Author: Tere D’Amato, CFP^®, CLU^®, ChFC, MSFS

Much as I’m embarrassed to admit, I love reading about the local business in the throes of a public family dispute. It intrigues me that those who can afford the best advice often ignore it or demonstrate incredible naïveté. For instance, everyone knows that no business owner should be without a succession plan. But a poorly thought out plan can cause more problems than it solves.

So kick off your shoes and join me as I air the dirty laundry of some family-run businesses. You may come away with some insights that can help you and your clients.

PUT IT IN WRITING
One of the most expensive and protracted cases in Massachusetts legal history revolves around a failure to plan. The Demoulas lawsuit is the story of a grocery business owned by two brothers. George and Telemachus (Mike) Demoulas verbally agreed that if one died, the other would take care of his family, and the business would be divided evenly between the two families. George died first, and Mike, true to his word, provided for his sister-in-law and his nephews. In fact, some would say that he provided very well indeed, buying them luxury condos and other trappings of a comfortable lifestyle. Yet, 16 years later, George’s sons claimed that Mike had cheated them out of millions.

Mike saw it differently. He contended that he had provided for his brother’s family by giving them a fair price for their stock. George’s family, on the other hand, claimed that the redemptions were done without their consent, and, one day, they found themselves owning not 50 percent but just 8 percent of the Demoulas supermarket chain. They also accused Mike of diverting profits into a new chain of supermarkets owned solely by Mike’s side of the family. The new chain, Market Basket, saw rapid expansion, while the Demoulas chain stagnated.

Details of the daily court room drama read like the script of a Jerry Springer show. Accusations of wiretapping, drug abuse, affairs, bribes, and forgery heated up emotions. At one point, state troopers were stationed on either side of the court room to break up fistfights. In one bizarre twist, several lawyers were disbarred for luring a law clerk to Canada for a phony job interview in order to elicit information about the Demoulas trial judge’s leanings. In the end, the courts agreed with George’s family; they returned the controlling interest of Demoulas Super Markets to the widow and sons and forced Mike to return $1 billion to the business.

This case is one example of how a handshake succession plan is subject to interpretation. A buy-sell agreement can be a separate document or written into a shareholder, operating, or partnership agreement or even part of a stock grant. To ignore the formality is a recipe for disaster.

ADD A DOSE OF REALISM
Flowerama was founded in 1952 by brothers Maurice and Herbert Frink; it grew into one of America’s largest franchises of mobile flower shops and mall outlets. Flowerama’s articles of incorporation stated that the redemption price for the company’s stock would be based on “book value,” as determined by the company’s CPA, also a stockholder. This was an improvement over Flowerama’s previous stock redemption agreement, which set the price at $100 per share, but the parties should have known that the plan had a flaw.

While it makes sense for someone knowledgeable about the business’s financials to set the redemption price, assigning this role to another shareholder can be seen as a conflict of interest.

When Maurice died in 2004, the company’s CPA determined a value for the stock, and Flowerama prepared a formal offer to the heirs. When the company offered $900,000 to the Frink estate, the executor refused to accept the price, claiming that the redemption clause was both ambiguous and unreasonable. The court disagreed. Despite the fact that the shares were undervalued, the Iowa Court of Appeals upheld the buy-sell agreement because Flowerama had consistently used book value for the redemptions of stock owned by two previously deceased shareholders, including Maurice’s brother.

You might ask why the executor felt that the estate had a strong case when the terms of the valuation clause were clear. The answer is estate taxes. The IRS challenged the value of the stock listed on Form 706, the federal estate tax return. Its appraisal of the Frink estate was based on the stock’s fair market value, while the heirs only received book value for their shares.

Flowerama and the Frink estate were in litigation for three years, at the same time the estate was defending its estate tax return. There is a common misconception that the price in the buy-sell agreement will fix the estate tax value of the deceased’s shares, even if that price is undervalued. This is a risky assumption. Two of the factors the IRS looks at are whether the price is based on fair market value and if the price is binding for lifetime redemptions.

When the IRS challenges a business valuation, the result is usually a higher valuation and higher estate taxes. Coordinating the business succession plan with the estate plan is essential to avoid court costs for attorneys, accountants, and appraisers, as well as the resulting taxes.

PUT YOURSELF IN THE PARTNER’S SHOES
Let’s turn to Ehlinger V. Hauser, a case between former friends that persisted for 10 years before it finally reached the Wisconsin Supreme Court.

Jon and Bill opened up a picture framing shop, Evald Moulding, Inc., in a small town in Wisconsin. Bill’s full-time profession was dentistry, but he enjoyed acting as a silent investment partner in several small businesses. Jon worked full-time at the framing shop as the managing partner. After the business took hold, Jon and Bill entered into a buy-sell agreement with several triggering events, including disability of one of the shareholders. The purchase price for a disability buyout was set at $350,000 or book value, whichever was greater.

Ten years later, Bill contracted Parkinson’s disease and closed his dentistry practice. He approached his partner about selling his Evald shares because he had lost interest in the business. Jon agreed to write up an offer. Bill was shocked when he received Jon’s proposal. Jon had triggered their buy-sell agreement’s disability clause and offered to buy out Bill for $400,000, Jon’s estimate of the current book value. Bill felt that the price was insufficient and asked to audit the books. Jon refused and each countersued.

Bill argued that he was not disabled for purposes of the buy-sell agreement because his inability to practice dentistry had nothing to do with remaining a shareholder of the frame shop, especially in light of the fact that the shop employed 30 other employees. He also contested the accuracy of the sales price. According to Bill, the price did not reflect that Jon had operated Evald to disproportionately benefit himself and his family. The compensation, bonuses, and expense reimbursements paid to Jon and his relatives were not taken into account in the valuation.

At trial, the court found the disability clause unenforceable. In addition, the shop’s book value could not be determined due to the way Jon kept the books. After a decade of litigation, Bill and Jon were back to where they started—either negotiate a fair settlement or liquidate the business assets.

I suspect this was a case where the business used a boilerplate legal agreement without customizing the terms to fit the situation. First, book value rarely represents a business’s fair market value.  Second, a disability buy-sell trigger may not have been appropriate in an agreement between a “silent investor” and the business. Typically, this type of investor doesn’t want to sell an asset if it is providing a steady flow of profits. Then, there is the question of whether a shareholder who is not an employee can meet the definition of disability. This is an example where the agreement provided incentive to trigger a buy-sell event inappropriately. Clearly, Bill thought he would never qualify for the disability trigger, and Jon used the agreement to offer a price to Bill for less than market value.

CROSS THE Ts
Clair Auto Group was one of New England’s largest auto dealership chains before its owners, the four Clair brothers, sold most of CAG for $80 million, retaining the land and a few other assets. Two brothers died shortly thereafter, leaving their business interest to their widows. By 2010, the widows were in court claiming that their brothers-in-law were trying to bully them into relinquishing their “valuable ownership interests.” According to the lawsuit, the two surviving brothers asked their sisters-in-law to sign over their ownership interests in the remaining assets because the widows received their husband’s life insurance proceeds.

Like most well-run businesses, in 2005, Clair Auto Group funded its stock redemption agreement by purchasing life insurance on all four brothers. The insurance was still in force when the bulk of the company assets were sold. Within a year of the sale, Mark Clair had died suddenly, and James Clair had discovered that he was terminally ill. James approached his surviving brothers with a proposal that each brother be allowed to purchase his individual policy from the business. In 2007, James transferred the $12 million life insurance policy formerly owned by CAG to an irrevocable life insurance trust and died the following year.

For the next two years, the surviving brothers consulted their sisters-in-law about financial decisions and provided them financial statements for the business. It wasn’t until the spring of 2009 that the surviving brothers claimed ownership of the widows’ stock. They informed the women not only that the life insurance proceeds must be applied to the buyout but that any excess proceeds had to be returned to CAG. The case is still tied up in the courts.

Even a good buy-sell agreement can be thwarted if life insurance policies are not set up or maintained correctly. Too often, business owners will look to simplify the buy-sell process by buying life insurance and naming their spouses as beneficiaries. Unless the buy-sell agreement is carefully worded, the spouses would understandably view personally owned policies as being outside the agreement.

THE MORAL OF THE STORY
These stories highlight why buy-sell agreements can fail. The seller is surprised by the price he or she previously agreed to. The price has no relation to a fair market price. Or the instructions in the document are ambiguous or, worse, impractical. There is rarely an opportunity to fix the agreement after the fact.

The courts will usually assume that the business owner understood that the terms were not fair but that he or she wanted to enter into the agreement anyway. Remember that fair is in the eye of the beholder. The court logs are filled with cases involving unhappy friends and relatives who claim that the company has been unfair to them.

Commonwealth Financial Network® does not provide legal or tax advice.

Tere D’Amato is the vice president of advanced planning. She is available at tdamato@commonwealth.com.