Should You Be Using a Buy-Sell Agreement to Establish Tax Value?
As part of an overall estate planning strategy, co-owners of closely-held businesses should consider buy-sell agreements to establish the fair market value of a business interest for estate tax purposes, especially if the value is expected to be more than the lifetime estate tax exemption (currently $5.45 million).
Buy-sell agreements that meet the requirements of both old rules and IRC Sec 2703 can avoid expensive disputes with the IRS. Buy-sell agreements generally fall into one of the following three categories: Redemption agreements, Cross-purchase agreements and Hybrid agreements.
A redemption agreement is also known as a liquidation agreement is a contract between the business entity (corporation, partnership, of LLC) and the entity’s owners. When a triggering event occurs, such as the death of an owner, the entity is legally obligated to buy out the withdrawing or deceased owner using the funds from the business itself.
A cross-purchase agreement is a contract between the entities owner. Upon a triggering event, the remaining co-owners are legally obligated to buy out the owner and the funds come from the co-owners.
A hybrid agreement is a combination of a redemption agreement and a cross-purchase agreement. When a triggering event occurs, the remaining co-owners have the right to first refusal to buy out the deceased owner. If that right is not exercised the entity is legally obligated to buy out the owner. This type of agreement can work either way.
When setting up a buy-sell agreement for an existing entity, the agreement must be coordinated with pre-existing documents (a corporation’s articles of incorporation or an LLC’s operating agreement) and contracts (franchise agreements, leases and loan covenants). Any of the buy-sell agreements seeks to achieve the following three goals upon a triggering event:
| 1. | Make sure there is a willing buyer for ownership interests |
| 2. | To prevent co-owners from transferring ownership interests to others outside the ownership group without consent |
| 3. | Provide a better certainty about the federal estate tax outcome |
Old rules and IRC Sec 2703 work in conjunction to establish a buy-sell agreement to establish a business interest’s estate tax value. Under the old rules the following four requirements had to be satisfied:
| 1. | The buy-sell agreement must establish a realistic price and the method for establishing the price must be determinable from the agreement. |
| 2. | The price set must indicate the agreement is a bona fide business arrangement and not a disguised bequest to family members. |
| 3. | The buy-sell agreement must obligate the decedent’s estate to sell the ownership interest at the price stated in the agreement. |
| 4. | The agreement must prohibit the lifetime transfer of the ownership interest at a price in excess of the price stated in the agreement. |
If a buy sell agreement met all four requirements the price established by the agreement was considered the fair market value of the business interest for estate tax purpose. IRC Sec. 2703 was enacted because congress was concerned that family members would transfer ownership interests using values of less than fair market value to avoid estate taxes.
The general rule of IRC Sec 2703(a) is that the value of an ownership interest is determined without regard to any buy-sell agreement to use or acquire the interest at a fixed price or price less than fair market value. Under this general rule a price set in a buy-sell agreement is irrelevant for estate tax purposes. IRC Sec 2703(b) provides an exception to the general rule. A price set by a buy-sell agreement will be respected for valuing an ownership interest if it meets the following three requirements independently:
| 1. | It is a bona fide business arrangement (a business purpose test) |
| 2. | It is not a device to create an artificially low value for estate purposes and transfer property to members of the decedent’s family for less than full and adequate consideration |
| 3. | Its terms are comparable to similar arrangements entered into by unrelated parties in the same business dealing with each other at arm’s length. |
The buy-sell agreement must meet a standard of commercial reasonableness. The valuation method used in the buy-sell agreement should be one that unrelated co-owners of the business would find reasonable and useful. Using an independent professional appraiser should be considered when trying to satisfy these tests as the valuation formula determined by the appraiser is more likely to withstand IRS scrutiny.
IRC Sec 2703 rules can be quite complicated. Fortunately, if the old rules are met, there is an easy out to satisfy the rules with the nonfamily ownership test. This test is met if more than 50% of the value of the business subject to the buy-sell agreement is owned directly or indirectly by individuals who are not members of the decedent’s family and ownership interests are subject to the same binding buy-sell agreement terms. If the 50% nonfamily ownership is not met the three Sec 2703 requirements as well as the old rules must be met before a buy-sell agreement price can be used for federal estate tax purposes.
For more information or if you would like to discuss your specific circumstances, please contact one of our Private Client Services niche partners at [email protected].
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
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