Buy/Sell Agreements
A primary element of any buy/sell agreement is the valuation of the business interest subject to the agreement. Often a formula is provided by the practitioner for inclusion in the agreement. However, only certain formulae will be considered “safe-harbors” for purposes of the estate tax in related-party situations.
Often, the buy/sell agreement will require a practitioner to determine the value for purposes of a buyout of an interest in accordance with specific procedures. In such cases, it is important that the agreement clearly specifies the basis upon which the value is to be determined. Often, when the agreement merely calls for fair market value, disputes arise concerning the application of discounts. It is often wise to include specific provisions for how discounts are to be handled in determining the value under the agreement.
Parties entering into a buy/sell agreement might want to ensure that the value used under the agreement establishes a proper value for estate and gift tax purposes that can withstand a subsequent challenge by the IRS. This, in turn, requires that consideration be given to a number of special rules that affect valuations for estate and gift tax purposes.
Buy/sell agreements are necessary business and estate planning tools. Buy/sell agreements have a number of valuable uses.
IRC Chapter 14 (IRC Section 2703)
The IRC Chapter 14 (IRC Section 2703) valuation rules, applicable to all transfers after October 8, 1990, deal with agreements including buy/sell agreements. IRC Section 2703 applies to any family-owned business in which family members (as defined in IRC Section 2703) control 50 percent or more of the voting control (as defined). Generally, any buy/sell agreement restriction falling under IRC Section 2703 will be ignored for estate or gift purposes unless the agreement satisfies a statutory exception. The statutory exception is met if all three of the following tests are met:
- The agreement rights and restrictions reflect a bona fide business arrangement.
- It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
- Its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction.
Pre-Chapter-14
Given the relatively recent effective date of IRC Section 2703, many older buy/sell agreements are grandfathered under the pre-Chapter-14 law. As long as the agreements are not substantially modified (as defined), the agreements will typically be binding for gift and estate purposes as long as all of the following are met:
- The agreement is binding in life as well as after death.
- The agreement creates a specifically determinable value as of a specifically determinable date.
- The agreement has at least some bona fide business purpose.
- The agreement resulted in a fair market value for the subject business interest when it was originally executed.
Buy/Sell Agreement Valuable Uses
Ensure a smooth and orderly transfer of a business interest upon the owner’s death, disability, or retirement.
Prevent a sale to outsiders (including non-active survivors of the owner and unwanted owners such as competitors), ensuring that control of the business stays with the remaining, usually active, owners.
Create a market for the interest of the transferring owner.
Provide a mechanism for funding the purchase.
Induce a key employee to stay with the business.
Furnish funds to pay estate tax and estate administration expenses.
Prevent transfers of ownership interests through litigation actions such as divorce or bankruptcy.
Determine the amount of insurance necessary to fund a buyout of an owner by the entity or remaining shareholders through the use of a price-setting formula.
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