Stockholders Agreements and Tax Planning
A stockholders agreement is generally recommended whenever a closely-held corporation has more than one stockholder. Typically, a stockholders agreement will restrict transfers of stock, protect an S election and preclude competition and disclosures of information. In addition, control issues are often addressed via unanimous or super-majority voting requirements for certain actions (such as issuing new stock, selling assets, paying bonuses, etc.).
The stockholders agreement almost invariably includes a requirement for the surviving stockholder(s) or the corporation to purchase the stock held by the decedent’s estate. The price is established by a formula. If the obligation is funded with life insurance, the formula usually is a function of the face value of the policy.
More comprehensive stockholder agreements include a "Trigger Offer" or “Push-Pull” procedure to enable a stockholder to “force a divorce.” Under this procedure any stockholder may make an offer at any time to buy the stock of another stockholder who then has, say, 30 days to either:
- Accept the offer and sell his or her stock at the offered price; or
- Match the price per share and buy the stock of the offeror(s).
Reorganizations, estate planning and asset protection issues are beyond the scope of this article. Rather, the focus here is on income tax planning.
Income Tax Planning
Almost all stockholders agreements call for a sale of stock at some point. If the purchase is by the corporation, the agreement is said to use a redemption model. If the purchase is by the other stockholder(s), it is called a cross-purchase model. Although more complex, the cross-purchase model is often considered advantageous from a tax perspective, because the purchaser(s) get basis in the purchased stock.
Many tax practitioners don’t like the tax effects of a stock purchase. So they recommend that the purchase price be set artificially low and that each selling stockholder receive one or more termination bonuses under his or her employment agreement. This arrangement is common with service businesses, particularly physicians. While this generally increases each seller’s income and employment tax liabilities, the remaining stockholder(s) benefit from the pass-through of compensation deductions. The net effect is considered more tax efficient than paying a high after-tax stock price.
Asset Purchase or Stock Purchase
There are two principal ways to buy a business: a stock purchase or an asset purchase. The stock purchase is usually favored by the seller, while the buyer usually prefers an asset purchase to avoid hidden liabilities and to secure tax benefits. If consideration includes a promissory note, the deal is referred to as a leveraged buy-out (LBO).
Capital Gain
Sellers of business assets generally report capital gain, with exceptions for:
- Recapture of depreciation
- Appreciated inventory
- Accounts receivable of cash-method taxpayers
Recapture can sometimes be avoided via leasing, but tax burdens are often negotiated. From the IRS's perspective, selling appreciated inventory or receivables is a wash because the acceleration of income is matched by income reductions for the buyer(s).
The Seller’s Economics
In essence, selling goodwill converts the seller’s expected future income stream from ordinary income into capital gain.
The Buyer’s Tax Benefits
In an asset purchase, the buyer receives full depreciation and amortization deductions. Goodwill is usually amortized over 15 years.
The Asset Purchase Stockholders Agreement
The heart of an Asset Purchase Stockholders Agreement is that buying stockholders (via another corporation) purchase corporate assets at a stepped-up price that yields the same after-tax proceeds to the selling stockholder(s) as a redemption or cross-purchase model — but with significantly greater tax benefits for the buyer.
Example 1
A and B are unrelated 50% stockholders. The corporation's only asset is goodwill. A dies and his estate is entitled to $1.5m under the agreement. B purchases the goodwill for $3m. On dissolution, A’s estate and B each receive $1.5m, reported as capital gain. A’s estate receives a basis step-up (IRC 1014), eliminating gain. B receives a $200,000 annual deduction for 15 years from goodwill amortization. (IRC 197).
The LBO Stockholders Agreement
A real-world issue is that the buyer may lack cash. Installment sales may be necessary. Complexities include:
- Potential Subchapter S “one class of stock” violations if consideration differs between stockholders
- Installment note planning to avoid acceleration of income
- Insurance proceeds funding installment notes
Three Stockholders
With three owners, related party rules complicate tax treatment. Solutions include:
- Solution #1: Adjust equity split (e.g., 5/6 and 1/6) with compensation agreements for balance.
- Solution #2: Use trusts or third parties to avoid related party restrictions.
Unwinding
LBO purchase money notes reduce equity in Newco, but tax consequences are locked in at the time of sale, even if later ownership changes occur.
Conclusion
Every tax practitioner who drafts stockholders agreements should consider the Asset Purchase Stockholders Agreement. It offers flexibility, equivalent outcomes for sellers, and substantial tax benefits for buyers. Existing agreements may merit amendment and additional life insurance coverage to take advantage of these opportunities.
