322 / How is a closely held business interest valued for federal estate tax purposes where there is a purchase agreement?

For purchase agreements entered into after October 8, 1990, or substantially modified after that date, the value of a closely held business interest is to be determined without regard to any purchase agreement exercisable at less than fair market value, determined without regard to the purchase agreement, unless the purchase agreement:

(1)     is a bona fide business arrangement;

(2)     is not a device to transfer property to members of the decedent’s family for less than full or adequate consideration in money or money’s worth; and

(3)     has terms comparable to those entered into by persons in an arm’s length transaction.¹

Whether or not an agreement is subject to IRC Section 2703, case law has established the additional following rules:

(1)     An estate must be obligated to sell at death under either a mandatory purchase agreement or an option held by the business or survivors.

(2)     The price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price.

(3)     The agreement must prohibit an owner from disposing of his or her interest during life without first offering it to the other party or parties at no more than the contract price.

(4)     The price must be fair and adequate when the agreement is made.²

If a business purchase agreement calls for shares to be purchased from an estate with installment purchase notes bearing a rate of interest lower than the market rate at the date of death, an executor may be allowed to discount the value of the shares by the difference between the interest rate called for in the buy-sell agreement and the prevailing rate at the date of death.³

A first-offer agreement, under which survivors have no enforceable right to purchase the business interest and can purchase the interest only if the executor wishes to sell, does not fix the value of the interest for estate tax purposes.⁴

If an agreement is between closely related persons and is merely a scheme for avoiding estate taxes, the price set in the agreement will not control.⁵

A buy-sell agreement is not binding unless it represents a bona fide business agreement and is not testamentary in nature.⁶ An agreement may be found to be a scheme for avoiding estate taxes even where it serves a bona-fide business purpose.⁷

No effect will be given to an option or contract under which a decedent is free to dispose of the interest at any price he or she chooses during life.⁸

On the other hand, an agreement that restricts sale during life, but not at death, will also fail to fix the estate tax value.⁹

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Planning Point: On August 2, 2016, the Treasury Department issued controversial proposed regulations under IRC Section 2701 et seq. and IRC Section 2704. In general, IRC Section 2701 governs valuation of interests transferred between family members, outright or in trust. Note that these were proposals that never became effective. The proposed regulations were eventually withdrawn in accordance with President Trump’s Executive Order 13789.

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