When a company finances or funds a purchase obligation of one its shareholders, there is a risk that the IRS will determine that this funding constituted a constructive dividend to the shareholder. Essentially, the IRS could conclude that the company’s payments were as if the company gave the funds to the shareholder–in the form of a dividend–to pay off the obligation.
When drafting a buy-sell agreement, attorneys and owners of closely-held companies (including corporations and LLCs) should take care to structure rights-of-first refusal and cross-purchase obligations in a way that a triggering event does not result in a constructive dividend to shareholders (or, for LLCs, to members).
For example, assume a buy-sell gives the company the first option to purchase a departing shareholder’s shares, with the remaining shareholders required to purchase what the company does not buy. This structure may result in a constructive dividend if the company purchases some or all of the shares, as the agreement formally gives the company the right to first “step in” and relieve the shareholders of an obligation. To avoid a constructive dividend, the buy-sell could be structured to give the shareholders the option to purchase the shares, instead of the obligation to do so. Alternatively, if the shareholders have an unconditional obligation to purchase the shares, the agreement can simply omit any requirement or right of the company to purchase the shares.
For this and many other reasons, I always strongly suggest to my clients that they work with an attorney and a tax professional when drafting a buy-sell agreement.
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