Taxation
A buy-sell agreement should be structured to minimize taxation. This is especially true for agreements funded by insurance policies. Insurance proceeds can be used to reduce income and estate taxes. However, the transfer in ownership of insurance policies must be planned properly to avoid “transfers-for-value” that subject otherwise tax-free life insurance proceeds to income taxation.
Although a buy-sell agreement might reflect different values for different triggering events, the buy-sell must include a provision that requires the business interest be valued at the greater of either the value determined by the buy-sell agreement or “as finally determined for estate tax purposes.” [Remember: When valuing for gift, estate and inheritance tax purposes, the IRS requires the interest reflect fair market value (FMV). FMV, as defined by Revenue Ruling 59-60 (IRS valuation guidelines) is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”]
Although the value stated in a buy-sell agreement may be binding upon the owners, it is not necessarily binding on the IRS. Basing the buy-sell agreement on FMV ensures that the deceased owner’s estate will not be forced to sell the shareholder interest back to the company or another owner for a synergistic price and owe a substantially different amount in estate taxes plus penalties in the event of undervaluation. Undervaluation penalties range from 20 to 40 percent depending on the IRS’ assessment.
Consider the Tax Court case of the Estate of H.A. True, Jr., and Jean D. True v. Commissioner, issued July 6, 2001 (T.C. Memo 2001-167). In this case, the IRS determined the estate had almost $76 million in unpaid tax with more than $30 million undervaluation penalties. The Tax Court’s position incorporated several factors. The Court ruled: 1) the buy-sell agreement did not pass the arm’s-length dealings test (as set by the Estate of Lauder v. Commissioner); 2) the buy-sell agreement set terms without negotiation; 3) the decedent failed to rely on the advice of a professional appraiser in selecting the business interest price; 4) the buy-sell agreement excluded significant assets; and 5) the agreement did not provide for periodic reviews or adjustments. This landmark case demonstrates the importance of a properly structured buy-sell agreement, including a valuation performed in compliance with IRS standards.
Conclusion
Death and taxes are inevitable. A buy-sell agreement serves as a business will and not only guarantees a market for a deceased shareholder’s interest, but also protects the living as well. Buy-sell agreements must be updated periodically. Similar to the timing of a business valuation update, a buy-sell should be modified if the business has a substantial change in assets or property, if there is a change in shareholder intentions or ownership or if there is a material and applicable change in tax law. Essentially, a business will provides peace of mind and survivor tranquility. A written, binding and properly funded buy-sell agreement resolves confusion and eliminates greed and mental anguish.
Buy-Sell Agreements and Valuation Requirements for Family Owned Businesses
Special valuation rules (under Section 2703 of the Treasury Regulations) apply to any family owned business in which the family members control 50 percent or more of the voting or value of the company. Any buy-sell agreement, restriction or other similar factor relating to the right to use or sell property (or a business) will be ignored for estate, gift and generation-skipping tax purposes UNLESS THE AGREEMENT MEETS ALL THREE OF THE FOLLOWING TESTS:
- It is a bona fide business arrangement.
- It must not be a device to transfer the property to the natural objects of the transferor’s bounty (such as family members) for less than adequate and full consideration in money or money’s worth.
- Its terms must be comparable to similar arrangements entered into by persons in an arm’s-length transaction.
Agreements put in place prior to October 8, 1990, will be “grandfathered” under the law; however, those agreements substantially modified after this date will be required to follow the rules of Section 2703.
What are the Purposes of a Buy-Sell Agreement?
- To establish the value of shares for estate tax purposes.
- To create a market for the owner’s business interests (by requiring a sale at certain triggering events, such as death).
- To provide a mutually agreeable price and terms (to reduce litigation and friction).
- To facilitate a smooth transition of management and control of business interests.
- To provide the family of a deceased owner with liquidity instead of non-marketable stock.
