by Scott A. Dondershine, attorney
Planning for the Transfer of a Successful Closely Held Business
The issues faced in drafting a buy-sell agreement are complex and difficult. This article analyzes some of the key concerns, such as the purpose of the agreement, the types of agreements, and methods for determining the price of the stock.
Many business owners work several decades to develop a successful business. But without a properly planned buy-sell agreement, the business may become worthless at the death, retirement, or disability of a key owner. This article examines some of the key concepts that must be considered in implementing a buy-sell agreement. Although this article discusses the buy-out of stock in corporations, the concepts are very similar for the buy-out of membership or partnership interests in limited liability companies (LLCs) or partnerships.
What is the purpose of a buy-sell agreement?
There generally are two types of buy-sell agreements: (1) agreements that only restrict the transfer of shares and (2) agreements that also establish the value of shares for estate tax purposes.
Establishing the value of shares for estate tax purposes. Establishing the value of shares for estate tax purposes is important because the value of shares owned by a decedent is one of the most heavily litigated and intensely disputed issues in determining the estate tax liability of a deceased stockholder. The IRS often takes the position that the actual value of stock in a closely held business owned by a deceased stockholder is significantly greater than the value of stock reported by the estate, resulting in substantially higher estate taxes owed by the estate. The worst case scenario is that the IRS successfully challenges the buy-out price. The estate would then find itself in the undesirable position of receiving a contractual agreement price for the shares that is lower than the valuation upon which it pays estate taxes.
Under Section 2703, buy-sell agreements are disregarded for valuation purposes unless all the requirements discussed below are met. An important point about applying the tests of Section 2703 is that an agreement is deemed to meet all three tests if it is between people who are not members of the transferor’s family and if non-family members own more than 50% of the value of the subject property.
The agreement must constitute a bona fide business arrangement. This test is not very difficult to pass. For instance, reasons found valid include (1) maintaining current management policies, (2) maintaining exclusive family control, and (3) retaining key employees.
The agreement must not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration. In order for a buy-sell agreement to meet this test, which traces its roots to Reg. 20.2031-2(h) and a plethora of cases, two requirements must be satisfied.
First, the buy-sell agreement must not be designed to serve a “testamentary purpose.” Factors considered in determining whether a buy-sell agreement has a “testamentary purpose” include:
1. Whether the decedent was ill at the time of entering into the agreement;
2. Whether there were extensive negotiations prior to entering into the agreement (as opposed to a parent dictating the terms of an agreement with his or her family, such as in Estate of True, Jr. );
3. Whether the agreement is consistently enforced with respect to other transactions involving company interests;
4. Whether the buy-sell price was formulated based on comparables or appraisals (as opposed to a formula such as book value chosen for “convenience,” as the courts held in True and Estate of Lauder );
5. Whether the drafters of the agreement sought professional advice in selecting the formula price;
6. Whether the agreement requires that the price be periodically reevaluated;
7. Whether significant assets (such as goodwill) are excluded from the formula price; and
8. Whether the agreement provides for below-market payment terms for the purchase of a decedent’s interest.
Second, the formula for establishing the purchase price of interests subject to a buy-sell agreement must be fair. In general, courts evaluate fairness as of the date that an agreement is executed rather than the date of a decedent’s death. The courts normally presume that unrelated parties to a buy-sell agreement will negotiate a fair formula. However, agreements between related parties (parents and children in a family-owned business) are subject to special scrutiny; the estate of a deceased shareholder may be forced to prove that the formula price will not result in an amount that is lower than what would be agreed upon by persons with adverse interests dealing at arm’s length. In Lauder and True, the court disregarded book value set forth in buy-sell agreements between related parties for estate tax valuation purposes.
The agreement must have terms comparable to those of similar arrangements entered into by persons in an arm’s-length transaction. The last test of Section 2703 can generally be met if the agreement could have been obtained in a fair bargain between unrelated parties or if the restrictions conform to standard practice in the business. A problem in analyzing whether this test is met is that most buy-sell agreements are negotiated to address unique facts and circumstances and are not public documents.
This Article appears in the July 2002 edition of Estate Planning as “Planning for the Transfer of a Successful Closely Held Business” 29 Estate Planning 335, July 2002.
Other tests established before enactment of Section 2703. Prior to the enactment of Section 2703, applicable law derived from Reg. 20.2031-2(h) established three tests that probably continue to apply in addition to the tests ultimately codified by Section 2703.
The first two of these prior tests are relatively easy to meet: the agreement must set forth the value or mechanism for establishing the value of the stock, and the estate of the deceased stockholder must be obligated to sell the shares upon the decedent’s death. The third requirement is more difficult to understand and originates from Reg. 20.2031-2(h), which states:
Little weight will be accorded a price contained in an option or contract under which the decedent is free to dispose of the underlying securities at any price he chooses during his lifetime.
The above Regulation could be interpreted as absolutely prohibiting a stockholder from obtaining a greater price for a lifetime transfer in contrast to a transfer at death. For instance, if the value established in an agreement for the purchase of stock at death is $1 million and the shareholder has an offer from a third party for a lifetime transfer for $1.1 million, the shareholder could not under any circumstance sell the shares for $1.1 million–he or she could receive only $1 million.
It is also possible to interpret Reg. 20.2031-2(h) as merely requiring that the shares must first be offered to the corporation or the remaining shareholders at the transfer price applicable at death. Then, if the offer is refused, the shareholder should be able to sell the shares for more. A right of first refusal in the corporation and/or the remaining shareholders at the agreement price–even if a third party’s price is greater–arguably means that the decedent is not “free to dispose of the underlying securities at any price he chooses during his lifetime.”
Other goals of a buy-sell agreement. In addition to establishing the value of stock for estate planning purposes, other goals for structuring a buy-sell agreement typically include: (1) creating a market for the owner’s business interests (e.g., by requiring a sale at certain triggering events, such as death); (2) providing a mutually agreeable price and terms (e.g., to reduce litigation and friction); (3) facilitating the smooth transition of management and control of business interests; and (4) providing the family of a deceased owner with cash instead of non-marketable stock.
Disadvantages of a buy-sell agreement. One must also analyze the potential drawbacks of a buy-sell agreement. Business owners should consider the cost of insurance and the potential use of premium payments for other company or personal purposes. Moreover, circumstances can change after adoption of a buy-sell agreement, causing the would-be purchasers to regret the obligation to purchase shares of a deceased owner. A buy-sell agreement probably will also preclude (1) the potential extension of time afforded by Section 6166 to pay estate taxes attributable to closely held business interests, (2) the deduction under Section 2057 for qualified family-owned business interests, and (3) application of the special-use valuation rules of Section 2032A.
Furthermore, a buy-sell agreement may adversely affect the use of family limited partnerships or similar tools that create valuation discounts. Business owners may also find that a better price can be obtained for the company if it is sold during the lifetime of a key owner rather than after his or her death.
Who wants the stock anyway?
There generally are two possible purchasers in a buy-sell agreement. The business entity itself can buy the stock pursuant to a “stock redemption agreement,” or the remaining stockholders can buy the stock pursuant to a “cross-purchase agreement.”
Advantages of a redemption agreement. A stock redemption agreement is favorable in two respects.
Only one insurance policy on the life of each stockholder is needed. If insurance is used to fund the purchase obligation at death, a cross-purchase agreement ordinarily requires each stockholder to own separate insurance policies on the lives of each other owner. For example, if a corporation has six stockholders, 30 insurance policies are needed. The number of required policies is computed using the following formula: NP = n2 ‘ n, where “n” is the number of shareholders (30 = 6 x 6 – 6). If a stock redemption agreement is used, the company purchases one policy on the life of each shareholder, greatly reducing insurance costs and simplifying implementation of the agreement.
The exposure of the insurance proceeds to taxation is reduced. Under Section 101(a), the receipt of life insurance proceeds is not subject to income tax unless the policy is transferred for valuable consideration. If a policy is transferred for valuable consideration, the transferee (new owner) recognizes as taxable income the difference between (1) the amount of death benefits paid to the new owner upon the insured’s death and (2) the amount paid to acquire the policy as well as any subsequent premiums paid by the new owner. For instance, assume that X transfers to Y a policy on X’s life in exchange for $100,000. Y then pays $100,000 of premiums before collecting $1 million of insurance proceeds. Y would recognize $800,000 of taxable income ($1 million minus $200,000).
Fortunately, there are several exceptions that permit a transfer for value without causing taxation of the insurance proceeds. The exceptions relevant to a buy-sell agreement include a transfer of a policy to (1) the insured, (2) a partner of the insured, (3) a partnership in which the insured is a partner, or (4) a corporation in which the insured is a shareholder or officer. Transfer-for-value problems are less common in stock redemption agreements than in cross-purchase agreements because of the exception permitting an insurance policy to be transferred to a corporation in which the insured is a shareholder.
Disadvantages of a redemption agreement. Although redemption agreements are easier to implement, they can result in adverse tax consequences.
No step-up in basis for remaining stockholders. Redemption of a deceased stockholder’s shares causes the percentage of company stock owned by the surviving shareholders to increase while the basis of the remaining stockholders in their shares remains the same. Assume A and B each own 50% of a company or 50 shares each, and each has a basis of $100 in his 50 shares. A dies and A’s shares are redeemed for $300. B would continue to own 50 shares after the redemption and would have a basis of $100 in his shares. B’s shares, however, now represent 100% of the issued and outstanding shares of the company. If B then sold his shares for $600, B would recognize $500 of capital gain ($600 amount received minus $100 basis).
Suppose that B purchases A’s shares for $300 under a cross-purchase agreement instead of the company purchasing A’s shares under a stock redemption agreement. In this scenario, B would own a total of 100 shares (representing all the issued and outstanding shares) with a basis of $400. If he subsequently sold his interest for $600, B would recognize only $200 of capital gain ($600 – $400).
Potential treatment of the sale as a dividend. The general rule for the taxation of a stock redemption is very different from the rules that apply to the treatment of a sale via a cross-purchase agreement. In a cross-purchase agreement, the other stockholders acquire the stock being transferred, and any gain is generally taxed at favorable capital gain tax rates.
The general rule applicable to a stock redemption agreement is very different. A stockholder redeeming his or her shares receives a dividend. Dividend treatment is disadvantageous because (1) dividends are treated as ordinary income (subject to higher tax rates than capital gains), and (2) the entire amount received is taxed with no offset for the basis of the stock that is redeemed. Fortunately, there are several exceptions to the general rule mandating dividend treatment and, with careful planning, dividend treatment can often be avoided.
Potential AMT on company’s receipt of insurance proceeds. A company usually does not incur any tax liability on the receipt of life insurance proceeds in connection with a stock redemption agreement. The main exception to the nonrecognition rule is that proceeds received by a C corporation may be subject to the alternative minimum tax (AMT). Fortunately, TRA ’97 limited the scope of AMT exposure by repealing the AMT for “small corporations.”
Advantages of a cross-purchase agreement.Step-up in basis for purchasing shareholders. Unlike a stock redemption agreement where the remaining stockholders do not receive a step-up in basis, one of the chief advantages of a cross-purchase agreement is that the purchasing shareholders receive a step-up in basis.
Capital gain may be minimized for purchases at death.The conveyance of stock owned by one shareholder to the other shareholders in a cross-purchase agreement is treated as the sale or exchange of a capital asset. If the sale is made by the estate of a deceased stockholder, the estate may not recognize any capital gains because the basis of the stock may be increased to the stock’s fair market value on the date of the decedent’s death, depending on when the decedent dies.
For decedents dying before 2010, the basis is increased to the fair market value at the date of death. Effective for decedents dying after 2009, inherited property will be assigned a carryover basis except for up to $1.3 million of basis increase, regardless of who inherits the property, and an additional $3 million of basis increase for appreciated property passing to the surviving spouse.
An unintended shift in control can be prevented.A redemption will result in a pro rata increase in the percentage of shares owned by all non-redeeming shareholders. A cross-purchase agreement can be structured to increase the shares of selective shareholders. For instance, if A owns 50 shares, B owns 30 shares and C owns 20 shares, a redemption of A’s shares will increase B’s percentage to 60% and C’s percentage to 40%. If the parties want C to take control after A’s death, a cross-purchase agreement with C will be necessary. Under such an agreement, C could buy A’s shares, increasing C’s percentage to 70% while leaving B’s percentage at 30%.
AMT impact of stock redemptions is avoided. As discussed above, one of the disadvantages of a stock redemption agreement is the potential for AMT on the receipt of life insurance proceeds. AMT is not a concern in cross-purchase agreements, and any insurance received usually will not be taxed (except possibly if a transfer for value is made, as discussed above).
Disadvantages of a cross-purchase agreement. There generally are two disadvantages of a cross-purchase agreement, although both drawbacks can be mitigated through careful planning.
Possible income tax applicable to insurance proceeds. In contrast to a stock redemption agreement, a cross-purchase agreement can easily give rise to a “transfer-for-value” problem, causing taxation of the proceeds. For example, owners swapping policies to implement a cross-purchase agreement results in a transfer for value. If A owns insurance on his life and B owns insurance on her life, A might want to transfer his policy to B (and vice versa) to fund the cross-purchase obligation. At A’s death, B would collect the insurance proceeds on A’s life and then distribute the proceeds to A’s estate in exchange for A’s shares. Although this strategy may sound like a good idea, the parties have transferred the policies for value. B would have to pay income taxes on receipt of the death proceeds, less the amount she subsequently paid in premiums.
An inadvertent transfer for value can also occur at the death of a stockholder. Assume that S, A, and T are equal stockholders. Each stockholder is the owner and beneficiary of a policy on the life of the other two stockholders. Assume that T dies and T’s estate sells T’s stock to A and S, increasing their percentage ownership in the company. T’s estate also sells the policy on A’s life to S and the policy on S’s life to A; this provides the remaining shareholders with additional insurance to purchase the other remaining stockholder’s increased interest in the company. Again, this strategy sounds like a good idea. The parties, however, caused a transfer for value via this transaction.
To reduce the exposure to the transfer-for-value problem, practitioners often recommend that clients form a business taxed as a partnership (such as an LLC). All shareholders of the corporation would be partners in the LLC in addition to continuing to own shares in the corporation. Because the shareholders would be partners in an entity taxed as a partnership, the shareholders could then transfer policies to each other either upon the death of a shareholder or initially to implement the buy-sell agreement, without fear of causing taxation of the insurance proceeds. The reason is that the transfer of the insurance policies would fall under an exception to the transfer-for-value rule as a transfer to a partner of the insured.
For example, suppose that A, B, and C own shares of stock in a corporation and wish to enter into a cross-purchase agreement. A cannot transfer a policy on his life to B (and vice versa) to start the agreement without triggering a transfer for value. Similarly, upon A’s death, A’s estate cannot transfer the policy that A owned on B to C and the policy that A owned on C to B without triggering a transfer for value. However, assume that before transferring the policies, A, B, and C form an LLC. A, B, and C would then be partners at the time of the transfer of the policies and, pursuant to the exception to the transfer-for-value rule that permits the transfer of insurance policies to partners of the insured or a partnership of the insured, A, B, and C could transfer the policies to each other or have the LLC own the policies.
A factor that complicates the use of an LLC in connection with a cross-purchase agreement is that the IRS has published a Revenue Procedure indicating that it will not issue written guidance addressing whether the use of an LLC or partnership avoids the transfer-for-value problem when substantially all the assets of the LLC or partnership consist of insurance policies on the lives of the members. The reluctance of the IRS to issue rulings on the business purpose issue may indicate that the IRS will take the position that the receipt of insurance proceeds is subject to income tax based on a transfer for value in situations where an LLC or partnership lacks an independent business purpose.
As a result of exposure to an IRS challenge on the issue of lack of business purpose, it is prudent to have the LLC or partnership engage in other meaningful business activities besides owning the insurance policies. One type of possible independent business activity is leasing real property or business equipment, such as copiers, computers or furniture.
Multiple policies required on the life of each shareholder. If insurance is used to fund the purchase obligation at death, a cross-purchase agreement ordinarily requires each owner to own separate policies of insurance on the lives of each other owner. There are at least two techniques for structuring a cross-purchase agreement with multiple owners so as to avoid the need for multiple policies on each owner’s life.
You might wonder why, for example, each of six shareholders cannot simply co-own policies on each other. For instance, shareholders A, B, C, D, and E could co-own a policy on the life of shareholder F. While co-ownership may solve the need for multiple insurance policies, co-ownership arguably creates a transfer-for-value problem because at the death of an owner, the remaining owners’ interests in each co-owned policy are “shifted.” Accordingly, when F dies, F’s estate arguably will make a transfer for value by transferring the portion of the policy on A’s life to B, C, D, and E.
The two feasible options are (1) establishing an LLC or partnership to own one policy on the life of each of the six shareholders or (2) appointing an escrow agent or trustee to own policies on the lives of each of the six shareholders.
Establishing an LLC or partnership to own the policies. The six shareholders in the above example could form an LLC or partnership to own one policy on the life of each shareholder. Each of the six shareholders would own the same LLC or partnership interest as the percentage ownership in the corporation and would contribute funds to the LLC or partnership, enabling the LLC or partnership to pay the premiums.
A shareholder who dies would automatically have his or her interest in LLC or partnership redeemed as of the date of death, based on the value of his or her LLC or partnership interest (excluding the insurance proceeds received by the LLC or partnership). The partnership or LLC would then collect and distribute the proceeds to the remaining shareholders, pro rata, based on each shareholder’s ownership interest in the partnership or LLC after redemption of the deceased shareholder’s interest in the LLC or partnership. The remaining shareholders would use the insurance proceeds received from the LLC or partnership to purchase the deceased shareholder’s stock.
Forming an LLC to own the insurance policies can be tricky. For example, the LLC operating agreement should clearly state that a deceased partner loses all rights as a partner in the LLC as of the moment of death, in order to avoid receipt of proceeds by the LLC being allocated to the deceased partner. In addition, the operating agreement would have to be structured in such a manner (discussed above) as to set the value of the deceased partner’s LLC interest at an amount that is based on the operating assets excluding the insurance proceeds.
Appointing an escrow agent or trustee to own policies on each shareholder. The six shareholders in our example could also appoint an escrow agent or trustee to own policies on each of the shareholders. The escrow agent would own one policy per insured and would credit each shareholder with a pro rata interest in the policies covering the other shareholders.
Upon the death of a shareholder, the escrow agent would collect and deliver the insurance proceeds to the estate of the deceased stockholder in exchange for the deceased stockholder’s stock. The escrow agent would then credit the account of each remaining stockholder with the appropriate pro rata percentage ownership of the purchased shares. Although the escrow arrangement can be effective to reduce the number of required policies, the shareholders would also have to establish a separate partnership or LLC with a distinct business purpose (as discussed above) to avoid a transfer-for-value problem upon the death of a stockholder.
What events trigger sale of the stock?
The next task in structuring a buy-sell agreement is defining the events that will trigger the sale of the stock.
Voluntary transfer. One of the most important concerns for business owners is restricting the transfer of shares during lifetime to a competitor or other unwanted business partner. Under the laws of most states, an unreasonable restriction on the transfer of shares is unenforceable. Section 6.27(c) of the Model Business Corporation Act specifies that a restriction on the transfer of shares is authorized for any “reasonable” purpose.
Because a prohibition on the lifetime transfer of stock may not be considered reasonable, shareholder agreements must strike a fine line between maintaining control over who owns shares and not unduly burdening the right of shareholders to sell stock. The most common mechanism to achieve the proper balance is to provide the corporation and/or the non-transferring stockholders with the right to purchase shares of a transferring stockholder at the price that a third party is willing to pay. If locking in the value of the stock for estate tax purposes is important, the price of the shares offered to the company and/or the non-transferring stockholders should be the lesser of (1) the price offered by the third party, or (2) the price that would be applicable at the death of the transferring stockholder.
Gift of stock. Buy-sell agreements generally permit a gift of stock upon the consent of the corporation and/or the remaining stockholders. Sometimes, there is a carve-out which allows the unilateral right to make gifts to family members, a revocable living trust, or a family limited partnership for estate planning purposes. If a gift is made, the donee should execute documentation consenting to be bound by the terms of the buy-sell agreement.
Pledge of shares. Shareholders may want to pledge shares as collateral for loans. While this may appear to be a benign use of the shares, the borrowing shareholder may default on the loan, and the other shareholders may wind up with an undesired bank as a partner. The issue is even more important in S corporations because having non-individual owners generally causes a termination of the S election. It is prudent for a buy-sell agreement to specify that no shareholder can pledge shares without the express written consent of the corporation.
Involuntary transfer of shares. Buy-sell agreements should also restrict the involuntary transfer of shares–i.e., the transfer of shares to a creditor or to an estranged spouse as part of a divorce settlement. The most common method of dealing with this issue is to provide for the automatic offer of stock subject to an involuntary transfer to the company and/or the remaining stockholders immediately before an involuntary transfer would otherwise take effect.
Although there is no downside risk to inclusion of such a clause in a buy-sell agreement, there unfortunately is no way to ensure that a bankruptcy court will uphold such a provision. Furthermore, depending on state law, a spouse may be able to take the position that a restriction on involuntary transfers is not effective unless the restriction complies with applicable statutes governing marital or premarital agreements. Such statutes generally require fair and reasonable disclosure of the assets or financial obligations of the other party (the shareholder-spouse in this case) prior to the spouse’s consenting to the marital or premarital agreement.
Practitioners can use two tools to reduce the possibility that a restriction on involuntary transfer will be held unenforceable. First, the spouse of each shareholder can execute a spousal consent as part of the buy-sell agreement. The consent would confirm that the spouse has read and agrees to the terms of the agreement, including the methodology for determining valuation of the shares in the event of an involuntary transfer. Second, the buy-sell agreement can provide a fair and reasonable method for determining the price used in the event of an involuntary transfer.
Termination of employment or retirement. It is a good idea to document the restrictions that apply to stock held by a stockholder who is terminating employment, whether due to retirement or some other reason. Most business owners do not want a stockholder who has terminated employment or retires to retain his or her shares. The build-up of cash surrender value in certain life insurance policies or money saved and placed in escrow can provide funds to buy all or a certain portion of a terminated stockholder’s shares. The balance of the purchase price can be paid pursuant to the terms of a promissory note. If funding is not assured, the purchaser (i.e., either the corporation or the remaining stockholders) can have the option but not obligation to acquire the shares. It may also be prudent to provide that the purchase price in the event of termination “for cause” is less than the purchase price that would otherwise have applied.
Disability. The parties may want to address–separately from other reasons for termination of employment–the disposition of shares if a stockholder has to terminate employment as a result of disability. The company or the other stockholders may want to acquire disability insurance to provide funds to buy a stockholder’s shares upon his disability.
Death. Determining what happens when a stockholder dies requires a detailed analysis of the goals of a buy-sell agreement (discussed earlier). If the main goal is restricting the transfer of shares during lifetime and a stockholder’s children are intended participants in the business, then the parties may intend for the decedent’s family to inherit the shares. In such an instance, a prudent drafter will require that the recipient(s) of the shares execute a joinder agreement, acknowledging that the shares are still subject to the terms and restrictions imposed by the original buy-sell agreement. If locking in the value of the shares for estate tax purposes or providing a market for the shares at a stockholder’s death is a goal, the buy-sell agreement can require the purchaser to purchase shares owned by a deceased stockholder. Insurance is frequently used to fund a mandatory buy-out.
How to determine the price of the shares?
One of the most important issues in drafting a buy-sell agreement is determining the purchase price.
Book value. Book value allocates the aggregate stockholders’ equity as reflected on the corporation’s balance sheet to the stock being valued. Although book value is easy to compute, it probably does not accurately reflect fair market value because it fails to account for current values and many intangible assets, such as goodwill. Book value also may not establish the value of shares for estate tax purposes in buy-sell agreements, especially between related parties.
Adjusted book value. Adjusted book value is basically computed as book value with certain adjustments that are appropriate to cause book value to approximate fair market value more accurately. Although using adjusted book value is probably more accurate than using unadjusted book value and the method is relatively quick and inexpensive to implement, adjusted book value still does not account for certain assets that are difficult to quantify, such as goodwill.
Formula approach. Stockholders using a formula typically apply a multiple to either earnings or net income for the preceding year. For instance, if companies in an industry typically sell for three times revenue and if revenue for the preceding year is $1 million, the formula would result in a value of $3 million. It is hoped that the multiple will account for all or a portion of goodwill or other intangible assets and result in a more accurate valuation than book value or adjusted book value.
There are two problems in using a formula as the sole factor for determining valuation. First, formulas can quickly become outdated. A multiple of three times revenue may be appropriate when the agreement is drafted, but if the multiple used in the industry changes to two times revenue, the purchasing stockholders and/or company may overpay for the shares. Second, it often is difficult to compare closely held businesses and, therefore, hard to derive an accurate formula based on the results of other companies.
Agreed value. Shareholders using an agreed value approach commit to devising an initial value by agreement and then updating the value, preferably once per year. The use of an agreed value may be appropriate for any type of corporation, assuming that the shareholders are somewhat sophisticated or at least have knowledgeable professional advisors to assist them in making an annual determination of value. I sometimes recommend that clients retain a qualified business appraiser to help determine the initial valuation and provide pointers as to how to update the value each year. I also specify in detail in the buy-sell agreement which factors the shareholders can consider each year.
The advantage of using agreed value is flexibility and low cost. Shareholders can use a formula combined with other factors that are viewed as important. The formula can also be changed from time to time. The disadvantage of using a formula is that some shareholders forget to agree upon an annual valuation. When using agreed value, it is prudent to provide for a fallback provision such as a formula, adjusted book value, or another mechanism in the event that the agreed value is not updated in a timely manner.
Appraisal. For more certain results, the shareholders can periodically use the services of a qualified business appraiser. Business appraisals are not necessarily expensive and can result in the most accurate valuation. Business appraisers will often provide routine updates to the appraisal for only a portion of the fee charged for the initial valuation. The disadvantage of using an appraisal is the perception that the cost will be high. Clients already paying attorneys and life insurance companies to implement a buy-sell agreement sometimes balk at the thought of paying additional fees to an appraiser.
How will the purchasers pay for the stock?
The last issue to be discussed here is how the purchasers will pay for the stock that is being purchased. If insurance proceeds are available, those proceeds (less any taxes due upon receipt of the proceeds) are usually used as a down payment. If the value of the shares exceeds the proceeds, the remaining amount due can be paid pursuant to a promissory note. Interest should be paid on the note, or the IRS will impute interest under Section 7872.
As this article demonstrates, drafting a buy-sell agreement is not a four- or five-hour exercise involving the manipulation of boilerplate language. The issues and tax traps of drafting a buy-sell agreement are difficult to navigate. This article has briefly touched on some of the key concerns; others remain lurking.
This Article appears in the July 2002 edition of Estate Planning as “Planning for the Transfer of a Successful Closely Held Business” 29 Estate Planning 335, July 2002.
See Estate of True, Jr., TCM 2001-167.
See Estate of True, supra note 2; Estate of Gloeckner, 152 F.3d 208, 82 AFTR2d 98-5748 (CA-2, 1998); and Estate of Lauder, TCM 1992-736.
See Informal Senate Report, 136 Cong. Rec. S15683 (10/18/90) (“The bill does not otherwise alter the requirements for giving weight to a buy-sell agreement. For example, it leaves intact present law rules …”).
See Section 302(b).
See Section 1014.
See new Section 1022.
See Ltr. Rul. 7734048.
Rev. Proc. 2001-3, 2001-1 IRB 111.