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.

Allegany County
Honorable Rebecca D. Drew
59 Prospect Square, 1st Floor
Cumberland, Maryland 21502
(301) 724-3760 or (888) 724-0148
Fax (301) 724-1249

Anne Arundel County
Honorable Lauren M. Parker
Circuit Courthouse
7 Church Circle
Annapolis, Maryland 21401
(410) 222-1430 or (800) 679-6665
Fax (410) 222-1467

Baltimore City
Honorable Mary W. Conaway
Courthouse East
111 North Calvert Street, 3rd Floor
Baltimore, Maryland 21202
(410) 752-5131 or (888) 876-0035
Fax: (410) 752-3494

Baltimore County
Honorable Grace G. Connolly
County Courts Building
401 Bosley Avenue, Room 500
Towson, Maryland 21204
(410) 887-6680 or (410) 887-6681 or    (888) 642-5387
Fax: (410) 583-2517

Calvert County
Honorable Margaret H. Phipps
Courthouse
175 Main Street
Prince Frederick, Maryland 20678
(410) 535-1600 – Ext. 2256 or (888) 374-0015
Fax: (410) 414-3952

Caroline County
Honorable James L. Phelps
Courthouse
109 Market Street, Room 119
Denton, Maryland 21629
(410) 479-0717 or (888) 786-0019
Fax: (410) 479-4983

Carroll County
Honorable Paul G. Zimmermann
Courthouse Annex
55 North Court Street, Room 124
Westminster, Maryland 21157
(410) 848-2586 or (888) 876-0034
Fax: (410) 876-0657

Cecil County
Honorable Allyn Price Nickle
Circuit Courthouse
129 East Main Street, Suite 102
Elkton, Maryland 21921
(410) 996-5330 or (888) 398-0301
Fax: (410) 996-1039

Charles County
Honorable Loraine D. Hennessy
Courthouse
11 Washington Avenue
PO Box 3080
La Plata, Maryland 20646-3080
(301) 932-3345 or (888) 256-0054
Fax: (301) 932-3349

Dorchester County
Honorable Doris K. Lewis
Courthouse
206 High Street
Cambridge, Maryland 21613
(410) 228-4181 or (888) 242-6257
Fax: (410) 228-4988

Frederick County
Honorable Virginia P. Fifer
Courthouse
100 West Patrick Street
Frederick, Maryland 21701
(301) 600-6565 or (888) 258-0526
Fax: (301) 600-6580

Garrett County
Honorable Rita Watson
Courthouse
313 East Alder Street, Room 103
Oakland, Maryland 21550
(301) 334-1999 or (888) 334-2203
Fax: (301) 334-1984

Harford County
Honorable Derek K. Hopkins
Courthouse
20 West Courtland Street – Room 304
Bel Air, Maryland 21014
(410) 638-3275 or (888) 258-0525
Fax: (410) 893-3177

Howard County
Honorable Byron E. Macfarlane
Circuit Courthouse
8360 Court Avenue
Ellicott City, Maryland 21043
(410) 313-2133 or (888) 848-0136
Fax: (410) 313-3409

Kent County
Honorable Nancy Lee Jewell
Courthouse
103 North Cross Street
Chestertown, Maryland 21620
(410) 778-7466 or (888) 778-0179
Fax: (410) 778-2466

Montgomery County
Honorable Joseph M. Griffin
Judicial Center
50 Maryland Avenue, Room 322
Rockville, Maryland 20850
(240) 777-9600 or (888) 892-2180
Fax: (240) 777-9602

Prince George’s County
Honorable Cereta A. Lee
Courthouse
14735 Main Street, Room D4001
Upper Marlboro, Maryland 20773
(301) 952-3250 or (888) 464-4219
Fax: (301) 952-0908

Queen Anne’s County
Honorable Winsie A. Cannon
Liberty Building
107 North Liberty Street – Suite 220
Centreville, Maryland 21617
(410) 758-0585 or (888) 758-0010
Fax: (410) 758-4408

St. Mary’s County
Honorable Lois A. Duke
Courthouse
41605 Courthouse Drive
Leonardtown, Maryland 20650
(301) 475-5566 or (888) 475-4821
Fax: (301) 475-4968

Somerset County
Honorable Gary W. Miller
Courthouse
30512 Prince William Street
Princess Anne, Maryland 21853
(410) 651-1696 or (888) 758-0039
Fax: (410) 651-3873

Source: State of Maryland Register of Wills

Obviously, when providing such a gift or bequest your intention is to improve the comfort of the person with special needs, not relieve the government of its burden. However, certain government benefit programs require that the person be financially needy. If the person with special needs has assets in excess of $2,000, then the beneficiary will not qualify for Supplemental Security Income (SSI). So, if you gave your child with autism $50,000, then their SSI, Medicaid, and other government benefits could stop and they would need to live on your $50,000 gift until their assets are back to being under $2,000. At the end of the day, the only one benefiting from such a gift would be the government. Because of this and similar issues, attorneys developed planning techniques by which the person with disabilities will receive the benefit of your contribution without losing their medical and other benefits.

While some choose to just give the gift outright to a third-party who promises to care for the person with special needs, this obviously could cause issues. Of course, the third-party may decide they would rather use the funds for another purposes, but they could also lose the funds due to their death or divorce or to their personal creditors. The person with special needs would be much better served if you protected their gift in a trust that’s insulated from creditors, caregivers, and the government.

The special needs trust is crafted so the beneficiary will not have unlimited access to the funds. In fact, the trustee may be able to completely shut off the flow of funds to the beneficiary if it jeopardizes the person’s government benefits.  When the trust meets the requirements, federal law will not allow the various agencies to consider the trust’s assets as a countable asset of the beneficiary when determining eligibility.  Hence, the trust will be able to be able to assist the beneficiary with certain expenses to improve their quality of life without allowing the government agencies to stop providing the person’s basic benefits.

The special needs trust must provide language making it impossible for the person with special needs to have unrestricted access to the funds. It must also give the trustee full discretion regarding how the trust’s funds are distributed. The trust must state that it is only intended to fund the supplemental needs of the person, rather than their basic support, which are the expenses covered by SSI and Medicaid. Further, the trust document should state that the trustee must administer the trust so the beneficiary’s right to government assistance is not affected. The special needs trust can either be established at death through your will or as an intervivos special needs trust, meaning you establish it while you are still alive. The slightest mistake could jeopardize the trust in its entirety, so an untrained person should never consider drafting these documents.

The best trustee for a special needs trust is generally going to be close family members of the beneficiary, since they would, for one, care about the beneficiary’s well-being and, second, would be most familiar with the beneficiary’s individual needs. Consideration should be given for the beneficiary’s predicted life expectancy, and successor trustees to assume the responsibilities over time should be named if possible. Nevertheless, flexibility may be a better course in some instances. While the person with special needs may be the focus of your attention, the trustees, family members, and other loved ones who will likely care for him or her should be considered. Those persons’ expenses can be considerable in assisting the person with special needs, and, if possible, should be relieved.

Numerous people can fund a single special needs trust.  By establishing the trust early, you will be able to personally transfer funds to the trust and will also be able to provide relatives with instructions on how to properly direct money for the benefit of the person, i.e. “I hereby leave”… “to the Jane Doe Irrevocable Trust”.  Further, you will be able to provide the trust’s name as the beneficiary of any investment account or life insurance policy.

When possible, the funds should always go directly into the trust rather than first to the person with special needs. There are many restrictions placed upon “self-funded” trusts, including requirements that, following the death of the beneficiary, the trust’s unused funds must be given to the state to the extent necessary to reimburse medical expenses it has paid, rather than other relatives or persons you may wish to benefit. Hence, it cannot be overstressed that you should form the trust as soon as possible so every person who may want to contribute to the trust can do so without making the mistake of giving the funds directly to the person. Even if the person does not currently qualify for government assistance, there is always the possibility they may at some point in the future.  In the meantime, anyone who may want to give a gift or bequest to the person may have no way of properly directing the gift.

Nonetheless, when a person with special needs finds comes into possession of funds, whether from inheritance, a lawsuit, or other means, they would still want to put funds into a special needs trust.  Even self-funded special needs trusts provide a substantial benefit to the person and allows the protection of the assets during their lifetime.

Using proper legal and financial planning can ensure that your relative or loved one with special needs will have an opportunity to enjoy a better life than otherwise provided solely by government assistance.

For more information about forming a special needs trust, please contact Jeff Rogyom at (410) 929-4578.

Most states, including Maryland, provide you with the following popular state entity choices: the sole proprietorship, the general partnership, the limited liability company, and the corporation. Other entities for more specialized purposes also exist, such as the limited partnership and the professional association (a P.A. or P.C.).

I. Brief summaries of the four most popular entities:

Sole Proprietorship: A sole proprietorship is the default business entity for any business owned by a single person. The sole proprietorship provides no limited liability (discussed in Section III below) protection for its owner. If you have not chosen an entity and have no partners, then this is likely your current entity. It is not recommended that any active business operate in this form given the owner’s exposure to the company’s liabilities and lawsuits. For tax purposes, the IRS requires income from this form of business be reported on your Form 1040′s Schedule C, or, if real estate, Schedule E.

General Partnership: A general partnership is the default business entity for any business owned by multiple owners. Similar to the sole proprietorship, there is no limitation of liability for the business owners, known as its “partners”. The business generally does not need to file with the state to be considered a general partnership. State laws determine if a partnership exists, whether the owners intend to or not. If the state laws determine the group is a “partnership”, then the partners can be liable for acts of the business and their fellow partners. Similarly, IRS tax laws determine whether the group is a partnership for income tax purposes. For income tax purposes, the IRS requires groups it considers partnerships to file a partnership tax return, Form 1065. The partnership issues a K-1 to each partner which informs both the IRS and the partner how much income and expenses the partner should report on their Form 1040.

Limited Liability Company: The Limited Liability Company, or “LLC”, is today’s most popular entity form. It is the most popular because of its flexibility both in its operation and its available tax classifications. To form an LLC, the entity must be registered with the chosen state’s department that registers businesses, such as the Maryland SDAT (State Department of Assessments and Taxation) or the Delaware Secretary of State. The LLC offers limited liability to its owners, known as its “members”. Thus, if the LLC is sued or otherwise becomes in debt, then the members in most situations will not be personally liable to the creditors of the LLC. LLC members can choose how they want the IRS to tax the entity. Without making an IRS election, an LLC generally will be ignored for tax purposes if it has only one member or will be taxed as a partnership if it has multiple members. But, when making IRS elections, an LLC member or members can choose that the LLC to be taxed as a c-corporation or as an s-corporation (discussed in Section II below). A tax attorney would be able to guide you toward the optimal tax classification for your LLC.

Corporation: The corporation, in its modern form, has existed as a business entity for more than a century. Unlike more recently developed entities, such as the LLC, the laws governing corporations are well-developed. Thus, shareholders can be assured there will be few opportunities for a judge to surprise shareholders with their own new laws. The corporation’s business owners, the “shareholders”, have limited liability. This is the entity form best-suited for companies that foresee themselves “going public” in the near future. But the corporation does have its downsides. Corporate laws usually impose administrative burdens, such as annual meetings, that the more flexible LLC laws usually do not. Further, for tax purposes, the corporation must be taxed as a corporation, i.e. unlike the LLC, the corporation cannot choose to operate as a sole-proprietorship or as a partnership, even when the tax filing requirements seem unreasonable. The corporation may; however, elect to either be taxed as a c-corporation or as an s-corporation (discussed in Section II below). To make the corporation more flexible for small businesses, some states have created simplified corporate forms, such as the Maryland close corporation.

II. Tax Issues in Entity Choice:

While states can create new and unique entities, such as Delaware’s “series LLC”, the IRS lumps them together into a limited number of possible tax entities. For instance, there is no IRS tax form for an LLC. Through IRS eyes, a business with multiple members will be either a partnership, a c-corporation, or an s-corporation with few exceptions.

As stated above, while an LLC is normally taxed as a partnership, an LLC may choose to be taxed as an s-corporation or as a c-corporation. If operating as a c-corporation, the corporation pays taxes upon its income, and the shareholders pay taxes when the income is distributed. Thus, a c-corporation’s income is taxed twice. If operating as an s-corporation, the corporation itself generally pays no income tax and the corporate income is taxed only to the shareholder, regardless of whether the income is distributed. Today, most businesses operating as c-corporations are those that have no choice, such as a widely-held or publicly-traded company, and those with out of the ordinary tax situations.

There sometimes are tax benefits to being a c-corporation, and the proponents of c-corporations often proclaim its superiority with a certain level of fanaticism. But, in general, the advantage of an s-corporation’s single-layer of tax far outweighs any benefits offered by a c-corporation. My experience as a tax attorney is that when a small business operates as a c-corporation, there is a temptation to illegally deduct personal expenses through the business in order to avoid the two-layers of tax. An IRS audit of those businesses can be devastating when discovered personal deductions suddenly turn into huge tax bills for both the corporation and the now dividend-receiving shareholder, plus penalties and interest.  Sadly, many such individuals were placed in that position by a tax consultant’s poor advice. Currently, few small companies have a legitimate reason to choose to be taxed as a c-corporation, and the only reasonable decision for most small companies is choosing to be taxed as either a partnership or as an s-corporation.

III. Limited Liability:

Some entities, such as the LLC and the Corporation, offer limited liability to their owners. Limited liability roughly means that the owners are not personally responsible for the company’s debts and that the company’s creditors can only seize the company’s assets, but there are exceptions. If an owner guarantees or “co-signs” for a company debt, then the company’s limited liability will not protect that the person from the co-signed debt. Despite an entity’s limited liability, individuals also can be personally responsible for tax debts created for “trust fund” taxes, such as employment taxes or state sales taxes. Often, by law, certain liabilities cannot be limited by forming an entity, such as civil or criminal penalties or professional liability. Further, if a court determines that an entity’s owners never truly honored the entity’s existence, then courts can sometimes “pierce the corporate veil” to go after the owners. Veil piercing generally occurs when owners fail to properly separate their personal life from that of the entity, such as commingling checking accounts or doing business in the owner’s name. Additionally, courts can pierce the veil when the owners egregiously fail to adhere to corporate formalities, such as never holding required meetings or never seeking corporate approvals when required.

IV. Conclusion:

In conclusion, taking these factors into consideration, a tax attorney should be able to guide you toward the proper entity choice. The excitement of starting your own business should not cause you to rush this very important decision. Seeking proper advice before committing your company to years of high taxes is well worth the investment.

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

Thanks for your continued support.

Sincerely,

Jeff Rogyom