This guide will show you the requirements of buying and selling insurance policies and how to negotiate a buy-sell agreement. Buy-sell agreements are used to accomplish many important estate planning objectives, the four most important of which are:
- To create a market for a shareholder’s stock which in turn reduces or eliminates the liquidity problems created by the ownership of closely-held stock and helps the owner harvest the fruit of his or her labor.
- To help establish the value of the stock of a closely-held enterprise for both federal and state death tax purposes and between the parties and their heirs.
- To prevent the sale or other transfer of stock or other equity interests beyond the current owners and therefore maintain the closeness of the closely-held business. Remaining shareholders are assured that they are protected against inactive and potentially dissident shareholders who often cause conflict over management policies such as the size of dividends relative to salaries or risks the corporation should take for growth.
- To preserve the tax status of an S corporation or the professional status of a professional corporation.
However, this technique comes with several important requirements, outlined below.
Restraints on Transferability of Stock
Restraints on the transferability of stock must be placed in the charter of the corporation. Absent these provisions, a disposition of stock may be effective to transfer the shares even if that gift or sale violates the buy-sell agreement. Even though the parties may successfully sue the person who breaches the buy-sell contract, the damages received will probably be in the form of cash rather than a restoration of the status quo, certainly an inadequate remedy.
Furthermore, absent a legend (warning of the existence of the buy-sell agreement) on the stock certificates, restrictions based solely on the buy-sell itself may be considered personal to the parties to the agreement. Subsequent shareholders may not have either the prohibitions or protections of the buy-sell agreement.
Stock Certificates Must be Marked with a Legend
Stock certificates in the corporation must be marked with a legend. This is a note which clearly states that the stock is subject to restrictions and specifies where those restrictions can be found. Generally, unless the stock certificate states there is a restriction on the transferability, that restriction will not be effective against a transferee. State law will determine the degree of detail necessary. The buy-sell should itself require that each stock certificate be marked with this legend.
A written document between the parties to the agreement should be drawn up and properly executed. This legal agreement should:
- state the business purpose to be served for the agreement;
- refer to the events which will trigger a buy-out;
- provide a formula for determining the price at which shares are to be exchanged;
- explain how and when the purchased stock is to be delivered;
- list any restrictions on lifetime transfers;
- state any exceptions to the general terms (for instance, to allow a gift or sale to immediate family members);
- explain how funding is to be arranged with specific reference to life insurance (a schedule of policies should be appended to the agreement or listed within it);
- specifically provide for the purchase of additional insurance as the value of the stock increases;
- state how funding of any sales price in excess of insurance proceeds is to be made including interest on the unpaid balance;
- explain what is to happen in the event of bankruptcy, receivership, or dissolution of the corporation, the purchase or disposal during lifetime or death of all the stock of a shareholder, or termination of the agreement by a voluntary action of the parties; and
- state the applicable jurisdiction under whose laws the document is to be construed.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM