9026 / How does the existence of a buy-sell agreement impact small business valuation?

As discussed in Q 8992 to Q 9007, a buy-sell agreement can function as an important business succession planning tool, as it allows the business owners to plan for the orderly withdrawal of one or more business owners and will specify a predetermined method for determining the price of the business interests. Despite this, IRC Section 2703 provides that the value of any interest must be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to the option, agreement, or other restrictions) or any restriction on the right to sell or use the property (i.e., buy-sell agreement), unless the agreement meets the following requirements:

(1)  It is a bona fide business arrangement;

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

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

Assuming these requirements are met, it is possible that the estate tax value of a business interest (including closely-held stock) may be controlled by the price or formula contained in a buy-sell agreement.

Though the facts of each case must be examined to determine whether the agreement price will be accepted for estate tax purposes,² case law has established that if the following conditions are met, the agreement price will hold, even though the fair market value of the business interest may be substantially more at the valuation date than the agreement price:

(1)  The estate must be obligated to sell at death (under either a mandatory purchase agreement or an option held by the designated purchaser, see Q 8998);

(2)  The agreement must prohibit the owner from disposing of his interest during his lifetime at a price higher than the contract or option price;

(3)  The price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price; and

(4)  The agreement must be an arm’s length business transaction and not a gift. Thus, the purchase price must be fair and adequate at the time the agreement is made, particularly if the parties are closely related.³

Therefore, the price set in a buy-sell agreement was found to control valuation issues in a number of cases involving estate tax valuation where these requirements were satisfied.⁴ For gift tax purposes, however, an agreement restricting lifetime sale will be considered with all other pertinent factors, and may tend to lower the value of the business interest.⁵

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. The IRS has ruled privately that it was relevant that (1) the purchaser was to buy the stock by means of installment payments plus interest over a 30-year period, and (2) the market rate of interest increased substantially from the time of the buy-sell agreement to the time of the decedent’s death. The estate had no right to the payment of interest or principal on the promissory note until each installment came due.⁶

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.⁷

If an agreement is between closely related persons and is found to be merely a scheme for avoiding estate taxes, the price set in the agreement will not control.⁸ A buy-sell agreement is not binding unless it represents a bona fide business agreement and is not testamentary in nature.⁹ An agreement may be found to be a scheme for avoiding estate taxes, however, even if it also serves a bona-fide business purpose.¹⁰

No effect will be given to an option or contract under which a decedent is free to dispose of the interest or shares at any price he or she chooses during life.¹¹

On the other hand, an agreement that restricts sale during life, but not at death, also will fail to fix the estate tax value.¹²