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DRAFTING AND UNDERSTANDING BUY-SELL AGREEMENTS __________ Prepared and Presented by

EDWARD L. PERKINS, JD, LLM (TAX), CPA CPE CREDIT -- TWO HOURS FIELD OF STUDY – BUSINESS LAW (1 CR.) AND TAXES (1 CR.) PREREQUISITES -- NONE PROGRAM LEVEL --- BASIC ADVANCE PREPARATION -- NONE PROGRAM DESCRIPTION -- THIS PROGRAM WILL PROVIDE A COMPREHENSIVE OVERVIEW OF LEGAL AND TAX ISSUES INVOLVED IN DRAFTING AND UNDERSTANDING BUY-SELL AGREEMENTS.

LAST UPDATED - 12/16/2015 REVIEW DATE – 02/15/2015


Š youronlineprofessor, llc All Rights Reserved


DRAFTING AND UNDERSTANDING BUY-SELL AGREEMENTS

Introduction This program will provide a comprehensive overview of legal and tax issues involved in drafting and understanding Buy-Sell Agreements. Among the topics examined in this program are: ▪

The Form of the Agreement

Determining the Restrictions on Transfer

Triggering Events

The Purchase Rights

The Terms of the Purchase

Determination of the Purchase Price

Setting the Purchase Terms for Each Triggering Event

Tax Consequences

Additional Issues to Address

Course Learning Objectives After course completion you will be able to: ▪

Distinguish the purposes for which Buy-Sell Agreements are used.

Recognize the issues addressed by Buy-Sell Agreements.

Distinguish between the characteristics of the various forms of Buy-Sell Agreements.

Identify the nature of the restrictions generally provided in a Buy-Sell Agreement.

Identify the events which generally trigger obligations under a Buy-Sell Agreement.

Recognize the purchase obligations generally provided in a Buy-Sell Agreement.

Identify the alternative methods of determining the purchase price in Buy-Sell Agreements.

Identify the manner in which price is determined under each of the alternative methods discussed.

Recognize the pros and cons of each of the alternative valuation methods.

Identify the various terms of purchase that the Buy-Sell Agreement should address.

Identify the appropriate purchase rights, purchase price, and terms of the purchase which should be provided in regard to the various triggering events.

Identify the tax consequences of the various forms of Buy-Sell Agreements as they relate to: (i) the party funding payment of the purchase price; (ii) the selling owner; (iii) the remaining owners, and (iv) the purchasing party.

Identify issues that should be addressed in a Buy-Sell Agreement in addition to those already discussed.


Contributors ▪

Prepared and Presented by Edward L. Perkins, JD, LLM (Tax), CPA

Reviewer - Stephen Loester, JD, LLM (Tax)

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Course Update Policy YOP’s policy is to have each webinar program reviewed prior to initial presentation and updated in the case of the re-presentation of a program by a qualified person other than the person who developed the program to assure that the program is technically accurate and current and addresses the stated learning objectives. Since all of our programs have been in the field of study of taxes, a tax attorney holding an LLM in Taxation has been the reviewer in each case. Any programs outside the field of study of taxes will be reviewed consistent with this policy by an expert in that field of study. Review Questions Throughout the course you will find Review Questions to help you test your knowledge and comments that are vital to understanding a particular strategy or idea. Answers to the Review Questions with feedback on both correct and incorrect responses are provided following each “Quizzer.” Final Exam This course is divided into 7 sections. Take your time and review all course sections. When you feel confident that you thoroughly understand the material, turn to the Final Exam on page 50 and complete it. Once completed, submit the Final Exam using the instructions found on page 52 to receive CPE credit.

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DRAFTING AND UNDERSTANDING BUY-SELL AGREEMENTS Contents UNIT ONE – Introduction ……………………………………………………………………………………

1

I.

Overview…………………………………………………………………………………………..…

1

II.

Uses of the Buy-Sell Agreement…………………………………………………………………..

1

III.

Issues to be Addressed…………………………………………………………………………….

1

UNIT TWO – The Form of the Agreement …………………………………………………………………

5

I.

Overview……………………………………………………………………………………………..

5

II.

The Cross Purchase Agreement…………………………………………………………………..

5

III.

Redemption Agreement…………………………………………………………………………….

5

IV.

Hybrid Agreement …………………………………………………………………………………..

5

V.

Alternative Documentation …………………………………………………………………………

6

UNIT THREE – Determining the Restrictions on Transfer, the Triggering Events and the Purchase Rights …………………………………………………………………………………………………………..

9

I.

Introduction…………………………………………………………………………………………..

9

II.

The Nature of the Restrictions…………………………………………………………………….

9

III.

The Triggering Events………………………………………………………………………………

11

IV.

The Purchase Rights……………………………………………………………………………….

15

UNIT FOUR – Determination of the Purchase Price ……………………………………………………..

19

I.

Overview……………………………………………………………………………………………..

19

II.

Agreed Upon Price………………………………………………………………………………….

19

III.

Price Determined by Appraisal…………………………………………………………………….

20

IV.

Price Determined by Formula………………………………………………………………………

22

UNIT FIVE – Terms of the Purchase………………………………………………………………………..

28

I.

Overview……………………………………………………………………………………………..

28

II.

Closing………………………………………………………………………………………………..

28

III.

Payment of the Purchase Price……………………………………………………………………

28

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UNIT SIX – Setting the Purchase Terms for Each Triggering Event…………………………………….

30

I.

Introduction…………………………………………………………………………………………...

30

II.

Death of an Owner…………………………………………………………………………………..

30

III.

Voluntary Transfers and Involuntary Transfers…………………………………………………..

31

IV.

Disability………………………………………………………………………………………………

32

V.

Termination of Employment………………………………………………………………………..

32

UNIT SEVEN – Tax Consequences…………………………………………………………………………

36

I.

Overview………………………………………………………………………………………………

36

II.

Income Tax Consequences…………………………………………………………………………

36

III.

Estate Tax Consequences. …………………………………………………………………………

39

UNIT EIGHT – Additional Issues to Address………………………………………………………………..

43

I.

Overview. ………………………………………………………………………..…………………...

43

II.

Consent to Joint Representation……………..…………………………………………………….

43

III.

Disposition of Insurance Policies. ……………………………………..…………………………..

43

IV.

Resignation as Officers and Directors. ……………………………………………..……………..

43

V.

Covenant Not to Compete and Non-Interference…………………………….………………….

44

VI.

Preserving the S Election……………………………………………………………………..…….

44

VII.

Provision for Distribution – S Corporations……………………………………………………….

46

VIII.

Take Along and Tag Along Provisions……………………………………………………….……

46

IX.

Spouse’s Signature………………………………………………..…………………………………

47

X.

Adoption by New Owner…………………………………………………………………………….

48

XI.

Legend. ……………………………………………………………………………………………….

48

CPE QUIZZER

50

Glossary of Terms…………………………………………………………………………………………….

53

Index……………………………………………………… …………………………………………………….

55

Appendix………………………………………………………………………………………………………… 57

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UNIT ONE – Introduction Learning Objectives After completing this Unit, you will be able to: ›

Distinguish the purposes for which Buy Sell Agreements are used. ›

I.

Recognize the issues addressed by Buy-Sell Agreements.

Overview.

A Buy-Sell Agreement is a contractual agreement among the owners of a business (i.e., the shareholders of a corporation, the partners of a partnership, or the members of a limited liability company) which restricts the right to transfer the ownership interests and establishes certain purchase and sale rights and obligations upon the occurrence of certain events. The agreement will generally provide that upon the occurrence of the triggering events, such as the death of an owner, the remaining owners will either have an option or an obligation to purchase the ownership interest of the affected owner. II.

Uses of the Buy-Sell Agreement.

A Buy-Sell Agreement may serve to achieve one or more of the following objectives: 1. Restriction of Transfer - By restricting the transfer of an ownership interest except as provided within the terms of the agreement, a Buy-Sell Agreement can insure that owners control and restrict who is part of the ownership group. 2. Provides Liquidity - If the agreement provides a purchase obligation in the event of the death of an owner and that obligation is funded with life insurance, the agreement can be used to convert the deceased owner’s equity interests into cash. 3. Fixes Value - By fixing the price which applies in the event of a purchase under the terms of the agreement, the estate tax value of the equity can be fixed in the estate of a deceased owner. III.

Issues to be Addressed.

The agreement should address the following issues: A.

The Form of the Agreement.

The Buy-Sell Agreement will generally be formed in one of the following ways: (1) a “Cross Purchase Agreement”; (2) a “Redemption Agreement”; or (3) a “Hybrid Agreement.” No matter what the form of the agreement, the objectives of the agreement are the same as discussed in section II, above. The differences lie in how the purchase options and obligations are allocated between the entity and the owners. 1 Example: A and B are the shareholders of XYZ, Inc. Each owns 50% of the issued and outstanding stock of the corporation. A and B enter into an agreement which provides that

1

The alternative forms of the agreement will be discussed in detail in Unit Two.

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neither shareholder may sell or otherwise transfer his or her stock without first offering it to the other shareholder at a price and terms set by the agreement. In addition the agreement provides that upon the death of either shareholder the corporation will redeem the stock of the deceased owner for the fair value of the stock. The corporation purchases life insurance on both A and B in order to fund this obligation. B.

The Nature of the Restrictions on Transfer.

One primary purpose of a Buy-Sell Agreement is to insure that before an existing owner can transfer his or her stock, the other owners will have the opportunity to buy that interest at a predetermined price and terms. In order to make sure that this objective is realized, the agreement should provide that any transfer not made within the terms of the agreement is null and void. C.

Defining the Triggering Events and the Purchase Rights.

The agreement, of course, should define the precise events that will trigger the purchase rights. Generally, these would include the death or disability of an owner, the termination of an owner’s employment by the entity, or the attempt to voluntarily or involuntarily transfer the ownership interest of an owner. Once the triggering event has occurred, the agreement should also provide whether the other owners, or in certain cases the entity, have an option or obligation to purchase the ownership interest of the affected owner.2 D.

Determination of the Purchase Price.

The agreement should provide either the price or a method for determining the price of the ownership interest to be purchased.3 F.

Payment Terms and Funding Mechanisms.

Finally, the agreement should set the terms of the purchase, i.e. when the closing will take place, and how the purchase price will be paid, whether lump sum or in installments. In addition, the agreement should also address the source of the payment. For purchases triggered by the death of the owner, life insurance is often purchased in order to fund the buyout. 4

2

This topic will be discussed in Unit Three. The various options available in determining price will be discussed in Unit Four. 4 Terms of the purchase are discussed in Unit Five. 3

2


Unit One Quizzer Which of the following is an issue not generally addressed by a Buy-Sell Agreement? A.

Providing restrictions on the right to transfer an equity interest in a business entity.

B.

Defining the event which triggers the purchase rights of the entity owners.

C. Determining the purchase price of the interest sold and purchased under the terms of the Agreement. D.

Determining the number of authorized shares of stock of a Corporation.

3


Answers A.

Providing restrictions on the right to transfer an equity interest in a business entity.

A is Incorrect - One primary purpose of a Buy-Sell Agreement is to insure that before an existing owner can transfer his or her stock, the other owners will have the opportunity to buy that interest at a predetermined price and terms. In order to make sure that this objective is realized, the agreement should provide that any transfer not made within the terms of the agreement is null and void. B.

Defining the event which triggers the purchase rights of the entity owners.

B is Incorrect - The agreement, of course, should define the precise events that will trigger the purchase rights. Generally, these would include the death or disability of an owner, the termination of an owner’s employment by the entity, or the attempt to voluntarily or involuntarily transfer the ownership interest of an owner. Once the triggering event has occurred, the agreement should also provide whether the other owners, or in certain cases the entity, have an option or obligation to purchase the ownership interest of the affected owner. C. Determining the purchase price of the interest sold and purchased under the terms of the Agreement. C is Incorrect - The agreement should provide either the price or a method for determining the price of the ownership interest to be purchased. D.

Determining the number of authorized shares of stock of a Corporation.

D is correct – The number of authorized shares of stock of a corporation is generally provided in the Articles of Incorporation.

4


UNIT TWO – The Form of the Agreement Learning Objectives ›

I.

After completing this Unit, you will be able to: Distinguish between the characteristics of the various forms of Buy-Sell Agreements.

Overview.

Before addressing other issues, we should first discuss the various forms Buy-Sell Agreements might take. The Buy-Sell Agreement will generally be formed in one of the following ways: (1) a “Cross Purchase Agreement;” (2) a “Redemption Agreement;” or (3) a “Hybrid Agreement.” No matter what form of agreement is used, the objectives of the agreement are those previously discussed. The difference generally lies in how the purchase options and obligations are allocated between the entity and the owners. II.

The Cross Purchase Agreement.

A “Cross Purchase Agreement” is an agreement solely among the owners of the entity, i.e. the shareholders, partners, or members. The entity itself is not directly involved in the purchase rights or obligations. The funding of the obligation under this type of agreement must occur at the owner level. Example: A and B are the sole shareholders of XYZ, Inc. They entered into a Buy-Sell Agreement. Under the terms of the agreement, A and B agree that neither will transfer his or her stock in XYZ without first offering to the other shareholder. In the event either of them dies, the survivor has agreed to purchase the deceased shareholder’s stock at an agreed upon price. III.

Redemption Agreement.

A “Redemption Agreement” is similar to a cross purchase agreement with the difference being that the purchase obligation falls to the entity rather than the owners. Under a stock redemption plan, the corporation must have sufficient assets to redeem the shareholder's stock when required under the stock purchase agreement. This may be accomplished through the retention by the corporation of liquid assets or by acquiring life insurance on the lives of the various owners. Example: A and B are the sole shareholders of XYZ, Inc. They entered into a Buy Sell Agreement. In the event either A or B dies, the Corporation has the obligation to purchase the deceased shareholder’s stock. IV.

Hybrid Agreement.

Under a “Hybrid Agreement,” the purchase rights and obligations are shared by the entity and the owners. Generally, the entity is given the first option to purchase the equity interests and then, to the extent the entity does not choose to exercise that option, the remaining owners would have the option or obligation to purchase the interests. In some cases the order could be reversed, giving the remaining owners the first option, and then the entity the subsequent option or obligation. The Hybrid Agreement gives the remaining owners the choice to use either entity or personal resources to effectuate the transaction. 5


Example: A and B are the sole shareholders of XYZ, Inc. They entered into a Buy Sell Agreement. In the event either A or B dies, the Corporation has the first option to purchase the deceased shareholder’s stock at an agreed upon price; if the corporation does not exercise its option, the surviving shareholder has the obligation to purchase the stock of the deceased shareholder. V.

Alternative Documentation.

In the case of corporations, the Buy-Sell provisions may alternatively be provided in the corporation’s Bylaws or in the Articles of Incorporation. In the case of partnerships and limited liability companies, the applicable provisions may also be contained in the partnership agreement or operating agreement of the limited liability company.

6


Unit Two Quizzer Which of the following best describes a characteristic of a Cross Purchase Agreement? A. The agreement is solely among the owners of the entity, i.e. the shareholders, partners, or members. The entity itself is not directly involved in the purchase rights or obligations. B.

The purchase obligations fall to the entity rather than the owners.

C. The applicable provisions may be contained in the By-Laws of the corporation, the partnership agreement, or operating agreement of the limited liability company. D.

The purchase rights and obligations are shared by the entity and the owners.

7


Answers Which of the following best describes a characteristic of a Cross Purchase Agreement? A. The agreement is solely among the owners of the entity, i.e. the shareholders, partners, or members. The entity itself is not directly involved in the purchase rights or obligations. A is Correct – This is a characteristic of a Cross Purchase Agreement. B.

The purchase obligations fall to the entity rather than the owners.

B is Incorrect - This is a characteristic of a Redemption Agreement. C. The applicable provisions may be contained in the Bylaws of the corporation, the partnership agreement or operating agreement of the limited liability company. C is Incorrect – Buy-Sell provisions are not always provided in a separate agreement. These are examples of alternatives to providing Buy-Sell provisions in an agreement. D.

The purchase rights and obligations are shared by the entity and the owners.

D is Incorrect - This is a characteristic of a Hybrid Agreement.

8


UNIT THREE – Determining the Restrictions on Transfer, the Triggering Events, and the Purchase Rights Learning Objectives After completing this Unit you will be able to: › ›

Identify the events which generally trigger obligations under a Buy-Sell Agreement. ›

I.

Identify the nature of the restrictions generally provided in a Buy-Sell Agreement.

Recognize the purchase obligations generally provided in a Buy-Sell Agreement.

Introduction.

This Unit will discuss the general nature of the restrictions that the Agreement should place on the transfer of the ownership interests, the events that trigger purchase options or obligations, and the nature of those purchase options and obligations. II.

The Nature of the Restrictions. A. General Nature of Restrictions

By restricting the transfer of an ownership interest outside of the ownership group, a Buy-Sell Agreement can help the owners control and restrict who is part of the ownership group. The Agreement should provide a general restriction on the transferability of the ownership interests. Here is some standard language: “The Shareholders agree that they will not except as provided in this Agreement, sell, exchange, give, bequeath, assign, mortgage, pledge, alienate, hypothecate or otherwise transfer or encumber, in any manner whatsoever (any such disposition being hereinafter referred to as a ‘Transfer’), the Stock Interests in the Corporation presently held, or hereafter acquired, by them, except in accordance with the terms of this Agreement.” The Agreement should also provide that any transfer made or attempted contrary to the terms of the Agreement is null and void. Here is some standard language: “Except as specifically provided herein, any Transfer by a Shareholder of all or any portion of the Stock Interests held by him, except in the manner specified in this Agreement, shall be null and void, and the Corporation shall not recognize or give effect to such Transfer on its books and records, or recognize the person or persons to whom such Transfer has been made as the legal or beneficial holder thereof. 9


In the event of an attempted Transfer by a Shareholder of all or any portion of the Stock Interests held by him in violation of this Agreement, the Corporation shall have the right to purchase all (but not less than all) of the Stock Interests in the Corporation held by such Shareholder at a price of One Dollar ($1.00) per share.” B. Permitted Transferees In many Agreements certain transfers are permitted as long as they are made to so-called “permitted transferees.” Here is some sample language: “4.9.4 As provided above, the following exempt transfers may be made: 4.9.4.1 Transfers to the spouse or a lineal ancestor or descendent of such Shareholder (whether by adoption, blood or marriage), or 4.9.4.2 Transfers to a trust for the exclusive benefit of such Shareholder or a spouse or lineal ancestor or descendent of such Shareholder (whether by adoption, blood, or marriage); and, provided further, that a change in the beneficial interests of such trust to include anyone other than the spouse or a lineal ancestor or descendent of such Shareholder (whether by adoption, blood, or marriage) shall be considered a Transfer of the Shares held by such trust, subject to the same restrictions, rights, and obligations otherwise provided hereunder in regard to such Shares. 4.9.4.3 Transfers to a corporation, partnership, or limited liability company, which is wholly owned by such Shareholder or a spouse or lineal ancestor or descendent of such Shareholder (whether by adoption, blood, or marriage); and, provided further, that the Transfer of an ownership interest of such corporation, partnership, or limited liability company to anyone other than the spouse or a lineal ancestor or descendent of such Shareholder (whether by adoption, blood, or marriage) shall be considered a Transfer of Shares held by such corporation, partnership, or limited liability company, subject to 10


the same restrictions, rights, and obligations otherwise provided hereunder in regard to such Shares. 4.9.5 The term “valid testamentary transfer” shall be defined as any testamentary transfer which legally transfers title to a decedent’s property by reason of his/her death, including, but not limited to, transfers by will, trust, intestacy, designation of beneficiary, and right of survivorship.” III.

The Triggering Events. A.

Overview.

The occurrence of the events that trigger the purchase options or obligations must be defined in the Agreement. B.

Death of an Owner.

In the event of the death of an owner, the Buy-Sell Agreement generally will provide that the ownership interest of the deceased owner must be sold and purchased. Here is some typical language: “(1) Upon the death of a Member (the ‘Deceased Member’), the Deceased Member’s personal representative shall sell and transfer such Deceased Member’s entire Membership Interest owned by such Member (the ‘Offered Interest’) according to the procedure provided in this subparagraph.” C.

Voluntary Transfers and Involuntary Transfers.

The Agreement should provide that an attempted “transfer” of the ownership interest triggers a purchase right in the other owners and/or the entity. The term “transfer” should be given a broad definition such as the following: “The Members agree that they will not, except as provided in this Agreement, sell, exchange, give, bequeath, assign, mortgage, pledge, alienate, hypothecate or otherwise in any manner whatsoever transfer or encumber (any such disposition being hereinafter referred to as a “transfer”) the Membership Interests of the Company presently held, or hereafter acquired, by them.” 1. A “voluntary transfer” is an attempted or proposed voluntary lifetime transfer of the ownership interest by an owner—generally by sale or gift. The following is a form definition of such:

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“The term ‘Voluntary Lifetime Transfer’ shall be defined as any Transfer made during a Member’s lifetime that is not an Involuntary Lifetime Transfer.” Sometimes transfers to so-called “permitted transferees” under the agreement are made exempt from the restriction. “Permitted transferees” may be defined to include spouses and descendants, and trusts for their benefit. 2. An “involuntary transfer” is generally any transfer made on account of a court order or otherwise by operation of law, including any transfer incident to any divorce or marital property settlement, or an owner filing a voluntary petition under any federal or state bankruptcy law. The following definition can be used: “The term ‘Involuntary Lifetime Transfer’ shall be defined as any Transfer made on account of a court order or otherwise by operation of law, including any Transfer incident to any divorce or marital property settlement or any Transfer pursuant to applicable community property, quasi-community property or similar state law, and also including a Member filing a voluntary petition under any federal or state bankruptcy, insolvency or related law or a petition for the appointment of a receiver, or making an assignment for the benefit of creditors, or being subjected involuntarily to such a petition or assignment or to an attachment or other legal or equitable interest with respect to his Interest in the Company and such involuntary petition, assignment, or attachment is not discharged within thirty (30) days after its effective date.” D.

Disability.

Normally a buyout based on “disability” is only appropriate if the owner is employed by the entity and the individual service contributions of the owner are vital to the business of the entity. Defining when a condition of “disability” occurs to the degree which would result in a buyout of an owner’s interest is a determination to be made by each ownership group. As a guideline, there are generally three stages of disability. First, a period during which the owner is not able to work, but it is foreseeable that he or she will return to work in the short term. During this period, wages are usually paid in full and ownership is not affected. In the second stage, the condition has been prolonged to the point that full wages are no longer considered appropriate. During this period, disability income insurance could make up some of the income short fall for the disabled owner. In this second stage, the ownership interest is again left unaffected. Finally, the third level of disability occurs at the point the disability is considered permanent, at which time the buyout is triggered. Again, defining this 12


point is difficult. If disability income or buyout insurance is in place, reference to the definition in those policies may be appropriate. Generally, the determination of the condition of “disability” should not be made by the board of directors or managing partner or member. A better alternative is to have the condition determined or confirmed by one or more physicians. Here is a sample provision based on the definition in the disability insurance policy: "Disability" or "total and permanent disability" for purposes of this agreement shall be considered that disability of an insured stockholder which is described and determined by the insurer as "total and permanent disability" in the insurance policies on such insured stockholder listed in Article 4 below and/or Schedule "B" attached hereto.” Here is a second sample provision: “The term ‘Total Disability’ shall be defined as a Member being unable, due to injuries or illness, to perform the substantial and material duties of his employment by the Company or the Corporation, as the case may be, for twelve consecutive months, and unless such care is of no further benefit, such Member is also receiving care by a physician which is appropriate for the condition causing the disability.” E.

Termination of Employment.

Another triggering event may be the termination of employment of an owner by the entity for reasons other than death or disability. This may occur because an owner/employee retires voluntarily at a certain age, is involuntarily terminated for cause, or simply quits. Whether termination of employment is included as a triggering event in an agreement is an interesting question. The answer depends on several factors; including, the basis for the termination and the nature of the owner’s employment by the entity. If the termination is voluntary, then whether this is a reason to trigger a buyout depends on the owner’s relationship to the company. If the owner is an integral contributor to the day-to-day operation of the business, then termination of employment may be considered a basis for a buyout. If, on the other hand, the owner is only a passive investor, then this type of restriction might not be appropriate. Here is some sample language to be used if the owner resigns his or her employment prior to normal retirement age: “ ‘Voluntary Termination of Employment’ shall be defined as the cessation of any Shareholder’s employment by the Corporation due to their own volition.

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6.

Voluntary Termination of Employment.

a. In the event of the Voluntary Termination of Employment of a Shareholder other than by reason of Retirement, the Other Shareholders shall have ninety (90) days from the Date of Termination in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. C.1.b. below. b. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation shall have an additional ninety (90) days in which it may elect to buy any of the Offered Stock not purchased by the Other Shareholders. The following provision addresses termination of employment by reason of retirement: “Retirement” shall be defined as the Voluntary Termination of Employment by a Shareholder after reaching age sixtyfive (65). 7.

Retirement of a Shareholder.

In the event of the Retirement of a Shareholder, the retiring Shareholder shall be deemed to have offered to sell his or her Stock Interest at the Agreement Price, and on the Agreement Terms, as provided herein. a. In such event, the Other Shareholders shall have ninety (90) days from the date of retirement in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. E.2. below. b. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation must purchase any of the Offered Stock not purchased by the Other Shareholders. A more difficult issue involves termination based for “cause,” where an owner-employee commits some act considered detrimental to the entity. Generally, most would agree that if such an act is extreme enough, it should constitute a fair basis for both termination of employment and the triggering of the buyout provisions. The difficulty comes in defining the term “cause” in such a way that it cannot be used as a carte blanche to force a buyout of an owner’s interest at the whim of the other owners. This may be a particularly contentious issue if the purchase price is affected adversely by the circumstances of the termination.

14


Just as critical is the question of who determines whether or not the definition has been fulfilled. The definition should be specific enough that it cannot be used as an arbitrary basis for terminating employment and triggering the buyout, but broad enough to encompass the full range of activity that would justify such termination. Here is some sample language: “2.

Termination for Cause.

a. In the event of the Termination for Cause of a Shareholder, the Other Shareholders shall have ninety (90) days from the Date of Termination in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Other Shareholders in accordance with the procedures outlined in paragraph III. B.2.b. below. b. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation shall have an additional ninety (90) days in which it may elect to buy any of the Offered Stock not purchased by the other Shareholders. c. If the Other Shareholders and/or the Corporation do not agree to buy in the aggregate all of the Offered Stock within such option periods, then the Offered Stock may be retained by the Shareholder, but shall remain subject to all of the provisions of this Agreement, other than this paragraph III.C.” d. ‘Cause’ is defined as conviction of or plea of guilty to a felony or misdemeanor, dishonesty, any other criminal conduct against XYZ, Inc., a continued breach of the owner’s duties and obligations arising under an employment contract with XYZ, Inc. or any written policy, rule, regulation of XYZ, Inc., for a period of five (5) days following his or her receipt of written notice from any officer of XYZ, Inc.” IV.

The Purchase Rights.

“Purchase rights” are rights of purchase which are created by the Agreement in the other owners and/or the entity upon the occurrence of a triggering event. Generally, depending on the form of the agreement and the event which triggers the purchase right, the other owners or the entity will have either an option to purchase the affected ownership interest or the obligation to purchase that interest. In either case, the owner of the affected interest will have the mandatory obligation to sell the interest. In some

15


cases an “either or option” clause might be used, i.e., the first option may fall to the other owners, with the second option or obligation falling to the entity. Here’s some sample language: “Each other Member shall have thirty (30) days from such notice of a Voluntary or Involuntary Lifetime Transfer in which to elect to buy all or any of the Offered Interest. The other Members may elect to buy the Offered Interest in proportion to their respective Membership Interests (excluding the Offered Interest) or in such other proportion, as they shall agree upon. If the other Members do not agree to buy in the aggregate all of the remaining Offered Interest within such option period, then the Company shall have the obligation to purchase any of the Offered Interest not purchased by the other Members. If the other Members and/or the Company does not agree to buy in the aggregate all of the Offered Interest within such option periods, such Lifetime Transfer may be completed.”

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Unit Three Quizzer Which of the following is not generally a “triggering event” in a Buy-Sell Agreement? A.

Death of an owner.

B.

A voluntary transfer of an ownership interest.

C.

The divorce of an owner.

D.

Termination for “cause.”

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Answers A.

Death of an owner

A is Incorrect – Death of an owner is a triggering event that should be included in every Buy-Sell Agreement. B.

A voluntary transfer of an ownership interest.

B is Incorrect – A voluntary transfer of an ownership interest is a triggering event that should be included in every Buy-Sell Agreement; however, transfers to so-called “permissible transferees” are often excepted. C.

The divorce of an owner.

C is Correct – It is not the divorce of the owner that generally triggers the purchase options or obligations, but rather an involuntary transfer of the ownership interest that may result from the divorce proceeding which is the triggering event. D.

Termination of employment for “cause.”

D is Incorrect – Termination of employment for “cause” should be a triggering event in most Buy-Sell Agreements. The difficulty is often defining the term ‘”cause.”

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UNIT FOUR - Determination of the Purchase Price Learning Objectives After completing this Unit, you will be able to: ›

Identify the alternative methods of determining the purchase price in Buy-Sell Agreements. ›

I.

Identify the manner in which price is determined under each of the alternative methods discussed.

Recognize the pros and cons of each of the alternative valuation methods.

Overview.

There are several methods that can be used to determine the price at which an owner’s interest is to be set under a Buy-Sell Agreement. As a general premise, the apparent objective in all circumstances may appear the same: to determine a fair value for the interest which is the subject of the purchase. However, the nature of the triggering event may suggest different approaches to the valuation and even call for different purchase prices in different circumstances. For instance, if the triggering event is the death of a founding shareholder, the objective may be to buy out that individual at a figure which represents the full realization of the value created by years of that individual’s hard work. On the other hand, if the sale is to that same owner’s family members who are going to take over and continue the business, the price may be set at a lower level in order to achieve an estate planning objective. And if the triggering event is the termination of employment for cause, a punitive price well below fair market value should be considered. This section will review three of the most commonly used methods in determining the purchase price: (1) agreed upon price, (2) price determined by formula, and (iii) price determined by appraisal. II.

Agreed Upon Price.

The price may simply be agreed upon by the parties. This method assumes that the parties have a realistic idea of what the business is actually worth, which may or may not be the case. In addition, if the price is not reviewed and updated periodically, it may well prove an inaccurate representation of value in any event. Therefore, the agreement should provide that the stated price will be reviewed and agreed to on at least an annual basis by the parties. Further, if the price has not been updated within the stated time frame, the price will be determined by an alternative measure, such as by an appraisal. Here’s some sample language: “1. The Fair Market Value of the Corporation shall be the amount set forth on the attached Exhibit “B.” The Fair Market Value may be determined on an annual basis as decided by the majority of the Shareholders. Exhibit B shall be amended to reflect any amended Fair Market Value. 2. In the event that the Shareholders have failed to agree as to a Fair Market Value of the Corporation, 19


within two years of the date of the event triggering the options and/or obligations of purchase provided herein, the Fair Market Value of the Corporation shall be determined by a Qualified Appraiser selected by the accountant then serving the Corporation; in making such appraisal, discounts for lack of marketability and minority shall be disregarded. 3. The initial Fair Market Value shall be One Million Dollars ($1,000,000).� III.

Price Determined by Appraisal. A.

In General.

An appraisal of the business will generally provide an accurate assessment of the current value of the business. However, there are a number of issues which should be addressed in the agreement with regard to the appraisal and how it should be conducted. B.

Who Chooses?

One of the questions involved in using this method is who chooses the appraiser. Obviously, the side that chooses the appraiser may have significant input in the result. Sometimes the agreement will provide that the buyer and seller will each choose his or her appraiser, with provision that if the two appraisals differ by a stated percentage, a third appraiser, agreeable to both parties, will be engaged to make the final determination of value. C.

Who Pays?

The agreement should provide for who will pay for the appraisal; either the entity, the owner whose interest is being appraised, or the costs are to be shared by all the parties. D.

What if there is a Short Fall?

One problem involved in using an appraisal, other than the expense, is that the value of the company is generally not determined until the event triggering the Buy-Sell obligation is triggered. This may create a situation where the source of funding may fall short of the actual purchase price. E.

How is Value Determined?

1. Life Insurance – In the case of a redemption agreement, the purchase obligation triggered on the death of an owner is usually funded with life insurance owned by the entity. A question which should be addressed in the agreement is how the life insurance itself should be taken into account for purposes of the appraisal. Specifically, whether the life insurance value is to be included as an asset of the entity in determining its fair market value and, if included, whether it should be valued at its book value or at the face value of the policy. Generally, since the appraisal is measuring the value of the business, both the asset value of the life insurance and the liability represented by the obligation to redeem the deceased owner’s interest should be disregarded by the appraiser in valuing the entity. 20


2. Other Factors – In valuing an interest in a closely held business, whether it is a corporation, partnership, or limited liability company, two other possible approaches to determining the value of an interest should be considered. Under the one method, the value of the entire entity is determined and the percentage of ownership held by the owner is then applied to that figure to reach a pro rata share of that value. Under a second method, the appraiser simply determines an appraised value of the particular interest actually held by the owner. It may appear that the two methods would arrive at the same figure; however, under the second method, there are several factors that could decrease, or in some cases increase, the value over its otherwise pro rata share of the value of the entire company. If the interest represents a “minority interest” in terms of vote, discounts of anywhere from thirty to forty percent could be justified. If the interest represents a controlling interest, a “control premium” might be applied. If the owner represents an essential part of the management team or if he or she adds significantly to the goodwill of the entity, a “key man” discount could apply. F.

Sample Language

“1.1.

The Sale Price.

In the event a Partnership Interest is to be offered for purchase under either Section 10.2, or 10.3, above, the Sale Price shall be determined by the following procedure: A. The Sale Price to be paid for the offered Partnership Interest shall be the “fair market value” of such Partnership Interest. B. “Fair market value” of such Partnership Interest will be determined in a manner consistent with the methods used for determining such Partnership Interest’s value for federal estate tax purposes, ignoring any alternate valuation date (under Internal Revenue Code Section 2032) or special use valuation (under Internal Revenue Code Section 2032A). C. If the purchasing party or parties and the offering Partner are unable to agree mutually upon the “fair market value” of the Partnership Interest within sixty (60) days from the date of the final acceptance of the offer, the fair market value of the interest will be determined by one or more Qualified Appraisers, selected under the procedures set forth in this Section 10.4. D. If the “fair market value” of the Partnership Interest is to be determined by Qualified Appraisers, the offering Partner and buyer or buyers collectively will each appoint a Qualified Appraiser, within ten (10) days following the 21


expiration of the sixty (60) day period within which the offering Partner and the buyer or buyers could not mutually agree on the fair market value. E. If the parties shall fail to appoint a Qualified Appraiser within this ten (10) day period, any appointed Qualified Appraiser shall unilaterally establish the “fair market value” of the Partnership Interest by delivering a written opinion thereof, and delivering the same to each of the parties to this Agreement. F. If the parties both appoint Qualified Appraisers within the said ten (10) day period, these two (2) Qualified Appraisers shall establish the “fair market value” of the Partnership Interest in a single written opinion agreed to by both of them. G. If these two (2) Qualified Appraisers cannot agree on the “fair market value” of the Partnership Interest within sixty (60) days of the appointment of the latter of them, they shall together appoint a third Qualified Appraiser whose sole written opinion shall establish the “fair market value” of such interest. H. The reasonable fees and reimbursed expenses charged by the Qualified Appraisers in the valuation under this Section shall be borne solely by the Partnership. I. The Partnership will provide such data as any Qualified Appraiser deems necessary or useful to make a determination of the “fair market value” of such interest.” IV.

Price Determined by Formula. A.

In General

Methods of valuation based on an agreed upon formula have the advantage of making sure the valuation of the enterprise is based upon current data. This should ideally translate into a valuation which reflects a current fair market value of the enterprise without the need on the part of the owners to constantly update that value. Sometimes the owners will have their own formula which is completely unique to their company or their industry to determine the fair market value of the business. Whatever formula is used, the buyer and the seller will both have some assurance that the price will reflect a current value of the business. In addition, the use of a formula makes it easy to track the value by simply applying the formula to current economic data. This should make adjustments in the levels of insurance and other funding sources, such as sinking funds, easier to track and implement without the need for a formal appraisal.

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B.

Net Book Value

One formula method which is sometimes employed, but not recommended, is the “net book value” method. The “net book value” of an entity is determined simply by determining the aggregate value of the entity’s assets and offsetting that value by its liabilities. The value of the assets is based on their original cost less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value does not include the value of its intangible assets, such as goodwill, unless they have been acquired by purchase. The net book value method is generally a poor way to determine the fair market value of an operating business entity. First, because the net book value of an entity, even in the best case, represents the value of the business if it were to be liquidated. Most operating businesses will have a higher value when valued as a going concern. In addition, the net book value method bases the value of the entity’s assets on their historic cost rather than their actual current value. Historic cost may or may not represent the actual current value of those assets. As a result, the net book value approach will in most cases lead to an understatement or overstatement of actual value of a business, even in liquidation. Here is a sample provision: “VI. SHARE VALUATION 1. Shares subject to mandatory sale under this Agreement shall be valued as provided in Section V. 2. (a) The Corporation’s “net book value” shall be computed on the Applicable Date by the accountant then serving the Corporation applying generally accepted accounting principles. (b) The Value Per Share shall be computed by dividing the Corporation’s Net Book Value by the number of shares outstanding on the Applicable Date. 3. The value of the Seller’s shares shall be the Value Per Share multiplied by the number of shares offered for mandatory sale as provided in Section III, hereof.” Due to inherent problems in using the net book value as a method, another variation is the “adjusted book value” method. Under this method, adjustments (increases and decreases) are made to the book value of specific assets; such as real estate and investment property. For example, the value of a building would be adjusted from its book value of $400,000 to its fair market value of $5,000,000. C.

Capitalization of Earnings

Alternatively, the value of the business determined by a formula, such as the capitalization of net earnings or EBITDA (i.e., earnings before, interest, taxes, depreciation, and amortization), based on a stated capitalization rate can be utilized. For an operating business, this method will generally produce a value more consistent with the actual current fair value of the enterprise. While this approach is more 23


consistent with the approach most business appraisers will take, it can oversimplify the valuation process leading to an inaccurate value. A qualified appraiser will generally take an average of at least three years’ earnings and will often weight them in the process. Further, the earnings may be adjusted to reflect expenses that might be overstated, such as the compensation of owner/employees compared to cost of a non-owner replacement doing the same job. In addition, the selection of the appropriate capitalization rate, normally based on an assessment of risk, is also an essential part of the appraisal process. A formula provision must make assumptions concerning these factors which may or may not be appropriate in valuing the business at a given point in time. Sample Language: “VI. SHARE VALUATION 1. Shares subject to mandatory sale under this Agreement shall be valued as provided in Section V. 2. (a) The Corporation’s average earnings shall be computed by dividing the sum of its pretax profits for each of the three fiscal years preceding the date on which a Shareholder (“Seller”) becomes obligated to sell his or her shares under this Agreement by three. Pretax profits shall be computed in accordance with generally accepted accounting principles. (b) The average earnings per share shall be computed by dividing the Corporation’s average earnings by the number of shares outstanding on the date Seller becomes obligated to sell shares. (c) The average earnings per share times five will equal the Value Per Share. 3. The value of the Seller’s shares shall be the Value Per Share multiplied by the number of shares offered for mandatory sale as provided in Section III, hereof.” Here is a second provision: “The following formula shall be used to determine the purchase price for a Partnership Unit: Net cash flow ÷11 % capitalization rate = Base Value of the Partnership. To the "Base Value" there shall be added the book value of all cash and personal property assets and there shall be subtracted therefrom the face value of all Partnership liabilities. The result shall be the value of the 24


Partnership. The value of the Partnership shall be divided by the then number of Partnership Units owned by the Partners to arrive at a value for each Partnership Unit. Such value shall then be multiplied by the number of Partnership Units owned by the Selling Partner to determine the purchase price to be paid to the Selling Partner.�

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UNIT FOUR QUIZZER Which of the following best describes how the value of the business entity is determined under the “net book value” formula clause? A.

The value of the business entity is simply agreed upon by the parties.

B.

The value of the business entity is determined by capitalizing earnings.

C.

The value of the business entity is determined by an appraisal.

D. The value of the business entity is determined by calculating the historic cost of the assets reduced by depreciation and offset by the entity’s liabilities.

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ANSWERS A.

The value of the business entity is simply agreed upon by the parties.

A is Incorrect – This describes the “agreed upon value” method. B.

The value of the business entity is determined by capitalizing earnings.

B is Incorrect – This describes the “capitalization of earnings method.” Under this method the value is based on a capitalization of net earnings or EBITDA, using a stated capitalization rate. C.

The value of the business entity is determined by an appraisal.

C is Incorrect – This describes the appraisal method. D. The value of the business entity is determined by calculating the historic cost of the assets reduced by depreciation and offset by the entity’s liabilities. D is Correct – Under the “net book value” method the value of an entity is determined simply by determining the aggregate value of the entity’s assets and offsetting that value by its liabilities. The value of the assets is based on their original cost less any depreciation, amortization or impairment costs made against the asset. The net book value method is generally a poor way to determine the fair market value of an operating business entity.

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UNIT FIVE – Terms of the Purchase Learning Objectives After completing this Unit, you will be able to: ›

I.

Identify the various terms of purchase that the Buy-Sell Agreement should address.

Overview.

Once a purchase right has been exercised and the purchase price determined, the next question is upon what terms the transfer of the ownership interest is to be made. The determination of the terms of the purchase should address when the closing on the ownership interest will take place and on what terms the purchase price is to be paid. II.

Closing.

The Agreement should specify when the closing on the transfer of ownership interests should take place. Here is some typical language addressing this issue: “4.

Closing.

Except as otherwise provided herein, the closing of a purchase pursuant to this Agreement shall take place at the principal office of the Company, within sixty (60) days of the date of the final acceptance of the Offer of Purchase.” III.

Payment of the Purchase Price. A.

Overview.

Purchase obligations under a Buy-Sell Agreement will occur either during the lifetime of the owner or at his or her death. The available options with regard to the source of funding will depend primarily on the triggering event. In the case of death, life insurance maintained on the lives of each of the owners can be an important source of funding. In the event of disability, disability buyout insurance is available as well. However, in all other cases—voluntary and involuntary lifetime transfers and termination of employment— the purchaser must depend on his, her or its current ability to fund the purchase. In many cases this may place a significant burden on the purchaser. In cases where the obligation is stated in terms of an option, inability to fund the purchase may cause the potential purchaser to decline the option altogether. To avoid placing an undue burden on the purchaser, the agreement should provide for a payment of the purchase obligation in installments over an extended period of time. B.

Life Insurance.

1. Overview – In a redemption agreement, life insurance is purchased by the entity on the lives of the owners in order to fund the purchase obligation. In a cross purchase agreement, each owner will individually purchase life insurance on the lives of the other owners. 28


2. Number of Policies Required – Under a redemption agreement, when the entity purchases the life insurance, the number of policies required will equal the number of owners. On the other hand, under a cross purchase agreement, when the owners purchase the insurance, the number of policies required will increase exponentially. If there are two shareholders, two policies are all that are required; however, if there are three shareholders, six policies will be needed; if there are four shareholders, then 12 policies will be needed, and so forth. In order to deal with a large number of policies, sometimes a trustee will hold the policies together in trust, one on each owner in a face amount equal to the aggregate buyout obligation of all the owners. On death of a particular owner, the life insurance on his or her life is paid to the trustee who pays out the proceeds to each of the surviving shareholders in direct proportion to their individual purchase obligation. 3. Premium Payments – The payment of the life insurance premiums will not be tax deductible in any circumstances, whether paid by the entity or the individual owners. 4. Taxation of Proceeds – The receipt of the proceeds of the life insurance will likely be tax free whether paid to the entity under a redemption agreement or the individual owners under a cross purchase agreement. There is one exception for when life insurance is paid to a C corporation—the proceeds may in certain cases create alternative minimum tax consequences. Increases in cash surrender value and certain life insurance proceeds are among the benefits added to a corporation’s ordinary taxable income in order to determine its alternative minimum tax liability. C.

Disability Buyout Insurance

Disability Buyout Insurance is insurance that pays a lump sum payment in the event the insured is determined to be “disabled.” The tax treatment of this type of insurance is rather straight forward—the premiums are not deductible and the benefit is not taxed. D.

Installment Note.

Absent insurance funding, an installment note issued by the purchaser is the next most common form of payment. The note should provide a long enough term so that the purchaser is not placed in a difficult cash flow position. The note should also provide for adequate security. If the note is issued by the entity, it ideally should be guaranteed by the individual owners. On the other hand, if the purchase right falls to the entity it should be guaranteed by the owners individually. At the very least, the interest being sold should serve as collateral for the obligation. Therefore, in the case of a default, the interest can be reclaimed. Interest should be provided at a level at least equal to the Applicable Federal Rate. When stock or a partnership interest is sold in exchange for an installment note, the transaction will generally qualify for installment sale treatment under the Internal Revenue Code. In the case of the sale of partnership interests, the portion of the gain that is attributable to substantially appreciated inventory or unrealized receivables will not qualify for installment sales treatment and will be treated as ordinary income.

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UNIT SIX – Setting the Purchase Terms for Each Triggering Event Learning Objectives After completing this Unit, you will be able to: ›

I.

Identify the appropriate purchase rights, purchase price, and terms of the purchase which should be provided in regard to each of the various triggering events.

Introduction.

The nature of the purchase right, i.e. whether an option or obligation is created, the terms of the purchase, and perhaps even the purchase price, may be determined by the event which triggers the buyout. This Unit will discuss the terms which may be appropriate in terms of the triggering event. II.

Death of an Owner. A.

The Event.

The death of an owner. B.

The Purchase Rights.

The purchase right is normally stated in terms of a mandatory obligation to sell on behalf of the estate of the deceased owner, and a mandatory obligation to purchase on behalf of the surviving shareholder in the case of a cross purchase agreement or the entity in the case of a redemption agreement. C.

The Price.

The determination of the purchase price in the event of the death of an owner may depend on the context in which the agreement is adopted and the identity of the individuals holding the purchase option. For instance, if the triggering event is the death of a founding shareholder, the objective may be to buyout that individual at a figure which represents the full realization of the value created by years of that individual’s hard work. On the other hand, if that sale is to the owner’s family members who are going to take over and continue the business, the price may be set at a lower level in order to achieve an estate planning objective.5 D.

Terms.

1. If the triggering event is the death of an owner, the funding of the purchase obligation generally involves life insurance on the life of the owners. Example: A and B are the sole shareholders of XYZ, Inc. In the event either of them dies, the survivor has agreed to purchase the deceased shareholder’s stock at an agreed upon price of $100,000. In order to fund the purchase obligation, A has taken out an insurance policy on B’s life in the face amount of $100,000. 5

See Section III in Unit Seven, for a further discussion of this issue.

30


2. If life insurance funding is being maintained, the payment terms should require that an amount equal to the life insurance proceeds should be paid at the time of the closing of the transfer. If the purchase price exceeds that amount, the excess should be paid in the form of the purchaser’s installment note over a stated period of time; e.g. in sixty equal monthly installments. III.

Voluntary Transfers and Involuntary Transfers. A.

The Event.

The “voluntary transfer” or “involuntary transfer” of an ownership interest by an owner. 6 B.

The Purchase Rights.

A voluntary or involuntary transfer will generally result in an option to purchase by the other owners or the entity rather than an obligation. Sometimes an “either or option” clause might be used, i.e. the first option may fall to the other owners, with the second option following to the entity. Here’s some sample language: “Each other Member shall have thirty (30) days from such notice of a Voluntary or Involuntary Lifetime Transfer in which to elect to buy all or any of the Offered Interest. The other Members may elect to buy the Offered Interest in proportion to their respective Membership Interests (excluding the Offered Interest) or in such other proportion, as they shall agree upon. If the other Members do not agree to buy in the aggregate all of the remaining Offered Interest within such option period, then the Company shall have an additional thirty (30) days in which it may elect to buy any of the Offered Interest not purchased by the other Members. If the other Members and/or the Company does not agree to buy in the aggregate all of the Offered Interest within such option periods, such Lifetime Transfer may be completed.” C.

Purchase Price.

The purchase price should be based on the actual fair market value of the interest being transferred. Whether the figure is discounted may depend on how the parties view the circumstances which trigger the buyout. An attempt to voluntarily transfer an interest may be viewed as an attempt to abandon the enterprise and should not be rewarded with a full value cash out. In addition, the owners who choose to carry on with their involvement may not want to be put in a position of choosing between buying out the

6

See section III.C in Unit Three for a discussion of the definition of these terms.

31


owner or accepting an unknown third party as a business partner. On the other hand, others may feel that if they choose to sell their interest they should not be forced to accept less than full value for the interest. D.

Terms.

The form of payment should be in the form of the purchaser’s installment note over a period long enough that the purchaser is not placed in a difficult cash flow position. IV.

Disability. A.

The Event.

The “disability” of an owner.7 B.

The Purchase Rights.

Whether the other owners or the entity should be obligated to purchase the ownership interest of the disabled owner is an individual choice. Sometimes the remaining owners are given an option with the entity given an obligation to the extent the other owners do not elect to pick up the option. Here is some sample language: “If the other Members do not agree to buy in the aggregate all of the remaining Offered Interest within such option period, then the Company shall have the obligation to buy any of the Offered Interest not purchased by the other Members.” C.

Purchase Price and Terms

The purchase price should equal the actual fair market value of the interest being transferred and should be paid in the form of the purchaser’s installment note over a period of time. V.

Termination of Employment. A.

The Event.

The termination of an owner’s employment by the entity.8 B.

Price.

The price should be determined by the circumstances which result in the termination. In the case of termination of employment, other than retirement, the purchase right is generally stated in terms of an option. In the case of retirement, the entity and/or the other owners should have an obligation to purchase the interest of the retiring owner. If the termination occurs because of retirement based on an anticipated voluntary retirement, the price should equal full fair value. Unless the payment has been prefunded in some fashion, the price should

7 8

See section III.D in Unit Three for a discussion of the definition of this term . See section III.E in Unit Three for a discussion of the definition of this term.

32


be paid over a term of years so that an unfair cash flow burden is not placed on the entity or the other owners. If the termination occurs because of termination based on “cause,� the price is often at something significantly less than full fair value. Often in the case of voluntary terminations or involuntary terminations not for cause, the purchase price will be less than full value. If such termination occurs within a stated period, such as five years from the date the ownership interest was acquired, the price may be limited to the amount invested by the owner in the ownership interest. (b) Purchase Price in Certain Events. Notwithstanding anything herein to the contrary, the purchase price of a Selling Partner's Partnership Interest who has been terminated from employment by Jones Medical Clinic "for cause" (as that term may be defined in said Partner's Employment Agreement with Jones Medical Clinic) shall be one-half (1/2) of the Agreed Value or the value determined pursuant to this Paragraph 14, however, such amount shall in no event be less than the amount paid by the Partner to the Partnership for the purchase of his or her Partnership Interest. C.

Terms.

The form of payment should be in the form of the purchaser’s installment note over a period long enough that the purchaser is not placed in a difficult cash flow position.

33


Unit Six Quizzer Which of the following is not generally a purchase term in the case of the death of the owner? A.

The payment of the purchase price is funded with life insurance.

B. The purchase right is stated in terms of a mandatory obligation to sell on behalf of the estate of the deceased owner and a mandatory obligation to purchase on behalf of the surviving owner or entity. C.

The determination of price may depend on the context in which the agreement is adopted.

D.

The full purchase price is paid in installments.

34


Answers A.

The payment of the purchase price is funded with life insurance.

A is Incorrect - If the triggering event is the death of an owner, the funding of the purchase obligation generally involves life insurance on the life of the owners. B. The purchase right is stated in terms of a mandatory obligation to sell on behalf of the estate of the deceased owner, and a mandatory obligation to purchase on behalf of the surviving owner or entity. B is Incorrect - The purchase right is normally stated in terms of a mandatory obligation to sell on behalf of the estate of the deceased owner and a mandatory obligation to purchase on behalf of the surviving shareholder in the case of a cross purchase agreement or the entity in the case of a redemption agreement. C.

The determination of price may depend on the context in which the agreement is adopted.

C is Incorrect - The determination of the purchase price in the event of the death of an owner may depend on the context in which the agreement is adopted and the identity of the individuals holding the purchase option. D.

The full purchase price is paid in installments.

D is Correct - If life insurance funding is being maintained, the payment terms should require that an amount equal to the life insurance proceeds should be paid at the time of the closing of the transfer. If the purchase price exceeds that amount, the excess should be paid in the form of the purchaser’s installment note over a stated period of time; e.g. in sixty equal monthly installments.

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UNIT SEVEN – Tax Consequences Learning Objectives After completing this Unit, you will be able to identify the tax consequences of the various forms of Buy-Sell Agreements as they relate to: ›

I.

(i) the party funding payment of the purchase price; (ii) the selling owner; (iii) the remaining owners; and (iv) the purchasing party.

Overview.

This Unit will discuss the tax consequences of the transfer of ownership interests to both the seller and the purchaser under the various forms of Buy-Sell Agreements. II.

Income Tax Consequences. A.

Tax Consequences of a Redemption Plan – Death or Retirement of an Owner.

1.

By a C Corporation.

a. To the Corporation – Unless the C Corporation distributes appreciated property in exchange for its stock, the corporation will experience no gain or loss as the result of the redemption of stock. There is one caveat, in the case of the death of the shareholder when life insurance is paid to the corporation as a means of funding the buyout. For corporations, there's an alternative minimum tax (AMT) adjustment for adjusted current earnings (ACE). ACE is calculated using concepts similar to those used in determining earnings and profits (E&P) for regular tax purposes, which would include life insurance proceeds. Then, to the extent ACE exceeds alternative minimum taxable income (AMTI) (as determined without the ACE adjustment and the alternative tax NOL deduction), 75% of the excess is added to AMTI. Where ACE is less than AMTI, a negative adjustment may result (subject to limitations). b. To the Selling Shareholder – A redemption is treated under Sec. 302(a), as an “exchange” provided, as is typically the case, it is: (1) “not essentially equivalent to a dividend;” (2) a “substantially disproportionate” redemption of stock; (3) a “complete termination” of the shareholder's interest; or (4) a partial liquidation distribution. Therefore, the exchange will, in most cases, result in capital gain to the departing shareholder to the extent that the proceeds exceed the shareholder’s basis. In the case of a deceased shareholder, the basis of the stock in the hands of the estate or heir to the stock will be “stepped up” to its value at the date of death, therefore, no gain will generally be recognized on the redemption of the stock. If the distribution does not fall into the general provisions of 302(a) listed above, the transaction is treated as if it were an Code Sec. 301 distribution to the shareholder (taxable as an ordinary dividend to the extent of the corporation's earnings and profits), then tax free to the extent of the shareholder’s stock basis, and capital gain for the excess. c. To the Remaining Shareholders - Under a redemption agreement, since the remaining shareholders are not parties to the transaction, they will receive no basis increase to their stock. 2.

By an S Corporation.

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a. To the Corporation –Unless the S Corporation distributes appreciated property in exchange for its stock, the corporation will experience no gain or loss as the result of the redemption. b. To the Selling Shareholder – Since the corporate earnings are taxed to the shareholders as earned, whether or not they are distributed, redemption of S corporation stock will generally be treated as a sale or exchange of the shareholder stock. c. To the Remaining Shareholders – To the extent the purchase is funded with life insurance, the remaining shareholder will receive a basis increase equal to their pro rata share of the insurance proceeds. 3.

Redemption by the Partnership –Death or Retirement of a Partner.

a. To the Partnership – A partnership generally does not recognize gain or loss on a distribution of property in redemption of a partner’s interest in the partnership upon death or retirement of the partner. b. To the Selling Partner – The tax consequences to the selling partner are dictated by Sec. 736 of the Code and the form of the agreement. Under Sec. 736 payments are either Sec. 736(b) payments or Sec. 736 (a) payments. The IRS will generally recognize an allocation between Sec. 736(b) and Sec. 736(a), and the valuation placed by the partners upon a partner’s interest in partnership property in an arm’s length agreement will be regarded as correct. (1)

Sec. 736(b) Payments.

Sec. 736(b) payments are treated as payments made in liquidation of the interest of a retiring partner or a deceased partner to the extent such payments are made in exchange for the interest of the partner in partnership property. Excluded from treatment under Sec. 736(b) are payments for a general partnership interest attributable to Sec.751(c) unrealized receivables and unstated goodwill. Sec. 736(b) payments are treated as liquidating distributions. They fall into two categories. The part attributable to appreciated inventory is treated as distributed to the shareholder and resold to the partnership – producing ordinary income. The balance is treated as paid in exchange for the partnership interest – producing capital gain to the extent the cash received (including reduction of the partner’s share of debt) exceeds basis. (2)

Sec. 736(a) payments.

Payments not treated as Sec. 736(b) payments are considered either as distributive share or guaranteed payment under Sec. 736(a). The section provides that payments made in liquidation of the interest of a retiring partner or a deceased partner shall, except as provided in Sec. 736(b), be considered: (1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership, or (2) as a guaranteed payment if the amount thereof is determined without regard to the income of the partnership. In either case, the payment will generally constitute ordinary income, as opposed to capital gain.

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c. To the Purchasing Partner(s) - The purchasing partner takes a cost basis in the acquired interest equal to the purchase price. Under Sec. 754 of the Code, the partnership may elect to adjust the basis of its assets with respect to the buying partner. Whether the payments made by the partnership are treated as Sec. 736(b) payments or Sec. 736(a) payments will directly impact the remaining partners. Sec. 736(b) payments are not tax deductible by the partnership and, as a result, additional partnership profit could be taxed to the remaining partners. Sec. 736(a) payments will, in effect, result in an allocation of partnership profit to the deceased or retired partner and away from the retiring partners. d. The Agreement - As stated above, the IRS will generally recognize an allocation between Sec. 736(b) and Sec. 736(a), and the valuation placed by the partners upon a partner’s interest in partnership property in an arm’s length agreement will be regarded as correct. If no allocation is made, although not stated in the regulations, it appears that payments for a partner’s interest in partnership property under §736(b) will be limited to the fair market value of the partner’s interest in the property. Amounts paid in excess of the value of the interest in the property of the partnership would be §736(a) payments. A provision like the following should be included in the Agreement: Section 13.04. Federal Income Tax Treatment. In the event the Partnership exercises the right to liquidate any Partner’s interest in the Partnership under this Article XIII, one hundred percent (100%) of all payments made by the Partnership to such Partner hereunder in consideration for such Partner’s Partnership interest will, for federal income tax purposes, be classified as a Code Section 736(b) payment except for such Partner’s share of the Partnership’s “unrealized receivables,” as defined in Code Section 751(c), which will be classified as a Code Section 736(a)(1) payment. The General Partner shall conclusively determine or cause to be determined any such Partner’s share of “unrealized receivables.” Neither the Partnership nor the General Partner shall be liable to any person or entity for any inaccuracy in determining any such Partner’s share of the Partnership’s “unrealized receivables.” B.

Tax Consequences of a Cross Purchase Plan

1.

Involving a C or S Corporation.

a. To the Corporation – Since the corporation is not involved in the transaction, it will not experience any gain or loss on the sale of its stock pursuant to a cross purchase obligation. b. To the Selling Shareholder – A shareholder that sells its stock to another shareholder pursuant to a cross purchase agreement will realize capital gain to the extent the purchase price exceeds the stockholder’s basis in the stock sold. If the sale is made by the estate of a deceased shareholder, the basis of the estate will be stepped up to fair market value at the date of death. c. To the Purchasing Shareholder – The purchasing shareholder will receive a basis equal to the purchase price. 38


2.

Involving a Partnership.

a. To the Partnership – The partnership will not experience any gain or loss on the sale of a partnership interest pursuant to a cross purchase obligation. However, the sale of more than 50 percent of the partnership interests within any twelve-month period will cause the constructive termination of the partnership. Normally this constructive termination will be without tax effect. b. To the Selling Partner – A partner who sells his or her partnership interest to another partner pursuant to a cross purchase agreement will realize gain to the extent the purchase price exceeds the partner’s income tax basis in the interest sold. To the extent of the partner’s share of the partnership’s substantially appreciated inventory and unrealized receivables, the gain will be considered ordinary rather than a capital gain. c. To the Purchasing Partner – The purchasing partners will be allowed to obtain a step up in basis in both his or her “outside” basis in its partnership interest and his or her share of “inside” basis, the basis in the assets of the partnership. The purchasing partner takes a cost basis in the acquired interest equal to the purchase price. Under Sec. 754 of the Code, the partnership may elect to adjust the basis of its assets with respect to the buying partner. C.

Life Insurance Funding.

1. Premium Payments – The payment of the life insurance premiums will not be tax deductible in any circumstances, regardless of whether paid by the entity or the individual owners. 2. Taxation of Proceeds – The receipt of proceeds of the life insurance should be tax free whether paid to the entity under a redemption agreement or to the individual owners under a cross purchase agreement. One exception is when life insurance proceeds are paid to a C corporation; as discussed above, the proceeds may in certain cases create alternative minimum tax consequences. D.

Disability Insurance.

The tax treatment of this type of insurance is straight forward—the premiums are not deductible and the benefit is not taxed. III.

Estate Tax Consequences. A.

Fixing the Value for Estate Planning Purposes.

As a general rule, if the owner dies owning an ownership interest in a closely held business, the value of that interest for federal estate tax purposes will be its “fair market value.” That value will be determined based on a number of factors. However, if a Buy-Sell Agreement is in place, the value provided in the agreement may fix the value of the business interest for estate tax purposes. In order for the agreement price to be determinative for estate tax purposes, the following requirements must be met: (1) the decedent's estate must be obligated to sell; (2) the agreement must prohibit the owner during life from disposing of the stock interest without first offering it to the prospective purchaser at the contract price (i.e. a right of first refusal); and (3) the purchase price at death must have been established through an arm's

39


length business bargain (and not as a device to pass the decedent's shares to the natural objects of his or her bounty for less than an adequate and full consideration in money or money's worth). B.

IRC Sec. 2703.

Under §2703, despite meeting the requirements stated above, any agreement may be disregarded for valuation purposes, unless the agreement: (1) is a bona fide business arrangement; (2) is not a device for transferring property to members of the transferor's family for less than full and adequate consideration; and (3) has terms that are comparable to similar arrangements entered into by persons in an arms’ length transaction. See §2703(b); Regs. §25.2703-1(a), (b). These requirements are deemed satisfied if more than 50% by value of the property subject to the right or restriction is owned directly or indirectly by individuals who are not members of the transferor's family. Regs. §25.2703-1(b)(3).

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Unit Seven Quizzer In a Buy-Sell Agreement involving C corporation stock, which of the following is the correct description of the tax consequence under both a cross purchase agreement and a redemption agreement? A.

The corporation will not experience any tax consequence.

B. Provided the stock is a capital asset in the hands of the shareholder, the shareholder will realize capital gain in every case. C. The non-selling shareholder will receive an increase is his or her basis in his or her stock equal to the purchase price. D.

The premiums paid on any life insurance acquired to fund the purchase are not tax deductible.

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Answers A.

The corporation will not experience any tax consequence.

A is Incorrect – In a stock redemption, if the C Corporation distributes appreciated property in exchange for its stock, the corporation will experience gain on the distribution. If life insurance is paid to the corporation as a means of funding the buyout, there could be alternative minimum tax consequences as well. In a cross purchase, since the corporation is not involved in the transaction, it will not experience any gain or loss on the sale of its stock pursuant to a cross purchase obligation. B. Provided the stock is a capital asset in the hands of the shareholder, the shareholder will realize capital gain in every case. B is Incorrect – In a stock redemption, the exchange will, in most cases, result in capital gain to the departing shareholder to the extent that the proceeds exceed the shareholder’s basis. However, if the requirements of IRC Sec. 302(a) are not met, the redemption may result in ordinary income in some cases. Under a cross purchase agreement, a shareholder that sells its stock to another shareholder will realize capital gain to the extent the purchase price exceeds the stockholder’s basis in the stock sold, provided the stock is a capital asset in the hands of the shareholder. C.

The purchasing shareholder will receive a basis equal to the purchase price.

C is Incorrect – Under a redemption agreement, since the remaining shareholders are not parties to the transaction, they will receive no basis increase to their stock. Under a cross purchase agreement, the purchasing shareholder will receive a basis equal to the purchase price. D.

The premiums paid on any life insurance acquired to fund the purchase are not tax deductible.

D is correct – In either a redemption agreement or a cross purchase agreement, the premiums paid on any life insurance acquired to fund the purchase are not tax deductible.

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UNIT EIGHT – Additional Issues to Address Learning Objectives After completing this Unit, you will be able to: ›

I.

Identify issues that should be addressed in a Buy-Sell Agreement in addition to those already discussed.

Overview.

This Unit will discuss some of the collateral issues which should be addressed in the Buy-Sell Agreement. II.

Consent to Joint Representation.

In drafting a Buy-Sell Agreement, the attorney should recognize that there may be an inherent conflict of interest. The parties should be asked to acknowledge and waive the conflict. The Shareholders and Corporation acknowledge that the Corporation’s counsel, Edward L. Perkins, Esq. and the law firm of Gibson & Perkins, PC, prepared this Agreement on behalf of and in the course of his representation of the Corporation, and that: “i. THE PARTIES HAVE BEEN ADVISED BY MR. PERKINS THAT A CONFLICT EXISTS AMONG THEIR INDIVIDUAL INTERESTS; AND ii. THE PARTIES HAVE BEEN ADVISED BY MR. PERKINS TO SEEK THE ADVICE OF INDEPENDENT COUNSEL; AND iii. THE PARTIES HAVE HAD THE OPPORTUNITY TO SEEK THE ADVICE OF INDEPENDENT COUNSEL.” III.

Disposition of Insurance Policies.

In a cross purchase agreement, the document should provide that upon the buyout of an owner, the insurance owned by that owner on the lives of the other owners can be purchased by the insured or perhaps the other owners. IV.

Resignation as Officers and Directors.

In the event an owner’s interest is purchased under the terms of a Buy-Sell Agreement, the former owner should resign as an officer and member of the Board of Directors. Here is some typical language: “6. Resignation as Director and Officer. If a party to this Agreement ceases to be a Member, such party hereby resigns as a director and as an officer of the Company, effective as of the Closing Date, as defined above, or such earlier date if so provided in the Operating Agreement of the Company.” 43


V.

Covenant Not to Compete and Non-Interference.

The agreement should provide that an owner whose interest is purchased is bound by a covenant not to compete with the entity for a reasonable time period after the sale. “XXIV.

Covenant Not to Compete.

A. During the term of this Agreement and for a period of three (3) years after termination of a Shareholder’s employment by the Corporation, a Shareholder or former Shareholder as the case may be shall not engage in any direct or indirect competition with the Corporation through the solicitation of the business of any of the Corporation’s customers on the Date of Termination or hire any employee of the Corporation, whether such competition is as an individual, partner, joint venture, employee, or agent for any person or entity. B. These covenants shall be construed as an agreement independent of any other provision of this Agreement; and the existence of any claim or cause of action of the terminating Shareholder against the Corporation, whether predicated on this Agreement or otherwise, shall not constitute a defense to the enforcement by the Corporation of this covenant.” VI.

Preserving the S Election.

The agreement should contain a provision that binds the owners to do nothing that will endanger the S Election. “7.1 Prohibited Transfers. 7.1.1 As long as the Company’s election for federal and state income tax purposes to be treated as an S corporation is in effect, no transfer shall be made or permitted if the transferee does not, at the time of transfer, consent to such election, or if, as a result of the transfer, the Company would lose its status as an S corporation under the then applicable federal and state income tax statutes and regulations. 7.1.2 Each Shareholder shall provide to the Company, immediately upon the Company’s request, such properly signed consents and other documents as, in the opinion of the Company, may be necessary or useful to perfecting and maintaining the Company’s status as an S corporation, and each Shareholder covenants that he shall 44


do nothing to interfere with the Company’s maintaining its status as an S corporation. 7.2

Revocation of Election.

7.2.1 Anything in this Agreement or the Articles or Bylaws of the Company notwithstanding, as required under Section 1362(d)(1), of the Internal Revenue Code of 1986, as amended (the “Code”) revocation of the Company’s status as an S Corporation may only be affected by the affirmative vote of Shareholders holding more than one-half of the shares of stock of the Company on the day on which the revocation is made, and with majority approval of the Board as required under Article III, Section 4.A of the Bylaws (an “Affirmative Vote”). 7.2.2 In such event, the Board shall provide each Shareholder with written notice of such determination. Each Shareholder, if requested, shall execute consents to such revocation in the forms prescribed by the Internal Revenue Code, and any other applicable statute or government regulation, and shall deliver such consents to the Company within the time required for timely filing as provided in the Code or other applicable statute or government regulation. 7.3 Inadvertent Termination of Status as S Corporation. 7.3.1 In the event of a termination of the Company’s status as an S corporation, other than as a result of an Affirmative Vote, the Company and the Shareholders agree to use their best efforts to obtain a waiver of the terminating event on the grounds of inadvertency from the Internal Revenue Service if the Company or any Shareholder desires that the Company’s status as an S corporation be continued. 7.3.2 The Company and the Shareholders further agree to take such steps and make such adjustments as may be required by the Internal Revenue Service pursuant to Sections 1362(f)(3) and (4) of the Code. 7.3.3 The Shareholder who caused the terminating event to occur shall bear the expense of procuring the waiver, including the legal, accounting and tax costs of taking such steps, and of making such adjustments as may be required, moreover, such Shareholder shall be liable to the Company and the other Shareholders for all damages, including additional taxes and costs that the Company and the other Shareholders may suffer as a result of any such termination of the Company’s status as an S corporation.” 45


VII.

Provision for Distribution – S Corporations. PROVISIONS REGARDING DISTRIBUTION OF S CORPORATION INCOME TO SHAREHOLDERS SECTION 9 - CORPORATE DISTRIBUTIONS. Each Shareholder agrees that Corporation will use its best efforts to make pro rata distributions of money with respect to its shares sufficient to pay the federal and state income taxes on the income that passes through from Corporation under IRC § 1366, net of any tax benefits produced by losses, deductions and credits that pass through under IRC § 1366. Corporation will use its best efforts to make such distributions either during its taxable year or during the three months after the end of its taxable year. For purposes of this section, a distribution shall be treated as made with respect to a particular corporate tax year if (1) it is made during the taxable year and not designated by Corporation as made with respect to another taxable year or (2) it specifically designated by Corporation as made with respect to that particular taxable year. The foregoing distribution requirement set forth in this section is subject, however, to the reasonably required needs of Corporation as determined by Corporation to maintain sufficient funds for working capital and business needs so as not to impair the ability of Corporation to continue its business operations”

VIII.

Take Along and Tag Along Provisions. A.

Take Along Provisions.

A take along provision generally will provide that if the majority of the owners decide to sell their equity interest in the business, the majority owners have the right to require each of the other owners to sell their interest on the same terms and conditions. The following is a sample: “8.1 Take-Along. 8.1.1 If, at any time, Shareholders owning not less than a majority of the then issued and outstanding Shares (the “Majority Shareholders”) decide to sell all of the Class A and Class B Shares held by such Shareholder, in a single transaction, or in a series of related transactions, to a third party, whether in a stock sale, share exchange, merger, consolidation or any other stock based transaction, the Majority Shareholders shall have the right, subject to the provisions of this Section 8.1, to require each of the other Shareholders who are not Majority Shareholders (the “Other Shareholders”) to sell all of the Shares held by 46


such Shareholders on the same terms and conditions as those on which the Majority Shareholders are selling their Shares to such third party (the “Proposed Third Party Sale”), including but not limited to, the per share purchase price and payment terms.” B.

Tag Along Provisions.

A “tag along” provision generally provides that if an owner agrees to a sale of his or her interest in the business the other owners have the right to participate in the transaction on the same basis. “8.2 Tag-Along. 8.2.1

Exercise of Right.

8.2.1.1 If any Offered Shares are not purchased pursuant to either Section 2.3.2 or Section 8.1.2, above, and thereafter are to be sold to a Proposed Transferee (such Offered Shares, the “Transfer Shares”), each respective Shareholder (other than the Selling Shareholder) who has not elected to purchase Offered Shares pursuant to either Section 2.3.2 or Section 8.1.2, shall have a right to tagalong in such sale. 8.2.1.2 A Shareholder holding such right to tag-along may elect to exercise such Shareholder’s tag-along right and participate on a pro rata basis in the Proposed Transfer (the “Proposed Transfer”) to the Proposed Transferee as set forth in Section 8.2.2 below and, subject to Section 8.2.4, otherwise on the same terms and conditions specified in the Offer. 8.2.1.3 Each eligible Shareholder who desires to exercise its tag-along right (each a “Participating Shareholder”) must give the Selling Shareholder written notice to that effect within 45 days after delivery of the Offer to such Selling Shareholder, and upon giving such notice such Participating Shareholder shall be deemed to have effectively exercised the tag-along right.” IX.

Spouse’s Signature.

The same types of restrictions that can be used to restrict other transfers, including other involuntary transfers, can be applied to restrict transfers pursuant to a divorce or a division of community property. However, restrictions contained in a separate Buy-Sell Agreement (as opposed to those contained in a corporate charter or bylaws or in a partnership or LLC agreement) may not apply to a spouse who never approved of the agreement. Such a spouse was not party to the agreement and neither gave nor received 47


consideration for participation in it. Therefore, it is useful for each party's spouse to sign a Buy-Sell Agreement, acknowledging that he or she has read it and agrees to be bound by it. A spouse's signature on the agreement does not make the spouse a party to the agreement, but it will raise serious equitable arguments against the spouse's potential contention that the agreement should not apply to him or her. X.

Adoption by New Owner.

As reviewed above, in situations when transfers are permitted to new owners who are not parties to the Agreement, there should be a provision which states that any third party purchaser is required to adopt the Agreement or that the ownership interest transferred is automatically subject to the terms and conditions of the agreement. “12.02 Conditions of Transfer by Members. A transferee who receives a Membership Interest in accordance with Section 12.01 shall become a Member only when the following conditions have been satisfied: (a) the Transferring Member, or his legal representative or authorized agent, must have executed a written instrument of transfer of such Membership Interest to the Permitted Transferee or Approved Assignee in form and substance reasonably satisfactory to the Managers, including certification that the transfer is exempt from registration under the federal and state securities laws; (b) the Permitted Transferee or Approved Assignee must have executed a written agreement, in form and substance reasonably satisfactory to the Managers, to assume all of the duties and obligations of the Transferring Member under this Operating Agreement with respect to the transferred Membership Interest (including the assumption of the Transferring Member's Capital Account, where appropriate) and to be bound by and subject to all of the terms and conditions of this Operating Agreement.� XI.

Legend.

In order to put potential purchasers on notice of the restrictions provided in the agreement, the following should be required: “8. Endorsement of Membership Certificates. Each certificate representing Membership Interests of the Company now or hereafter acquired by the Members shall be imprinted with a legend in substantially the following form:

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“The transfer or encumbrance of the Membership Interests represented by the within certificate is restricted under the terms of the Buy-Sell Agreement dated the _____ day of __________________, 2015, and any amendments thereto, a copy of which is on file at the office of the Company.�

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Final Examination Instructions In order to obtain CPE credit, you must complete the following Final Examination. Credit can be obtained by two means: (1)

Complete the Final Examination by circling the answers you believe are correct. Remove or print the Final Examination portion of this booklet and mail to: YourOnlineProfessor, LLC c/o Gibson & Perkins, P.C. 100 W. Sixth Street, Suite 204 Media, PA 19063

Your Final Examination will be graded and your results will be sent to you by regular mail or e-mail. (2) Go to www.youronlineprofessor.org and under the “Course Info” section select “Course Examination.” On that page, enter the title of the course and follow the instructions to electronically submit your Answers to the Final Examination.

CPE QUIZZER 1.

Under a Redemption Agreement: A.

The purchase obligation falls to the entity rather than the owners.

B.

The purchase rights and obligations are shared by the entity and the owners.

C.

The entity itself is not directly involved in the purchase rights or obligations.

2.

True or False – Buy-Sell provisions are always provided in a separate agreement.

3.

A “permitted transferee” is:

4.

A.

A transferee to whom transfers of ownership interests would be allowed under a Buy-Sell Agreement.

B.

A disabled owner.

C.

A retired owner.

Who should make the determination that an individual is disabled; triggering a Buy-Sell provision? A. The Board of Directors. B. The individual member. C. A medical professional.

5.

The Agreed Upon Value Method may not result in a fair value of a business because: 50


6.

A.

The value of the business entity is determined by capitalizing earnings.

B.

The value of the business entity is determined by calculating the historic cost of the assets reduced by depreciation and offset by the entity’s liabilities.

C.

The agreed upon value has not been updated.

Under the Capitalization of Earnings Method, the value of the business is determined by: A.

A formula based on net earnings.

B.

An appraisal.

C.

A formula based on asset values.

7. True or False – In the event of retirement of an owner, the purchase price under a Buy-Sell Agreement should normally be paid in a lump sum. 8.

Sec. 736(b) payments are treated: A.

As a distributive share or guaranteed payment.

B.

As payments made in liquidation of the interest of a retiring partner.

C.

Exclusively ordinary income.

9. Under IRC Sec. 2703, any agreement may be disregarded for valuation purposes, unless which of the following is true:

10.

A.

The agreement is a device for transferring property to members of the transferor's family for less than full and adequate consideration.

B.

The agreement has terms that are comparable to similar arrangements entered into by persons in less than arms’ length transactions.

C.

The agreement is a bona fide business arrangement.

A “take along provision” will generally provide: A.

If the majority of the owners decide to sell their equity interest in the business the majority owners have the right to require each of the other owners to sell their interest on the same terms and conditions.

B.

If an owner agrees to a sale of his interest in the business, the other owners have the right to participate in the transaction on the same basis.

C.

If an owner leaves the employment of the business, he or she is permitted to “take along” existing employees of the business.

[MAILING INSTRUCTIONS ON FOLLOWING PAGE]

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MAILING INSTRUCTIONS Carefully remove, or print, these pages and mail them to: YourOnlineProfessor, LLC c/o Gibson & Perkins, P.C. 100 W. Sixth Street, Suite 204 Media, PA 19063 Complete the following: Name:

_______________________________

Organization:

_______________________________

Address:

_______________________________ _______________________________

E-Mail:

_______________________________

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GLOSSARY OF TERMS Agreed Upon Price Method – The “agreed upon price method” is a method of determining the value of an ownership interest in a business. Under the “agreed upon price method” the price may simply be agreed upon by the parties. Appraisal Method – The “appraisal method” is a method of determining the value of an ownership interest in a business. Under the “appraisal method,” the value of an ownership interest or a business entity is determined by a formal appraisal. Buy-Sell Agreement – A “Buy-Sell Agreement” is a contractual agreement among the owners of a business (i.e., the shareholders of a corporation, the partners of a partnership, or the members of a limited liability company) which restricts the right to transfer the ownership interests and establishes certain purchase and sale rights and obligations upon the occurrence of certain events. Capitalization Method – The “Capitalization Method” is a formula method for determining the value of a business. The value is determined based on a formula, such as the capitalization of net earnings or EBITDA (i.e., earnings before, interest, taxes, depreciation, and amortization) based on a stated capitalization rate. Cross Purchase Agreement – A form of Buy-Sell Agreement solely among the owners of the entity, i.e. the shareholders, partners, or members. Disability Buyout Insurance – Insurance that pays a lump sum payment in the event the insured is determined to be “disabled,” usually to fund a purchase obligation under a Buy-Sell Agreement. Formula Method – The “formula method” is a method of determining the value of a business. Under the formula method of valuation, the value of a business is based upon an agreed upon formula. Hybrid Agreement – A form of Buy-Sell Agreement where the purchase rights and obligations are shared by the entity and the owners. “Net Book Value” Method – The “net book value method” is a formula method of determining the value of a business. Under this method, the value of the business is determined simply by determining the aggregate value of the entity’s assets and offsetting that value by its liabilities. “Purchase Rights” – Rights of purchase which are created under a Buy-Sell Agreement in the other owners and/or the entity upon the occurrence of a triggering event. “Redemption Agreement” – A form of Buy-Sell Agreement where the purchase obligations fall to the entity rather than the owners. Restrictions on Transfer – A Buy-Sell should provide a general restriction on the transferability of the ownership interests; such restrictions are sometimes referred to as “restrictions on transfer.” Tag Along Provisions – A “tag along” provision generally provides that if an owner agrees to a sale of his interest in the business, the other owners have the right to participate in the transaction on the same basis.

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Take Along Provisions – A “take along provision” generally will provide that if the majority of the owners decide to sell their equity interest in the business, the majority owners have the right to require each of the other owners to sell their interest on the same terms and conditions. Terms of the Purchase – The “terms of the purchase” are the terms on which the closing in the ownership interest will take place and on what terms the purchase price is to be paid. Triggering Events – Events such as death or disability of an owner, voluntary or involuntary transfer of an ownership interest, and termination of employment, which trigger purchase and sale obligations under a Buy-Sell Agreement. Sec. 736(a) payments – Payments not treated as Sec. 736(b) payments are “Sec. 736(a) payments” and are considered either as distributive share or guaranteed payments for income tax purposes. Sec. 736(b) payments – “Sec. 736(b) payments” are treated as payments made in liquidation of the interest of a retiring partner or a deceased partner to the extent such payments are made in exchange for the interest of the partner in partnership property.

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INDEX Additional Issues to Address, 43 Adoption by New Owner, 48 Agreed Upon Price, 19 Alternative Documentation, 6 Capitalization of Earnings, 23 Closing, 28 Consent to Joint Representation, 43 Covenant Not to Compete, 44 Cross Purchase Agreement, 5 Death of an Owner, 30 Determination of the Purchase Price, 19 Disability, 12 Disability Buy Out Insurance, 29 Disposition of Insurance Policies, 43 Estate Tax Consequences, 39 Form of the Agreement, 1, 5 Income Tax Consequences, 36 Installment Note, 29 IRC Sec. 2703, 40 Issues to be Addressed, 1 Legend, 48 Life Insurance, 28 Nature of Restrictions, 9 Net Book Value Method, 23 Non-Interference, 44 Payment of the Purchase Price, 28 Permitted Transferees, 10 Preserving the S Election, 44 Price Determined by Appraisal, 20 Price Determined by Formula, 22 Provision for Distribution – S Corporations, 46 Purchase Rights, 15 Redemption Agreement, 5 Resignation as Officers and Directors, 43 Sec. 736(a) payments, 37 Sec. 736(b) Payments, 37 Setting the Purchase Terms for Each Triggering Event, 30 Spouses Signature, 47 Tag Along Provisions, 46 Take Along Provisions, 46 Tax Consequences, 36 Tax Consequences of a Cross Purchase Plan, 38 Tax Consequences of a Redemption Plan, 36 Termination of Employment, 13 55


Terms of the Purchase, 28 Triggering Events, 11 Uses of the Buy-Sell Agreement, 1 Voluntary Transfers and Involuntary Transfers, 11

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APPENDIX

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SHAREHOLDERS’ AGREEMENT

AGREEMENT made this _________ day of June, 2011, by and between THOMAS SMITH, ELLEN SMITH, JOSEPH SMITH, DAVID SMITH, MICHAEL MILLER and KATHLEEN STEVENS (such individuals are sometimes separately referred to as “Shareholder” and together sometimes referred to as “Shareholders”), and ABC, INC., a Pennsylvania Corporation (referred to herein as the “Corporation”). BACKGROUND WHEREAS, the Shareholders are the sole owners of the issued and outstanding shares of capital stock of the Corporation in the percentages as stated in Exhibit “A” attached hereto (the “Stock Interests”); and WHEREAS, the Shareholders wish to provide for certain restrictions on the transfer of Stock Interests in the Corporation, and to create certain mutually dependent options and obligations for the purchase and/or sale of such Stock Interests upon the occurrence of certain events, all as provided in this Agreement; and WHEREAS, the Shareholders and the Corporation have entered into a Trusteed Insurance Agreement designated as the “ABC Trusteed Insurance Agreement” (the “Trusteed Insurance Agreement”) of even date herewith which will own certain Insurance on Timothy Smith, Daniel Smith, and Michael Miller in order to fund certain of the obligations provided herein. NOW, THEREFORE, in consideration of the mutual agreements and covenants contained herein and for other valuable consideration, receipt of which is hereby acknowledged, it is mutually agreed and covenanted by and between the parties to this agreement as follows: I.

Restriction on Transfer.

A. This agreement by the Shareholders and the Corporation supersedes any and all prior agreements. B. The Shareholders agree that they will not, except as provided in this Agreement, Transfer the Stock Interests in the Corporation presently held, or hereafter acquired, by them, except in accordance with the terms of this Agreement. C. Except as specifically provided herein, any Transfer by a Shareholder of all or any portion of the Stock Interests held by him, except in the manner specified in this Agreement, shall be null and void, and the Corporation shall not recognize or give effect to such Transfer on its books and records, or recognize the person or persons to whom such Transfer has been made as the legal or beneficial holder thereof. 58


D. In the event of an attempted Transfer by a Shareholder, of all or any portion of the Stock Interests held by him, in violation of this Agreement, the Corporation shall have the right to purchase all (but not less than all) of the Stock Interests in the Corporation held by such Shareholder at a price of One Dollar ($1.00) per share. E. No provision of this agreement shall be construed so as to limit the ability of a Shareholder to freely Transfer any Stock Interest held by them in any manner as they see fit. II.

Encumbrance.

A. As stated above, except as provided in paragraph B., below, no Shareholder may Encumber any or all of his or her Stock Interest in connection with any debt. B. The foregoing notwithstanding, a Shareholder may Encumber his or her Stock Interest if it is required to secure financing for the benefit of the Corporation. III.

Permitted Transfers and Restrictions on Transfers. A.

Transfers to Immediate Family.

Notwithstanding anything to the contrary contained herein, THOMAS AND ELLEN SMITH may Transfer any or all of their Stock Interest by right of survivorship to each other. B.

Voluntary and Involuntary Lifetime Transfers.

Except as provided in paragraph III.A., above, no Shareholder may make any Voluntary Lifetime Transfer or Involuntary Lifetime Transfer except pursuant to this Section. 1. Any Shareholder (i) who wishes to make a Voluntary Lifetime Transfer or (ii) believes that an Involuntary Lifetime Transfer is foreseeable, must promptly send a notice to each of the Other Shareholders and shall be deemed to have offered to sell his or her Stock Interest otherwise to be Transferred at the Agreement Price, and on the Agreement Terms, as defined herein. 2. Such notice shall include (i) a statement of the type of proposed Transfer, (ii) the name, (iii) address (both home and office), and (iv) business or occupation of the person to whom the Offered Stock would be otherwise Transferred, as well as (v) any other facts that are or would reasonably be deemed material to the proposed Transfer. a. In the event that such notice is not sent to a particular Shareholder or is not actually received by a particular Shareholder, then 59


such Shareholder shall be deemed to have received such notice as of the date the Shareholder has actual notice. b. Notice sent to a Shareholder’s last known address by regular mail shall be considered actual notice for this purpose. 3. In the event of a proposed Voluntary Lifetime Transfer or a foreseeable Involuntary Lifetime Transfer by a Shareholder, the Other Shareholders shall have ninety (90) days from such notice of a Voluntary Lifetime Transfer or Involuntary Lifetime Transfer, or from actual notice of such a Transfer, in which to elect to buy all or any of the Offered Stock. Any shares not so purchased, under this paragraph III. B.3, shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. B.4., below. 4. If the Other Shareholders do not agree to buy in the aggregate all of the Offered Stock within such option period, then the Corporation shall have an additional ninety (90) days in which it may elect to buy any of the Offered Stock not purchased by the Other Shareholders. 5. If the Other Shareholders, and/or the Corporation do not agree to buy in the aggregate all of the Offered Stock within such option periods, a proposed Voluntary Lifetime Transfer may be completed in regard to all of the Offered Stock; free of the restrictions provided herein; and a proposed Involuntary Lifetime Transfer may be completed in regard to the Offered Stock which the Other Shareholders and the Corporation have not agreed to buy. 6. If a Lifetime Transfer is not consummated within ninety (90) days after the expiration of such option periods, the provisions of this Agreement will again apply to such Offered Stock as if no such Lifetime Transfer had been contemplated and no notice had been given. 7. A Lifetime Transfer is consummated when the Corporation has been given notice that legal title to the Stock Interest has been Transferred, subject to recordation on its books. C.

Termination of Employment.

The Shareholders and the Corporation desire to limit the ownership of Stock Interests to Shareholders who are also employees of the Corporation, it being in the best interests of the Corporation and the Shareholders. Therefore, in the event of the Termination of Employment of a Shareholder, such Shareholder shall be deemed to have offered to sell his or her Stock Interest at the Agreement Price, and on the Agreement Terms, as provided herein. 1.

Voluntary Termination of Employment. 60


a. In the event of the Voluntary Termination of Employment of a Shareholder other than by reason of Retirement, the Other Shareholders shall have ninety (90) days from the Date of Termination in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. C.1.b. below. b. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation shall have an additional ninety (90) days in which it may elect to buy any of the Offered Stock not purchased by the Other Shareholders. c. If the Other Shareholders and/or the Corporation do not agree to buy in the aggregate all of the Offered Stock within such option periods, then the Offered Stock may be retained by the Shareholder, but shall remain subject to all of the provisions of this Agreement, other than this paragraph III.C. 2.

Termination for Cause.

a. In the event of the Termination for Cause of a Shareholder, the Other Shareholders shall have ninety (90) days from the Date of Termination in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Other Shareholders in accordance with the procedures outlined in paragraph III. B.2.b. below. b. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation shall have an additional ninety (90) days in which it may elect to buy any of the Offered Stock not purchased by the other Shareholders. c. If the Other Shareholders and/or the Corporation do not agree to buy in the aggregate all of the Offered Stock within such option periods, then the Offered Stock may be retained by the Shareholder, but shall remain subject to all of the provisions of this Agreement, other than this paragraph III.C. 3.

Termination of Kathleen Stevens.

Notwithstanding anything to the contrary contained in Paragraphs III.C.1. or III.C.2., in the event that KATHLEEN STEVENS’s employment with the Corporation prior to May 31, 2016, KATHLEEN STEVENS shall remit all shares of the Corporation held by her to the Corporation in exchange for no consideration. 61


D.

Total Disability of a Shareholder.

In the event of the Total Disability of a Shareholder, the Shareholder, or the personal representative of such Totally Disabled Shareholder, shall be deemed to have offered to sell his or her Stock Interest at the Agreement Price, and on the Agreement Terms, as provided herein. 1. In such event the Other Shareholders shall have ninety (90) days from the date of the end of the twenty-four month period which determines such Total Disability in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. D.2. below. 2. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation must purchase any of the Offered Stock not purchased by the Other Shareholders. E.

Retirement of a Shareholder.

In the event of the Retirement of a Shareholder, the retiring Shareholder shall be deemed to have offered to sell his or her Stock Interest at the Agreement Price, and on the Agreement Terms, as provided herein. 1. In such event the Other Shareholders shall have ninety (90) days from the date of retirement in which to elect to buy all or any of the Offered Stock. Any shares not so purchased shall be made available for purchase by the Corporation in accordance with the procedures outlined in paragraph III. E.2. below. 2. If the Other Shareholders do not agree to buy in the aggregate all of the remaining Offered Stock within such option period, then the Corporation must purchase any of the Offered Stock not purchased by the Other Shareholders. F.

Death of a Shareholder.

In the event of the Death of a Shareholder, the personal representative of such deceased Shareholder will immediately be deemed to have offered to sell, and the Other Shareholders shall be deemed to have accepted, such offer and shall purchase all of the deceased Shareholder’s Stock Interest. 1. Each Other Shareholder’s purchase shall be made in proportion to their respective ownership of Stock Interests in the Corporation (excluding the deceased Shareholder’s Stock Interest), or in such other proportion as they shall agree upon.

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2. Such purchases shall be made at the Agreement Price and on the Agreement Terms, provided below. IV.

Agreement Price. A.

The Agreement Price.

The “Agreement Price� is the price at which, pursuant to the terms of this Agreement, a Shareholder must offer to sell all or any of his Stock Interest determined as follows: 1. In the event of a Voluntary Lifetime Transfer the Agreement Price shall be Seventy-five percent (75%) of the Fair Market Value of the Offered Stock as determined in paragraph B., below. 2. In the event of an Involuntary Lifetime Transfer the Agreement Price shall be fifty percent (50%) of the Fair Market Value of the Offered Stock as determined in paragraph B., below. 3. In the event of a Voluntary Termination of Employment by a Shareholder, the Agreement Price shall be seventy-five percent (75%) of the Fair Market Value of the Offered Stock as determined in paragraph B., below. 4. In the event of a Termination for Cause of a Shareholder, the Agreement Price shall be one dollar ($1.00) per share. 5. In the event of the Total Disability of a Shareholder, the Retirement of a Shareholder, or Death of a Shareholder the Agreement Price shall be one hundred percent (100%) of the Fair Market Value of the Offered Stock as determined in paragraph B., below. 6. The foregoing notwithstanding except in the event of Total Disability of a Shareholder, Retirement of a Shareholder, and Death of a Shareholder in the event that the Shareholder has not held Offered Shares for more than three (3) years prior to the Closing Date, as herein defined the Agreement Price shall be the greater of (i) One Dollar ($1.00) per share or (ii) the amount such shareholder paid for their stock. B.

The Fair Market Value of the Offered Stock.

The Fair Market Value of the Offered Stock shall be determined as follows: 1. The Fair Market Value of the Corporation, as defined below in paragraph IV.C., below, shall be divided by the total number of shares of the Corporation issued and outstanding on the Closing Date to obtain the Fair Market Value per Share. 63


2. The Fair Market Value per Share shall then be multiplied by the number of shares comprising such Offered Stock to obtain the Fair Market Value of the Offered Stock. 3. The foregoing notwithstanding, in the event of the Death of Shareholder the Fair Market Value of Offered Stock shall never be less than the aggregate of the net proceeds of all life insurance policies required to be maintained on the life of such deceased Shareholder under Article VII, hereof. C.

The Fair Market Value of the Corporation.

1. The Fair Market Value of the Corporation shall be the amount set forth on the attached Exhibit “B.� The Fair Market Value may be determined on an annual basis as decided by the majority of the Shareholders. Exhibit B shall be amended to reflect any amended Fair Market Value. 2. In the event that the Shareholders have failed to agree as to a Fair Market Value of the Corporation, within two years of the date of the event triggering the options and/or obligations of purchase provided herein, the Fair Market Value of the Corporation shall be determined by a Qualified Appraiser selected by the accountant then serving the Corporation; in making such appraisal, discounts for lack of marketability and minority shall be disregarded. 3. The initial Fair Market Value shall be One Million Dollars ($1,000,000). D.

Cooperation by the Corporation.

The Corporation shall provide such data (including information related to life insurance) as deemed necessary or useful to make such determination of the Agreement Price. V.

Agreement Terms. The Agreement Terms, as provided herein are as follows:

A. The Agreement Price paid for the Stock Interest by reason of the Death of a Shareholder, to the extent of the face amount of the Required Insurance, as hereinafter defined, shall be paid in cash or by good personal check on the Closing Date. B. Other payments of the Agreement Price shall be paid in sixty (60) equal monthly payments of principal and interest payments. C. Such payments shall begin on the first day of the month immediately following the Closing Date and shall include interest in arrears compounded annually at

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the applicable federal rate established under Code Sec. 1274(d) on the Closing Date added to each installment after the first installment. D. Each buyer hereunder shall deliver to the seller at the Closing a negotiable promissory note as evidence of this debt, on the terms provided in section VI, below. E. The purchase of the Offered Stock pursuant to this Agreement will take place at a Closing, held at 1:00 PM. on the thirtieth (30th) day after the later of (i) the date on which the last option to purchase is exercised or lapses, or (ii) in the case of a purchase under section. III.C. on the thirtieth (30th) day after the Termination of Employment of the Shareholder (the “Closing Date”). 1. The foregoing notwithstanding, in the event that any or all of the obligations hereunder are to be funded with insurance and a dispute arises as to the right of the owner to the receipt of such insurance proceeds then the Closing shall occur within ninety (90) days of the resolution of such dispute. 2. The Closing shall take place at the Corporation’s primary place of business, or at any other place to which the parties agree. 3. closing,

At the Closing, the buyer or buyers will pay for the Offered Stock.

4. If the seller or his personal representative does not appear at the then: a. The buyer or buyers shall deposit the purchase price by check or by check and note, as this Agreement requires, with an escrow agent appointed by them (the “Escrow Agent”); b. The Escrow Agent shall deposit such funds with any bank with which the Corporation has a bank account on the date of the closing, to be paid to the seller as soon as is reasonably practicable, less an appropriate fee to the Corporation (not to exceed five hundred dollars ($500.00)) to pay for the additional administrative costs; and c. The Corporation will adjust its transfer books to reflect that the Offered Stock has been Transferred.

VI.

The Promissory Note.

A. Any promissory notes delivered in consideration of the Agreement Price, as provided herein, shall provide that the obligor shall have the privilege of prepaying all or any part thereof at any time without interest to the date of prepayment, and that a default in the payment of any installment shall cause the remaining unpaid installments to become due and payable forthwith.

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B. The obligations pursuant to such promissory note shall be secured by a pledge of and security interest in the Stock Interests so purchased. C. Obligations of the Shareholders shall be guaranteed by the Corporation, and the obligations of the Corporation shall be guaranteed by each of the Other Shareholders as provided in paragraph XXVIII, hereof. VII.

Insurance.

A. The Shareholders, other than Thomas SMITH and Edda SMITH, each agree to maintain life insurance on the lives of the other shareholders, in an amount adequate to fund their individual purchase obligations created by the terms of section III.F., hereunder. The amount of such insurance is listed on Exhibit “C”. B. Such insurance shall be owned, maintained, and payable pursuant to that certain Trusteed Insurance Agreement, entered into of even date herewith. C. The Shareholders shall acquire additional policies of life insurance that they deem appropriate to carry out this Agreement. All additional policies shall be listed on Exhibit “B” D. The insurance which is required to be maintained as provided in this section shall be referred to as the “Required Insurance”. VIII.

Protecting S Election.

Each shareholder shall do or cause all the following to be done until such person is no longer a Shareholder of the Corporation: A. Cause the Corporation to operate as an “S corporation” under §1361 et seq. of the Code, unless all the Shareholders mutually agree otherwise in writing. B. Not consent to the revocation of the Corporation’s “S corporation” status under the Code, without the prior written consent of all the Shareholders. C. Not transfer or agree to transfer any Shares owned by such Shareholder by contract, will, or otherwise to any person or entity which shall cause the revocation of the Corporation’s “S corporation” status under the Code, without the prior written consent of all the Shareholders. D. Not take or permit any other action which would result in the termination or revocation of the Corporation’s “S corporation” status, including but not limited to causing the Corporation to issue or accepting from the Corporation any notes, stock options or other instruments that would constitute a second class of stock under §1361(b)(1)(D) of the Code or the regulations there under.

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E. If the Internal Revenue Service (“IRS”) finds that the Corporation’s “S corporation” status has been inadvertently terminated, consent to all adjustments required by the IRS as a condition to waiving the tax effect of the terminating event or events pursuant to §1362(f) of the Code. F. All the Shareholders shall take appropriate action to make an effective election under §1377(a)(2) of the Code to close the Corporation’s books on the effective date of transfer if: 1.

any Shares are transferred,

2. such transfer results in the complete termination of a Shareholder’s interest in the Corporation at that time during which the Corporation is an “S corporation”, 3. taxable year, and 4.

the effective date of such transfer occurs during the Corporation’s any Shareholder so requests.

G. All the Shareholders shall take appropriate action to make an effective election under §1362(e)(3) of the Code to close the Corporation’s books on the date immediately preceding the date on which the termination of “S corporation” status occurs if: 1. the Corporation’s “S corporation” status terminates during the course of its taxable year for any reason, and 2. any Shareholder so requests, then all the Shareholders shall take appropriate action to make an effective election under §1362(e)(3) of the Code to close the Corporation’s books on the date immediately preceding the date on which the termination of “S corporation” status occurs.

IX.

Resignation as Director and Officer.

If a party to this Agreement ceases to be a Shareholder, such party hereby resigns as a director and as an officer of the Corporation, effective as of the Closing Date or such earlier date if so provided in the Bylaws of the Corporation. X.

Affirmative Acts. The Corporation and the Shareholders agree to perform all acts and to execute and deliver all documents which may be necessary to consummate a purchase pursuant to this Agreement. 67


XI.

Endorsement of Stock Certificates.

Each certificate representing Stock Interests in the Corporation now or hereafter acquired by the Shareholders shall be imprinted with a legend in substantially the following form: “The Transfer or encumbrance of the shares represented by the within certificate is restricted under the terms of a Shareholders Agreement dated the April 28, 2010, and any amendments thereto, a copy of which is on file at the office of the Corporation.” XII.

Counterpart Agreement.

This Agreement may be executed in several counterparts, one such counterpart for each party hereto and each copy of which shall serve as an original for all purposes, but all counterpart copies shall constitute but one and the same Agreement. XIII.

Attorney’s Representations.

The Shareholders and Corporation acknowledge that the Corporation’s counsel, Edward L. Perkins, Esq. and the law firm of Gibson & Perkins, PC, prepared this Agreement on behalf of and in the course of his representation of the Corporation, and that: i. THE PARTIES HAVE BEEN ADVISED BY MR. PERKINS THAT A CONFLICT EXISTS AMONG THEIR INDIVIDUAL INTERESTS; AND ii. THE PARTIES HAVE BEEN ADVISED BY MR. PERKINS TO SEEK THE ADVICE OF INDEPENDENT COUNSEL; AND iii. THE PARTIES HAVE HAD THE OPPORTUNITY TO SEEK THE ADVICE OF INDEPENDENT COUNSEL. XIV.

Arbitration.

All disputes that may arise in connection with this Agreement and are not resolved by the parties themselves shall be submitted to arbitration under the rules and regulations then existing of the American Arbitration Association. A.

The Laws of the Commonwealth of Pennsylvania shall apply.

B. The arbitrator shall not convene or vary in any respect any of the terms or provisions of this Agreement.

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C. All costs of the Arbitration shall be divided equally between the parties. However, the successful party shall be entitled to be reimbursed for its costs, expenses, and reasonable attorney’s fees. Said Arbitration shall take place in the county of the principal office of the Corporation or at any place mutually agreeable to the parties. D. The award shall be binding and conclusive upon each of the parties, and it may be enforced by the successful party with any court of competent jurisdiction, at the option of the successful party. E. The Arbitrator shall have all the power and be able to decree any and all relief of an equitable nature, including but not limited to a temporary restraining order, a preliminary injunction and a permanent injunction, and shall also be able to award damages, with or without an accounting. F. In addition, the Arbitrator shall have those powers provided for under the rules and regulations of the American Arbitration Association. XV.

Subsequent Shareholders to Become Bound.

A. Any person or entity not an original signatory hereto who becomes a Shareholder shall be bound by all of the terms and provisions of, and shall be entitled to all of the benefits and privileges of, this Agreement and the Trusteed Insurance Agreement. B. Before any person or entity not a party to this Agreement, including any person or entity to whom Transfers of Stock Interest may be made hereunder, may be entitled to be a Shareholder of the Corporation, such person or entity shall be required first to execute and deliver to Shareholders an Agreement pursuant to which such person or entity agrees to be bound by all of the terms and conditions of this Agreement and the Trusteed Insurance Agreement (as they may have then been amended). C. The failure of any such person or entity to do so shall preclude such person or entity from becoming a Shareholder in the Corporation. XVI.

Passage of Rights; Power of Attorney.

Each Shareholder appoints the President of the Corporation as his or her agent and attorney-in-fact to execute and deliver all documents needed to convey his or her Stock Interests, if such selling Shareholder is not present at the closing. This power of attorney is coupled with an interest, which does not terminate on the Shareholder’s disability or death, and continues for as long as this Agreement is in effect. XVII. Notice.

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Any notice required to be given pursuant to this Agreement shall be in writing and sent by registered mail to the Corporation at its principal office and to the Shareholders at their last known residence address. XVIII. Invalid Provision. The invalidity or unenforceability of any particular provision of this Agreement shall not affect the other provisions hereof, and the Agreement shall be construed in all respects as though such invalid or unenforceable provisions were omitted. XIX.

Interpretation.

This Agreement shall be interpreted in accordance with the laws of the Commonwealth of Pennsylvania. XX.

Modification.

This instrument constitutes the entire Agreement between the Shareholders and the Corporation and may be altered or amended only by an amendment approved by the unanimous vote of the Shareholders of the Corporation. XXI.

Benefit.

This Agreement shall be binding upon and inure to the benefit of the Shareholders and the Corporation hereto and their respective heirs, legal representatives, successors and assigns. XXII.

Waiver Paragraph.

Any failure on the part of any party to exercise and any delay in exercising any right, power, or remedy shall operate as a waiver thereof; nor shall any single or partial exercise of any right, power, or remedy preclude any other or further exercise thereof or of any other right, power, or remedy. XXIII. Headings. Any headings preceding the text of paragraphs or sub-paragraphs hereof are inserted for convenience of reference and shall not constitute a part of this Agreement, nor affect its meaning, construction or effect. XXIV. Covenant Not to Compete. A. During the term of this Agreement and for a period of three (3) years after termination of a Shareholder’s employment by the Corporation, a Shareholder or former Shareholder as the case may be shall not engage in any direct or indirect competition with the Corporation through the solicitation of the business of any of the Corporation’s 70


customers on the Date of Termination or hire any employee of the Corporation, whether such competition is as an individual, partner, joint venture, employee, or agent for any person or entity. B. These covenants shall be construed as an agreement independent of any other provision of this Agreement; and the existence of any claim or cause of action of the terminating Shareholder against the Corporation, whether predicated on this Agreement or otherwise, shall not constitute a defense to the enforcement by the Corporation of this covenant. XXV. Indemnification of Corporation. The Corporation shall indemnify each Shareholder against all expenses, including attorneys' fees, actually and reasonably incurred by such Shareholders in connection with the defense and/or settlement of an action, suit or proceeding against a Shareholder in regard to a debt of the Corporation imposed for whatever reason on such Shareholder; in addition each Shareholder shall indemnify each other Shareholder in regard to such liability to the extent such liability is in excess of the amount of such liability satisfied by the Corporation, and also exceeds such Shareholders “pro-rata share” of such liability; a Shareholders pro rata share of such liability shall be in proportion to their respective ownership of Stock Interests in the Corporation. XXVI. Minimum Distribution. The Corporation shall, prior to April 15 of each year, make a minimum cash distribution to each Shareholder in an amount equal to the income tax liability incurred by such Shareholder by reason of such Shareholder’s allocation of undistributed taxable income of the Corporation in regard to the most recently concluded prior tax year. Such distribution shall be equal to such Shareholder’s pro rata share of undistributed taxable income unless the Shareholder can prove a higher amount to the satisfaction of the accountant then serving the Corporation. XXVII. Shareholder Compensation. A. It is the intention of the Shareholders that each Shareholder shall receive equal Compensation for their efforts as employees of the Corporation. B. The amount of Compensation to be received by each Shareholder shall be determined annually by the Shareholders (the “Annual Compensation”). C. “Compensation” means any income earned by a Shareholder through their status as an employee of the Corporation, including, but not limited to, wages, salaries, sales commissions, and manufacturer incentives. D. In order to allow for equal Compensation to the Shareholders, each Shareholder’s salary paid by the Corporation shall be adjusted in the following manner: 71


1. Prior to January 31 of every year, each Shareholder shall provide to the accountant then utilized by the Corporation all W-2’s, 1099’s, or similar documents related to income earned during the previous year in the Shareholder’s capacity as an employee of the Corporation. 2. The accountant then used by the Corporation shall determine the previous year’s Gross Income earned by each Shareholder. For purposes of this Agreement, “Gross Income” shall mean only that income earned by a Shareholder in their capacity as an employee of the Corporation during the previous year. 3. In the event that a Shareholder’s Gross Income exceeds the Annual Compensation, such Shareholder’s salary for the current year shall be reduced, but not below zero, by an amount equal to such Shareholder’s Gross Income less the Annual Compensation. 4. In the event that a Shareholder’s Gross Income is less than the Annual Compensation, such Shareholder’s salary for the current year shall be increased by an amount equal to the Annual Compensation less such Shareholder’s Gross Income. 5. Notwithstanding the foregoing, in the event that any Shareholder’s Gross Income, exclusive of any salary received from the Corporation during the previous year, exceeds the Annual Compensation, the Annual Compensation shall be increased to an amount equal to that Shareholder’s Gross Income exclusive of salary received from the Corporation during the previous year. XXVIII.

Guarantees.

A. The Shareholders agree to guarantee any obligations to purchase Offered Stock undertaken by the Corporation pursuant to this Agreement. B. The Corporation shall guarantee any obligations to purchase Offered Stock undertaken by the Shareholders. XXIX.

Health Insurance Coverage.

The Corporation shall maintain health insurance coverage for Thomas SMITH and Edda SMITH for their individual lifetimes at a level that is equal to the coverage that is provided by the Corporation at the time of the execution of this agreement whether they are employed by the Corporation of not. XXX.

Shareholder Approval.

A. Except as specifically provided herein all matters requiring the consent of the Shareholders shall be subject to approval by a majority of the Shareholders entitled to vote. 72


B. The foregoing notwithstanding Termination for Cause of a Shareholder must be approved by the unanimous approval of the Shareholders other than the Shareholder being considered for termination. C. The Bylaws of the Corporation shall be amended without additional approval of the Shareholders to incorporate the provisions of this paragraph. XXXI. Definitions. A. “Agreement.” The “Agreement” is this Purchase Agreement as amended from time to time. The Agreement will include all exhibits, as they may be amended from time to time. B. “Agreement Terms.” “Agreement Terms” refers to the terms of purchase and sale of Stock Interests as provided in section V, hereof. C. “Agreement Price.” “Agreement Price” refers to the purchase price for the sale of Stock Interests as provided in section IV, hereof. D. “Closing Date.” The “Closing Date” refers to the settlement date where shares of stock are presented for a predetermined consideration. E. “Corporation.” “Corporation” refers to D & K Appliances, Inc. as incorporated under the laws of the Commonwealth of Pennsylvania. F. “Date of Termination.” “Date of Termination” refers to a defined point of time at which a Termination of Employment occurs. G. “Days.” Any reference in this Agreement to “Days” means all calendar days, whether or not such days are legal holidays under the laws if the United States or any State. H. “Encumber” or “Encumbrance.” “To Encumber“ means to pledge, hypothecate, or otherwise secure any type of debt or obligation with a Shareholder’s Stock Interest, whether incurred voluntarily or involuntarily, and in any manner whatsoever. An “Encumbrance” is any type of security or security interest created by such Encumbering. I. “Immediate Family.” A Shareholder’s “Immediate Family” shall be defined as such Shareholder’s spouse, children, grandchild, parent or grandparent. J. “Involuntary Lifetime Transfer.” An “Involuntary Lifetime Transfer” is any Transfer made on account of a court order or otherwise by operation of law, including any Transfer incident to any divorce or marital property settlement or any Transfer pursuant to applicable community property, quasi-community property or similar state law, and also 73


including a Shareholder filing a voluntary petition under any federal or state bankruptcy, insolvency or related law or a petition for the appointment of a receiver, or making an assignment for the benefit of creditors, or being subjected involuntarily to such a petition or assignment or to an attachment or other legal or equitable interest with respect to his Stock Interest in the Corporation and such involuntary petition, assignment, or attachment is not discharged within thirty (30) days after its effective date. K. “Lifetime Transfer.” “Lifetime Transfer” refers to both a Voluntary Lifetime Transfer and Involuntary Lifetime Transfer of stock of the Corporation. L. “Offered Stock.” “Offered Stock” refers to any and all stock offered for sale and transfer by an existing shareholder to other Shareholders or to the Corporation pursuant to the terms of this Agreement. M. “Offering Shareholder.” An “Offering Shareholder” refers to a Shareholder, or personal representative of a Shareholder, who is deemed to offer to sell some or all of his stock interests to other Shareholders or the Corporation pursuant to the terms of this Agreement. N. “Other Shareholder(s).” An “Other Shareholder” or “Other Shareholders” shall be defined as those Shareholders, who have been offered to buy an Offered Interest by an Offering Shareholder. O. “Qualified Appraiser.” A “Qualified Appraiser” is a professional appraiser or independent certified public accountant who is qualified by experience and ability to appraise the Offered Interest. P. “Retired Shareholder.” who has entered Retirement.

A “Retired Shareholder” shall be a Shareholder

R. “Retirement.” “Retirement” shall be defined as the Voluntary Termination of Employment by a Shareholder after reaching age sixty-five (65). S. “Required Insurance.” The “Required Insurance” is the insurance required to be maintained under section VII of this Agreement. T. “Shareholder(s).” Shareholder(s) refers to the person or persons owning an equity interest in shares of stock of the Corporation. U. “Termination for Cause.” Subject to the provisions of paragraph III.C., above, Termination for Cause” shall be defined as the termination of a Shareholder’s employment with the Corporation by reason of: conviction of, or a plea of guilty to, any criminal conduct committed against the Corporation; a breach of the Shareholder’s duties and obligations arising under employment with the Corporation; or the continued breach of any written policy, rule or regulation of the Corporation for a period of at least Five (5)

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days following his or her receipt of written notice from any officer of the Corporation specifying such breach. V. “Termination of Employment.” “Termination of Employment” shall be defined as the cessation of a Shareholder’s employment with the Corporation whether such cessation is due to Voluntary Termination of Employment, Retirement or Termination for Cause. W. “Total Disability.” “Total Disability” shall be defined as the inability of a Shareholder to perform his or her duties as an employee of the Corporation for a period of twenty-four (24) consecutive months. X. “Totally Disabled Shareholder.” A “Totally Disabled Shareholder” shall be defined as a Shareholder who has experienced Total Disability. Y. “Transfer.” A “Transfer” shall be defined as a sale, exchange, gift, bequest, assignment, mortgage, pledge, alienation, hypothecation, conveyance or other transfer or encumbrance, in any manner whatsoever. Z. “Voluntary Transfer.” “Voluntary Transfer” refers to the voluntary transfer of an interest in the Corporation for consideration or otherwise. AA. “Voluntary Termination of Employment.” “Voluntary Termination of Employment.” shall be defined as the cessation of any Shareholder’s employment by the Corporation due to their own volition.

IN WITNESS WHEREOF, the parties hereto have executed this Agreement the date and year first above mentioned. WITNESS:

SHAREHOLDER:

____________________________

_____________________________ THOMAS SMITH

____________________________

______________________________ ELLEN SMITH

____________________________

_____________________________ JOSEPH SMITH

____________________________

_____________________________ DAVID SMITH

____________________________

_____________________________ 75


MICHAEL MILLER ____________________________

_____________________________ KATHLEEN STEVENS

ATTEST:

ABC, INC.

____________________________

_____________________________ By: THOMAS SMITH, President

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EXHIBIT “A” Ownership of ABC, Inc.

Thomas Smith and Ellen Smith, Husband and Wife as Tenants by the Entireties

250 Shares - 20%

Timothy Smith

250 Shares – 20%

Daniel Smith

250 Shares – 20%

Michael Miller

250 Shares – 20%

Kathleen Stevens

250 Shares – 20%

77

Profile for Gibson & Perkins, PC

Drafting and Understanding Buy-Sell Agreements  

Prepared by Gibson & Perkins, PC attorney Edward L. Perkins Media, PA www.gibperk.com 484-326-8285

Drafting and Understanding Buy-Sell Agreements  

Prepared by Gibson & Perkins, PC attorney Edward L. Perkins Media, PA www.gibperk.com 484-326-8285

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