With a solid plan in place, ownership transitions can be orderly
By John Nardozzi, CPA, CVA, MST
We all want to think only good things will happen to us, our families and the people we know. But sometimes, despite our best intentions, things go wrong. It can happen in business. Which is why, if there is more than one owner in your business, I strongly recommend you have a shareholder agreement.
Shareholder agreements (sometimes called stockholder agreements) generally come in two flavors: buy/sell agreements and shareholder redemption agreements.
A buy/sell agreement is typically made between the shareholders. If certain events happen (triggering events) then the remaining shareholder(s) are obligated to buy the interest of one shareholder. A redemption agreement is different because it is between the shareholders and the company. Under the redemption agreement, when a triggering event happens the company is obligated to purchase the interest.
Triggering events can take many forms. The most obvious would be the death of one of the owners. But many agreements are triggered by one or more of the following occurrences.
- Incapacitation: An owner is unable to perform their normal duties due to mental or physical issues.
- Voluntary departure: An owner decides they want to leave the business and pursue other interests, or take an early retirement.
- Retirement: An owner retires at a more customary time.
- Involuntary: An owner is arrested, loses a critical license, takes action detrimental to the business, steals from the business, or fails to perform their obligations. Such reasons should be clearly defined in the agreement.
The Agreement Is Triggered
When one of these triggering events takes place the next step is to go back to the agreement to determine the value or price to be paid to the departing owner. There is no sense in having an agreement if the document does not spell the amount to be paid out. The amount can be determined in one of the following ways.
- Pre-determined amount: Owners agree to the value of the ownership interest in advance; but unless the value is visited and readjusted annually this technique does not allow for changes in the value, and can—and will—be challenged.
- Formula value: Many companies use the formula value, which should include a real calculation of the value as a basis for all future calculations; formulas include:
—Net Income times a multiple
—Net income, plus owner salaries, times a multiple
—EBITDA (earnings before interest, taxes and depreciation) times a multiple
—Book Value times a multiple
—Percentage of revenue
—Multiple of Gross Profit
—Estimated value of Assets (defined) less Liabilities
- Annual agreed-to value: Many companies require that the valuation be performed by an outside professional on an annual basis and that the owners sign off on the valuation report each year.
- Any formulas and values used should have a provision for tax consequences.
Another critical part of the shareholder agreement is “When and how much will be paid?” Remember you don’t want to kill the golden goose.
One Size Does Not Fit All
Not all triggering events carry equal weight. Should someone who leaves early or has damaged the business be paid the same as someone who worked to normal retirement age or died? Logic says, “No,” and most shareholder agreements reflect that sentiment. A typical balance might be:
- Death or Normal retirement: 90 percent of the value of the owner’s interest;
- Early retirement or voluntary departure: 75 percent of the value of the owner’s interest
- Involuntary departure: 60 percent of the value of the owner’s interest.
Payment terms should also be included up front in a shareholder agreement. I frequently see terms stating that payments will be made in 120 equal monthly installments, or with a lump sum partial payment up front and the balance paid equally over a specified term.
“Key man” life insurance is useful for paying a portion of the buyout and for offsetting the cost to replace a departed owner. If so who owns the insurance? Who is the beneficiary? Spell it out in the shareholder agreement at the time the insurance is purchased.
If the agreement is a redemption agreement (the company is buying the owner’s interest) the company is normally the owner and beneficiary of the life insurance. If the agreement is a buy/sell agreement between the owners, they buy insurance on each other.
Let’s look at an example:
- Nardozzi Oil, Inc. has two owners, each with a 50 percent share of the business.
- There is a buy/sell agreement between the owners (brothers).
- Triggering events are death or retirement at age 70 (90 percent payout), and involuntary departure (60 percent payout).
- There is a 10-year buyout term, with equal payments.
- Value by formula is used by determining the average of last three years’ gross margin, plus all other assets at book value, less liabilities
Average Gross Margin $ 1,200,000
Vehicles (book value) $ 300,000
Cash $ 200,000
Accounts Receivables (net) $ 425,000
Inventory $ 175,000
Total $ 2,300,000
Less Liabilities ($ 600,000)
Net Value $ 1,700,000
Value per owner at 90 percent (50/50) $ 765,000
Based on the buy/sell agreement, each owner would be obligated to pay the retiring partner (or a deceased partner’s estate) $76,500 per year ($6,375 per month) for 10 years. But if the departing brother leaves the business early, or gets caught with his hand in the company cookie jar, he would receive only $45,900 per year ($3,825 per month) per year for 10 years.
Is Payout Tax Deductible?
Which brings us to a last big issue: Are those payments tax-deductible? Unfortunately, they are not. Using a buy/sell agreement, the brother remaining in the business would need to increase his salary by enough to pay the departing (or departed) brother $85,000 per year. The good news? His cost basis goes up by the amount paid for his shares to offset the gain when/if the remaining brother sells the business. The money paid to the former owner would be taxed to him as a long-term capital gain (the lowest tax rate).
Would using a redemption agreement instead of the buy/sell, with the company making the payments, result in a tax deduction for the business? Sorry, but no. Stock redeemed by the company is treated as treasury stock, and the payment(s) are not tax deductible.
Is there a way to avoid these tax consequences? There are some creative vehicles that may be used to minimize the tax bite, such as deferred compensation agreements or shifting part of the payment to rental income. But keep in mind that if the company is allowed to deduct the payment, then it is ordinary income to the recipient and therefore taxed at a higher rate.
These simple examples clearly demonstrate the need for a shareholder agreement in any multiple owner business. Whether you choose to use a buy/sell agreement or redemption agreement, it is essential that you craft it carefully and that all owners understand and consent to abide by the rules set forth in the agreement.
John H. Nardozzi, CPA, CVA, MST is the owner of Nardozzi, LLC (www.nardozzillc.com) which provides consulting and valuation services for oilheat and propane dealers.