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By: Patrick B. Mathis

Buy-Sell Agreements are helpful in clearing up disputes between shareholders. When properly drafted, the company and shareholders can reduce the amount of confusion or disconnect between parties. These agreements can have some additional terms to help bring clarity to situations that arise with shareholders. These additional terms include arbitration, S Corporation provisions, life insurance, voting rights, put options, prenuptial agreements and confidentiality provisions.

Arbitration

Some agreements may provide for any dispute regarding valuation, exercise of options or other provisions of the agreement to be resolved through arbitration rather than litigation.

In that case, the agreement would provide for a method for selection of an arbitrator, i.e. through rules of the American Arbitration Association or a third party selected as arbitrator, who would consider the facts and arguments of the parties and then make a binding determination.

In most cases arbitration serves to expedite the hearing and final resolution of the question, may provide for broad or limited discovery, minimizes the expense of litigation, and provides that information regarding the business such as financial statements, proprietary information related to intangible assets of the business and other matters, does not become public record.

S Corporation Provisions

Because the S corporation tax status for corporations is dependent upon the corporation and its shareholders meeting the criteria under subchapter S of the Internal Revenue Code many shareholder agreements (either free standing or incorporated into the shareholder agreement related to buy-sell issues) will include provisions which restrict the transfer of shares to non-qualifying shareholders under IRC Section 1361 or which would otherwise result in the termination of the corporation’s S corporation status.

For example, the agreement may prohibit the transfer of the company’s shares to a trust which would not qualify as a shareholder under Section 1361 as either a grantor trust, qualified subchapter S trust, or electing small business trust.

Typically, these restrictions will provide that prior to any transfer of shares by a shareholder he or she must notify the corporation of the proposed transfer and provide evidence (including sometimes an opinion of counsel by the transferring shareholder’s attorney) that the transfer will be to a transferee who will qualify as an S corporation shareholder and will not effect the corporation’s status as an S corporation. Any transfer contrary to these restrictions will be deemed “void ab initio” in order to avoid the potential of the transfer having been completed and consequently terminating the S corporation status.

This area of an agreement may also include provisions requiring minimum distributions of the corporation’s annual income sufficient to cover the anticipated federal and state income tax liabilities which might be generated to shareholders as a result of the flow through of each shareholder’s proportionate share of the S corporation income. In some cases, the corporation will make distributions on a quarterly basis, based upon the estimated year to date income, in amounts sufficient to cover the shareholder’s quarterly federal and state income tax estimated payments with a “truing up” at the end of the year when the final amount of income is ultimately determined.

These provisions do not necessarily restrict additional dividend distributions but serve to ensure that the corporation’s shareholders will receive tax distributions sufficient to cover their tax cost on the S corporation earnings without being forced to cover such tax expenses through other sources.

Life Insurance

Some agreements will require that the corporation (or other shareholders in a cross purchase agreement) will maintain minimum levels of life insurance on the shareholders to cover part or all of the anticipated purchase price due to a deceased shareholder’s estate or heirs.

The amount of such coverage may be determined at the time of the agreement or adjusted periodically and may include the provisions requiring that coverage is only mandated if a shareholder may be insured at standard rates or that the obligation is only in place until the shareholder reaches a specified age in order to control the potential cost of insuring an older shareholder.

In those cases in which a shareholder’s stock is redeemed prior to death, i.e. at retirement, resignation, or through the exercise of a put or call option, and the purchase price is being paid over a term of years, if the selling shareholder dies while any amount remains outstanding the agreement may provide that the life insurance proceeds will be applied to reduce the outstanding principal balance upon the shareholder’s death.

The parties may execute a collateral assignment with the insurance company referencing that the policy is owned and held with the benefits payable subject to the terms of the buy-sell agreement in order to protect the selling shareholder as well as the company or other shareholders.

The agreement may also give the insured shareholder the option to purchase the policy prior to cancellation by the company.

Voting Rights

The buy-sell agreement may also provide that upon the death or disability of a shareholder, a designated shareholder or group of shareholders may be vested with the voting rights of the deceased or disabled shareholder’s shares during the period following death or disability until the redemption of those shares. This arrangement may serve to protect the interests of the other shareholders and the company without disruption by a family member who may have limited knowledge or interest in the business, and may be particularly appropriate in those instances in which the redemption as a result of death or disability is imminent per the terms of the agreement.

Put Options

In an agreement which includes a put option whereby a shareholder may tender his or her shares to the company for redemption a “safety valve” option may be included for the remaining shareholders and company. In that scenario upon a shareholder tendering his or her shares under the put option the company and remaining shareholders (without including the vote of the selling shareholder) may elect to put the company on the market for sale in lieu of redeeming the selling shareholder’s shares. This may be particularly appropriate where the agreement provides for a method of valuation which the remaining shareholders or company feel is inappropriate or will reflect a value in excess of the anticipated future value of the company, or where the selling shareholder may be critical to the business and the remaining shareholders feel that it is most appropriate to sell the company in toto at that time.

Typically this clause will give the selling shareholder the option to withdraw his or her election to sell shares if he or she felt a sale of the company was inappropriate at that time.

The agreement may also incorporate a period of time for the sale process, such as a one year term from the date of the election so that there is sufficient time to market and complete the sale of the business.

At the conclusion of the sale term the agreement may further provide that the company and non-selling shareholders may be required to liquidate the company if it has not been sold in order to generate the funds to pay all shareholders at the same price, or elect to proceed with the redemption of the selling shares.

If the agreement provides for liquidation upon the end of the sale period, the agreement may also provide that the selling shareholder would be given a period to withdraw his or her put option election and allow the company to continue in business without liquidation.

Prenuptial Agreements

Some buy-sell agreements will include a provision that any shareholder is required to secure a prenuptial agreement prior to marriage related to the stock of the corporation under which the future spouse would acknowledge the non-marital character of the stock which is owned by the shareholder, including not only the shares owned at the time of marriage but any additional shares which might be received by gift or bequest in the future. Because states may vary on the definition and concept of marital and non-marital property this provision is included and intended to attempt to avoid future disputes in the event of divorce, or the death of a shareholder, from the shares passing outside of the family shareholder group.

In some instances the format of a prenuptial agreement may be included as an exhibit to the buy-sell agreement.

Confidentiality Provisions

Buy-sell agreements may also include express language that any information obtained by a shareholder related to the company’s business is confidential and may only be shared with other shareholders, family members and/or advisors such as accountants and attorneys.

In the event a shareholder wishes to attempt to sell his or her shares the agreement may expressly provide that a shareholder may not share any corporate information with a third party unless and until he or she secures a confidentiality agreement executed by such third party hand delivered to the corporation. This agreement may provide that not only is the selling shareholder a party with enforceability rights under the agreement, but the company similarly has the right to enforce the confidentiality provisions against any third party who may have received such information.

The form of this agreement may be attached to the buy-sell agreement as an exhibit in order to have a template in place and avoid negotiation of the terms in connection with a potential sale or offering.

Professional Services Disclaimer: Please note that the information presented here is as an educational service, and while it contains information about legal issues, it is not legal advice. No warranty is made regarding the applicability of the information presented to a particular client situation, and the information set forth is not a substitute for original legal research, analysis and drafting for a particular client situation.