Will FASB 150 Have A Chilling Effect On Entity Buy-Sell Plans?
On May 3, the Financial Accounting Standards Board (FASB) issued Statement 150–Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities.
This statement represents the first phase of a larger FASB project. In this phase the board addressed the accounting for three particular financial instruments that, under previous guidance, issuing companies could account for as owners equity. (See sidebar.)
Are stock redemption and other entity buy-out arrangements between businesses and their owners subject to this new accounting? In many, if not most cases, the answer is yes.
It is typical in entity buy-out arrangements to mandate the purchase of shares at certain triggering events (death, retirement, disability, etc.). In many cases, the mandatory redemption is an integral part of the agreement. It protects the surviving or remaining owners and helps support the sellers claim to the agreements stated valuation.
As a result of this new treatment, some private companies will have no shareholders equity and no net income. Also, companies need to be particularly careful regarding the covenants in their debt agreements with lenders and suppliers. These accounting changes may cause covenant violations based on revised debt to equity ratios.
What can companies do to react to these changes? The first step should be to avoid debt covenant violations. If possible, these covenants should be renegotiated with waivers or amendments added to take these changes into account. Future financial agreements should have clauses providing for covenants based on benchmarks that remain stable for the life of the agreement rather than subjecting them to the changes in GAAP.
The second step companies should take is to address mandatory buy-back agreements that may be in place. Removing the certainty of the redemption is one approach. A mandatory buy-back could be replaced with a put option given to the owners. This could be coupled with a company call option in the event that the shares are not offered for sale by an owner.
The owners should be careful to avoid side agreements that would assure that, one way or another, the sale would take place. The side agreement or understanding may make the shares mandatorily redeemable and subject to Statement 150.
If the owners of a business want to obligate themselves to sell upon certain triggering events, they may want to consider changing to a cross purchase agreement between themselves. Cross purchase agreements are beyond the scope of Statement 150.
Funded cross purchase agreements for some companies, especially “C” corporations, may provide added benefits such as avoidance of alternative minimum taxes (AMT), protection of the funding from the reach of company creditors and an increased basis for co-owners who purchase shares directly.
From the standpoint of the insurance industry, FASB Statement 150 presents an opportunity for agents and financial advisors to meet with those clients who have entity redemption plans. Those businesses that wish to make adjustments to their agreements may need changes or additions to their funding. Updated funding may require additional insurance purchases.
Business owners, opting for a cross purchase buy-sell agreement must take care if they are transferring insurance policy ownership from their corporation to each other. Such ownership transfers may trigger the transfer-for-value rule. A violation of the transfer-for-value rule might subject some or all of the insurance death proceeds to federal income tax.
Agents and financial advisors should help business owners determine if the ownership change fits into one of the exceptions to the transfer-for-value rule.
In addition to ownership changes, insurance policies that fund cross purchase arrangements may need to be paid for using corporate dollars. Premium bonuses and split-dollar arrangements may solve the problem but will require the owners to get involved in these more complicated funding arrangements. New proposals and financial models will be needed.
Business disposition planning has always been an important aspect of the owners personal, financial and estate planning. Its also crucial to the continued viability of the business itself. Although legal advisors have often recommended entity redemption plans based on the ease of funding and the relative simplicity of the transactions, alternative plans may now become more popular.
More than ever, business owners must rely upon their accounting, financial and insurance advisors to help them navigate through the decision-making process.
, JD, CLU, is director, advanced sales, for Penn Mutual Life Insurance Company, Horsham, Pa. He can be reached via e-mail at firstname.lastname@example.org.
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 15, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.