Three ways to value the business. Four lousy alternatives.
By Ed Mendlowitz
77 Ways to Wow!
The right thing to do is have a buy-sell agreement, but many owners stupidly neglect to get this done. Here is a suggested buyout plan where one owner drops dead, unexpectedly, and there is no agreement.
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A caveat is that the right way is to engage an appraiser to determine the value and go through an entire process that was explained in my previous post. However, with smaller businesses where the families want to keep costs low, not cause excessive time and stress, and remain friends … what follows is a suggested plan. This might not work in every situation and is certainly not ideal. However, it does offer a manageable method of price and terms.
Valuation Method #1
- The price for the deceased owner’s share of the business will be equal to two times the average salary and benefits paid to the deceased plus two times his proportionate share of the average retained profits over the last three calendar years.
- Payment will be paid monthly over five years.
- An example is the deceased’s salary and benefits plus his proportionate share of retained profits for each year for the previous full three years were $300,000, $250,000 and $200,000 … averaging $250,000. The price is two times that amount or $500,000.
- The payment will be $100,000 per year.
- Interest will be added at the applicable federal rate (“AFR”).
- The payment will be treated as a capital gain to the recipient. Note that this will not be deductible by the buyer. Alternatively, depending on the nature of the business, the buyer can elect to treat part of the payment as for goodwill and amortize the total payment over 15 years.
- Upon signing the agreement, the ownership interest will be turned over to the buyer, but will be held in escrow pending full payment to the buyer.
- This company or remaining owners can be the purchasers at their option.
Valuation Method #2
- The price will be the proportionate book value (on the accrual basis) if this results in a higher valuation.
- The valuation date will be the last day of the previous fiscal year.
- Payment will be monthly over 60 months with AFR interest.
Valuation Method #3
- This becomes effective if the company is sold within two years after the agreement is executed.
- The seller will receive 80 percent of their proportionate interest of the sales price if that amount is greater than the price under this method; and payment will be made in full at closing regardless of how payment is made by the ultimate buyer.
- There will be a reduction for principal payments previously made.
Owner Loans
- Any owner loans will be treated separately and repaid over five years with interest at the AFR.
- The estate will agree to subordinate this amount to any bank debt for which the deceased was a personal guarantor as long as the estate is released from the guarantee.
- If there was no personal guarantee or no release, then no subordination.
Other Issues
- All passwords, websites, social media sites, intangibles and any other property of the business will be retained by the company.
- If there is any IRS challenge to the valuation amount, each party will deal with it themselves and at their cost. Regardless of what the IRS’ final determination is, this price will not change.
The above sets forth a workable plan if the two parties agree to it. A reality test is to determine whether the survivor can handle the payments without undue stress. I believe this is a reasonable method for a smaller business in that it gets it done quickly, without consternation and a minimal amount of legal and professional fees. For larger businesses where the costs are relatively insignificant to the total transaction, this will not work.
Nothing is perfect but this plan can work well in the right circumstance. It is a practical compromise and a get-it-done plan. If the owners cared, they would have had an agreement and this plan wouldn’t be necessary. Get it done right if you can or, if too late, do it this way and let the families get on with their lives.
Four Not-So-Good Alternatives
If nothing is agreed to, there are a few alternatives. Except for Alternative 1, the others do not seem reasonable.
Alternative 1: Nothing must be done. The estate can remain an owner. The surviving owner likely will have to account for his actions, but the business will still be intact and because he will be running it, he should have a greater element of control and would still earn his living.
Alternative 2: The estate can look to sell their interest to a third party and then see if the survivor could match or exceed it.
Alternative 3: The business could be sold intact to a third party.
Alternative 4: The business could be liquidated.
Keep in mind, if the owners cared, they would have had an agreement and none of this would be necessary. The best thing to do is to not make a bad situation worse. I believe that getting something done is better than the alternatives presented.
Restrictions When Stock Is Transferred to an Employee
On occasion a primary owner might want to transfer some ownership or stock to an employee. Regardless of the value and how it is treated for tax purposes, and whether it will be reported properly (it should), there must be restrictions placed on the employee from transferring those shares. Not having restrictions has the potential to cause serious damage to the company.
Improper tax recording or a failure to document the valuation can result in some tax or financial penalties and if the transaction is de minimis in size, the cost won’t really be significant. However, without restrictions on a later transfer, the company could end up with owners it would not want. My suggestion is to do everything right, but in that absence then at least impose restrictions on a further transfer of that ownership.
Without restrictions the ownership could be transferred to a spouse, children, siblings, an elderly parent or other heirs or even to an in-law or soon-to-be-former spouse. It could also be transferred to a creditor, competitor, major customer, another employee or a bankruptcy trustee. If not all, then most of these would not be wanted as co-owners.
The restrictions should be in the form of an owners’ agreement, i.e., a buy-sell agreement. A buy-sell agreement signed by all owners would be the best way to restrict the transfer. An alternative would be to have the shares placed in a trust for family members that would also be part of an asset protection and wealth transfer plan. And another alternative – which should also be used in conjunction with the buy-sell, but can be used without it – would be to place an iron-tight clause with restrictions on transfers prominently on the document evidencing the ownership, e.g., stock certificate or partnership or members’ agreement.
The reason the buy-sell agreement is best is because it would spell out every situation where a transfer could occur and would cover why transfers cannot otherwise be done. The agreement would contain restrictions on transfers because of death, disability, personal bankruptcy, execution of a judgment or tax lien, retirement, no longer being employed by the company and myriad other circumstances. It would also work out the valuation amount and the method and terms of payment.
Once shares are issued without the buy-sell or restriction clauses it is very difficult, at best, to have the owners agree to restrictions. The only lever is when additional shares are to be issued and that is made contingent on permitting the restrictions on the previously issued shares.
This is a serious matter and needs special attention beforehand to make sure that very grave, burdensome and costly future problems are avoided.
