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© Michael Best & Friedrich LLP 2007 SHAREHOLDER AGREEMENT AND REDEMPTION ISSUES THAT IMPACT GROWTH Richard A. Latta Michael Best & Friedrich LLP One South Pinckney Street, Suite 700 Madison, WI
© 2007 Michael Best & Friedrich LLP 2 1.Need a Shareholder Agreement whenever: a.Company has more than one shareholder. Need to say what happens when shareholder dies, becomes disabled, gets divorced, etc. b.Where want to use life insurance or “slow-pay” notes to pay for stock of departing shareholder. c.Company is an “S” corporation and shareholders want to protect the pass-through tax treatment of the company. d.Want to sleep at night without thinking about who will run the company in the event of untimely death of a key shareholder.
© 2007 Michael Best & Friedrich LLP 3 2. Why have more than one shareholder? To gain benefit spreading- out economic ownership. a.Spread-Out Ownership By Gifting. By having nonvoting stock, the (typically majority-owner older generation can start spreading the economic ownership of the business by making annual gifts of stock (for example, with a value of less than $12,000 per donee per year). Typically, the stock that is gifted is non-voting stock. Thus, the majority-owner/donor can make these gifts without losing control because the voting stock is retained by the majority-owner/donor.
© 2007 Michael Best & Friedrich LLP 4 Example: John has operated his business as an S corporation for 25 years. The approximate value of the company is $3.5 million (i.e., John is in the 45% estate bracket). The company has 1,000 shares outstanding (value $3,500/share) and John owns all the shares. John has 4 children and 12 grandchildren. John wants to keep control of his business but does not want 45% of the value of his business to go to the government on his death. By causing there to be a 10 for 1 split of his shares (i.e., 1,000 shares into 10,000 shares), John can “create” 9,000 non-voting shares while “retaining” his 1,000 voting shares. The newly-created shares will have a value of $350 per share and will not participate in the control of the company. John can now start a gifting program for these shares, gifting $12,000 worth of non-voting shares to his 16 (i.e., ) children and grandchildren, thereby decreasing his taxable estate by at least $192,000 per year (before discounting the value of the shares) and decreasing his estate tax by $86,400 ($192,000 * 45%) for each year John makes these gifts. If John gift splits with a spouse, he can double the annual gifts to $24,000 per year.
© 2007 Michael Best & Friedrich LLP 5 b.Tax Benefits: The spreading-out of ownership has multiple benefits: The gifted nonvoting stock is now out of the donor’s taxable estate (as is any future appreciation on the stock). The income of the company is often spread-out to persons who are in lower tax brackets (e.g., 10%, 15%, 25%, 28% or 33% tax brackets as compared to 35% bracket. Future appreciation on the stock is out of the donor’s taxable estate. c. Disadvantage: The principal disadvantage is that the dividends must be paid evenly on a per-share basis to all shareholders. Thus, if one shareholder gets a dividend (e.g., the donor, John), all shareholders have to get a dividend. Where this creates a cash issue for the donor, then increase the donor’s salary (subject to limits on reasonable compensation). A second disadvantage is donees receive John’s tax basis in the shares – and so will pay higher taxes on sale of the stock.
© 2007 Michael Best & Friedrich LLP 6 3. Use of Shareholder Agreements: When stock in a private company is owned by more than one shareholder, it is a best practice to have a shareholder agreement controlling the ownership, transfer and disposition of the stock. a. Typical Provisions: Such agreements will typically contain provisions regarding: Rights of first refusal if a person wants to transfer the stock during his or her life; Will control the ability to transfer stock to spouses and/or children; Will control the disposition of stock upon the death of shareholder or of a spouse of a shareholder (which is especially important in a marital property state such as Wisconsin); and Places requirements on the shareholder to timely pay the shareholder’s taxes relating to the stock. b. Redemption v. Cross Purchase: Two common methods of reacquiring stock (for example, when a shareholder wants to transfer the stock, dies or becomes disabled) are by redemption by the company or cross-purchase among shareholders.
© 2007 Michael Best & Friedrich LLP 7 c. Redemption: Redemption is typically used where the company is on-going and the transferring shareholder is living. The company would then typically reacquire the stock for a long- term note (a/k/a, “slow-pay” note), which note will typically be secured by the stock, and the shareholder would be paid-out over a period of time. Capital Gains: Typically, the shareholder will receive capital gains treatment on the sale of the stock, assuming the shareholder meets various rules regarding reducing the amount of stock held or completely terminates ownership and all other affiliations of the company (e.g., as an officer, director or employee of the company). Tax on Real Estate. An exception to this treatment is where the company is an “S” corporation and has appreciated real estate or collectables, in which case a 25% or 28% federal tax rates may apply to gain on these assets.
© 2007 Michael Best & Friedrich LLP 8 d. Cross-Purchase: Cross-purchase is typically used on the death of a shareholder where the ability to repurchase a decedent’s shares using life insurance. In a cross-purchase of stock, each shareholder holds an insurance policy on the life of other shareholders. When a shareholder dies, the insurance money is used to buy the stock of the deceased shareholder. Keep Insurance Proceeds Out of Company: The reason for structuring the purchase on death as a cross-purchase is to keep the insurance proceeds out of the company and thereby: Not increase the value of the company for estate tax purposes; and Not increase the value of the company when determining the value at which the stock will be purchased from the deceased shareholder’s estate.
© 2007 Michael Best & Friedrich LLP 9 4.Discounting for Valuation Purposes 4.1Overview. Because each of the holders of stock in a company often own only a minority interest, and because that interest would be subject to the restrictions (such as upon transfer) the valuation of stock can be discounted. These discounts are generally referred to as discounts for minority ownership and lack of marketability and may range from 15% to 35% and in some cases more. 4.2Value for Transfer Tax Purposes. The types of discounts and premiums are: Minority Interest Discount Lack of Marketability Discount Control Premium Swing Vote
© 2007 Michael Best & Friedrich LLP 10 a.Minority Interest Discount. This discount reflects the minority owner’s lack of control in the entity. As a result of the lack of control or voting power, the owner has no ability to influence the entity’s future (e.g., the management of the entity or the liquidation or merger of the entity) or the future of the owner’s investment (i.e., control the payment of dividends or make cash distributions.) b.Lack of Marketability Discount. This discount reflects the inability or limited ability of the owner to liquidate his or her investment. (i)Available to All. This discount, unless limited by the IRS valuation rules, should logically be available to all closely held business owners who are under restrictions on the disposition of their ownership interests, regardless of their percentage ownership in the entity. (ii)Control Premium. Where a shareholder owns more than 50% of the company’s voting stock, the value of the interest in the company is valued at a premium to reflect the control the owner has over the company. (iii)Swing Vote Premium. Another IRS argument is that a minority interest, when combined with other ownership interests in the entity, may actually have enhanced value because such interest represents the “swing vote” as to the entity and its assets.
© 2007 Michael Best & Friedrich LLP Principal Authorities. In Rev. Rul , the IRS stated that, if a donor transfers shares in a closely held corporation to each of his children, the factor of family corporate control is not considered in valuing each transferred interest. Accordingly, the IRS will allow a minority discount for each interest transferred even though the family members hold, in the aggregate, a majority of the shares.
© 2007 Michael Best & Friedrich LLP Chapter 14. Internal Revenue Code Sections 2701 to 2704, which were enacted in 1990, subject gifts of interests in corporations, partnerships and other entities to family members to special valuation rules, for gift tax purposes. Once a value for the entire entity is established, certain interests, usually the interests retained by the donor, are valued under these special valuation rules that ignore the economic effect of certain rights or restrictions placed on the interests. These interests are then subtracted from the value of the entire entity and what (if anything) remains determines the value, for gift tax purposes, of the interests in the entity that have been given away. Increase the amount of gift tax. The lower the value of the retained interests (because certain rights these interests hold are ignored), the higher the value of the remaining interests in the entity. Because these remaining interests are usually the interests given away, a higher gift tax results.
© 2007 Michael Best & Friedrich LLP Section 2703 and Shareholder Agreements. IRC 2703 provides that an agreement or right to acquire or use property at a price less than fair market value (without regard to such option, agreement or right), or a restriction on the right to sell or use property, will be disregarded in valuing such property unless the option, agreement, right, or restriction meets each of the following three requirements: a.Three Requirements: (i)It is a bona fide business arrangement (“business arrangement” test). (ii)It is not a device to transfer such property to members of the decedent’s family for less than adequate and full consideration in money or money’s worth (“device test”). (iii) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction (“comparability test”). b.Applicability of This section applies to buy-sell agreements entered into or “substantially modified” after October 8, 1990.
© 2007 Michael Best & Friedrich LLP Anatomy of a Shareholder Agreement. Article 1 – Restrictions on Transfer 1.1 General Restrictions on Transfer In this section the agreement will provide for a prohibition on all transfers except as otherwise permitted by the agreement. That way, unless a transfer is expressly permitted, it is prohibited. Often this section will provide for “permitted transfers” which are typically transfers to a trust for a shareholder, or the shareholder’s children or descendents. 1.2 Voluntary Transfer In certain cases, where shareholders are unrelated and want to permit for some limited transfer of shares, a company may permit a voluntary transfer to occur. A typical format is to provide a right of first refusal to the company, and then to the other shareholders, to match the price and terms of a bona fide third-party offer to a shareholder for their shares. If the company or other shareholders choose not to purchase the shares, then the shareholder can typically sell within a limited period of time (e.g., 60 days), to the person making the bona fide third-party offer.
© 2007 Michael Best & Friedrich LLP Involuntary Transfers In a “involuntary transfers” section, the agreement will generally provide that if a shareholder is adjudicated bankrupt, makes assignment for the benefit of creditors, is in default under terms of the shareholder agreement, commits an act of gross negligence, willful misconduct or a willful violation of law, has been convicted of a felony or crime involving moral turpitude, has misappropriated funds from the company, or has engaged in certain specified acts (e.g., a cease and desist order for a banking organization), then the shares owned by the shareholder are subject to being redeemed by the company or, if not redeemed by the company, then purchased by other shareholders. The “involuntary transfers” acts also can include no longer being employed by the company for employee/shareholders. The price for the shares, and payment terms, are typically set out in one section of the agreement (see below for Sections 3.1 to 3.3).
© 2007 Michael Best & Friedrich LLP Termination of Marital Relationship The agreement will describe what occurs in the event of a divorce, or death of a shareholder’s spouse (which death of a spouse is particularly important in a marital property state such as Wisconsin). Generally, the agreement will require the surviving spouse or spouse holding title to the shares to buy the stock from the ex- or deceased spouse. If the titled shareholding spouse does not buy the stock, then there are generally rights to purchase by the company and the other shareholders. This section will also typically require that if a shareholder marries or remarries, then within a designated number of days (e.g., 60 days), the spouse has to sign a consent agreeing to be bound to the terms of the agreement. 1.5 Loans by Shareholders and Other Agreements It is often advisable to include a provision about what happens to shareholder loans and guarantees in the event there is a purchase of the stock of the person making the loan or guarantee. Typically, loans either must be repaid in full by the time of the purchase of the shareholder’s shares. Similarly, guarantees generally need to be released by the date of purchase or, if not released, then there is typically a requirement that the buyer or buyers will indemnify the selling shareholder on the guarantee.
© 2007 Michael Best & Friedrich LLP Take Along Rights It is often advisable to include a “take along” rights provision (a/k/a a “drag along” right). This provision says that if shareholders owning at least 50% of the stock of a company wish to sell all of their shares to a third-party purchaser (other than the company), then the shareholders with more than 50% can require the remaining shareholders to sell their shares to the third-party purchaser at the same price and subject to the same terms and conditions. 1.7 Co-Sale Rights It is also often advisable to include a co-sale right provision (a/k/a a “tag along” right). In a co-sale right, if shareholders owning more than 50% receive an offer to sell all of their stock to a third-party purchaser, then the shareholders owning more than 50% may not accept the offer unless the third-party purchaser also offers to purchase all of the stock held by the remaining shareholders at the same price and on the same terms offered to the controlling shareholders.
© 2007 Michael Best & Friedrich LLP No Preemptive Rights Depending upon the circumstances, it may be appropriate to add a provision that shareholders waive any preemptive rights. A preemptive right is the right given to existing shareholders to purchase shares of a new issuance of shares before newly-issued shares are offered to others. Its purpose is to protect current shareholders from dilution of value and control when new shares are issued. If a company wants to be able to issue shares without making a first offer of newly-issued shares to current shareholders, then a waiver of preemptive rights can be useful to the company.
© 2007 Michael Best & Friedrich LLP 19 Article 2 – Redemption and Purchase of Stock 2.1 Death of a Shareholder A well-drafted shareholder agreement will provide that in the event of death then either (1) a redemption by the company will occur, or (2) a cross-purchase of the shares will occur. A redemption is used where it was the decision of the shareholders to use the resources of the company to buy back the shares. A redemption by the company can be financed either by insurance (the disadvantage of which is it increases the valuation of the company on death), or by a “slow pay” note (such as a promissory note with a term of five to ten years from repayment of the principal of the note at market rates). Similarly, a cross-purchase of shares (i.e., by the other shareholders) can be funded by insurance or by “slow-pay” notes.
© 2007 Michael Best & Friedrich LLP Permanent and Total Disability Similar provisions will typically apply upon the “permanent and total disability” of a shareholder. The principal issue is how to define “permanent and total disability”. One common method is to provide that disability is when the shareholder is unable to continue active employment in a position consistent with his or her training, experience and professional qualifications for a period of at least one year, as determined by a physician reasonable acceptable to the company.
© 2007 Michael Best & Friedrich LLP 21 Article 3 – Purchase and Redemption Price 3.1 Determination of Value for Purchase of Shares The determination of value describes how shares will be valued for purposes of purchase upon death, disability, or other involuntary acts. The methods for valuation are unlimited. Common methods include: Single appraiser. Multiple appraisers (or average of multiple appraisers). “Baseball” method where values are set by each of the parties, with an appraiser to determine the more correct of two values. Formula values.
© 2007 Michael Best & Friedrich LLP Payment Similar to determination of value, the methods for payment on transfer of shares are numerous. Common methods include: “Slow-pay” notes (promissory notes at market rates or IRS applicable federal rate payable over 5 to 15 years). Insurance proceeds. Part slow-pay note and part up-front payment financed by operations of business or bank loans. Where appropriate, can also provide that payment of a note will be secured by collateral of the transferred stock. 3.3 Closing Procedures Typically provide for closing dates as determined by the buyer where the date is no later than 60 days after the date of a triggering event or, in the date of a death, up to 120 days after date of death.
© 2007 Michael Best & Friedrich LLP 23 Article 4 – Stock Legend Certificates representing shares of stock subject to a shareholder agreement are required to bear a legend describing the restrictions on transfer in the agreement. The best practice is for the legend to be conspicuously noted on the front of the certificate (usually by a short statement referring to the restrictions shown on the reverse of the share certificate), along with a more complete statement on the reverse of the share certificate referencing the restrictions on transfer. Article 5 – Representations Representations typically will include a representation by the shareholder that the shares are held free and clear of any option, lien or encumbrance except for encumbrances created by the shareholder agreement.
© 2007 Michael Best & Friedrich LLP 24 Article 6 – S Corporation Provisions 6.1 Subchapter S Provisions If the company is an “S” corporation, then best practices are to include provisions regarding: Not having a disqualifying transfers for S corporation purposes. Failure to report S corporation income and withholding regarding such non-reporting of income. Tax distributions. Decisions to maintain S corporation election. Article 7 – Termination Typically a shareholder agreement will provide the agreement terminates on the earlier of the sale of substantially all of the assets of the company, the merger of the company where shareholders receive publicly-traded stock, or an offering of publicly-traded stock by a company.
© 2007 Michael Best & Friedrich LLP 25 Article 8 – General Provisions An agreement will contain general provisions regarding notices, that the agreement is the entire agreement between the parties, that the agreement applies to their successors and assigns and is governed by the law of a particular state (e.g., Wisconsin). It is often advisable to incorporate an arbitration provision so that, in the event there is a dispute as to the terms of the shareholder agreement, the dispute can be resolved in a private forum such as an American Arbitration Association arbitration (or similar arbitration format).
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