1. Module 7: Primer on Buy-Sell Agreements
Part 1: Overview of Buy-Sell Agreements
Part 1: Overview of Buy-See, when to use and how to use them.
Part 2: Use of B/S in PSC (briefly since not at issue)
Part 3: Funding Buy-sell agreements

2. Goals Provide an exit strategy via options and triggers.
Maintain control of company.
Establish future value of shares.
Establish a market for shares.
How to get out of the company in the event something unforeseen happens; or intentional to ensure a smooth transition or continuation of the business. Critical question is the ease of transferability of interest. Key is control and liquidity, have enough money to prevent undesirables from becoming owners, thereby determining who owns shares or an interest. Company or owners have the option to redeem or repurchase the shares to preserve control; and gives the company some stability in valuation by creating a mechanism to determine the value of the company and therefore the owner’s interest.
in a closely held corporation, established either by a separate agreement among the parties or in the shareholder agreement. In an LLC or Partnership, it will be established in the Pship agreement or the LLC operating agreement. ,

3. Objectives of Buy-Sell Structure
Control: Keep stock away from undesirable owners
Fair Value: Establish fair mechanism for valuing stock of departing owner
Transition: Assure smooth transitions of control and ownership issues as owners come and go
Market: Assure “market” for shares at appropriate exit points
Expulsion: Assure expulsion rights of group, if desired
Source of Cash: Assure funding mechanisms and procedures
Estate planning: Establish estate tax valuation
Trying to spell it out up front to prevent tense negotiations later. Don’t want to have to negotiate when there is a crisis. Leverage changes and may not reflect what is in the best interests of the company.
Expulsion, termination are of interest to toilers and professional service organizations.
Cash: life and disability insurance can provide the proceeds to pay the heirs of an estate. Also want to assure than value of the equity does not exceed the amount actually received.

4. Mandatory Provisions
Trigger event for mandatory purchase (redemption) or option (rt of 1st refusal);
If Toiler, link between buy-out and voluntary termination of employment;
Price or Formula for valuing shares;
Process for resolving disputes.
Mandatory or option to purchase by the corporation; Obligation of seller/heirs to sell if event. Should make them mutual.
For Toilers, tie it to salary or employment; put in long notice provision, transition, and pay-out of period of time in installments. Have a process for resolving disputes

5. The Buy-Sell Triggers Uncontrolled Controlled Third party imposed
Death*
Disability*
Voluntary sale of interest*
Expulsion
Employment termination
Divorce*
Bankruptcy
*Most common
Different triggers should be provided for each investor based upon age, interest, personal and financial status. Toilers: all three; Golfers: uncontrolled and 3rd party; Sell- terms for buyer, Expulsion should require supermajority vote or unanimous, depending upon the number.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

6. Considerations Who is in the best position to buy?
Whose interests are protected by the buy-sell: company or owner(s)?
Are heirs likely to want to come into business?
How do you define disability and does it apply only to toilers?
In estate situations, big fish or family business head dies, family will not want the minority owners to have the right to buy. Instead, shares can be put into trust to pass along to heir.l
Be careful where give shareholder special voting rights, e.g., seat on the board, veto power.

7. Special Rules for Estate Planning
Must be arms length business deal;
At a fair value; and
Reasonable terms.
N/A if >50% of value owned by unrelated persons with comparable and mutual terms.
Price must be fixed or formula, estate has to sell at price; and corp. have right of first refusal.
Be careful: price agreed upon may not be the same as value used for estate tax; Designed to avoid abuse by family members. IRS may assign a higher value than agreed ‘cause find does not reflect fmv.
The 2703 Requirements:
1. Agreement is bona fide business arrangement; 2. Agreement not device to transfer property to family members for less than full and adequate consideration; 3. Terms of agreement must be comparable to similar arrangements entered into by persons in arm’ length transaction
2703 requirements not apply if:
- Over 50% of the value of property subject to the agreement is owned by non-family members
- Non-family members subject to the agreement the same extent as decedent
Pre-2703 requirements must be met: 1) Price must be fixed or determinable pursuant to formula or procedure in agreement. 2)Estate must be obligated to sell at determined price. 3) Decedent must have been restricted from selling or gifting during life to any person not subject to same restriction. Redemption At a minimum, should have right of first refusal.

8. Redemption vs Cross Purchase
Company gets interest;
Shareholders’ basis is unchanged.
Treasury or repurchased.
Company can deduct interest on installments.
*Preferred 1st Option
Owners get interests
Stepped-up basis to purchase price.
Lower capital gain on later sale.
Interest paid on installments subject to limitations.
*Preferred 2nd Option
Big difference between a cross purchase and redemption is not in effect of preserving control, but in basis of the stock after the transaction. Only issue relates to effect on existing shareholders and whether they want to increase basis. Affects basis in the stock that they acquire.
E.G. Redemption and distribution A and B own 20% and 60% w/ basis of $30K and 60K respectively. Each person receives their pro rata share of the 20% sold = 5% and 15%, which leaves A with 25% and B with 75% with the original basis. C leaves selling back C’s basis would step up and be assumed by A and B, which is added to their existing basis, so A would have total $130K basis and B have a total basis of $160K (e.g., A would allocate 30K to 20% and 100K to 5%) In a cross purchase, C’s basis of $100,000 each would change their basis. A’s basis would increase to $130,000 and $160,000. When the sell it, they will be able to recover the $100,000 tax free. N/A to S corporations, LLC and Pships ‘cause their basis will step up under either. If it is redemption, then receipt of the income will increase their outside (ownership) basis of the equity interest.
Redemption is generally preferred ‘cause easier to administer and fewer unknowns. Be careful about the Alternative Minimum Tax if gross receipts over $5 million in 1st 3 years where receipt of life insurance pay-out on the death of an owner. N/A in LLC & Pship. AMT would arise if there is a huge payout.

9. Cross Purchase – Redemption Trade-off
Cross-Purchase Pluses:
Stepped-up basis to buyers
No AMTI life insurance issues
No state law redemption restrictions
No loan agreement or creditor restrictions
Redemption Pluses:
Easier – less cumbersome
Insurance structuring easier
Easier transfer-for-value issues
Deductibility of interest on installment payments
No need to get funds out of corp to fund buy-out
The Option Strategy – Not death trigger answer
Big advantages of cross-purchase is stepped up basis and no AMT.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

10. Valuation Techniques Third Party – Appraisal or Appraisal/Arbitration
Formula – Use modified book value.
- Focus on earnings (set cap rate)
- Discounted value of estimated future cash flows
- Asset market value
- Combo formula
Costly, objective but uncertain.
May not reflect goodwill, current changes.
Best to use some combination of book and fmv.
Variety of options with pros and cons for each. Select different for different triggers. E.G. discounted price if voluntary w/drawal w/o long notice or go to competitor.
Third party appraisal-more objective but level of uncertainty; can be expensive. May not be accurate.
Formula-Usu. A combination of book value and market. Book value likely to be simple lower because it does not reflect changes in the asset value or goodwill.
Modified book value: adjusts balance sheet assets to current fmv but still fails to account for goodwill.
Formula: focus on capitalized earnings capacity that includes goodwill, but is based upon historical data, not recent changes in the business.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

11. Valuation Techniques
Periodic owner agreement procedure – with back-up.
Mixed formula – periodic agreement procedure.
Requires revaluation by shareholders. Need back-up if can’t resolve.
Three-tiers may be best if agreement is unlikely or difficult.
Fixed price with periodic adjustments by shareholders. They will have to focus on valuation every year so can be burdensome. Need a back-up valuation method that allows focus every couple of years.

12. The Big Mistakes Misused Right of First Refusal
Misused Showdown Clause
Failure to honor unique rights – too much democracy
Precludes market for minority shares if company does not exercise.
Unfair advantage to deep pockets. Best for golfers.
Big fish may have different interests than minority.
Showdown clause allows the owner to present offer to the other owners as purchase price and payment terms. Owners have to choose to be buyers or sellers if want to accept per terms. Present an offer and existing owners get right of first refusal to buy. If don’t accept, then he can sell to other party. Forces payment terms and price to be fair because one presents the offer and the other decides which he wants to do. Take a piece of candy, cut it in half and allow the other person to select piece they want. Not fair in Big fish/small fish ‘cause it gives big fish a huge advantage. May be used to squeeze minorities out. They may have to pay more to buy out big fish and have less net worth to buy it with. May be unfair to toilers if they have disparate net worth, even if they have equal interest. Not good in hybrid because it may force toilers to buy, simply to preserve their jobs. It should be limited to case where all owners have equal interests and financial worth.
Unique rights: majority may have different rights than the others. Big fish. Assumes everyone is treated alike but may be differences in control or where minority shareholder has guaranteed seat on the board. Majority may have most of the stock but not control the board. Big fish may want to hang on to the stock vs sell it, so that he can pass it along.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

13. Big Mistakes Dumb payment terms Ignore the downside
No anticipation of S Election Requirements
Bad life insurance structuring
If no security is provided as collateral.
Who is stuck with debt after w/drawal.
Can’t make a transfer to ineligible shareholder.
Constructive dividend if obligation to owners but insurance is paid by corporation & beneficiary.
--Payment terms: There should be a pledge of stock to secure deferred payment. Must specify terms of the pledge, e.g, if payments current, then voting rights and distribution rights belong to owner/buyer. They will shift to the seller if there is a default. May want to consider restrictions on payment of dividends to the remaining as long as it is outstanding.
--Agreement should provide that some debt will be repaid so that remaining are not stuck with debt.
-Want to include an agreement that requires corporation to fund any tax liability to owners.
-Primary, unconditional promise to buy by shareholders can be defeated if funding it through insurance and the corporation takes out the policy. It can constitute a constructive dividend because the money has to get from the corp. to the owners, which is done via distribution. If the corporation is the beneficiary, then forced to redemption since other shareholders can’t get the cash w/o it being a distribution. May want to make the beneficiaries the heirs vs. owners.
-Make sure there is cash to pay tax bill.

14. Buy-Sell Constructive Dividend Trap
Cash or Property C
Corp
Stock
Constructive
Dividend
Shareholder A
ShareholderB
Cross Purchase Obligation
Primary and unconditional Cross purchase agreement that is unconditional with the flexibility to to allow for a redemption. If there is a primary obligation of shareholder to purchse stock of a departing, and the obligation is paid by the corporation, all payments by corporation will be taxed as a constructive dividend. Shareholder B gets a constructive dividend so distribution of profits, subject to double taxation. If get stock via redemption but don’t pay, then value of what get may be treated as a constructive dividend.
Shareholder must buy, but corporation pays Constructive Dividend
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

15. Staged Exit Procedure
Stage One: Shareholder gives notice, wants out per price in agreement
Stage Two: Extended reaction period – others have time to secure funding to purchase or find replacement partner (3 to 6 months)
Stage Three: Negotiation period if Stage Two not produce solution (1 to 2 months)
Stage Four: Extended search period for acceptable replacement partner (2 to 4 months)
Stage Five: If still nothing, exiting partner has option to force sale of business. Any partner or group can buy. Tax-free structuring will be accommodated.
Long term notice and negotiation period to find buyer. Usually never gets to stage 4.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

16. CWB Problem: Alton Inc.
Alton Inc. provides take-out laundry services to hospitals and health-care providers in the Northwest. It is a C corporation with three shareholders, all of whom work full time for the business. The three owners have been "buddies and partners" since high school, but now they are all over forty. The business has 80 employees and continually grows. The owners have decided that they need some kind of "buy-out" agreement in case something happens to one of them.
Service business. 3 toilers over employees and expanding. ? How essential are toilers, can they be replaced?Loyalty becomes important so build in forfeiture provisions and tie to performance. Can treat equally.
In the event a member wants to sell their stock but remain as an employee, this may be appropriate, so long as the pay-out for the stock in done in stages over a period of time. The parties may agree to include disability, bankruptcy and divorce if there are facts that warrant such provisions. Expulsion is possible but would require both the remaining owners to agree since there are only three owners. The parties may want these provisions to retain control over the business. Pay-out should also be handled on an installment basis.

17. CWB Problem 1: Alton Inc. Triggers: - Death: Insurance funded.
- Employment Termination: Installment, perhaps wrapped with owner deferred compensation. Amount reduced if no non-compete – goodwill presumed lost. (N/A in Calif.)
- Expulsion: Tough with only three. Require other two vote. Payout same as employment termination.
- Disability: Same as employment termination with non-compete.
- Bankruptcy, Divorce: Purely optional. Payout same as employment termination without non-compete.
- Voluntary Stock Exit: Min. vesting period. Employment remains. Staged exit program-installments. Pricing presumes no non-compete.
Since all of the parties are toilers, working in the business, it appears that they are equally valuable. As a result, the loss of any of them would likely have some impact on the business, but the parties would want to ensure that they remained in control. All of the triggers may be included, but some are more important than others, e.g., death, termination, disability, and withdrawal.
Death should be funded by insurance paid for and held by the corporation. This means that in the event of death and disability, the corporation will redeem the deceased shares. The funds to acquire the shares will be paid for out of the proceeds. In the event the company also has disability insurance on the owners, this trigger can be handled in the same way as death.
In the event any of the members choose to leave or are terminated, any pay-out should likely be handled on an installment basis, payable over time. This will accommodate the cash flow needs of the business and minimize any hardship. If the parties agree to non-compete clauses, then the clause should be narrow in scope and duration. It is advisable that some consideration be paid for non-compete clauses. In California, be aware that non-compete clauses are strictly unenforceable.
In the event a member wants to sell their stock but remain as an employee, this may be appropriate, so long as the pay-out for the stock is done in stages over a period of time. The parties may agree to include disability, bankruptcy and divorce if there are facts that warrant such provisions. Expulsion is possible but would require both of the remaining owners to agree since there are only three owners. The parties may want these provisions to retain control over the business. Pay-out should also be handled on an installment basis.
They may allow a showdown clause if they think there is a market, but they may want to put restrictions to prevent giving the departing partner too much control.
To ensure loyalty, they may want to put in a forfeiture provision.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

18. Professional Service Organizations
Lesson 2.2.2
Professional Service Organizations

19. Fragile Group Exit Protections
Key person disaster protection
Long-term exit notice to escape overhead and other burdens
The “Lights Out” option
The “Locked-In Equity” Option
Early transition financial payment requirement
Life and disability insurance to cover overhead, lost profits.
6 mo.-1yr. Notice
Mass exit option to liquidate
Equity in large asset preserved
Penalty for early departure
Professional corp. LLPs, LLCs in some states. Key person should have insurance on life; required to give long- term notice. Often co has few hard assets, large overhead, and substantial income ‘cause it is service, medical, legal, programming. Players are educated and independent w/ options. This makes the organization fragile. Loyalty is important. Fringe benefits are critical, but under Tax Reform, many of perks eliminated, income has been flat, and cost of carrying A/R has gone up; stronger competition from groups for good people; buy-in costs are high.
1)Key person-Life and disability insurance separate from buy-out in that it allows you income to carry share until replacement can be found.
2) Notice: discount buy-out price if give shorter notice; or required to cover overhead for the balance.
3) Lights out-if one departure triggers others, then remaining can elect to liquidate, which may be under a different formula than buy-out. Share the burden of winding down. If don’t trigger option, then each is allowed to terminate employment at the end of notice, but likely have installment sale.
4) Locked in-Where group invested in appreciable asset and departure, others need not buy out interest in asset, but instead, equity of departing is locked and continues to receive tax and cash flow from ownership. Usu. Used for real estate.
5) Transition payment-burden of early departure is shifted to person leaving. Discourages early w/drawal.
Copyright 2005 Dwight Drake. All Rights Reserved.
Business Planning: Closely Held Enterprises
www. drake-business-planning.com

20. Scenario: A retires, B &C buy-in
A has a successful practice, e.g, $1.4 million and turning away business.
B &C want to take over practice, but have no money
Execute promissory note payable monthly.
Payments made with after tax dollars.
Bottom line: B & C have a big debt on top of operating expenses.
Problem with this scenario is that burden on cash flow; A is a big creditor, and using after-tax dollars.

21. Scenario: A retires, B &C buy-in
Alternative: Keep as is, Wait until A dies.
Sub S election so pass-thru;
Employment agreements for B & C;
Salaries tied to productivity, bonus for increase tied to benchmarks;
A remains, and gets a draw with pre-tax earnings. Taxed on distribution;
Life insurance policy on A to fund buy-out at death.
A’s payments can be a distribution related to stock. At A’s death, stepped up basis, amounts paid to estate are tax-free. A will have to maintain license. B &C can buy stock if they want to or wait until A dies. B&C can serve on the board to have some control. Could make A’s stock nonvoting so all he gets is a distribution. If there is a problem with B&C, A can step back in .

22. Module 7: Buy-Sell Agreements
Part 3: Funding Buy-Sell Agreements

23. Criteria for Funding Provide liquidity for departing owner.
Offer financial security of payout.
Minimize risk to remaining owners.
Minimize tax cost for payment.

24. Strategy 1: Accumulate Earnings
Company funds
buy-sell K out of earnings.
Bottom line:
Should be used as a
Last Resort.
Exit is before saved enough.
Need $ for operations.
Using after-tax dollars.
Threat of AMT.
May not be reasonable business need.
Few companies have the luxury of accumulated earnings; most need the money to cover operating expenses. Those that do have to be careful that they are not subject to AE$250K in retained earnings for corp/ $150K for PSC. N/A if retirement plan ‘cause qualified as business purpose.

25. Strategy 2: Death/Disabilty Benefit Insurance
Company takes out insurance on Toilers or Majority Owner.
Bottom line:
Should be used by LLC or small corp. where few shareholders of equal importance, can corp. will redeem interest of departing.
Perk for employee.
Protect business.
Provide $$ to pay.
Provide in Employment K.
Base upon stock value, not Owners’ need for cash.
Decide cross-purchase or redemption.
Can’t transfer for value, unless sell back to corporation.
Can be administrative burden.
Threat of AMT for corp.
Pay the heirs to buy back the stock using the proceeds from insurance policy.
Premiums paid by corporation are not deductible, but receipt of proceeds is tax-free. (Get a benefit if you ultimately pay the burden, OR as here, cannot deduct on front so no tax liability on the back-end.
Whether to use a Cross-purchase, i.e. each person has a policy on the other’s life; or redemption i.e., corporation has the policy on shareholders. Decision is based upon 1) No. of shareholders (ok for few); 2) Transfer for value problem, i.e., when sale insurance to another for value, lose tax-free benefit. Proceeds will be taxed to recipient. Arises when someone dies or leaves, some disposition of the policy is required, either selling it or canceling it. Sale is transfer for value; 3) Who pays for the premium, corporation or shareholder often depends on who has the money; and 4) Avoiding AMT (N/A p-ships and LLCs. Partners can sell policy to other partners without transfer for value problem or AMT) May not be able to avoid transfer for value issue by putting in a trust so that the trust owns the policies.
Cross purchase can also be problematic where disparate % interest between owners. Minority would have to get big policy to cover the major. Could allocate the financial burden among owners so proportionate. Or the one who gets the benefit bears the burden. If the Corporation redeems then more proportionate.
AMT will apply to corporations with income > $7.5 million. So if corporation gets a death pay-out, must treat as AMT income, 75% of excess of book value over taxable income. Proceeds – cash value = book income, but not taxable; and 75% of that amount will be added to CMT income.

26. Strategy 3: Cash Value Insurance
Company takes out insurance for death only, but can loan for other triggers.
Bottom line:
Should be used by LLC or small corp. where few shareholders of equal importance; corp. can redeem interest of departing.
May be subject to accumulated earnings tax.
Threat of AMT for corp.
Limit on the interest a corp. can deduct on loan up to $50K.
Must fund with after-tax $.
Earnings accumulated is tax-deferred.
Most insurance has a cash value that can be recovered if cash in, or can borrow against it. Tied to the premiums paid.
AMT= $7.5 million in income. Accumulated earnings cap is $250K for C cor/ $150K for PSC

27. Strategy 4: Split-Dollar Insurance
Company pays part of premium, employee pays balance. Allocate proceeds based on who pays.
Bottom line:
Should be used if perk to employee and needed to fund buy-sell.
Tax impact based upon who owns the policy, the company or employee.
Employee-owned: Collateral assignment back to co. treated as below-market loan.
Company-owned: Endorsement back to employee treated as employee paid salary and co. gets deduction.
Death benefit does not reduce purchase price of interest.
Insurance is used as a perk, to protect, and provide $. Allows accumulated earnings. Company pays portion of the premium = yearly increase on the cash surrender value of the policy. The employee pays the rest of the premium. Inexpensive cost-sharing arrangement that funds for any trigger. Good to use where it is a perk to employee and funds benefit. When employee dies, co. receives a portion of proceeds = total premiums paid by copr. Or cash surrender value right before employee dies. Balance is paid to beneficiaries as death benefit. Co gets $ back. Sometimes, co pays entire premium.
Treated as a loan payable with interest (employee-owned collateral assigned) ; or salary paid to employee w/ co. deduction (co owned endorsement back).
Downside: Benefit paid to the family does not reduce purchase price. Family gets it over and above price of shares.

28. Strategy 5: Retirement Plan Insurance
Company set up a retirement plan to fund future triggers. Plan owns the insurance and pays premium.
Bottom line: Good for start-ups that have no money but potential future income.
Upon death of insured, retirement account collects proceeds and uses it to buy interest.
Stock ends up in the plan, not corporation or owners.
Special rules apply to ensure it is a qualified plan.
Downside is that stock ends up in the retirement account, not in corporation or other shareholder. Estate gets immediate cash, surviving shareholder maintains control as trustee of the qualified plan, where the stock is held.

29. Strategy 6: Installment Purchase
Company or owners buy back over time. Pay interest on the installments.
Bottom line:
Use with insurance to reduce cash burden on company or other owners.
Eliminates accumulating funds issues.
Requires less cash, but family gets no lump sum unless insurance.
Fund death benefit with insurance and use for other triggers.
Secure not by stock.
Interest paid deductible, taxable to recipient.
Use to fund triggers such as termination, withdrawal, divorce or bankruptcy.
Redemption-corporation pays; Cross-purchase-shareholders pay. Issue promissory note. Secure by pledge of stock or personal guarantees.
Interest is deductible by the co. and decrease over-all after-tax buyout. In a cross-purchase, shareholders should be able to deduct interest as active trade or business interest. Passive investors in LLC, Sub S, may not be able to deduct as a passive.

30. Strategy 7: ESOP
Qualified retirement plan for employees that is tax deductible by corporation.
Bottom line:
Perk for employees and low cost to company. Good for toiler with fewer employees to fund long term exit strategy.
Allows accumulation for business purpose that is deductible by corp.
Defer tax on earnings.
Can borrow funds from company to pay before fully funded. Repayment is tax deductible.
Not a problem at death, but other triggers may result in capital gains tax.
Administrative costs.
If used at death ,then stepped up basis so no tax impact ‘cause purchase price is stepped up basis at death. If used before hand, then special rules apply to avoid capital gains tax: ESOP has to own 30% of stock afterwards, no reallocation of the stock to shareholders with 25% or more; Seller must invest the proceeds in marketable US stock.
Careful planning can allow avoid capital gains tax of seller. Provides financial security and liquidity to shareholder.
Can be costly to get appraisal of stock once a year, maintain and administer. Possible for group of shareholders to lose control since discrimination rules require other employees to get benefits under ESOP. Potential dilution can be mitigated where primarily toilers so can separate eligibility to classes of persons. When shareholder dies, control could shift since shares would be held in trust, who vote on behalf. Focus is on ESOP, not company. Ensure control issues remain as intended.

31. Strategy 8: Supplemental Exec. Retirement Plan (SERP)
Non-qualified Retirement Plan that provides right in future profits as tax deductible compensation by corporation.
Bottom line:
Perk for executives as deferred compensation, used with another option.
Way to convert part of purchase price to tax deductible payments.
Should be used with another option.
Contract right to future profits in the form of deferred compensation.
Usually not fully funded.
Payments deductible by corp., taxable to seller/shareholder.
Only available to toilers.
Stock redemption creates a double tax, using after-tax dollars, and seller pays capital gains tax on the transfer. SERP is a contract between the company and shareholder that allows person to get future contract right to profits as deferred executive compensation to supplement income. Plan is not funded, but an accrued liability on the books, which reduces the fmv of the stock. Payments made under SERP are tax deductible to co, and ordinary income to departing owner. Usu. Tax break in savings for the co is greater than tax paid by departing having it taxed as ordinary income vs. capital gains. Company can also increase payments to offset the tax.