the deceased shareholder in lieu of the shareholders purchasing the stock.

This is advantageous in that the stock of the deceased owner can be retired, which benefits the surviving owners because each survivor will own the same number of shares of stock but his percentage of ownership increases as the total number of shares decreases by the redemption. Although the surviving shareholders will have greater equity in the business, he is not deemed to have received a dividend for tax purposes because the decedent’s shares are retired by the corporation upon purchase.

Another advantage is that the corporation bears the financial burden of purchasing the life insurance policy, and the disparity of premiums that may be associated with the age and health of each shareholder are not realized by the shareholders. Also, the premium associated with the life insurance policy is guaranteed to be paid.

Drawbacks to the stock-redemption structure include the loss of the benefit to the surviving owners of a stepped up basis for tax purposes regarding the value of their shares. The corporation will have purchased the deceased owner’s stock and retired it, leaving each surviving shareholder with his original basis in the corporation. Consequently, if an owner elects to transfer his shares prior to death, the transfer will likely be subject to greater capital gains. One must also be aware of unintended consequences such as the possibility that earnings and profits of the corporation may increase as a result of the proceeds received from the life insurance, and thus, affect the corporate accumulated earnings tax.

Setting the price for which the decedents’ stock will be purchased upon death is important. One way to value the stock is an agreed price per share. However, because the value of stock is determined at a set price, the value may need to be adjusted from time to time so as to avoid undervaluing or overvaluing the stock.

A second method for valuing the stock is to have it appraised at the time of death of the shareholder. The advantage of this method is that it is relatively easy to employ both in the agreement and in practice, so long as it agreed upon that the parties will mediate and or arbitrate any disagreement with respect to the appraisal. The disadvantage of an appraisal, however, is that the price of the stock may be greater than what the shareholders anticipated at the time of creating the buy-sell agreement making it difficult to purchase.

Another method for setting the price of a deceased shareholder’s stock is to value the stock based upon the earnings of the corporation for the past five years capitalized at a defined percentage of those earnings.

Whatever method chosen to structure a buy-sell agreement, the agreement should be designed to alleviate the financial uncertainties at the death of a shareholder. The agreement should be re-visited periodically to ensure that the method for the purchase and the value of stock is appropriate given the inevitable changing landscape of the economy and the economic circumstances of the business.

Aaron J. Harris is an attorney with the Wenatchee law firm Johnson, Gaukroger, Smith & Marchant, P.S.