Asset Purchase Stockholders’ Agreements
A stockholders’ agreement is generally recommended whenever a closely held corporation has more than one stockholder.1 T ypically, a stockholders’ agreement will restrict transfers of stock, protect an S election, and preclude competition and disclosures of information. In addition, control issues are often addressed via unanimous or super-majority voting requirements for all or selected actions (such as issuing new stock, selling assets, paying bonuses, etc.).
Stockholders’ agreements almost invariably include a requirement for the surviving stockholder(s) or the corporation to purchase the stock held by the decedent’s estate, with the price being established by a formula. If the obligation is funded with life insurance, the formula usually is a function of the face value of the policy.2
More comprehensive stockholder agreements include a “trigger offer” or “push-pull” procedure to enable a stockholder to “force a divorce.” Under this procedure, any stockholder may make an offer at any time to buy the stock of another stockholder who then has, for example, 30 days to either 1) accept the offer and sell his or her stock at the offered price, or 2) match the price per share and buy the stock of the offeror(s).3
Reorganizations, estate planning, and asset protection issues are beyond the scope of this article. Rather, the focus of this article is on income tax planning, and for such purpose, it is assumed that the corporation has been an S corporation with two equal, unrelated stockholders since the business began more than 10 years ago.4
Income Tax Planning
Almost all stockholders’ agreements call for a sale of stock at some point. If the purchase is by the corporation, the stockholders’ agreement is said to use a redemption model. If the purchase is by the other stockholder, it is called a cross-purchase model. Although more complex, the cross purchase model is often considered advantageous from a tax perspective because, in comparison to the redemption model, the purchaser gets basis in the purchased stock.5
Many tax practitioners do not like the tax effects of a stock purchase and will recommend that the purchase price be set at an artificially low price and that each selling stockholder receive one or more termination bonuses under his or her employment agreement. Such an arrangement is common with professional corporations. Although such an arrangement generally increases each seller’s income and employment tax liabilities, the remaining stockholder presumably is able to benefit from the pass-through of reasonable compensation deductions. The planning benefit is that the pattern of matching income and deductions is considered more tax efficient than the income tax consequences with a high stock price, which generally must be paid with after-tax dollars. For most tax practitioners, that is about the extent of income tax planning regarding stockholders’ agreements.
Asset Purchase or Stock Purchase
It is generally understood that there are two principal ways to buy a business: a stock purchase or an asset purchase. The stock purchase is usually favored by the seller, but the buyer usually wants to purchase assets not only out of concerns regarding hidden liabilities or other historical problems at the corporate level, but also out of a desire to get the income tax benefits of purchasing assets instead of stock (discussed below). When part or all of the consideration for the asset purchase consists of a promissory note, the transaction is referred to as a leveraged buy-out, or LBO.
If not related to the buyer, the seller of business assets is entitled to report capital gain.6 The major exceptions relate to 1) recapture of depreciation, 2) appreciated inventory, and 3) accounts receivable owned by cash-method taxpayers. Recapture of depreciation can be avoided via leasing selected assets to the buyer. In many cases, this is unnecessarily complex in that the buyer would get matching depreciation deductions. So instead of leasing, the seller sells the depreciable asset and thereby triggers the recapture, but the price is adjusted via negotiations. Selling appreciated inventory and accounts receivable merely accelerates income that would have been recognized soon anyway. Again, the buyer gets matching tax benefits that can be shared via a price adjustment.
The Seller’s Economics
Presumably, the price in an asset sale reflects the discounted value of the future income stream of the business, at least to the extent the purchase price is allocated to goodwill. In essence, selling goodwill converts the seller’s expected future income stream from ordinary income to capital gain.7
The Buyer’s Tax Benefits
The buyer in an asset purchase gets all of the available depreciation and amortization deductions stemming from the purchased assets. Unless the anti-churning rules apply, goodwill is amortized over a 15-year period.8
The Asset Purchase Stockholders’ Agreement
The heart of an asset purchase stockholders’ agreement is that the buying stockholder is required to either purchase each seller’s stock (or cause a redemption at that price) or purchase the corporate assets for a stepped-up price that would yield the same after-tax consideration to the selling stockholder on a dissolution immediately after the sale.9 The corporation then dissolves and the excess consideration passes back to the buying stockholder.
The effects to the selling stockholder of a properly structured asset sale would be essentially the same as under the redemption or cross purchase model, but the buying stockholder receives significant income tax benefits.
Example 1 — A and B are unrelated 50 percent stockholders of a corporation with no liabilities and no assets other than goodwill. A and B each has no basis in his or her stock. A dies and is entitled to receive $1.5 million under an asset purchase stockholders’ agreement. B elects to purchase the assets for a price of $3 million. A’s estate and B would each get $1.5 million on the post-sale dissolution of the corporation, and each would be entitled to report the sale as a capital gain transaction. However, A’s estate presumably would be entitled to a date of death fair market value stock basis10 and a $1.5 million basis step-up from the sale,11 and, thus, would have a long-term capital loss of $1.5 million on the dissolution to offset its $1.5 million of gain. Because the entire price is allocated to goodwill, B will be entitled to a $200,000 annual deduction for each of the next 15 years.
Thus, A’s estate is essentially in the same economic and tax position as a cross purchase, but B gets to deduct the entire $3 million purchase price against ordinary income at the “cost” of reporting $1.5 million of capital gain. Assuming a 20 percent capital gains tax rate and the deductions offset income — which would otherwise be taxed at 40 percent — the income tax savings for B would be $900,000.12
Clearly, an asset purchase stockholders’ agreement has potentially significant overall income tax advantages relative to a redemption or cross purchase stockholders’ agreement. However, the author is not aware of attempts by tax practitioners to take advantage of the asset sales rules in planning for stockholders’ agreements. It is as if we miss the fact that, in many instances, the stock acquisition via a stockholders’ agreement is essentially equivalent to a business acquisition.
The Best of Both Worlds
All of the administrative difficulties inherent in the sale of a business would generally be involved in an asset sale. Presumably, the buying stockholder would form a new entity to make the purchase, which entity would have a new taxpayer identification number, sales tax number, unemployment tax number, checking account, etc. Most, if not all, of the corporation’s contractual relationships would have to be shifted to the new entity (but the new entity can have the seller’s name, phone number, etc.), and fringe benefits may vest.
However, it is possible to avoid such difficulties. In Example 1, B could form an S corporation (Newco) that would purchase all of the stock of both stockholders. In effect, the original corporation (Oldco) becomes the target. A QSUB election would be made for Oldco,13 thus, rendering it a disregarded entity for income tax purposes. Newco and the selling stockholders would also make an election to treat the stock purchases as the purchase of all of Oldco’s assets, followed by a hypothetical dissolution of Oldco to its (former) stockholders.14
For the decedent’s estate, the set of transactions would be essentially equivalent to a redemption or cross purchase. But the structure would not involve an assignment of contracts or other assets. Accordingly, the structure would be much simpler to implement and administer than a traditional asset sale, and it would put the buying stockholder in essentially the same economic position as with the redemption or cross purchase model, but with substantially reduced income tax exposure.
The LBO Stockholders’ Agreement
An obvious problem with Example 1 in the real world is that B may not have the cash to fully fund the transaction. An installment sale would be necessary. In Example 1, if the transaction takes the form of an actual asset sale, then Oldco must adopt a 12-month plan of liquidation before the sale if B is to be entitled to defer gain via the installment method.15 In addition, B must utilize Newco as the buyer. Otherwise, B would owe the money to himself or herself after the dissolution of Oldco, which would accelerate the note.
An immediate issue arises if A’s estate receives cash (e.g., the sales proceeds traceable to the life insurance proceeds) and B receives an installment note. Regardless of whether the transaction is an asset purchase followed by an actual dissolution or a stock purchase followed by a deemed dissolution, the stockholders receive different consideration, which might violate the subchapter S single class of stock requirement.16
The regulations provide that different consideration received by the stockholders in a deemed dissolution pursuant to the deemed asset sale election will not be considered to violate the single class of stock rule if the different consideration was determined via arms’ length negotiations.17 The stockholders could argue that the test is met, but we are in unchartered territory.
An alternative designed to 1) avoid the one class of stock problem, 2) get cash to A’s estate, and 3) provide installment reporting for B would be for the price to be paid via long-term installment notes, which would allow the holder to accelerate almost all of the face value. A’s estate could then demand payment, and B could transfer the insurance proceeds to Newco to fund the payment.
Example 2 — A, B, and C are three equal, unrelated stockholders. A dies, and B and C have an obligation to either buy A’s stock or purchase the corporate assets for a price which nets A’s estate — upon a corporate dissolution — the same after-tax consideration as the stock purchase. The planning problem is that if B and C were to form Newco as 50 percent stockholders, and Newco were to buy the assets at triple the price to A, the gain on sale of the depreciable assets (e.g., goodwill) would be taxed as ordinary income because the buyer and seller have more than 50 percent common ownership.18 There are many possible solutions to this problem. Two are presented here.
Solution 1 — Because the related party rules effectively require a 50 percent equity shift, B and C could own 5/6 and 1/6, respectively, of Newco. C might be satisfied with that solution if he or she had equal voting rights and an employment or management agreement calling for compensation greater than B’s compensation by 40 percent of profits determined before compensation.
Solution 2 — Because the beneficiary of a nongrantor trust is treated as the owner of stock owned by the trust for purposes of the related party rules,19 B could own 25 percent of the outstanding stock directly and declare that he or she is holding another 25 percent as trustee for the benefit of an unrelated person, such as an in-law or key employee. C does the same.20
But besides the flexibility, the more important point to note is that the planning problem does not necessarily arise until the identity of the seller is known. For example, there may be a different solution if A dies than if B or C dies. Further, the solution one designs today might not suffice when the purchase has to be made. So this aspect of the drafting problem for the asset purchase stockholders’ agreement is reduced to merely leaving enough flexibility for future planning, typically including assignable options to purchase all of the assets or stock.
Regardless of the solution chosen, the purchase money note in an LBO reduces the equity in Newco. And because the income tax consequences are determined by the facts at the time of the sale, a later change in the ownership of Newco (e.g., sales to B and C of the stock held in trust in solution two) would not affect the tax consequences of the purchase transaction.21
Every tax practitioner who drafts stockholders’ agreements should seriously consider putting an asset purchase stockholders’ agreement in his or her toolbox. It is a flexible device that can mimic the results for the selling stockholder, yet yield very significant income tax benefits for the buying stockholder. The numbers can be so impressive that consideration should be given to reviewing all existing stockholders’ agreements to see if an amendment — and perhaps an increase in life insurance coverage — would be advisable.
1 The article only deals with entities taxed as corporations, but essentially the same considerations are appropriate for entities taxed as partnerships.
2 An alternative which would generally be more favorable for estate planning purposes would be for each stockholder to purchase insurance on his or her own life, perhaps via an irrevocable life insurance trust. In this type of arrangement, the stock price under the stockholders’ agreement would typically be set at a low figure, such as book value.
3 To ensure that the trigger offer process actually happens as planned, a trustee can hold the stock certificates signed in blank and act as a middle man, holding the offered consideration, issuing notices, etc. If the consideration is to be paid over time, promissory notes and security documents can be attached as exhibits to the agreement. The trigger offer procedure can be used in capturing the benefits of the asset purchase technique described in this article.
4 Thus, avoiding the built-in gains tax of I.R.C. §1374.
5 The “lost basis” problem is merely that the decedent’s estate gets some of the basis increase from the insurance proceeds at a time when it already has a fair market value on date of death basis step-up under I.R.C. §1014, and the extra basis may generate an unusable capital loss on the redemption. With a cash method corporation, that problem can be avoided via a redemption in exchange for an installment note and paying off the note with the later-arriving insurance proceeds.
6 I.R.C. §§1221, 1231, 1239, 197(f)(7) and 453, but see I.R.C. §453A requiring additional tax payments if more than $5 million of installment sales obligations are received by the taxpayer during the year ($10 million for husband and wife).
7 Essentially the same conversion of ordinary income to capital gain occurs whenever rental real estate is sold, at least to the extent that the price reflects the discounted value of the future rental stream.
8 I.R.C. §197 provides the rules for amortizing goodwill purchased in a business acquisition. I.R.C. §197(f)(7) treats amortizable goodwill as depreciable property. I.R.C. §1239 converts the character of the gain to ordinary income if the sale is of depreciable property to a related person, as defined therein. I.R.C. §197(f)(9) provides the anti-churning rules, which apply to certain intangibles that were used by a related party before August 10, 1993. In determining the related parties for purposes of the anti-churning rules, the 50 percent figure is replaced with a 20 percent figure.
9 Of course, the agreement could simply call for the buying stockholder to purchase the assets for a price set by a formula. To help mimic the effects of a stock sale, the buying stockholder might be required to indemnify the selling stockholder with respect to any liabilities of the corporation.
10 I.R.C. §1014. The basis adjustments on death can be more complex in larger estates.
11 I.R.C. §1367(a).
12 The time value of money affects the economics of the transaction. But this factor is reduced to the extent the consideration is paid via a note, and B uses the installment method to report his or her gain.
13 I.R.C. §1361(b)(3).
14 I.R.C. §338(h)(10). Treas. Reg. §1.197-2(e)(5) provides that even though the transaction took the form of a stock purchase, §197 applies if a §338(h)(10) election is made.
15 Assuming the dissolution occurred within the 12-month period. I.R.C. §453B(h).
16 I.R.C. §1361(b)(1)(D).
17 Treas. Reg. §1.1361-1(l)(2)(v). I.R.S. P.L.R. 199918050.
18 I.R.C. §1239.
19 I.R.C. §267(c)(1).
20 Instead of the trusts, the planner might be tempted to utilize nonvoting stock. I.R.C. §1361(c)(4) provides that different voting rights do not create a second class of stock. That would be a mistake, however, because I.R.C. §267(b)(11) provides that two S corporations are related if more than 50 percent of the value of their stock is held by the same persons. Note also that solution two could be used to avoid the anti-churning rules of I.R.C. §197(f)(9) by having the original stockholders collectively own not more than 20 percent of the stock of the buyer, with the other 80 percent being held in trusts for the benefit of unrelated persons. IRC §§267(b) and (c).
21 Unless, of course, some judicial doctrine applied (e.g., step transaction).
Steven M. Chamberlain practices tax and business law in Melbourne. He has a B.S. from MIT and a J.D. and LL.M. in taxation from the University of Florida. He is a member of the executive council of The Florida Bar Tax Section and has had numerous publications in The Florida Bar Journal.
This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.