After a business owner understands the benefits to be had with a buy-sell agreement, and recognizes the need for one, one of next question that must be addressed is what sort of buy-sell agreement he or she should have, and what the tax consequence between the two main types are.
As explained in more detail on this site, a “buy-sell agreement” is an agreement that sets the terms under which an owner’s interest in a closely-held business is purchased upon his death or other stated events. Also explained elsewhere on this site are the benefits of buy-sell agreements. As a summary, there are at least four such benefits. First, such agreements help leverage income and transfer tax planning by helping to establish the valuation methodology of the business. Second, a buy-sell agreement can help provide liquidity to the surviving owners or deceased owner’s family. Third, the agreement can help provide the existing business owner’s family with sufficient income after the owner’s death. Fourth, a buy-sell agreement can help ensure that the business can continue seamlessly e.g. in management and investment decisions to be implemented after the owner is gone.
There are two basic types of buy-sell agreements. First, there are so-called “entity” agreements, where the business itself buys out the decedent’s interest. Second, there are so-called “cross purchase” agreements, where the surviving owners are the buyers. Therefore, after deciding that a business needs a buy-sell agreement, the question becomes whether such an agreement should be structured as an “entity” agreement or a “cross purchase” one.
For businesses organized as partnerships or LLCs, there used to be (prior to 1993) a significant tax different depending upon whether an “entity” or a “cross purchase” agreements was used. Mainly, the differing treatment resulted from the tax treatment of a business’ “goodwill.”
Basically, the law used to require that when a cross-purchase agreement was used (and the surviving business owners purchased the decedent’s interest), the part of the purchase price that was attributable to “goodwill” was deemed a capital transaction (for income tax purposes). Consequently, this meant that the partnership could not deduct that portion of the purchase price.
Contrast that situation with the one where the owner used an entity agreement (where the business itself purchases the decedent owner’s interest). With an entity agreement, there was the possibility of some tax flexibility. This is because, with an entity agreement, the partners were able to decide whether their agreement would specifically designate part of the purchase price to goodwill.
On the one hand, if the partners declined in the entity agreement to specifically address the treatment of goodwill, then part of the purchase price (the part allocable to goodwill) was taxable as ordinary income (IRC §736) to the decedent business owner’s estate. Thus, the partnership could have deducted it. The main upshot of this was that the surviving business owners received the benefit of taking a deduction for the payment of goodwill. Thus, before 1993, they were willing to pay more for goodwill.
On the other hand, if the partnership did specifically address the treatment of goodwill (i.e. how it would be allocated in the purchase of a decedent owner’s interest) in the entity agreement, then the partnership could not deduct that part of the purchase price. This is because the purchase of the goodwill was deemed a capital transaction.
The above rules applied before 1993. After 1993, IRC Section 736 was amended, with the consequence that there was no (or little) flexibility on how the partnership could treat the payments for goodwill (i.e. whether they may be treated as an item of income). Accordingly, the parties must treat the payment for goodwill as a capital transaction. The only exception to this rule is where the withdrawing partner is a general partner (as opposed to a limited partner) and provided that the capital is not a “material income-producing factor” for the partnership. See IRC 736(b)(3).