Take-Away: With all the discussion these days with regard to the tax benefits of making lifetime gifts, it is important to recognize the role of a restrictive buy-sell or shareholder agreement. However, it is difficult to distinguish between legitimate and artificial restrictions in a closely-held business’ buy-sell agreement to depress values. Legitimate restrictions will reduce the value of the business interest subject to the agreement. Artificial restrictions in a buy-sell agreement will be ignored under the Tax Code. Figuring out which is which is the challenge and can lead to drafting nightmares.

Background: Since 1958, the IRS has identified factors to be considered used to value securities in closely held businesses held in an estate that are subject to an option or contract to purchase. [Treasury Regulation 20.2031-2(h.) Consequently, since that time the evaluation of a buy-sell agreement for tax purposes has required additional scrutiny with regard to: (i) whether the buy-sell agreement fulfilled a bona fide business purpose; and (ii) whether the buy-sell agreement was not some form of testamentary substitute. Accordingly, a buy-sell agreement is just one of many factors that will be considered to determine the fair market value of a closely held business interest. [Revenue Ruling 59-60.] However, even with this guidance and the added scrutiny applied to buy-sell agreements, Congress still felt that buy-sell agreements were often used to intentionally distort transfer tax values, and thus additional rules were needed in order to distinguish between those agreements created for a legitimate business purpose and those buy-sell or restrictive transfer agreements designed to avoid federal transfer taxes.

Chapter 14: Those additional rules appeared in 1990 with the adoption of Chapter 14 to the Internal Revenue Code. Chapter 14 added four new sections to the Tax Code: (i) IRC 2701 applies to transfers of interests in partnerships and corporations; (ii) IRC 2702 applies to transfers of interests in trusts to a member of the transferor’s family where the transferor retains an interest; (iii) IRC 2704 applies to the lapse of voting or liquidation rights; and (iv)  IRC 2703 applies to buy-sell agreements that are created (or substantially modified) after October 8, 1990. IRC 2703 is intended to supplement, not replace, the earlier requirements for a buy-sell agreement to be respected, i.e. the bona fide business purpose and the not-a-testamentary-substitute requirement.

IRC 2703: The general rule created by IRC 2703 is that the value of any property will be determined without regard to any option, agreement, or other right to acquire or use the property at a price that is less than fair market value or any restriction on the right to sell or use such property. [IRC 2703(a).] While the language of the statute refers to a decedent, this general rule also applies for purposes of the federal gift and generations skipping transfer taxes. [Treasury Regulation 25.2703(1)(a)(1).]

Safe Harbor: There is, however, an exception or safe harbor to the general rule that disregards the buy-sell agreement’s restrictions when the taxable value of the business or property interest is determined. [IRC 2703(b).] The general rule, which ignores the impact of a buy-sell agreement’s restrictive terms for valuation purposes, will not apply if the buy-sell agreement’s option, right or restriction meets each of the following three requirements:

  1. Bona Fide Business Arrangement: The agreement is a bona fide business arrangement, codifying the prior common law;
  2. Not A Device: The agreement is not a device to transfer such property interest that is the subject of the agreement to members of the decedent’s family for less than full and adequate consideration, again, codifying the prior common law, although the Regulations refer to nature objects of bounty, not family members; and
  3. Comparable to Similar Arm’s-Length Transactions: The terms of the agreement are comparable to similar arrangements entered into by persons in arms’-length transactions. A new condition or hurdle to overcome.

Each of these three requirements must be independently satisfied for a right or restriction to meet the safe harbor exception of IRC 2703(b).

Non-Family Members: A right or restriction will be considered to meet each of IRC 2703(b)’s three requirements but only if more than half (50+%) of the property or interest that is subject to the right or restriction is owned directly or indirectly by non-family members of the of the transferor. Family members include: the transferor, the transferor’s spouse, ancestors of the transferor and his/her spouse, any lineal descendants of the parents of the transferor and his/her spouse, and any individual who is a natural object of the transferor’s bounty. [Treasury Regulation 25.2703-1(b)(3).]

Requirements for a Buy-Sell Agreement to Establish Federal Estate Tax Value: Taken together IRC 2703(b) means that a stated price that is used in a buy-sell agreement will control for federal transfer tax valuation purposes, but only when:

  1. The price is fixed or determinable from the agreement (pre-2703 law);
  2. The terms of the agreement are binding throughout both life and death (pre-2703 law);
  3. The agreement is a bona fide business arrangement (pre-2703 law);
  4. The agreement is not a testamentary device to pass the decedent’s interest to the natural objects of his or her bounty for less than full and adequate consideration (pre-2703 law); and
  5. The terms of the agreement are comparable to similar arrangements entered into by persons in arm’s-length transactions (IRC 2703(a).]

Bona Fide Business Arrangement: Such a restriction can qualify, for example, if it furthers maintenance of family ownership and control of a business. Estate of Bischoff v. Commissioner, 69 Tax Court 32 (1977.) For the purposes of IRC 2703, ‘family control’ is critically important since IRC 2703(b) targets family controlled businesses. It makes economic sense that a value-maximizing family business could be motivated to contractually mandate sustained family control. Thus, it makes sense that business owners, like shareholders, may be willing to decrease the immediate value of their holdings, through agreement restrictions and buy-sell options, to assure family control of the business. Thus, IRC 2703(b)(1) respects that that business purpose as legitimate. A quick summary of other business purposes that the courts have accepted include: (i) keeping the company or business private; (ii) providing continuity of management; (iii) planning for future liquidity needs of the transferor’s taxable estate on death; and (iv) seeking to mitigate the risks of holding a minority interest in a closely held business.

Impact of Buy-Sell Agreements on Values for Gift Tax: As a general rule, buy-sell agreements do not control value for federal gift tax purposes. In several gift tax cases, the court has noted that the transferring owner, i.e. the donor, is under no immediate obligation to sell the asset. Rather, the donor merely agrees to offer his or her interest to the other owners on stated terms if and when he or she decides to sell or transfer his or her interest. Accordingly, the obligation to sell has not matured in the gift tax setting, and therefore the agreement cannot set a ceiling on the transfer tax value.

  • Ward v. Commissioner, 87 Tax Court 78 (1986): In this case there was a stock purchase agreement that gave other shareholders a right of first refusal at a set price of $2,000 for two years. The Tax Court found the agreement had only minimal effect on the values of the gifts of that stock during the two years, where there was no indication that the donee-children intended to sell the stock before the $2,000 price lapsed. Once the two-year period lapsed, the five shareholders would all have to agree on a new price or have the stock independently appraised. However, because the stock could not be given away without the written consent of the other shareholders, and because the gifted shares would remain subject to the restrictions in the hands of the donee, the value of the stock was depressed, but only to a minor degree.
  • A buy-sell agreement may be a factor to consider in the gift tax value, but it is no dispositive. Resale value is not the only factor a court will consider in the determination of fair market value for federal gift tax purposes. Courts have thus found that gift tax fair market value should include a ‘retention value’ which most buy-sell agreement prices seldom capture.

Safe Harbor Examples: Since 1990 there are only a few decisions with regard to the impact of IRC 2703. In one, Amlie the value of the interest subject to the buy-sell agreement was successfully reduced below its fair market value. In Holman, gifts did not meet the requirements of IRC 2703(b)’s safe harbor, so a restrictive partnership agreement was ignored. More recently, in Kress, the buy-sell agreement did not satisfy all of IRC 2703(b)’s requirements.

  • Amlie, Tax Court Memo 2006-76: Here, the transferor held a substantial minority interest in a privately-held bank. Consequently, the subject interest was passive. The bank merged into another bank. The transferor’s conservator (she was old with cognitive limitations) considered it prudent, as part of his fiduciary duties,  to obtain a fixed-price repurchase guarantee from the acquiring bank. The transferor’s estate argued that the put/call option that had been negotiated provided “a hedge against the risk…in holding a minority interest in a closely held bank.” The Tax Court held that planning for future liquidity needs of the decedent’s estate constituted a bona fide business purpose under IRC 2703(b)(1). The IRS argued that the decedent’s interest in the business was worth $1,489,725. The Tax Court adopted the estate’s valuation of the same interest at $993,757.
  • Holman v. Commissioner, 601 F.3d 763 (8th 2010): This was a different situation when the restrictions or options had no relationship with the management of an actual business. The Holmans moved their publically traded Dell stock into a restrictive partnership, and then gifted partnership interests to their children. The issue was the partnership’s partner-buyout provision for impermissible transfers. The parent general partners could force the purchase of partnership interests from their children trying to sell their interests. The partnership-interest purchase price was far below the value of the underlying Dell stock equity. The benefit of that value discrepancy would accrue to the other children in the partnership. On their gift tax returns the Holmans took steep discounts on the gift tax values reported. Thus, in this context, family business  control rationale had no relevance. The partnership agreement’s restrictions on transfer did nothing to further efficient family management of an enterprise, since there was no enterprise; the judge called the partnership “a mere asset container.” In sum, the partnership agreement’s restrictions were outside the safe harbor of IRC 2703(b) and the judge found that the partnership restrictions constituted a vehicle for below-market transfers to the Holmans’ children..
  • Kress, 382 F.Supp. 3d 820 (DC Wisc. 2019):  The IRS contended that the buy-sell agreement was not a bona fide business arrangement because it did not prevent a dissident family shareholder from causing management discontinuity by failing to maintain confidentiality about the business or by starting a competing business. The District Court judge disagreed. The judge noted that an agreement can be a bona fide business arrangement even if the agreement’s objectives are not fail-proof. However, while the judge found that the Kress’ buy-sell agreement met the business purpose requirement, it did not meet the requirement that the terms must be comparable to agreements between parties to an arms’-length transaction. [IRC 2703(b)(3).]

A Device to Transfer: As noted, in order to qualify for the safe harbor under IRC 2703(b), the option or restriction in question must not be a device to transfer such property for below-market value.  Normally courts will look at objective evidence to determine if there is testamentary intent behind the option or restriction price. A summary of the objective evidence that a court will consider were summarized in Estate of True, 390 F. 3d 1210 (10th Cir. 2004)  where the court listed the following factors: (i) the decedent’s ill health when entering into the agreement; (ii) the lack of negotiations between the parties before executing the agreement; (iii) the lack of (or inconsistent) enforcement of the buy-sell agreement; (iv) the failure to obtain comparables or appraisals to determine the buy-sell agreement’s formula price; (v) the failure to seek professional advice in selecting the formula price; (vi) the lack of provisions in the buy-sell agreement that require periodic review of a stated fixed price; (vii) the exclusion of significant assets from the formula price; and (viii) the acceptance of below-market payment terms for the purchase of the decedent’s interest.  These factors are evaluated at the time the buy-sell agreement was entered, not with the benefit of hindsight.

IRC 2703(a) gives the IRS, when valuing property or interests in closely-held businesses, broad authority to disregard “any option, agreement, or other right to acquire or use” the property, as well as “any restrictions on the right to sell or use such property. The IRS must respect those restrictive agreements only if they qualify for the safe harbor under IRC 2703(b) and all of its conditions. That safe harbor attempts to define and respect legitimate buy-sell agreements and restrictions. The requirements imposed to qualify for the safe harbor however cause some drafting ambiguities that have, over time, created unnecessary complexities to satisfy both requirements of earlier case law and Regulations and the requirements of the now 30-year old IRC 2703(b) safe harbor.

Conclusion: It is possible for a buy-sell agreement to set a value for gift tax, or federal estate tax, purposes below fair market value. However, an improperly structured agreement can produce undesired and unintended results. In a worst-case scenario [one that I litigate decades ago!] the price in the buy-sell agreement does not set the estate tax value, resulting in the estate owing more in estate taxes than it received for the sale of the business interest.