Minority Position with Buy-Sell over Time
What is it?
Combines transfer of minority ownership and buy-sell agreement
A minority position with a buy-sell over time strategy uses a combination of the transfer of a minority ownership interest and an entity purchase (stock redemption) buy-sell agreement. You bring your active beneficiary into the business as a minority shareholder and use the buy-sell agreement to structure a sale of the rest of your business interest upon the occurrence of a triggering event. Typical triggering events include death, disability, or retirement. The business entity pays for your interest by making installment payments to you or your estate over a set period of time, and then you (or your estate) make gifts of the payments to your nonparticipating children or other beneficiaries. Your successor takes over the business, and the other beneficiaries receive periodic cash payments.
How it works
Here's how it works: You are the sole shareholder of a closely held business entity. You transfer a minority share of that business to your successor (for instance, a participating child) during your lifetime, thus preventing the automatic dissolution of the business at your death as prescribed by corporate law. You — the business entity — and your participating child enter into a buy-sell agreement that is funded with installment payments. When a triggering event happens, the business redeems (buys) your majority share of the company from you (or your estate) in exchange for promissory notes. Your successor, formerly a minority shareholder, becomes the sole shareholder of the business, and the notes are transferred to the beneficiaries. These beneficiaries receive cash payments as holders of the promissory notes.
When can it be used?
You own a business
You are an owner of a closely held business. The business can be organized as a partnership, C corporation, S corporation, or professional corporation. This method tends to work best when there is one owner. An entity purchase agreement can't be used with a sole proprietorship because the sole proprietorship is not a separate entity that can make the stock purchase. If you are a sole proprietor and want to be able to use this strategy, you may want to reconsider your choice of entity.
Strengths
Includes all the strengths of a buy-sell agreement
Buy-sell agreements can provide the following strengths:
- Provides a guaranteed buyer for the business interest
- May provide liquidity for payment of estate taxes and settlement expenses (but only if the agreement is funded)
- Avoids potential conflicts of interest
- Establishes the taxable value of the business, if structured properly
- Maintains stability of business operations
- Improves creditworthiness of the business (by delaying the outflow of cash)
- May allow the maintenance of the legal status of your S corporation, partnership, or professional corporation (if relevant)
Provides mechanism for drawing cash out of business
The minority position with buy-sell agreement over time method draws cash out of the business for the benefit of your nonparticipating beneficiaries. Payments tendered under the buy-sell agreement allow your nonparticipating beneficiaries to enjoy a share of your wealth.
The buy-sell agreement over time is funded by future profits of the business, so the payments to nonparticipating beneficiaries are contingent on the continuing liquidity of the business.
Allows participating beneficiaries to own and control business
Once your share of the business has been sold back to the company, your participating beneficiaries will be the new majority owners. Accordingly, they will have complete ownership and control of the business. Your nonparticipating beneficiaries will not be able to interfere with business decisions or operations.
Gives company time to fund repurchase of stock
Your company may need time to raise money for the full repurchase of your interest. The extended payment period allows the company to fund the purchase with future profits and avoids issues related to accumulated earnings.
Tradeoffs
Subject to all tradeoffs of entity purchase agreements
- Restrictions can affect personal estate planning
- Restrictions could limit your access to outside credit
- Restrictions may be unenforceable under state law
Payment of cash to nonparticipating beneficiaries delayed
Your nonparticipating beneficiaries must wait until the company makes scheduled payments under the terms of the buy-sell agreement. If the buy-sell agreement gives the company 10 years to pay off the promissory notes, then your nonparticipating beneficiaries will receive their inheritance over a period of 10 years. They may resent the fact that while they are waiting, they have no influence or control over business decisions and operations.
Distribution to nonparticipating beneficiaries contingent on liquidity of business
The business must generate earnings sufficient to make scheduled payments on the promissory note. If your participating beneficiaries mismanage the business or if the business becomes illiquid, the nonparticipating beneficiaries may not receive their share of your wealth.
How to do it
Decide upon details of buy-sell agreement
Factors such as size, structure, and tax bracket of your business and the number of co-owners, if any, will influence your choices in setting up your buy-sell agreement. A tax advisor, financial planner, and/or attorney can be helpful. You will need to make decisions about the price (valuation method) and terms.
Consult your tax advisor
When your corporation buys back your shares of stock, it is called a redemption. Depending on the size of your business interest relative to your entire estate, and assuming that your business is organized as a corporation, you might qualify for favorable tax treatment as a Section 303 stock redemption. Your sale may also qualify for favorable tax treatment as a Section 302 stock redemption. You will need expert tax advice with respect to these issues.
Meet with your attorney
Setting up a buy-sell agreement involves legal and tax issues. You should consult an attorney and/or a tax specialist, and each shareholder should have separate legal counsel.
Establish a minority position for participating beneficiaries
If you die as a sole shareholder, your business may be dissolved by operation of law. You should, therefore, give or sell part of the business to your participating beneficiaries during your lifetime. This will establish them as owners with a minority position in the company.
Execute buy-sell agreement binding company and participating beneficiaries
Your attorney can ensure that the agreement is executed in a form that complies with the laws of your state.
Periodically review agreement
The agreement should be reviewed periodically to determine whether the plan still serves the purpose for which it was intended. You may also need to conduct annual valuations of the business and review any changes in circumstances that could affect pricing.
Tax considerations
Income Tax
Tax impact on the business
- The cost of redeeming shares is not a tax-deductible expense for a business. When cash is distributed in exchange for the stock, the business recognizes no gain or loss on the transaction.
- Interest paid on the promissory notes may be a deductible business expense. Generally, interest paid by a C corporation is deductible, while interest paid by an S corporation is tested at the individual shareholder level and is deductible for material participants in the business (subject to passive activity rules).
Tax impact on your estate
- May be able to avoid dividend treatment of stock redemption, where part or all of the distribution is first treated as a dividend, any remaining distribution is then received tax-free to the extent of basis, and any distribution still remaining is taxed as capital gains. Generally, when a corporation (other than an S corporation) redeems the stock of a shareholder, it receives dividend treatment. An exception may apply when the corporation conducts a complete redemption by redeeming all of its stock held by your estate. A complete redemption is treated as a sale or exchange subject to capital gains tax, and only the amount in excess of basis is subject to tax. Note: This exception may not apply when family members or related entities are also shareholders. Achieving favorable tax treatment may be complicated or impossible under the constructive ownership-attribution rules. Consult your tax advisor.
- Stock received by your estate will generally receive a step-up in basis. The stock received by your estate receives a new basis equal to the fair market value at the date of your death. This is called a step-up in basis. When the sale price under a stock redemption is accepted as the fair market value, there shouldn't be any capital gain or loss realized by your estate upon sale of the shares.
Tax impact on participating beneficiary
- No step-up in basis for minority shareholder. As noted, the stock sold by your estate receives a step-up in basis equal to its fair market value as of the date of your death. However, the stock now held by your participating beneficiaries — which was transferred to them during your lifetime to establish a minority position — does not receive the same increase in basis at that time.
Tax impact on nonparticipating beneficiary
- Principal payments not subject to income tax. The transfer of principal payments in satisfaction of the promissory notes from the estate to the children does not trigger an income tax because payment received in satisfaction of principal indebtedness is not deemed income.
- Interest on promissory notes taxable as income. Interest received on the promissory notes is taxable as income to the recipient.
Gift and Estate Tax
Gift of stock to establish minority position is subject to gift tax
Gifting stock to your participating beneficiary to establish a minority position may be subject to gift taxes. All or part of the stock gift may qualify for the federal annual gift tax exclusion ($19,000 in 2025), and/or gift tax owed on the transaction may be offset by the federal applicable exclusion amount ($13,990,000).
Redemption price sets estate tax value
When your company redeems your shares under the buy-sell agreement, the amount received from the sale usually sets the value of the business interest that is included in the value of your estate.
If the price received is determined to be less than fair market value, the estate will be taxed on the difference between the sale price it received and the fair market value determined by the IRS. This means it is possible that the estate will be required to pay tax on value it did not (and never will) receive. This is one reason why the choice of determining the value of your business is important.
