When you own a closely held business, deciding who should inherit and manage it when you are no longer involved is not easy. How can you ensure your business will continue to prosper when you die, become disabled or retire?

Whether you are a majority or minority shareholder, a Buy-Sell Agreement is an important tool to avoid problems that arise when a key shareholder is no longer present. It addresses who can buy a departing shareholder’s stock and at what price. In addition, it provides for an orderly transition that can minimize turmoil during an unsettling time. If your company is an S Corporation, a Buy-Sell Agreement should address the special S Corporation issues that may arise.

S Corporations defined

To be treated as an S Corporation for federal income tax purposes, a company must:

Be a domestic corporation;

Have 75 or fewer shareholders who are either individuals (but not nonresident aliens or spouses of nonresident aliens who, under applicable local law, have a current interest in the U.S. citizen’s stock), estates, certain trusts, tax-exempt pension plans or some other tax-exempt organizations;

Have only one class of stock; and

Not be an ineligible corporation, such as a financial institution, an insurance company, or a current or former domestic international sales corporation.

In Buy-Sell Agreements, the key issue to consider is who can hold stock. The agreement should bar a stock transfer that would violate the above requirements and disqualify the S Corporation election. In addition, it should give the corporation or other shareholders the immediate right to acquire the transferred interests in such a situation -- perhaps at a discount or penalty price.

What happens with a grantor trust, where the grantor is treated as the trust’s owner for income tax purposes? In that instance, the grantor is treated as the shareholder for S Corporation purposes, and the trust does not have to meet any additional requirements. The Buy-Sell Agreement or the particular trust instrument should take into account what happens to the S Corporation stock when the trust ceases to be a grantor trust, such as when the grantor dies.

Nongrantor trust as an S Corporation shareholder

If a trust is not a grantor trust, it can qualify as an S Corporation shareholder either as an electing small business trust (ESBT) or a qualified subchapter S trust (QSST).

ESBTs must meet three requirements:

1. Beneficiaries can be only individuals, estates and qualified charitable organizations;

2. Beneficiaries ca not buy interests in the ESBT; and

3. The trustee must make an ESBT election and cannot have made a QSST election.

ESBTs have three disadvantages. First, they pay income tax at the highest rate applying to trusts and estates (37.6% in 2004) -- unless the capital gains tax rate applies. Second, they ca not deduct income distributions. Third, they must treat each beneficiary (including each potential beneficiary under an appointment power) as a shareholder for purposes of the 75-shareholder limit.

QSSTs must have only one income beneficiary, and he or she must be a U.S. citizen or U.S. resident. QSSTs must distribute all income to the beneficiary, and may distribute principal only to that beneficiary. The income interest must terminate on the earlier of the beneficiary’s death or the trust’s termination. If the trust terminates while the beneficiary is alive, it must distribute all assets to the beneficiary.

The advantage of a QSST is that the trust’s income is taxed at the trust beneficiary’s tax rate. The disadvantage is that the trust can have only one beneficiary at a time. A common trust fund for the benefit of children or grandchildren will not qualify as a QSST. If you want to transfer S Corporation stock to them in trust, the trust agreement should authorize the trustee to create separate trusts, one for each beneficiary. Each separate trust would then be administered under the original trust’s terms. (Some state laws automatically grant the trustee this authority.) This division into separate trusts allows each trust to qualify as a QSST, but each trust counts against the 75-shareholder maximum. Each QSST then must agree to be bound by the Buy-Sell Agreement’s terms.

Your buy-sell options

You can structure a Buy-Sell Agreement as either a corporate redemption, with the S Corporation buying the stock, or as a cross-purchase, with the remaining shareholders as the buyers of the stock. In addition, you can create a hybrid agreement if you are not sure whether a redemption or cross-purchase would work best when the time comes. In the past, corporate redemptions have been less favorable because the redemption might result in a dividend to the selling shareholder. But the recent tax-rate reduction on dividends may make this method just as favorable as a cross-purchase.

If the buyout is to be funded with life insurance, a corporate redemption minimizes the number of policies needed. With a cross-purchase, each shareholder needs to own a policy on the life of each other shareholder. If the company has numerous shareholders, the multiple insurance policies needed can be cumbersome.

How can we help?

Buy-Sell Agreements are important for all closely held businesses. But if your company is structured as an S Corporation, there are additional complexities to consider. If you would like to discuss how a Buy-Sell Agreement can benefit your business, please give us call.

(Copyright © 2004, all rights reserved. Provided by Martin L. Pierce, a Member of the Chattanooga office of Husch & Eppenberger, LLC. Martin is a Business and Tax attorney who is Certified as an Estate Planning Specialist in Tennessee and through the ABA-approved national professional and testing organization. He is also licensed in Georgia.

DISCLAIMER: This article provides general coverage of its subject area. It is provided free, with the understanding that the author, publisher and publication do not intend this article to be viewed as rendering legal advice or service. If legal advice is sought or required, the services of a competent professional should be sought. The author and the publisher shall not be responsible for any damages resulting from any error, inaccuracy or omission contained in this publication.)