Dan Isard
on
Dear Dan,
I am 54 years old and finally ready to buy out my father. I really should say Dad is 78 years old and finally thinks I am ready to buy him out. Regardless, my lawyer is telling us that we should use a cross-purchase agreement and my accountant is telling us to use a corporate redemption agreement. I don’t see the difference. Both ways, I own the business and Dad retires (finally). I’m sure you know the difference and can sim- ply tell us which to use.
Signed, Finally Ready to Buy in Findley
Dear Finally Ready,
Your question is a very common one, and most people don’t know which agreement to use. Let’s start by explaining each route.
A cross-purchase agreement is an agreement between shareholders – if one party sells, the other party buys. A corporate redemption agreement is an agreement in which the corporation buys the shares of the party that wants to sell. It sounds simple, but trust me – between cash flow, taxes, lenders and the subsequent party selling, this gets very confusing.
The concept gets even crazier when dealing with a present sale versus an agreement to sell in the future. An agreement to sell in the future is called a buy and sell agreement. This is applicable to both a corporate redemption and cross-purchase agreement. It generally takes place upon a future triggering event such as the death, disability or retirement of a shareholder. It can also cover the divorce of a shareholder from his or her non-shareholder spouse and in situations where the shareholders don’t like each other anymore and one wants to get out. A buy and sell agreement, regardless of whether it’s in the form of a corporate redemption or cross-purchase agreement, needs to take into consideration all of the issues of cash flow, taxes, lenders and the subsequent party selling.
The most confusing issue presented in your question is that you are buying shares from your father. Allow me to explain why this is confusing. Picture, if you will, a C or S corporation with one shareholder. Imagine that this one shareholder needs money for lunch. She goes to her comptroller and says, “Hey, give me an advance of $100.” The comptroller does, and the shareholder realizes that it is subject to a 39 percent C corporation tax rate or her individual tax rate if it’s an S corporation. Under a C corporation, this $100 advance costs about $150, as $50 is the tax to net $100.
The shareholder then realizes that if she were to sell one share of her company (valued at $100) to her corporation, she would only have to pay a capital gains tax, which is 20 percent. Therefore, she needs to generate about $124 to pay for lunch. While this seems ingenious, it is lacking a basic understanding of the U.S. Tax Code.
More specifically, if there were 100 shares outstanding before lunch, there are 99 shares outstanding after lunch. The one shareholder owned all of the 100 shares so she will own all of the 99 shares outstanding. Her 100 percent ownership is maintained.
The tax code has protections in place when shareholders try to treat income as a capital gain. Section 301 states that all redemptions of shares are deemed to be a dividend unless they are substantially equal to a corporate redemption. The IRS looks at the control of shares before redemption and after. If you want to qualify for a capital gain, you must have less than 50 percent of the shares after a redemption than you did before. Therefore, if someone owns 100 shares and sells one to the company, they owned 100 percent before and 100 percent after. This does not qualify.
If you were to buy out your father with a corporate redemption and assume he sold 100 percent of his stock to the corporation, we would have a small problem. First, no one would own any outstanding shares. If you bought one share personally and then the corporation was to redeem the balance of Dad’s shares, you would be the only share outstanding. On its surface, it looks as if it would qualify. However, it doesn’t.
To get a master’s degree in taxation, you have to show up every day for class. I was a speed reader so I have the tax knowledge but not the degree. The tax law has a tax trap called “attribution.” Attribution is kind of like setting up teams of different people with a common relationship. For example, there is family attribution, in which all members of that team are looked at for their combined ownership. If you own one share and Dad owns 99 shares before the transaction, you both own 100 percent under the rules of family attribution.
Let’s assume Dad sold his 99 shares to the corporation. That means you own one share after it is concluded. You own 100 percent after the transaction. When you look at this as teammates, you and Dad own 100 percent after the redemption. The redemption doesn’t qualify as a capital gain because of the constructive ownership caused by the parent and child relationship.
Family attribution is like a bad spider web. Family attribution construes that the ownership of a shareholder extends to their spouse, their children, their grandchildren and the shareholder’s parents. The law does not discriminate against adopted children or grandchildren. It goes one generation up and three generations down; it does not cover siblings (the test case on that is Cain vs. Abel).
Attribution gets even more complex as it covers family relationships, trust/beneficiary, corporations, partnerships and other common relationship situations. On its surface, it would seem there is no way to use corporate redemption in family situations. But there is one exception to the rule. It’s a three-part qualifying test spelled out in Section 302 of the Internal Revenue Code. The 302 waiver will waive attribution if you meet all three parts:
- The 10-year look-back test determines how the attributed parties acquired their shares during the previous 10 years before the sale.
- The 10-year look-forward test states that if the selling party reacquires shares during the next 10 years after the sale, you will notify the IRS.
- Finally, the substantially equivalent test. This is the easiest of all and confirms that the sale is a routine sale and not intended to violate the law in order to cause a capital gain out of what would otherwise have been an ordinary income event. Of course, rather than have the corporation redeem the shares, you could always use a cross purchase and avoid this entire attribution problem.
You want a sale of shares to qualify as a capital gain. Hopefully, due to the long-term nature, it would be a long-term gain. If so, you have two big benefits. First, you get a tax-free return of your basis (basis is the amount you paid for an investment). It can be increased by any new contributions of capital and it can be reduced by depreciation or amortization. Second, the federal tax rate on the gain is 20 percent. Imagine you own a corporation and paid $200,000 for the shares. Someday you hope to sell this for $1 million. This would present itself as a long-term capital gain of about $800,000. The federal tax would be about $160,000. After tax, your sale would net you about $840,000. If this were ordinary income and you had no tax-free recovery of basis, the entire distribution would be taxed as ordinary income with a 39 percent federal tax rate.
Cash flow is another important consideration. In most cases, the buyer will need financing from the seller or a third party (or both) to fund the transfer of shares. If I personally owe money to a bank, how do I get the cash flow to pay the note? Typically, it will come from the profits of the business.
Remember, interest is probably deductible, but principal is not. If I owe a bank $100,000 a year, part of that payment is interest and part is the repayment of principal. In the early years, most of that payment amount is interest. Over time, principal gets to be a greater amount. If in one year I have to pay $30,000 of principal, I have to earn about $12,000 extra. That is the tax on $30,000 of non-deductible principal. As a loan gets older, more and more of the payment is principal. During those last years, the tax cost on the principal is a real nightmare.
If you use a cross-purchase agreement, you have to take added compensation out of a business or the business should be set up as an LLC or Subchapter S corporation. This is so earnings can flow to the shareholder. These earnings can be used to pay the principal and interest on any purchase debt. We still have the same problem with the principal payments not being deductible, as stated above; however, the tax law may change over time.
Note: When buying a C corporation’s shares, the interest is not deductible! Interest is only deductible in a few qualified purchase situations. Interest is deductible for investment purchases only to the degree that the investment produces income to the shareholder. Most C corporations don’t pay dividends and therefore the interest on a C corporation is not deductible in a cross-purchase agreement.
If the corporation is the borrower, to redeem the shares we don’t have to worry about getting cash to the individual to pay the debt. That saves a lot of time, but the after-tax effect is still the same cost. However, many lenders would rather loan the money to the entity for the redemption and have the individual shareholder as the co-guarantor of the loan. Some lenders won’t fund a cross-purchase agreement as they want to have the corporation as the primary guarantor.
The basis is another concern. If you buy your father’s shares, you are going to have an increase in basis. Any principal you pay for the shares is going to reduce your capital gain when you sell the shares to your child when he or she turns 54. However, if you use a corporate redemption agreement, there is no basis change. It is the same dollars, but because the shares are retired, there is no change in the basis for your shares. Upon your retirement, the capital gains will be much greater.
Some 1,800 words ago, you worried that this was just a simple issue upon which no one could agree, but as you can see, it is not so simple. I am reminded of the client who told me he had a two-handed lawyer. I said I didn’t understand the reference and he replied, “For the past 30 years, if I asked my lawyer a question, he would say… ‘On the one hand, we could do this; on the other hand, we could do that…’ Now I just want a one-handed lawyer.”
But I learned a long time ago that it just ain’t that simple.
Daniel Isard, MSFS, is president of The Foresight Companies LLC, a Phoenix- based business and management consulting firm specializing in mergers and acquisitions, valuations, accounting, financing and customer surveys. He can be reached at 800-426-0165 or danisard@f4sight.com. For copies of this article and other educational information, visit www.f4sight.com.
The financial and tax advice contained in this article is for informational purposes only and may or may not apply to your individual position. Readers are strongly encouraged to seek the counsel of qualified advisors before undertaking any action based on this information.