Beside the practical business and tax benefits, a buy-sell agreement also allows the parties to plan in advance of the moment when the ownership change will eventually occur, and, thus, allows the parties to avoid much of the tension and emotion that can result from delaying such discussions.  In addition, the buy-sell agreement also forces the parties to consider financial issues that often can only be solved if addressed well in advance, such as whether the company should purchase life insurance to fund the transfer.

The buy-sell agreement is a legal contract that dictates how, when, and for how much a company or remaining owners will be required to pay to acquire the interests of a departing owner.  The buy-sell agreement will typically provide for various triggering events that will either gives one party the obligation or the option to buyout the interests of another.  Typical events include: death, disability, divorce, bankruptcy, retirement, or otherwise changing their role in the company.  Many owners will be concerned about the ownership rights and control of the company.  Other owners will want to ensure payment for the departing owner, and still other owners will want the buy-sell agreement to minimize the tax burdens of the company and the departing and remaining owners.  Thankfully, buy-sell agreements are not one-size-fits-all, and an attorney will be able to address many, if not all, of these concerns.

While an attorney is virtually unlimited in choices that can be made in drafting and implementing the buy-sell agreement, there are primarily two types of agreements: the redemption agreement and the cross-purchase agreement.  Of course, even this choice can provide alternatives, such as a mixed agreement that allows members or shareholders the option to purchase the interests of the departing owner before requiring the company itself to purchase the owner’s interests.

Redemption Agreements

A redemption agreement will cause the entity to purchase the interest of the departing owner.  Many favor using the redemption agreement for buy-sells because of its simplicity, particularly when there are numerous owners.  If life insurance is needed to fund the purchase, a redemption agreement will typically require the purchase of only one policy.  And, since the company purchases the interests of the departing owner, no particular owner will have their interests increased in relation to the other remaining owners.  Of course, if one remaining owner already controls a substantial position of the company, then this could push that owner over a threshold such as the 50% ownership mark or other critical amount designated in the company’s bylaws or operating agreement.

While a redemption agreement has its advantages, it does have its limitations as well.  The redemption agreement will cause the entity to purchase the interests of the departing owner.  Thus, while the value of the remaining owners’ interests will increase in value, the shareholders of a c-corporation will see no increase in their tax basis.  So, when those shareholders sell their interests in the c-corporation, they will pay gain on the increased value of their shares.  In contrast, the tax basis of remaining s-corporation shareholders and partners in an LLC or partnership can be increased, regardless of whether the chosen method is a cross-purchase or a redemption.

In addition, if the entity using the redemption agreement is a c-corporation, then attribution rules may prevent the redemption from being considered a “complete redemption”, and, thus, may be considered taxable as a dividend to the departing owner.  This is particularly relevant when the remaining owners are closely related to the departing shareholder.  Further, a redemption of c-corporation shares may have alternative minimal tax consequences if the corporation receives insurance proceeds to fund the transfer.

Regardless of the entity’s tax status, insurance proceeds going to an entity to fund a buy-sell redemption agreement may be subject to claims of the entity’s creditors.   A redemption agreement, on the other hand, requires only one life insurance policy per owner and is typically the simplest transfer to structure and implement.

Cross-Purchase Agreements

A buy-sell agreement can also be structured as a cross-purchase agreement.  The cross-purchase agreement can be more complicated.  The cross-purchase agreement requires that some or all of the remaining owners be required to purchase the interests of the departing owner.  If life insurance will be used to finance the purchase, then each owner may need a policy on each of the other owners.  The individual owners would receive the insurance proceeds and will then use the proceeds to purchase the interests of the departing owner.  Since the individual owners, rather than the corporation, purchases the shares, this removes the tax basis issues that exist for c-corporations under a redemption agreement.  Further, for c-corporations, since the individuals receive the life insurance proceeds, the corporation should not encounter any corporate alternative minimum tax issues.

Mixed Agreements

Mixed agreements are those providing options to buy the interests by either the entity or the remaining interest holders followed by either the remaining interest holders or the entity having the right or obligation to purchase.  Either of these parties may purchase life insurance to fund the transfer.  Of course, the agreement can allow new parties to purchase the interests, such as a child of the departing owner.

Funding the Transfer

While much has been discussed in this article regarding the use of life insurance policies to fund buy-sell agreements, life insurance may not be  helpful if it is likely an owner will desire to sell their interests to fund their retirement.  In such case, the entity has several options.  The entity or remaining interests holders could, of course, stockpile cash over time through investments.  In addition, the parties may use insurance policies that will accumulate a cash value.  Still another possibility is the use of an installment agreement whereby the shares are purchased over time from either the entity’s future earnings or through dividends to the remaining interest holders.  Again, if the departing interest holder continues to have interests in the entity, whether directly or through IRS attribution rules, the departing owner of a c-corporation may be considered to have received dividends rather than capital gains.  Depending upon the tax rates then in effect, the IRS the reclassifying the payments as a dividend may have a negative effect.

Estate Tax Uses

The buy-sell agreement generally provides some method of valuation of the owners’ interests, whether by calculation or a fixed amount.  The value, as calculated under a buy-sell agreement, can often be used for estate tax valuations.  The IRS; however, may challenge values to be used for inter-family buy-sell agreements, particularly when the amount is less than reasonable and cannot be justified.  In choosing whether to use a cross-purchase agreement or redemption agreement, a person concerned about estate taxes may favor a cross-purchase agreement.  If an owner dies controlling the majority of a business that used a life insurance policy to fund a redemption buy-sell agreement, then both the business and the life insurance policy could be considered owned by the person’s estate.  Since entity-owned policies are typically used for redemption agreements, this situation may favor the use of cross-purchase agreements for owners with estate tax issues.

In Summary

Buy-sell agreements provide many benefits to business owners, but careful consideration should be used when determining how the buy-sell agreement should be structured.  Since buy-sell agreements are naturally forward-looking, reasonable projections must be made regarding financial requirements, both for funding and valuation purposes.  Moreover, when ultimately the success of the buy-sell agreement requires that the business survive, consideration should be given to ensure the future owners are given the necessary means and training to make this transition successful.  Your attorney, in drafting your buy-sell agreement, should be willing to meet with the owners, financial planners, accountants and any other individual needed to ensure the buy-sell agreement meets the current and long-term goals of the owners and the company.

For additional information or to obtain a buy-sell agreement for your company, please contact Jeff Rogyom at (410) 929-4578.

Many believe their businesses will receive tax or legal benefits for forming in an alternative state, and legal document mills often perpetuate these beliefs to sell incorporation packages… While some businesses benefit from the differing tax laws of other states, the vast majority of small business realize no benefit and forming in another state only creates financial and administrative burdens. For instance, many sell Nevada as a place to incorporate since there is no corporate income tax, but most businesses will not be able to legally take advantage of that tax difference. In addition, your home state often provides adequate legal attributes and liability protections for your business, despite the often promoted liability protection benefits of having a Delaware entity.

Most major corporations choose to register their companies in a handful of states, and this sometimes creates the perception that companies are doing so solely to limit their tax liabilities. Often these decisions are based upon those states’ corporate governance requirements, meaning certain states do not impose many requirements on how a company must be run or funded. Start-up companies that anticipate selling stock to the public often form in Delaware. Other states provide benefits to companies in certain industries, such as the lax usury laws that may attract banks or credit card companies. This does not necessarily mean, however, that the average small business will receive any benefit by following the lead of these corporations.

For tax purposes, if your company operates in Maryland, then it will be required to file a Maryland income tax return in Maryland. Further, the company’s income that originates in Maryland must be reported on the Maryland tax return as Maryland income. The Maryland tax return must be filed regardless of the state that the company chose for formation or incorporation.  Therefore, unless your company has operations in multiple states, then your company usually has no tax reason to form outside its home state.

A small business registering in another state will run into several problems. First, even if the company is registered in another state, most state’s require the business to also register as a “foreign business” in their state and pay the associated fees. Second, the state may also require the company to obtain an in-state mailing address and hire an in-state person to be the company’s “registered agent”. Unless you have a contact living in the state, then you often will need to pay the local person to perform these duties. Finally, by registering in another state, you may find yourself being sued in that state’s courts. Your registration state’s courts will have jurisdiction to accept a lawsuit filed against your small business and may require you to defend your company in a very inconvenient or unfriendly location.

In conclusion, unless you can identify a specific benefit of being registered in a certain state, then you should generally choose to register in your home state. Few businesses benefit from forming in another state. Further, filing in another state may cause you to incur substantial costs and many administrative and legal burdens.  You should certainly consult your attorney before making a choice that may be very costly to reverse.

For further information, please contact Jeff Rogyom at (410) 929-4578.

Many business buyers’ greatest challenge is obtaining financing.  While a business purchase requires substantial funding, the buyer’s financing options are numerous.  Factors determining the best financing choice include: the seller’s needs, the buyer’s ability to pay, the company’s cash flow and assets, and the general economic climate.

In certain situations, the buyer’s only available financing source will be the seller, and buyers regularly use installment payment agreements to purchase businesses.  But if the seller needs immediate payment, seller financing may be limited or may require higher interest payments.  The buyer would then need to explore other financing options.

Funding methods generally fall into two categories: debt financing and equity financing.  But business purchases regularly combine both debt and equity financing to meet cash requirements.

Debt Financing

Debt financing means borrowing money in the form of a loan from a third-party.  The source for debt financing can be a bank or other business financing company, but can also include friends and family.  Remember, a buyer’s loan collateral can include both the buyer’s personal assets and the target business’s assets as well.  The buyer should seek a pre-qualified loan, even if the target business has not been identified.  A buyer’s pre-qualifying can improve the buyer’s price negotiations and reduces risks should lending terms change.

The buyer may also obtain financing through Small Business Administration loans and local business promotion programs, such as those provided by Maryland’s Department of Business and Economic Development.  SBA-guaranteed loans generally provide longer terms than loans regularly offered by the bank.  Most commercial financing sources will fund up to 75% of the purchase price.  If the buyer cannot contribute the remaining 25%, the buyer may seek equity financing for at least that portion.

Equity Financing

Equity financing means selling an interest in the business to be purchased.  While not always appealing to a buyer, a silent or limited partner’s contributions will assist with immediate cash needs.  Using a silent or limited partner generally requires the buyer give up some control and profits.  As co-owners, the buying group’s documents such as partnership agreements, LLC operating agreements, and corporate bylaws should consider each owner’s rights and obligations to the company.  These agreements may address issues such as: how much the partner must contribute, whether there will be required payments to the partner, whether the partner has an equity (ownership) interest or only a profits interest, how much control the partner will have, whether the partner can sell their interest, whether the company can purchase the partner’s interest, and, if the company exercises that option, how much the partner will be paid.

Third parties always complicate a transaction, and attorneys may be needed to negotiate the terms and draft the necessary agreements.  You should never presume business partners will honor the deal, and the result of poorly drafted agreements is often litigation and soured relationships.

Customized Financing

As stated above, many buyers choose to combine both debt and equity financing, but the transaction itself can be structured to ease financial constraints as well.  For instance, if the company owns real estate, it may be possible to strip the real estate from the business for a separate sale using traditional real estate financing.  Using a similar transaction, a buyer may be able to locate an investor interested in owning the property, but not the business.    The business buyer would have to be satisfied with leasing the property, but a lease with an option-to-buy or right-of-first-refusal may be a way to make these transactions work for everyone.  Further, certain leasing companies will actually purchase the company’s equipment and lease it back to the company.  There can be both cash flow and tax benefits to such arrangements.

In addition, certain financing companies provide loans on or will purchase outright otherwise illiquid assets, such as the business’s accounts receivable.  While not always the best financing source, certain companies will purchase promissory notes offered by buyers.  For a seller primarily interested in receiving cash, this may be incentive enough to allow a buyer to purchase a business using only a buyer’s note.

In conclusion, while the business purchase requires substantial funding, the financing options are numerous.  Before signing the bank loan, the buyer should consider the benefits of other funding sources.

For further information, please contact Jeff Rogyom at (410)929-4578.

A business transfer’s success or failure often depends upon retaining the company’s employees and their knowledge of the business.  Many times, a company’s most valuable employee is its soon-to-be former owner.  Further, the buyer must consider the company’s obligations to the employees and consider whether employee departures could harm the company.  Of course, the seller showing confidential company information to prospective buyers has concerns as well.

Agreements for Employees:

Generally, businesses will limit their employee obligations through employment agreements.  Companies often require employees accept confidentiality agreements, non-compete agreements, and non-solicitation agreements.  Confidentiality agreements restrict persons from sharing information, while non-compete agreements restrict the person from working for a rival.  Non-solicitation agreements limit the employee’s ability to encourage fellow employees to follow them to a new employer.  In addition, employment agreements should limit an employee’s ability to claim ownership of their work-product, such as client lists.  As a buyer of a business, you cannot assume your predecessor properly protected the business.

The buyer should analyze the company’s employment contracts and related agreements.  Inevitably, some employees will either be dismissed or leave following an ownership or management change.  But do not focus solely upon those employees.  The buyer’s attorney should review all existing contracts and determine whether the company will need new employment agreements.

Further, the buyer’s attorney should be asked to determine whether the current contracts create any contractual commitments to these employees, particularly any clauses overriding employment-at-will laws or granting severance packages, sometimes referred to as “golden parachutes”.  Other contractual obligations the business buyer can inherit include previously agreed upon compensation, bonuses, and fringe benefits.

Non-compete, or Non-competition, agreements can be crucial to preserving a business.  It is not only salespeople who are worthy of a non-compete agreement.  Any employee with knowledge of your business, its contacts, or its processes could be a valuable asset to your competitor.  The laws regarding non-compete agreements are extensive and vary greatly from state-to-state.  The slightest mistake can make the non-compete agreement unenforceable, so I suggest seeking professional assistance.

Agreements for Sellers:

On a positive note, employment agreements or consulting agreements are sometimes used to retain an otherwise departing owner.  Rather than compensating the owner outright through a lump sum or installment payment, it is often worthwhile to keep the seller involved to make the ownership change less shocking to the business and its partners.  The seller may not be thrilled to remain active in the business, so the consulting agreements should consider delegating specific functions or tasks as a requirement for the employment or consulting agreement.

The seller should be required, as part of the sale, to agree to confidentiality agreements, non-compete agreements, and non-solicitation agreements.  No matter how intent the seller is to leave the business, the buyer will want to protect their interests should the seller have a change of heart.

Agreements  for Buyers:

Finally, the business seller should consider requiring prospective buyers sign confidentiality agreements. During the business sale process, the seller will be disclosing sensitive business information.  This could be particularly damaging if the potential buyer is in the position to use the information.

For further information, please contact Jeff Rogyom at (410)929-4578.

When purchasing a Maryland business, the buyer must ensure all desired assets are properly transferred regardless of the chosen sale method. As discussed in earlier articles, attorneys will consider many issues when deciding to structure a sale as either an asset sale or a stock sale, including tax and liability issues.  When utilizing an asset sale, the transferring documents must reference and account for all assets purchased. Even if the attorney structures the transaction as a stock sale, the buyer should confirm the purchased company actually owns the desired assets.

All desired assets will need to be documented for an asset sale. A bill of sale can be used to account for most equipment, inventory, and supplies. New deeds must be issued for each transferred real estate parcel. Company vehicles will need to be retitled with Maryland’s Motor Vehicle Administration. If leased equipment is included in the asset sale, then the lease will need to be assigned to the new owner.  Real property transfers and leases are discussed in more detail in a separate article.

In addition to these material assets, the buyer should not forget the company’s intellectual property. If the company has client lists, business processes, trade names, trademarks, or patents, then the buyer should specifically address these assets. Careful attention should be given these assets as many state and federal laws govern intellectual property. In some instances, it can be difficult to determine the true owner of the intellectual property. For example, is the company or an employee the real owner of a valuable patent? A review of the employees’ contracts may be necessary.

Assuming the ownership transfer is successful, intellectual property owners must regularly submit notices to regulatory agencies to preserve their rights. The time of sale would be a proper occasion to investigate upcoming trademark filing deadlines.

For further information, please contact Jeff Rogyom at (410)929-4578.

For many businesses, the business location is its most valuable asset.  This remains true even if the company only leases the location.  Therefore, maintaining the right to use the property following the transfer is of utmost importance.  If the lease is valuable to the buyer, it should not be assumed the seller has the right to sublease or assign the lease to the buyer.

As early as possible, an attorney should review any lease agreements and should contact the landlord to gain approval for a sublease or assignment.  Generally, lease agreements will not permit a sublease or assignment, but do not lose hope.   First, the lease agreement often allows a business to retain the lease if the business entity’s ownership changes.  Second, the landlord may be more willing to allow a sublease or assignment than the landlord’s lease agreement indicates.

In addition, the buyer should note any limitations in the lease agreement on the tenant’s permitted uses of the property.  If not permitted, your dream to change the current coffee shop into a coffee & oil change shop may be dashed.

There are notable differences between a sublease and assignment, and the buyer and seller should be aware.  A sublease is typically a continuation of the current lease, with the seller/tenant remaining responsible should the buyer/subtenant default or otherwise create a liability.  An assignment is an agreement between all parties (current tenant, new tenant, and landlord) that the lease will, going forward, be between the new tenant and the landlord.  An assignment may relieve the former tenant of liabilities for the lease, but, ultimately, the written agreements between the parties will dictate the terms.

If the lease does not readily permit a sublease or assignment, negotiations between the seller, buyer, and the landlord may permit a discussion of the future lease price, term, uses, etc.  Of course, depending upon each party’s power, this may be either favorable or unfavorable.  The transfer of a lease can have tax ramifications as well, so your attorney should be notified of both the assignment and any changes made to the agreement.

Even if not required, it may be advisable to have the seller, buyer, and landlord sign a document acknowledging the sublease or assignment.  When leased real estate is an integral asset of the business, an abundance of caution is warranted.

For further information, please contact Jeff Rogyom at (410)929-4578.

A major consideration when purchasing an existing Maryland business should be minimizing the tax burden.  Certain transactions provide tax benefits to either the purchaser or the seller while providing a tax burden to the other.  Therefore, tax consequences should be considered when determining the appropriate purchase price.  The general rule is that the sale of a business is a taxable event; however, the parties may be able to structure the transaction using a tax-free reorganization.  The IRS provides several forms of tax-free reorganizations, but to qualify the parties must meet numerous requirements.  Since the IRS only allows tax-free reorganizations under limited circumstances, I will first discuss taxable transactions.

As a taxable transfer, the buyer and seller have two general options: using stock sale or asset sale tax rules.  Though conceptually similar, I will discuss the tax consequences of a partnership sale in a separate article.  The seller generally favors a stock sale because the seller is taxed upon sold stock using the capital gains rate (15%).  In contrast, an asset sale’s seller may be required to use the higher ordinary income tax rate for certain sold assets.  The buyer generally favors an asset sale, because an asset sale increases the basis of the company’s assets (rather than the basis of the purchased stock).  Therefore, following the purchase of the business, the buyer may sell assets realizing less income tax and may depreciate the acquired assets for tax purposes using the assets’ new, higher basis.

Balancing the buyer and seller’s opposing tax burdens and benefits requires an analysis by a tax expert.  While, as stated above, certain transaction forms are generally better for one party, an analysis of the company and the company’s assets may conclude the tax benefit to one party is minimal compared to the tax burden to the other.  Therefore, well-advised buyers and sellers generally choose transactions favoring the parties in aggregate, rather than favoring the IRS.

To qualify as a tax-free transaction, the transfer must meet IRS requirements.  Generally, it requires the “seller” to remain a partial owner of the resulting company.  There are several forms of tax-free reorganizations appropriate for buying or selling a business.  Each referencing a paragraph of the Internal Revenue Code, the relevant reorganization formats are known as Type A, Type B, and Type C reorganizations.

Each reorganization type requires some compensation be paid to the seller in the form of the purchasing corporation’s stock.  A Type A reorganization requires at least 50% of the compensation value be paid in stock, while a Type B requires at least 80%.  Type A permits compensation using either voting or nonvoting stock, in contrast to Type B which only permits compensation using voting stock.  A Type C reorganization requires the purchaser acquire 80% of the target’s assets and pay the target solely in voting stock.  Regardless of the tax-free reorganization type, amounts paid in something other than stock are immediately taxable.

State and local taxes must also be considered.  In addition to income and corporate taxes, most states will impose a sales tax upon owned or leased tangible personal property transferred during the sale.   This form of sales tax is generally referred to as a “bulk sales tax”.  The Maryland Comptroller’s bulk sales tax imposes a 6% tax on the price of tangible personal property included in the purchase, unless an exemption applies.  The Maryland bulk sales tax does not apply to inventory held for resale, titled vehicles, and certain production equipment.  The Maryland bulk sales and use tax specifically applies to furniture and fixtures, computer software, business records, customer lists, and non-capitalized goods and supplies.

For further information, please contact Jeff Rogyom at (410)929-4578.

Parties seeking to buy or sell a Maryland business must consider both known and unknown liabilities.  Certain business lines obviously raise more concern for liabilities than others, but you need not purchase a former asbestos company to inherit exposure.  If a buyer purchases a company without considering potential liabilities, the buyer may purchase the seller’s potential lawsuits and contractual liabilities with no recourse against the seller.  In addition, many regulatory and tax liabilities may pass to subsequent purchasers and put company assets at risk.

The transaction can be structured to limit some forms of liability.  If the buyer purchases a business using a “stock sale” transaction, the buyer purchased the entire entity, including its assets and liabilities.  But if the buyer purchases a business using an “asset sale” transaction, the buyer can purchase company assets and limit ongoing exposure to claims originating prior to the sale against the purchased business.

An asset sale alone, however, may not eliminate all liabilities.  The buyer should accept debts necessary to continue the business, and fraudulent conveyance rules limit the seller’s ability to fleece the company of assets at the expense of its creditors.  In addition, if the seller’s liabilities created liens against company assets, then those assets remain at risk.  Buyers must confirm purchased assets are not subject to undisclosed liens.  Liens can result either through commercial financing agreements, through tax debts, or by operation of law.

The buyer should consider these potential liabilities and either account for the liability in the purchase price or seek indemnity agreements with the seller.  Of course, indemnity agreements only have value if the agreement can be enforced against the seller.

From the seller’s perspective, the seller should ensure regulating agencies, suppliers, and other potential creditors no longer consider the seller or the selling business responsible for future company debts.

Only after analyzing potential liabilities should your attorney determine the desired structure for the sale of a Maryland business.  In addition to properly structuring the business sale transaction, the parties’ attorneys should also consider indemnification agreements, contingent payment arrangements, and the escrow of funds.

For further information, please contact Jeff Rogyom at (410)929-4578.

Buying or selling a business in Maryland can be a very exciting time but can turn into a nightmare if not planned correctly.  There are many things to consider, including what structure the transaction will take.  A list of typical structures include:

An Asset Sale – the buyer purchases the business’s assets but not the company itself;
A Stock Sale – instead of assets, the buyer purchases the seller’s corporate shares, LLC interests, or partnership interests;
A Business Merger – the purchased company merges with an existing business;
A Franchise Purchase – the buyer purchases the right to operate a business using the identity, property, or expertise of a franchisor.

The structure chosen by the buyer and seller of a Maryland business can sometimes rightfully ignore the intended result. For instance, a transaction whose ultimate purpose is to purchase the company assets can be structured as a business merger if a merger improves the tax or business consequences. Such a decision requires an attorney with tax and business knowledge.

Generally, the seller’s primary concerns are reducing taxes to be paid, obtaining relief from future liabilities, and ensuring any deferred payments are satisfied. Conversely, buyer concerns include acquiring the business or assets without interrupting the business, ensuring the seller’s claims about the business are truthful, obtaining relief from past or potential liabilities, ensuring the seller will not compete with his former business, and improving the business’s tax attributes, such as the tax basis of assets. Cautious business owners will not proceed through this process without the assistance of a business attorney addressing these concerns.

While the business sale documents address many concerns, there are additional necessary steps to accomplish a successful transition of company ownership.  In addition to the business sale documents, an attorney will often be needed to assign or negotiate the commercial leases, to amend the companies’ standard contracts with suppliers and customers, and to draft the many related agreements.

For further information, please contact Jeff Rogyom at (410)929-4578.