Family Business: Attention to Detail
THE WILSON FAMILY
Using the Wrong Terminology in a Purchase And Sale Agreement Can Have Disastrous Results
In the early 1960s, two friends, Al Wilson and Bob Babbit, decided to invest in commercial real estate in Portland, Maine. They believed that Portland would prosper in the next 20 years and commercial rents would increase significantly. Both of them had good credit and had banker friends who would have 100% financed the buildings they wished to buy, but they were also very careful. First, they always put in their own cash for at least 40% of the purchase price. Second, they contributed $100,000 each, upon the formation of the S corp. used for this real estate business so that they would have a reserve to protect against vacancies and any economic downturn. Third, they always purchased property that was either fully leased to good tenants or that with some renovations would be able to attract good tenants.
Their concept of good property selection and hard work paid off. They were very successful. Al’s son, Al Jr., came to work for the company in 1975 and handled a variety of responsibilities, none of which he did very well. He seemed to disappear for parts of every day – a situation that irritated Bob. Bob’s children lived out of state and were successful in their independent careers. For Bob, watching Al Jr. being well paid, but not performing well was a constant irritation. Bob was a full time, successful stockbroker and also maintained all the financial records for the S Corp., A & B Realty.
Their Concept of Good Property Selection and Hard Work Paid Off
Al and Bob were thrifty and had done most of professional work themselves, but they did have a local law firm form the S corp. They also had a local accounting firm file the form 2553 to elect S Corp. status and prepare annual tax returns. Al and Bob, however, prepared all of their own purchase and sale agreements and leases. They even prepared a simple stock purchase and sale agreement for themselves using someone else’s agreement as an example.
The situation with Al’s son as an employee got much worse when Al hired his daughter Joanne to replace the longtime bookkeeper who had retired. Joanne, unlike her brother, was very competent and feisty. She did not like Bob asking for and going over the monthly bank statements and rent payment information. She complained to her dad but was told that Bob was an owner and could look at whatever he wanted. The atmosphere in the small office was not pleasant. One of the tenants in the building was the accounting firm that David Reed worked for. He met Joanne in the elevator one Saturday morning in March. Joanne asked what he was doing working so early on a Saturday and David responded that it was tax season and all tax professionals would be working every Saturday until April 15. Joanne asked if he would take a look at the tax return she just received from her accountant before she filed it,to see if David could find any missed opportunities. She was like her dad and said, “I do not want to pay for your quick look, but if you find some opportunities I will ask my dad to consider hiring you and your firm.” David knew his boss would not like him doing such a review for nothing, but said he would stop and pick up a copy of the tax return and any further information around noon.
When David stopped at Joanne’s office at 12:15 that afternoon, she had a box full of papers for him saying that it was the tax return, all the information she had given the accountant, and the accountant’s compiled financial statement for the company. David inwardly groaned as he knew it was going to take hours to go through all this. However, he had also learned that the best way to earn promotions and raises in his accounting firm was by bringing in clients.
David actually liked the challenge presented by Joanne and was determined to find some opportunities. It was not hard. During the taxable year, the Al and Bob had purchased two buildings and sold some surplus land associated with another building at a large gain. Each of the purchases used a simple purchase and sale agreement prepared by Al which did not attempt a purchase price allocation to obtain favorable depreciation. The accountant had just allocated the purchase price between land and building using the city assessed values which were notoriously inaccurate. David explained to Joanne in his review memorandum (delivered Monday morning) that he would have asked to view the building and from that view determine with Al’s help what the acquired personal property was worth (carpeting, partitioning, overhead doors, water coolers, portable air conditioning units, any special plumbing and electrical needed just to support equipment etc.). In addition, he would have asked what the raw land was worth compared to the building, and what value should be allocated to the paved parking area, the security fence and the landscaping. He did not want to give away all his ideas, just enough to have the chance to talk with Al. David did a rough calculation of how much more depreciation expense he thought was available making sure it was high enough to be enticing but not so much that he could not deliver on the estimate.
David Actually Liked the Challenge…and was Determined to Find Some Opportunities
David also mentioned that when buildings are to be purchased during a year when the company also expects to sell real estate at a gain the owners should always think about a like kind exchange. He prepared a rough calculation as to how much in taxes Al and Bob as owners of the S corp. would have saved by not being taxed on the sale of the land. David did not try to explain in the memo the method of using a multiple party like kind exchange hoping to leave that discussion for his meeting with Al.
David got the client and reworked the tax return with a very favorable result for Al and Bob. However, before David finished his work, Bob died unexpectedly from a long existing condition that he had told no one about. Several weeks later the attorney for his estate called Al to discuss the shareholders’ agreement. It was not a good conversation for Al. The attorney discovered that the agreement provided that upon the death of either shareholder, the survivor was required to buy out his fellow shareholder at 50% of the ‘book value’ of the corporation. Al vaguely remembered that provision but was taken completely by surprise when the attorney showed him the previous year’s financial statement which showed that assets exceeded liabilities by over $2 million (book value). Al could not believe it. He did not have $1 million to complete such a purchase requirement and was bewildered how such a figure could exist. He left the lawyer’s office in a daze and upon arriving at his office went to his file cabinet and grabbed his copy of that financial statement and went to look for David.
David Says You Need a Lawyer
Al was so upset that David had trouble understanding what he wanted. Finally it became clear. The prior year’s balance sheet contained the same item David had seen on the draft financial statement for the current year. The stockholders’ equity section contained a line item entitled ‘appraisal surplus’ in the amount of $1.5 million. David asked Al how that came to be. At first Al did not remember but then he recalled that several years before, (in fact the year that Joanne came to the company) Bob suggested they augment the balance sheet to bring the owned real estate up to fair market value before going to the bank for a loan to acquire another building. Bob had said that keeping older but valuable properties on the balance sheet at historical cost was very inaccurate and always caused a difficult conversation with the bank. Al agreed, so the change was made.
Al was very angry at the thought that what had occurred years before (for a whole different reason) could now cost him a lot of money. David said quickly, “You need a lawyer.”
The lawyers negotiated for weeks and after they failed to reach an agreement, a lawsuit was filed. It was discovered that not only the formal financial statements contained the appraisal value increase, but so did the company’s general ledger and adjusting entries for the year of the increase (the ‘books’ as argued by the lawyer for Bob’s estate). Al’s attorney argued that increasing balance sheet assets to fair market value was not a generally accepted accounting method and that book value was a term of art used by accountants to match their accounting rules. Unfortunately, the purchase and sale agreement did not define the phrase ‘book value’ used in the agreement.
After a lot of legal bills, Al eventually settled with Bob’s estate and had to sell two buildings to pay the $350,000 settlement.
It was this experience that caused David to look over every shareholder’s agreement he came across to see what the buyout terms were. He never counted how many agreements needed to be changed during his career but knew it was more than 20.