Take-Away: Some buy-sell and redemption agreements that attempt to establish a value or price for stock on the shareholder’s death may not be binding on the IRS for estate tax purposes.

Background: A stock redemption agreement may control the value of stock for estate tax purposes. However, several conditions must be met before such an agreement will be binding for estate tax valuation purposes.

IRC 2703(b): Generally, the fair market value of an interest in an entity is determined without regard to a buy-sell agreement. [IRC 2703(a).] However, the Tax Code also allows such an agreement to control the value if three standards are met under IRC 2703(b):

  1. The arrangement is a bona fide business arrangement;
  2. The arrangement 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; and
  3. The agreement’s terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.

Treasury Regulations: In addition to the conditions imposed under IRC 2703(b), the Regulations under the Tax Code also impose several additional requirements to establish a price that will be binding for federal estate tax purposes. Treasury Regulation 20.2031-2(h) also imposes three additional requirements before a buy-sell agreement will be binding for valuation purposes:

  1. The offering price must be fixed and determinable under the agreement;
  2. The agreement must be legally binding on the parties  both during life and after death; and 
  3. The restrictive agreement must have been entered into for a bona fide business reason and not be a substitute for a testamentary disposition for less than full and adequate consideration.

A recent federal District Court decision demonstrates how these conditions and limitation can thwart a redemption agreement.

Estate of Connelly v. United States, (U.S. District Court, Eastern District of Missouri, Case No. 4:19-c-01410):

Facts: Brothers Mike and Tom owned Crown C. Mike owned 77.18% of the outstanding stock, Tom owned 22.82%. Crown C purchased $3.5 million of life insurance on each of the shareholder’s lives.

The brothers needed into a Stock Purchase Agreement in 2001. The surviving brother had the option to purchase the deceased brother’s interest in Crown C. If that option was not exercised then Crown C was required to redeem the deceased brother’s shares in the corporation. Like many shareholder agreements, the brothers agreed to annually set the price per share at the end of each tax year. If they failed to do so, then the agreement provided that two appraisals would be obtained to set the price under the agreement. Like many shareholders, the brothers failed for all 12 years before Michael’s death to set the value per share.

When Michael died in October, 2013, the life insurance policy on his death was paid to the corporation, since it (not Tom) owned the policies. Tom negotiated an agreement with Michael’s estate and paid to it $3.0 million for his stock, which was redeemed, leaving Tom the sole shareholder of Crown C. No appraisals were obtained, as required by the stock redemption agreement.

Michael’s estate reported a value of $3.1 million for his shares of stock in Crown C on his federal estate tax return. The IRS audited the Form 706 and found that Michael’s shares of stock in Crown C were worth $6.86 million, which amount reflected the net asset value of the corporation’s assets of $3.36 million and the entire death benefit paid to the corporation on Michael’s death of $3.5 million.

Court Decision: The District Court judge found that the Crown C stock redemption agreement failed to satisfy IRC 2703(b).

2703(b): The judge found that the agreement satisfied the bond fide business arrangement condition, but that it failed the not a device to transfer property for less than full and adequate consideration ‘test.’ Important to the judge was that not only did the brothers fail to set the per share value each year as anticipated by the stock redemption agreement, Tom and Michael’s estate did not follow the procedure outlined in the stock redemption agreement that required two appraisals to set the value of the corporation on Michael’s death.

Control Premium: The judge also noted that the ‘negotiated’ purchase price of $3.0 million did not reference the fact that Michael owned 77% of the Crown C stock and thus some ‘control premium’ should have been applied to Michael’s interest in Crown C.

Life Insurance Death Benefit: As noted, the corporation, not Tom, owned the life insurance policy on Michael’s death.

Because there was no ‘cross-purchase’ agreement, which each shareholder owned the life insurance policy on the other’s life, it was appropriate for the IRS to add to the corporate asset value ($3.36 million) the $3.5 million death benefit that was paid to the corporation on Michael’s death.

It reached this conclusion by finding what a ‘willing buyer’ would pay for the company subject to the redemption obligation. “Only by including the insurance proceeds in the fair market value of Crown C to Michael’s shares and Thomas’s shares hold an equal value on the death of Michael’s death.”

The judge found that the corporation’s redemption obligation was not a liability that should reduce the value of the shares in Crown C: “so a redemption obligation does not change the value of the company as a whole before the shares are redeemed.”