Introduction.  A stockholders agreement is generally recommended whenever a closely-held corporation has more than one stockholder.[1] ¹  Typically, 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 certain actions (such as issuing new stock, selling assets, paying bonuses, etc.)

          The stockholders agreement almost invariably includes a requirement for the surviving stockholder(s) or the corporation to purchase the stock held by the decedent’s estate.  The price is 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] 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, say, 30 days to either (i) accept the offer and sell his or her stock at the offered price; or (ii) match the price per share and buy the stock of the offeror(s).[3] 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 a few years ago.

          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(s), 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(s) get basis in the purchased stock.[4] ⁴

          Many tax practitioners don’t like the tax effects of a stock purchase.  So they 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 service businesses, particularly physicians.  While such an arrangement generally increases each seller’s income and employment tax liabilities, the remaining stockholder(s) presumably are 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 price generally must be paid with after-tax dollars.   For most tax practitioners that’s about the end 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 (discussed below) instead of stock.  Where 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.

          Capital Gain. If not related to the buyer, the seller of business assets is entitled to report capital gain.[5] ⁵  The major exceptions relate to (i) recapture of depreciation, (ii) appreciated inventory and (iii) 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 which would have been recognized soon anyway.  And again, the buyer gets matching tax benefits which 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.[6] ⁶

          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.  Goodwill is usually amortized over a 15 year period.[7] ⁷ 

          The Asset Purchase  Stockholders Agreement .  The heart of an Asset Purchase Stockholders Agreement is that if all of the stockholders are involved in the transaction as either buyers or sellers, the buying stockholder(s) purchase the corporate assets (via another corporation) for a stepped-up price that would yield the same after-tax consideration to the selling stockholder on a dissolution immediately after the sale.[8] ⁸ 

          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(s) receive significant income tax benefits.

          Example 1:  A and B are unrelated 50% 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 $1.5m under an Asset Purchase Stockholders Agreement.  B purchases the assets for a price of $3m.  A’s estate and B would each get $1.5m on the post-sale dissolution of the corporation and each would be entitled to report the sale as a capital gain transaction.  However, A presumably would be entitled to a date of death fair market stock basis and thus would have no gain.[9] ⁹   Because all of the price is allocated to goodwill, B will be entitled to a $200,000 annual deduction for each of the next 15 years.  

          Thus, B gets to deduct the entire $3m purchase price against ordinary income at the “cost” of reporting $1.5m of capital gain.  Assuming a 15% capital gains tax rate and the deductions offset income which would otherwise be taxed at 35%, the income tax savings for B would be $825,000.^{1[10] 0}    That’s 55% of the after-tax proceeds to A.

          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’s 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 a sale of a business would generally be involved in an asset sale.  Presumably the buying stockholder(s) 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”) which 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,^{1[11] 1} 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.^{1[12] 2} 

          For the decedent’s estate the set of transactions would be essentially equivalent to a redemption or cross purchase.  But it 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.^{1[13] 3}  In addition, B must utilize Newco as the buyer.  Otherwise, B would owe the money to himself 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.^{1[14] 4}

          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.^{1[15] 5}  The stockholders could argue that the test is met, but we are in unchartered territory. 

          An alternative designed to (i) avoid the one class of stock problem, (ii) get cash to A’s estate and (iii) 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.

         Three stockholders.  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% 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% common ownership.[16] ⁰ 

    There are many possible solutions to this problem.  Two are presented here. Solution #1:  Because the related party rules effectively require a 50% equity shift, B and C could own 5/6ths 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 which called for compensation which was greater than B’s compensation by 40% of profits determined before compensation. 

Solution #2:  Because the beneficiary of a non-grantor trust is treated as the owner of stock owned by the trust for purposes of the related party rules,^{1[17] 7} B could own 25 shares directly and declare that he or she is holding 25 more shares as trustee for the benefit of an unrelated person, such as an in-law or key employee. C does the same.^{1[18] 8}

      An 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.

     Unwinding.  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 #2) would not affect the tax consequences of the purchase transaction.^{1[19] 9}

     Conclusion.  Every tax practitioner who drafts stockholders agreements should seriously consider putting an Asset Purchase  Stockholders Agreement in his toolbox.  It is a flexible device that can mimic the results for the selling stockholder(s), yet yield very significant income tax benefits for the buying stockholder(s).  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.

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© 8/25/2008 Steven M. Chamberlain. All rights reserved. Republication with attribution is permitted.