What is a buy-sell agreement?
A buy-sell agreement is a legal contract common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement. When carefully drafted, your buy-sell agreement may be used to set the taxable value of your business interest.
Does it matter if your buy-sell agreement is with a family member?
The IRS tends to scrutinize transactions between related parties, so almost any business transaction between you and a family member could be subject to the attention of the IRS. The definition of family member includes your spouse; parents of you and your spouse plus their lineal descendants, including spouses; and any other "natural objects of the transferor's bounty." There are rules in effect that can make the sale of an interest in a family business seem more difficult. However, you can take steps to ensure that your related party buy-sell agreement stands up to an IRS examination.
Considerations for buy-sell agreements with family members
Make sure your buy-sell agreement price represents fair market value
When setting the valuation method to be used under the buy-sell agreement, make sure that the transaction will represent fair market value (FMV). There are serious tax consequences that may result from using a price that the IRS determines to be higher or lower than FMV. To ensure that the IRS accepts your sale price, your buy-sell agreement must meet three requirements:
- It must reflect a bona fide business arrangement
- It must not be a device to transfer your interest to family members for less than full and adequate consideration
- ts terms must compare with those of agreements between parties in an arms-length transaction
Tip: A professional appraisal should be conducted to establish the FMV of your business interest.
Attribution rules may apply and affect tax treatment when buyer is family corporation
If your buy-sell agreement is between you and the business entity itself (entity purchase buy-sell agreement), if shareholders are related to each other, and if your business is a corporation, the attribution rules of Section 318 must be considered. The definition of related shareholders includes spouse, parents of either spouse and their children and their spouses, and any natural objects of the transferor's bounty. The attribution rules can affect the tax treatment of a shareholder's stock redemption.
Depending upon the circumstances and the way the buy-sell is structured, the proceeds (payment) the seller receives from the redemption of the business interest may be classified as a sale or exchange of the seller's interest (subject to capital gains tax) or as a dividend distribution.
Tip: In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, dividends and capital gains are generally taxed at 20% for taxpayers in the new 39.6% tax bracket for high-income taxpayers. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
There remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution, despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. That is, in the case of dividend treatment, the entire amount paid to the shareholder is subject to tax. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock.
Tip: If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the fair market value of the shares at the time of your death, and little or no tax may result.
In a family corporation, the sale of stock to the business under a stock redemption plan usually results in dividend treatment to the redeeming shareholder.
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To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
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