Promissory notes are used as a funding mechanism in many buy-sell agreements. The topic is discussed in my book, Buy-Sell Agreements for Closely Held and Family Business Owners. In a recent blog post, Shareholder (Promissory) Notes in Buy-Sell Agreements, we addressed the topic in even more detail.
Two appraisals (two separate years) prepared by Mercer Capital several years ago were used by clients for gifting purposes. The gifting values were challenged by the Internal Revenue Service. Annual valuations had been prepared for many years prior to the two years in question pursuant to the company’s buy-sell agreement.
Promissory Note Maturity Challenged
In addition to questioning Mercer Capital’s appraisal conclusions, the IRS also raised challenges under Code Section Section 2703. The shareholders’ agreement in question called for the issuance of a ten year promissory note in the event that stock was purchased due to the operation of the agreement. The IRS questioned this aspect of the agreement, indicating that it was too long and was not similar to comparable transactions among arm’s length parties.
Since the great majority of buy-sell agreements are between privately owned companies and their owners, it is particularly difficult to prove what “the market” is for the maturities of promissory notes in shareholders’ agreements.
Research of “the Market”
As an expert, I did not want to be in a position of simply stating that “in my professional experience” a ten year note maturity is typical, or at least fairly common for promissory notes issued in accordance with buy-sell agreements. It occurred to me that evidence of “the market” existed within the historical files of client engagements at Mercer Capital.
I proceeded to look at “the market” for maturities of promissory notes issued by the operation of buy-sell agreements. Since the interest rate in the agreement was also challenged, I also looked at the interest rate for each promissory note identified and the amortization method.
My search of Mercer Capital’s files was not random, but it was not performed with any preconceived identification method. Our electronic files of corporate documents are mostly in pdf format, and they are not easily searchable. The methodology was straightforward:
- Begin with a list of corporate clients (i.e., non-banks, because banks, for some reason, seldom have buy-sell agreements)
- Begin at the top of the list and go to the client folder on the server to locate the buy-sell agreement. This is actually more difficult than it might seem, because many of our clients obtain annual appraisals. Each new engagement receives a new client number. So I had to search back, year-by-year, to find the client number and file where we actually had the buy-sell agreement.
- Once I found a particular company’s buy-sell agreement, I read the agreement, seeking to identify three things, the term of any promissory note that might be issues (if any), the amortization method, and the indicated interest rate.
- When I had found and reviewed 20 buy-sell agreements, I stopped.
The entities, of course, shall remain anonymous. However, the information derived from this study of 20 buy-sell agreements is informative. We can learn something from the collection of information and glean aspects of certain of the negotiations leading to decisions regarding promissory notes.
- On the question of maturity raised by the IRS, seven of the 20 agreements have maturities of ten or more years, which indicates that this maturity selection is quite common.
- The most frequent maturity is five years, with eight agreements having this length for maturity.
- The first note is a single payment note with a maturity of one year. The interest rate is 15%. It is clear that these shareholders wanted to insure that their company (and the other shareholders) were under some pressure to pay promptly!
- The 18th note is interesting. It calls for varying maturities, depending on the dollar size of the block of stock — the larger the dollar amount, the longer the maturity.
- Twelve of the agreements call for note payments in annual installments. This decision likely reflects minimal involvement of shareholders, or at least minimal thinking about the issue. Most people, if they think about it, would negotiate monthly or quarterly installments. Regular payments increases cash flow and minimizes risk.
- The interest rates vary a good deal. Ten agreements use the prime rate of a named bank or prime, plus or minus a bit. Three of the agreements use the AFR.
- Four notes clarified that the applicable prime rate would vary with a selected bank’s prime and be reset on the anniversary date of the transaction each year. The other notes using the prime rate were sometimes less than clear as to whether the selected rate was fixed at the date of note issuance, or would vary in some way. If these companies issue notes and rates vary significantly over their durations, there could be some interesting discussions about the language in those agreements!
As with every aspect of buy-sell agreements, it is important that any promissory notes that might be issued be appropriately defined and documented. In the post on promissory notes linked above, we provided the opportunity to download a Checklist for Shareholder (Promissory) Notes in Buy-Sell Agreements. If you missed it before, now is a good time to download it.
The Checklist for Shareholder (Promissory) Notes in Buy-Sell Agreements is excerpted from Chapter 13 of my book, Buy-Sell Agreements for Closely Held and Family Business Owners. You will find a discussion of shareholder, or promissory notes, there as well. If you like the checklist, you will love the book. Quantity discounts available.
By the way, after being scheduled for U.S. Tax Court and extensive preparations, the valuation issues raised by the IRS that were mentioned above were settled on the eve of trial at the original conclusions rendered by Mercer Capital. All other issues were also resolved in favor of the taxpayer.