Buy-sell agreements often play a crucial role in the succession of family businesses. It's therefore essential to structure and fund them properly — and to understand how they can help fix estate tax values.

The stakes are high for the business-owning family. When the controlling shareholder of a family business dies, is disabled or retired, it's often a time of great upheaval and uncertainty. Such transitions, if not adequately planned, can lead to the business's being unnecessarily liquidated or sold to an unrelated third party. The very fabric of the family can be destroyed, as a family's self-image is many times inextricably tied to its business.

For the practitioner, the challenge is great. Business succession planning for family business owners is perhaps the most complicated area of estate planning because it crosses several disciplines. Good planning requires a working knowledge not only of all of the tools in the estate planner's toolbox, but also corporate, partnership and limited liability company law as well as the income tax issues relating to each. Throw in the need to understand psychology and to be as persuasive as Clarence Darrow to get the business owner to decide to actually go through with the estate plan and it all adds up to a field that many estate planners would prefer to ignore.

But we can't ignore such a large and vibrant segment of our economy and one that needs our skills desperately. It's also a growth area for practices. Statistically, family businesses account for more than half of the nation's employment and half of our Gross National Product.1 It's estimated that over the next several years, more than 40 percent of family business will change leadership.2 About 80 percent of family business owners would like the business to stay in the family.3 We practitioners can help make this dream come true.

Buy-Sell Agreements

Successful business succession planning can take years, even decades, to complete. There has to be a starting point. A good place to begin is by creating a buy-sell agreement.

A buy-sell agreement is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder's interest, either by the other existing shareholders or by the business itself (or some combination of the two), upon the occurrence of certain events described in the agreement (the so-called “triggering events.”) Such triggering events typically include the death, disability, retirement, withdrawal or termination of employment, bankruptcy and sometimes even the divorce, of a shareholder. Buy-sell agreements are appropriate for all types of business entities, including C corporations, S corporations, partnerships and limited liability companies (LLCs). A buy-sell agreement does not have to be a standalone agreement, because buy-sell provisions can be incorporated into the entity's other organizational documents. In fact, it is typical to find there are already buy-sell provisions in existing organizational documents and these provisions may not reflect the family's desires but were merely part of a standard package of documents provided by the family's business lawyer. These existing provisions may need to be amended or overridden by a standalone buy-sell agreement if the family's business succession plan is to be effective.

The buy-sell agreement's primary objective is to provide for the stability and continuity of the family business in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer of ownership to unwanted third parties by setting forth how, and to whom, shares may be transferred. The agreements also usually provide a mechanism for determining the sale price for the shares and how the purchase will be funded.

Other reasons for a buy-sell agreement depend on the party to the agreement:

  • The founder — For someone who's built the business from nothing and feels no one can run it as well as he can, a buy-sell agreement allows him to maintain control while providing for a smooth transition to his chosen successors upon his death or disability. Structuring a buy-sell agreement provides a non-threatening forum for the founder to begin thinking about which children should be managing the business in the future and which should not. Typically, a founder will want only those children who are active in the business to own a controlling interest in the stock, but will want to treat all children equally in terms of inheritance. A buy-sell agreement allows the founder to sell control to children who are active in the business and use the proceeds from the sale to provide for the children who are not. By specifically carrying out the founder's intent, a properly structured buy-sell agreement avoids the inevitable disputes between the two sets of children with their competing interests. If the founder becomes disabled or retires, a buy-sell can provide him with the security that his cash flow won't disappear, as the agreement can provide for the corporation and/or the other shareholders to purchase the shares, at a predetermined price, either in a lump sum or installments, typically at preferable capital gains rates. Sometimes disability insurance is purchased to provide cash flow should a shareholder become disabled.

  • The next generation — For those children who're active in the business, a properly structured buy-sell agreement will allow them to purchase the founder's shares over time on terms that have been negotiated at arm's length, will not cripple their ability to operate the business, and may have been at least partially paid by life insurance. The agreement also provides a mechanism for not having to go into business with siblings (and spouses of siblings) who are not active in the business. (See “Peace in the Sandbox,” p. 42.)

  • The business — A buy-sell agreement can help keep the business in the family and ensure a smooth transition to the next generation. The agreement also can void transfers that would result in the termination of the entity's S corp. or partnership status.

  • The founder's estate — A buy-sell can provide: (1) a market for an illiquid asset avoiding a fire sale because the sale price is determined by the agreement; (2) liquidity to pay any estate taxes; (3) money for a surviving spouse; and (4) sometimes even a reduction in share values for federal estate tax purposes.

Structure

It's essential to consider a variety of factors when structuring a buy-sell agreement for a family business. First, understand that each family business is unique and that a buy-sell agreement cannot be mere boilerplate. Really. What works for one family can be disaster for another. A buy-sell agreement must be tailored to such factors as:

  • Is the business a C corp., S corp., LLC or partnership?

  • What is the proper way to value this type of business: by fixed amount, formula, appraisal or some other method?

  • Do non-family members own shares and will family members be given preference?

  • Are the owners young and healthy enough to qualify for life and/or disability insurance?

  • Should the business or the other shareholders purchase the shares?

  • Which family members should be allowed to become owners?

  • How will the terms of the buy-sell agreement impact provisions in the business' other organizational documents or loan agreements?

  • Other than insurance, what sources of liquidity are available to fund the purchase of shares?

  • Which of the many triggering events (such as death, disability or retirement) will be included in the agreement and which will require a mandatory purchase by the business and/or the other shareholders as opposed to a right of first refusal?

Choose the Right Type

There are three different types of buy-sell agreements:

  1. a cross-purchase;
  2. a redemption; and
  3. a hybrid.

In a cross-purchase agreement, the remaining shareholders are required to buy, or given a right of first refusal over, the shares of the deceased or withdrawing shareholder. In a redemption agreement, the business itself is required or given an option to buy the shares. In a hybrid agreement, the business typically has the first opportunity to purchase the shares. Any shares the business doesn't buy must be purchased by, or optioned to, the other shareholders.

Clearly, the choice of which type to use depends on who'll be the buyer. And how does that get decided? Here are some critical factors:

  1. Life insurance — One of the most important factors is whether life insurance will partially or fully fund the purchase. If it will and there are multiple shareholders, a cross-purchase agreement may not be appropriate. The reason: unless a partnership is used to own the insurance, a typical cross-purchase agreement requires each shareholder to own a policy on every other shareholder.

    For example, if there were four shareholders, there would need to be 12 policies, as each shareholder would need to own separate policies on the other three shareholders. Six shareholders would require 30 policies. With a redemption agreement, there would need to be only one policy on each shareholder, because the business is the only purchaser. But be careful: If the business is a C corp. and a redemption agreement is used, the corporate alternative minimum tax may apply, making taxable 75 percent of the otherwise non-taxable life insurance proceeds.

  2. Ability to pay and income tax — Can the corporation or shareholders afford the purchase? This question of course prompts the corollary: What will the income taxes be? The taxes depend on the nature of the entity. For example, if the family business is a C corp., the attribution rules under Internal Revenue Code Section 318 (attributing shares owned by certain family members, estates, trusts and businesses to other family members) may result in the redemption not qualifying for capital gains treatment under IRC Section 302(b) and therefore being treated as a dividend. (This is not currently a problem because capital gain and dividend rates are both 15 percent.) A cross-purchase agreement always will be considered a capital gain transaction. If the business is an S corp. or a partnership, a redemption agreement would not result in ordinary income, so it's important to note that the nature of the entity can result in different income tax consequences depending on the type of buy-sell agreement chosen.

Set the Price

One of the most important things a buy-sell agreement does is set the purchase price for an otherwise illiquid asset. This decision about price is determined at a time when each owner is negotiating from a position of strength, because no one knows to whom the terms of the agreement will apply first.

There are several ways in which the agreement can set the purchase price.

A common way to proceed is to have the owners periodically agree to a price. The main concern here is that the owners fail to meet regularly. Therefore, the price does not reflect current values.

A second approach is to set the purchase price by a formula that takes into consideration such factors as book value and multiples of earnings. It's a good idea to use a valuation expert if a formula clause is used.

Another common method is to require that the purchase price be determined by an independent appraisal of value as of the date of the triggering event.

Fix Estate Tax Values?

Perhaps the most complicated issue in buy-sell planning is the extent to which the Internal Revenue Service will respect for estate tax purposes the price the agreement sets for the business. The government's concern is that in the family business context the price set forth in the agreement does not reflect true fair market value (FMV), because using an artificially low valuation would benefit the family by minimizing the estate tax. Because family businesses represent such a large percentage of wealth in the United States, both Congress and the IRS are concerned about a significant loss of estate tax revenue if families are allowed to fix the value of the business for estate tax purposes using a buy-sell agreement. As a result, a complex body of case law and statutory responses developed in the last 80 years. The bottom line: If you don't use the actual FMV in a family business buy-sell agreement, it's unlikely you'll get the IRS to respect the value. And, although the value set forth in the agreement is not necessarily binding on the IRS, it will be contractually binding on the parties to the agreement — potentially causing a disaster.

For example: let's assume that Dad agrees to sell the business to his daughter Sally for $100, as set forth in a buy-sell agreement. Dad dies and Sally pays his estate the $100. The IRS does not respect the agreement price and sets the value of the business at $300 for estate tax purposes. Dad's estate owes $135 in estate taxes ($300 × 45 percent) but is contractually only entitled to $100. Such a result, which is not uncommon, could have a devastating impact on the family and lead to a possible malpractice suit against the estate planner. It's therefore extremely important to have an understanding of both the statutory and common law concepts involved in determining when a buy-sell agreement price will be respected for estate tax purposes — and when it will not.

Until about 50 years ago, the courts typically would respect the price set in a buy-sell agreement for establishing estate tax values. As long as the agreement was binding on the shareholders during life and at death and it was legally enforceable, the agreement price would be respected even if it was significantly lower than the FMV. In 1958, the IRS issued regulations under IRC Section 2031 meant to curb perceived valuation abuses. Treasury Regulations Section 20.2031-1(b) defines FMV as the price a willing buyer would pay a willing seller for the property, both with reasonable knowledge of the relevant facts and neither being under a compulsion to buy or sell. The regulations under IRC Section 2031 concede that the restrictions in a buy-sell agreement impact the value of closely held business interests. However, according to Treas. Regs. Section 20.2031-2(h), the price set in the agreement will be disregarded in determining value for estate tax purposes unless it's determined under the circumstances of the particular case that the agreement represents a bona fide business arrangement and not a device to pass the decedent's shares to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth. Courts have elaborated upon the regulations and established a four-part test that, if satisfied (at least until the enactment of IRC Section 2703 in 1990), meant the IRS would respect the agreement price for estate tax purposes. The four requirements are:

  1. The agreement sets a fixed price for the shares or one that is determinable by an ascertainable formula.
  2. The agreement is binding both during the deceased owner's lifetime as well as at his death. This requirement is satisfied as long as the deceased shareholder's estate is required to sell, even though the other parties are not required to purchase the shares but instead only have a right of first refusal.
  3. The agreement prohibits lifetime transfers at a price higher than the agreement price. Gratuitous transfers during life are permissible as long as the donees become subject to the restrictions of the buy-sell agreement.
  4. The arrangement is a bona fide business arrangement and not a device to pass the business interests to the natural objects of the decedent's bounty for less than adequate consideration.

Historically, courts considered the fourth requirement to be satisfied as long as the price set in the agreement reflected FMV at the time the agreement was entered into, not at the date of the shareholder's death. In Randolph v. United States,4 which dealt with a buy-sell agreement predating IRC Section 2703, the district court rejected the IRS' position that FMV should be determined as of the shareholder's date of death, holding that the price set in the agreement should be evaluated based on the facts in existence on the date the agreement was executed. So for agreements executed before IRC Section 2703 was enacted in 1990, the price in the agreement would be valid for estate tax purposes, as long as the agreement met the four-part test of the regulations under IRC Section 2031. This was so even if the agreement price was substantially lower than the actual FMV. For example, in Estate of Hall v. Commissioner,5 the Tax Court accepted the agreement price of a pre-1990 agreement that satisfied the four-part test even though the FMV at the shareholder's death without the restrictions was more than $170 million higher.

Section 2703

The IRS and Congress grew increasingly frustrated with this taxpayer-friendly arrangement. On Oct. 8, 1990, the federal lawmakers enacted IRC Section 2703 to curb the perceived valuation abuses. This section applies to all buy-sell agreements entered into after Oct. 8, 1990, as well as to those entered into before Oct. 8, 1990, but substantially modified after that date. For family businesses, Section 2703 effectively ends the ability of buy-sell agreements to artificially depress the value of the business for estate tax purposes. Section 2703 is to be applied in addition to and in conjunction with, not in lieu of, the traditional four-part test for determining whether a buy-sell agreement will be respected for estate tax purposes. The section expands the four-part test, by breaking the fourth into two requirements and adding a third.

Now, under Section 2703(a), the estate tax value of property is determined without regard to:

  1. any option, agreement or other right to acquire or use the property at a price that is less than the property's FMV (without regard to such option, restriction or right); or

  2. any restriction on the right to sell or use such property.

This means that the general rule under Section 2703 is that the restrictions on price in a buy-sell agreement or similar provision of any other document will be disregarded in determining the estate tax value of the property. Section 2703(b) provides that such option, agreement, right or restriction will not be disregarded for estate tax valuation purposes if all three of these requirements are met:

  1. The option, restriction or agreement is a bona fide business arrangement.

  2. The option, restriction or agreement is not a device to transfer such property to members of the decedent's family (expanded to the “natural objects of the transferor's bounty” in the corresponding regulations) for less than full and adequate consideration in money or money's worth.

  3. The terms of the option, restriction or agreement are comparable to similar arrangements entered into by persons in an arm's length transaction.

These first two requirements divide the requirements of the fourth requirement of the traditional test into two parts because, not only must the option, restriction or agreement be part of a “bone fide business arrangement” but also such option, restriction or agreement must not be merely a “device” to transfer such property to the natural objects of the deceased owners bounty for less than full and adequate consideration.

The third requirement is entirely new and undermines completely buy-sell agreements' ability to reduce a family business's values below FMV for estate tax purposes. Section 2703(b) requires that, to be binding for estate tax purposes, the terms of the option, restriction or agreement must be “comparable to similar arrangements entered into by persons in an arm's length transaction.” Treas. Regs. Section 25.2703(1)(b)(4) provides that a right or restriction is treated as comparable to similar arrangements entered by person's in an arm's length transaction if the right or restriction could have been obtained in a fair bargain negotiated among unrelated parties in the same business dealing at arm's length. In determining whether a right or restriction meets the “fair bargain” requirement, the regulations require consideration of such factors as:

  1. the agreement's expected term;
  2. the property's current FMV;
  3. anticipated changes in value during the term of the arrangement; and
  4. the adequacy of any consideration given in exchange for the rights granted.

Now, the only way to truly know what the interest in the family business will be worth for estate tax purposes is to wait for a final determination from the IRS.

Some commentators, including us, believe it's best to base the purchase price in the agreement on one or more appraisals at the owner's death by independent valuation experts using valuation standards that would satisfy the comparability requirements of Section 2703(b). This approach has the highest probability of winning the IRS' respect. If the estate planner and/or the family are concerned that the IRS won't honor the appraisals, the buy-sell agreement can include an adjustment clause that would kick into effect if the IRS valuation was different from the appraisal valuation, adjusting the purchase price under the buy-sell agreement to reflect the final valuation as agreed upon with the IRS for estate tax purposes.

There is one notable exception to the Section 2703 requirements: When more than 50 percent of the value of the property subject to the agreement is owned directly or indirectly by individuals who aren't the object of the transferor's bounty.

Funding

Proper funding of a buy-sell agreement is crucial to its success. The primary funding alternatives are:

  1. insurance;
  2. an installment note;
  3. a sinking fund; and
  4. some combination of the first three alternatives.

Life insurance is an extremely common and effective funding choice. Whether owned by the business in a redemption agreement or by the other shareholders in a cross-purchase agreement, it provides the purchasers with the ability to guarantee a certain amount of money will be there when the owner dies — as long as premiums are paid. The type of life insurance typically purchased in the family business context is some form of permanent insurance (such as whole life, universal life or variable life) rather than term insurance, which gets more expensive as the insured ages and may not be able to be renewed beyond a certain age (usually between 60 and 70 years of age.)

There are downsides in certain circumstances to using life insurance in this manner. As mentioned, if a cross-purchase agreement is chosen and there are more than two shareholders, each shareholder will need to purchase a life insurance policy on every other shareholder (unless a partnership is established to own the insurance.) In addition, although life insurance proceeds are typically income tax free, if a C corp. uses life insurance to fund a redemption agreement, 75 percent of the life insurance proceeds will be subject to the corporate alternative minimum tax if the corporation has gross receipts in excess of $7.5 million. Perhaps the biggest concern is the possibility that the insurance proceeds will be included in the valuation of the business for estate tax purposes. That worry was somewhat mollified by a recent federal appeals court ruling: The U.S. Court of Appeals for the Eleventh Circuit in Estate of Blount v. Comm'r6 recently overturned a Tax Court finding that insurance proceeds should be included in the valuation of the business, holding that the proceeds were offset by the corresponding obligation of the corporation to pay the amounts to the decedent's estate pursuant to the buy-sell agreement and therefore should not be included in the estate tax valuation.

Life insurance also doesn't solve the problem of transferring the business while the founder is still alive and is disabled or simply wants to retire. If disability is the triggering event, disability insurance could be purchased to satisfy the obligation. With retirement, the cash value of the life insurance could be used to satisfy a portion of the payout.

The second most common funding alternative is to use an installment note that qualifies for capital gains deferral under IRC Section 453. An installment note is sometimes used in lieu of, and sometimes in addition to, life insurance funding (for example, “any amounts not satisfied by the life insurance will be paid pursuant to an installment note.”) Structuring the installment note is like structuring any other kind of promissory note. You need to choose a term, which typically runs between 10 and 20 years. A commercially reasonable interest rate based on what lending institutions would charge can be chosen or the interest rate can be tied to IRC Section 1274(d)'s applicable federal rate (AFR). In the family business context, the AFR should be the floor for the interest rate, as it guarantees that the IRS won't recharacterize a portion of the loan as a taxable gift. In many cases, the buy-sell agreement will require the purchaser to pledge the purchased shares as collateral until the loan is completely paid.

A third, and the least common way to fund the agreement, is to have the corporation create a sinking fund that will accumulate over time for the purpose of funding the buyout.

Coordinate with the Estate Plan

For a buy-sell agreement to have its best chance at success, its terms should be coordinated with the rest of the owner's estate plan. Too often, we see the terms of estate plans and buy-sell agreements actually contradict each other. What a recipe for disaster!

Important issues to consider include:

  1. the choice of fiduciaries (for example, is an independent trustee necessary);
  2. how should the estate tax be apportioned and who will pay any additional tax if the IRS says the buy-sell price is too low; and
  3. how the terms of the buy-sell agreement will impact the estate's ability to take advantage of certain post-mortem planning opportunities, such as qualifying for the election to defer estate taxes under IRC Section 6166.

Finally, the estate-planning attorney needs to notify the parties to the agreement regarding the scope of the legal representation for the buy-sell agreement and inform them that each should consider obtaining his own legal counsel. The lawyer should obtain waivers of any conflict if any party chooses not to obtain separate counsel.

Although buy-sell agreements can no longer artificially depress the family business's value for estate tax purposes, they remain a foundational document in most business succession. Properly structured, these agreements ensure that a business will pass to the intended beneficiaries and minimize the possibility of family discord. The agreement also provides a market for an otherwise illiquid asset and a source of funds to pay any estate taxes that may be due. Start preparing — or reviewing — your business-owning clients' buy-sell agreements as soon as possible.

Endnotes

  1. Pricewaterhouse Coopers 2007/2008 Global Family Business Survey.
  2. Mass Mutual 2007 American Family Business Survey.
  3. Ibid.
  4. Randolph v. United States, 93-1 USTC para. 60,130 (S.D. Ind. 1993).
  5. Estate of Hall v. Commissioner, 92 T.C. 312 (1989).
  6. Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005).

David T. Leibell and Daniel L. Daniels are partners in Wiggin and Dana LLP in Stamford, Conn.

SPOTLIGHT

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