Shareholder Agreements

By Daniel B. Evans
Copyright © 1995 Daniel B. Evans. All rights reserved.

Agreements among the shareholders of a corporation can take a number of different forms, and it is important to consider all possible options.

PERMITTED TRANSFERS. An agreement can prohibit all transfers, or it can permit gifts to certain family members, outright or in trust, and during lifetime or at death. (Permissible recipients can be limited to the founders, their issue, and the spouses of issue, so that stock does not pass to parties unrelated to the original shareholders.)

REDEMPTION OR CROSS-PURCHASE. An agreement can require (or allow):

• Redemption of stock by the corporation;

• Cross-purchases by the other shareholders; or

• Both an option to the corporation to redeem and an option to the shareholders to purchase any stock not redeemed.

MANDATORY OR OPTIONAL SALES. When a death or other triggering event occurs, the rights of the parties will fall into one of three possible patterns:

• Mandatory buy-sell. The shareholder is required to sell and the corporation (or other shareholders) is required to buy.

• Call option. The shareholder is required to sell if the corporation (or the other shareholders) decide to buy, but they are not required to buy.

• Put option. The shareholder can decide whether or not to require the corporation (or the other shareholders) to buy, but they cannot require the shareholder to sell.

EVENTS REQUIRING SALES OR OFFERS. An agreement can provide for sales or redemptions of stock in any or all of the following cases:

• Voluntary offers to sell to a third party. (The rights of the corporation or shareholders to purchase stock before it can be sold to another person is sometimes called a “right of first refusal.”)

• Bankruptcy, insolvency, or involuntary attachments. So that stock does not wind up in the hands of creditors or trustees for creditors.

• Death of the shareholder.

• Disability of the shareholder, making him or her unable to work for the corporation.

• Termination of employment with the corporation (other than by death or disability).

An agreement can deal with different situations in different ways. For example, an agreement could give the corporation the option to purchase stock in the event of an insolvency or third party offer, but could also give a shareholder the right to require the redemption of stock in the event of death or disability.

PURCHASE PRICE. The purchase price for shares to be sold or redeemed can be determined in a number of different ways:

• Third party offer. When the corporation or other shareholders have a right of first refusal, the option price is usually the price offered by the third party.

• Independent appraisal. An independent third party can be hired to appraise the stock of the company and set the purchase price.

• Book value formula. The audited financial statements of the corporation can be used as the basis for the purchase price, and there may be adjustments for the appraised value of real estate and tangible assets, discounts of inventory or receivables, or a predetermined value for “goodwill.”

• Earnings formula. The current year’s earnings, or an average of two or three recent years, can be multiplied by a predetermined “capitalization factor” (or price/earnings ratio) to determine a value for the corporation.

• Periodic agreements. The shareholders can agree to set a value themselves, and review that value periodically. (This works best of all of the shareholders are equally likely to buy or sell stock, so that no shareholder will have a reason to undervalue or overvalue the stock.)

OTHER TERMS. An agreement can also provide for:

• Installment sales of stock, so that the corporation or purchase shareholders can pay the purchase price in installments, with interest. The unpaid purchase price is usually evidenced by a note, and there is usually a security interest in the stock sold.

• Escrow of certificates, so that the certificates are held by a third party, who enforces the agreement.

• Arbitration of any disputes.

 Rights of Families of Comatose Patients

The Pennsylvania Supreme Court has recently upheld the right of the family of a patient in a permanent vegetative state to remove life support from the patient without court approval and without a written advance health care declaration (or “living will”), provided at least two doctors agree with the decision. However, other family members, doctors, hospitals, or other interested parties who disagree with a family’s decision to remove life support can still challenge the decision in court. In re Fiori, 543 Pa. 592, 673 A.2d 905, 1996 Pa. LEXIS 551 (April 2, 1996), aff’g, 438 Pa. Super. 610, 652 A.2d 1350 (1995).

This decision will make it easier to remove life support when there is no advance health care declaration. However, the decision only applies to patients in a “permanent vegetative state,” while an advance health care declaration would allow a family to terminate life support or other medical treatments when the patient is suffering from a terminal condition (an incurable and irreversible medical condition that will result in death), but not in a “permanent vegetative state”. Another advantage to an advance health care declaration is that it make your wishes known and can reduce the possibility of disputes within your family or between your family and your doctors.

What is the Inheritance Tax Rate on the Inheritance Tax?

By Daniel B. Evans

Copyright 2003-2005 Daniel B. Evans. All rights reserved.
Last updated: 1/27/2005

[Originally published in the Philadelphia Bar Association Probate and Trust Law Section Newsletter, Vol. 106, p. 5 (April 2003).]

It is said that hard cases make bad law, but sometimes hard cases force courts to rethink what everyone “knows.”

Everyone “knows” that the Pennsylvania inheritance tax is imposed on the beneficial shares of the estate before taxes. So, you figure out what the shares of the estate would be if there were no federal estate tax and no inheritance tax and then apply the appropriate inheritance tax rate to the different shares of the estate. The burden of the tax (i.e., who pays the tax) is a separate issue.

Faced with a somewhat unusual estate, the Commonwealth Court re-examined what we “know” and came up with a very different result, holding that the tax rate on the taxes paid from the residue of the estate should be the rate for the beneficiaries creating the tax, and not the beneficiaries of the residue from which the taxes are paid. In re Estate of Ray Bloom Ross, 815 A.2d 30, 2002 Pa. Commw. LEXIS 1005, 2652 CD 2001, (12/20/2002), rehearing den. (2/12/2003), app. den. 177 MAL 2003 (Pa. Supreme Ct. 7/22/2003). Although the decision was based on unusual facts, the rationale of the decision could change the way the inheritance tax is calculated in many (if not most) estates in the future.

The Facts

The problem in Ross was that the will left the bulk of the estate in specific gifts to lineal descendants and a relatively small residue to collateral heirs. Also, the will directed that all taxes were to be paid from the residue. As a result, the Pennsylvania inheritance tax and federal estate tax completely consumed the residue, leaving nothing for the collateral heirs. The Commonwealth Court was therefore confronted with an estate which was required to pay inheritance tax at 15% even though the 15% beneficiaries actually received nothing.

The estate argued that the lower tax rate for lineals (6% in this case, because the decedent died in 1999) should apply to the pre-tax residue because it was used to pay the taxes for the benefit of the lineal descendants. Both the Board of Appeals and the Orphans’ Court disagreed, saying that the estate was essentially trying to deduct the taxes, which is not allowed. (See 72 P.S. § 9128.)

The Commonwealth Court reversed, holding that the taxes could not be deducted, but that the tax rate for lineals should apply to the pre-tax residue if the taxes paid out of the residue benefitted the lineals and not the collaterals. The court relied on the language of section 2116(a)(1) of the Inheritance and Estate Tax Act (72 P.S. § 9116), which states that the lower rate of 6% (now 4.5%) applies to property passing “to or for the use of” lineal descendants. Because the funds of the residue were “used” to pay the inheritance tax on property passing to lineal heirs, the residue was used for the benefit of the lineal heirs and the the lower tax rate of 6% should apply to the residue. (In a footnote, the court noted that, if the residue were insufficient to pay the tax then the beneficiary would be required to pay the tax directly, which the court said supported its holding that the payment of taxes from the residue benefitted the 6% beneficiaries. P. 8, note 11.)

Applying the Holding

Some questions to ponder:

Is it critical that the entire residue was consumed by taxes? In other words, does the holding in this case only apply to estates with no residue, or does it apply to estates with enough of a residue to pay taxes and make distributions to beneficiaries? The rationale of the decision, which is that the payment of tax from the residue for pre-residuary gifts is a payment for the benefit of the pre-residuary beneficiaries, should apply whether or not the residue is sufficient to pay the tax. The court also observed that the residue “can fully satisfy the six percent taxes,” which means that there might be a small amount left for the residuary beneficiaries (in which case the 15% rate would apply). (P. 8, note 11.) So there is nothing in the decision to indicate that the absence of any residuary distribution was critical to the holding.

Does it matter whether the taxes are paid from the residue by the direction of the decedent or by operation of law? In this case, the will directed that the death taxes be paid from the residue, and the court stated that “Decedent made the decision that any taxes due were to be paid out of the residuary estate” (p. 3) and repeated that the use of the residue to pay the taxes on the gifts to the lineal descendants was “pursuant to instructions to in paragraph NINTH of her will” (p. 8). However, the court also recognized that the same payments would have been made by operation of law in the absence of instructions in the will, in accordance with 72 P.S. § 9144(a). (P. 3, note 7.) In conclusion, the court stated that it was the intent of the decedent “to benefit the collateral beneficiaries only to the extent that monies remained in the residuary estate after the payment of, inter alia, all death taxes.” (P. 9) However, such an intent could be inferred even without a specific direction as to the payment of taxes, because the same result would occur by operation of law. All things considered, the existence of a direction in the will to pay the taxes from the residue should not be necessary to the holding in the case. A contrary decision would mean that a will that restates existing law is taxed differently than a will that relies on statutory law without restating it, which makes no sense.

And does the decision only result in a decrease in taxes? Can it work the other way around, and result in an increase in inheritance tax when the residue that would otherwise pass to a lineal descedent is used to pay the inheritance tax on a gift to a collateral heir? What is sauce of the goose is sauce for the gander, and there is no reason to believe that the decision only benefits estates, and never the Department of Revenue. And that is why the decision is so worrisome (and so important), because the more usual estate will make a few specific gifts to friends, collateral heirs, and other 15% beneficiaries, and leave the rest of the estate to lineal descendants, and so the application of the principal of Ross Estate will most often result in an increase in inheritance tax, and not a decrease.

For example, suppose there is a total of $100,000 given to one or more 15% beneficiaries out of a $1,000,000 net estate, with the residue to children or other descendants. Before Ross, the inheritance tax would be $15,000 on the $100,000 in collateral gifts and 4.5% on the remaining $900,000, for a total of $55,500. However, if the tax is paid from the residue and the tax on the residue should reflect the rate for the beneficiary who benefitted from the payment of the tax, then there is a tax on the $15,000 paid from the residue at the rate of 15%, not 4.5%. In fact, the calculation will be circular (tax on a tax on a tax), with a resulting effective tax rate of 17.647% on the $100,000. So $117,647 is subject to tax at 15%, resulting in a tax of $17,647, while the remaining $882,353 is subject to tax at 4.5%, resulting in a tax for the lineals of $39,706, or a total tax of $57,353. Which is $1,853 more than the tax would have been before Ross.

And not only is the tax more in dollars, but (as demonstrated above) it is also harder to calculate, because the taxes have to be applied on the shares of the estate after taxes, which automatically results in a circular calculation.

Promoting Fairness

Having said all that, it must be admitted that the result in Ross is objectively fairer, because the tax rates are based on what beneficiaries actually receive, rather than what the will says that the beneficiaries should have received. So the effect of the decision is to protect beneficiaries from poor estate planning.

Take the situation faced by the court in Ross itself. The “gross estate” was $892,979, but $763,850 was payable to lineal heirs and the remainder was (supposedly) payable to collateral heirs. Ignoring any other deductions, the federal estate tax would have been $65,499 and, according to the Pa. Department of Revenue, the inheritance tax should have been $65,200 (6% on $763,850 and 15% on the rest), for a total death tax liability of $130,699. That would leave $762,280 for the lineal heirs and nothing for the residuary beneficiaries. However, suppose that the lawyer doing the estate planning had done the calculations and thought through the situation in advance, and then convinced the testator to change the will to leave $10,662 to the collateral heirs and the rest of the estate to the lineal heirs. In that case, the inheritance tax would be only $54,538 (15% of $10,662 plus 6% on the rest of the estate), resulting in total death taxes of $120,037, a savings of $10,662. In that case, the lineal heirs would still get the same $762,280 (after taxes), but the collateral heirs would get the $10,662 saved in inheritance tax, a saving due entirely to changes in the will which had no effect on the distribution of the estate other than to change the rate of tax to be applied to the large paid of the estate paid in taxes.

Before the decision in Ross, it was best for Pennsylvania inheritance tax purposes for the death taxes to be paid out of the fund passing to the beneficiaries with the lowest inheritance tax rate. That way, the amounts which are paid in death taxes, and not to beneficiaries, would be taxed at the lowest possible rates. The Ross decision would eliminate this kind of gamesmanship.

As a matter of tax policy, it is desireable for similar situations to be taxed similarly, and the Ross case should allow estates with the same values and the same net distributions to beneficiaries to be subject to the same taxes, regardless of what the governing document might label as the “residue” and which beneficiaries might be labeled as the “beneficiaries” of the amounts paid in taxes. But is the objective fairness worth the costs of more complicated tax calculations? And (most importantly of all) is this the tax system the legislature really intended?

Conclusion

The Ross case was appealed to the Supreme Court, but the Supreme Court denied the appeal. As of this update (January 2005), the Commonwealth Court decision has not yet been cited by any other court, and so it is too soon to tell whether the decision represents another hard case making bad law, or a new and improved look at an old problem.

Until there is a definitive answer from the Supreme Court or the legislature, the issue of the tax rates to be applied to the amounts paid in taxes is going to be debated and disputed and practitioners will need to be aware of the issue for the protection of their clients.

Pennsylvania Inheritance Tax Marital Exemption

By Daniel B. Evans
Copyright © 1995 Daniel B. Evans. All rights reserved.

By Act 21 of 1995, Pennsylvania finally joined the federal government and most other states in exempting transfers to a surviving husband or wife from death taxes.

Pennsylvania began phasing out the inheritance tax on transfers to a surviving husband or wife with the enactment of Act 48 of 1994, but the exemption was supposed to be adopted in stages over four years. Beginning July 1, 1994, transfers to a husband or wife were subject to Pennsylvania inheritance tax of only 3%, instead of the 6% that had previously applied. In 1996 and 1997, the tax was to have been reduced to 2% and 1%, and then eliminated in 1998. However, the legislature has accelerated the reduction, and the zero tax rate will apply retroactively to all deaths in 1995.

Beginning January 1, 1995, there is no tax on transfers to a surviving spouse. There is also not tax on transfers to a trust for the surviving spouse if the trust is for the sole benefit of the spouse during the spouse’s lifetime (unless the executor elects for the inheritance tax to apply to the trust). However, the full value of the trust will be taxed on the death of the spouse.

When an estate passes into a trust and the surviving spouse is a beneficiary of a trust but not the sole beneficiary (or the spouse is the sole beneficiary but the executor elects to have the trust taxed), the interests of the surviving spouse and the remaindermen (usually children or other relatives) must be valued separately, and the inheritance tax applied to the value of the interests other than the interests of the surviving spouse. For example, the actuarial value of a life interest in a trust might be 85% for a fifty-five year old widower, so that 85% of the value of the trust would be free of tax and the remaining 15% of the trust would be taxed at 6%.

Before the 1995 amendments of the inheritance tax laws, the rules regarding the taxation of a trust after the death of the surviving spouse could have caused problems for wills and estates that pour over into revocable trusts or irrevocable life insurance trusts, because non-taxable assets (like life insurance) might have been mixed with taxable assets in a trust for the sole benefit of the surviving spouse and would have become taxable upon the death of the spouse. The flexible election provisions of the new law should allow families to avoid unnecessary taxes as long as the correct tax decisions are made after the death of a husband or wife.