Using a buy/sell agreement to establish the value of a business interest

 A buy/sell agreement is a contract between the members of an LLC that provides for the sale (or offer to sell) of a member’s interest in the business to the other members or to the LLC when a specified event or events occur. Common events triggering a buy/sell agreement include death, disability, retirement, and divorce. The sales price is determined under a valuation method specified in the agreement. Common valuation methods include a fixed price, an independent appraisal, a formula approach such as a multiple of earnings, or book value.

Establishing the value of an LLC interest prior to a client’s death helps to identify and quantify the liquidity needs of the client’s estate. A properly structured buy/sell agreement can help establish this value. However, if the valuation provisions in a buy/sell agreement are not recognized for estate tax purposes, the estate may face costly valuation disputes with the IRS, as well as potential liquidity problems.

Transferability restrictions

A fundamental purpose of a buy/sell agreement for a family LLC is to restrict the owners’ ability to freely transfer their interests, to avoid unwanted owners. This is usually accomplished by limiting the situations in which an owner can dispose of his or her interest to the identifiable events specified in the agreement. Accordingly, the buy/sell agreement facilitates the creation of a market for the ownership interests at times when an owner may need liquid assets.

When a triggering event occurs, the buy/sell agreement will provide the entity or the other owners with certain requirements or options (e.g., a mandatory obligation to purchase the selling owner’s interest or a right of first refusal), depending on the client’s objectives. In a sense, it establishes an exit strategy for the owners at the inception of the entity, which reduces the potential for conflict later, when a triggering event occurs.

Buy/sell agreements and restrictions on transferability are useful in determining how a member’s interest will be valued for transfer-tax purposes, and the owners will be bound by the terms of the agreement. Possible methods for determining the value of an ownership interest (i.e., purchase/sale price) under a buy/sell agreement include (1) a fixed price per unit; (2) requiring an independent appraisal; or (3) using a formula approach. The authors recommend that the chosen method establish the fair market value (FMV) of the interest at the date of sale, net of any applicable discounts. A fixed price as of the date the agreement is drafted is not appropriate for transfer-tax purposes (Bommer Revocable Trust, T.C. Memo. 1997-380).

Warning:If the IRS determines that the buy/sell agreement is a device to transfer property to family members for less than full and adequate consideration, it can redetermine the value of the transferred interest for gift, estate, and generation-skipping transfer (GST) tax purposes. The IRS may also challenge the value established in a buy/sell agreement when it appears the decedent was attempting to transfer property for less than full consideration (a partial disguised gift) to a nonfamily member (Gloeckner, 152 F.3d 208 (2d Cir. 1998)).

Sec. 2703 requirements: General rule

The value of a closely held business (or other property) is determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the FMV of the property, or any restriction on the right to sell or use the property (Sec. 2703(a)).

Exceptions to general rule

The general rule does not apply if certain requirements are met. Careful adherence to these requirements will allow the buy/sell agreement to be used to value the closely held business for transfer-tax purposes. The general rule does not apply to any option, agreement, right, or restriction that meets all of the following requirements (Sec. 2703(b)):

• It is a bona fide arrangement;
• It is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration; and
• Its terms are comparable to similar arrangements entered into by persons in arm’s-length transactions.

Caution:The unilateral ability to modify a buy/sell agreement renders it ineffective in establishing the value of a business (Estate of Blount, T.C. Memo. 2004-116, aff’d, 428 F.3d 1338 (11th Cir. 2005)). A careful analysis should be performed on any proposed modification to a buy/sell agreement before the change is formally adopted.

An agreement is deemed to satisfy all of these requirements if more than 50% of the value of the property subject to the restriction is owned directly or indirectly by individuals who are not members of the transferor’s family (Regs. Sec. 25.2703-1(b)(3)). This applies only if the interests owned by nonfamily members are subject to the same restrictions as the property owned by the transferor. Members of the transferor’s family include the transferor’s spouse, ancestors of the transferor or the transferor’s spouse, and any other individual who is a natural object of the transferor’s bounty. The statute and regulations do not specify who is a natural object of the transferor’s bounty, making it unclear whether siblings and cousins automatically fall within this definition. (The Second Circuit in Gloeckner held that an individual without a blood or marital relationship is not the natural object of the decedent’s bounty unless their relationship is so close as to appear they were related.) This determination is based on the pertinent facts and circumstances. In general, a long-term personal friend will be treated as an unrelated person.

Example 1. Buy/sell agreement not restricted when nonfamily ownership exceeds ٥٠٪:A, B, and C, three unrelated individuals, each own one-third of D LLC. The three members enter into a buy/sell agreement requiring the remaining two members to buy the interest of a member who retires or dies. The amount paid for the retiring or deceased member’s interest is based on a capitalized earnings formula. A dies and leaves his share of the company to his son, G. Because more than 50% of the LLC is owned by unrelated individuals, all three requirements under the exception of Sec. 2703 are deemed to be satisfied. Accordingly, the LLC’s value can be determined based on the terms of the buy/sell agreement.

Example 2. Buy/sell agreement must satisfy each test when family ownership is 50% or more: Assume the same facts as Example 1, except two of the members are siblings. Now the buy/sell agreement must meet each of the three tests in Sec. 2703(b) for the valuation formula in the agreement to determine the estate tax value of the interest. The agreement (١) must be a bona fide business arrangement; (2) must not be a device to transfer the business to members of the decedent’s family for less than FMV; and (3) must provide terms comparable to arrangements entered into by persons in arm’s-length transactions.

Satisfying the requirements of Sec. 2703(b)Bona fide business arrangement

The statute and regulations are silent as to the specifics of this requirement. It appears the requirement is met if it can be shown that the purpose of the buy/sell agreement is to maintain continuity of management and family control (Estate of Lauder, T.C. Memo. 1992-736). The business reason(s) for executing the agreement should be well documented (e.g., in written correspondence between the practitioner and the client). In addition, the Tax Court has held that planning for future liquidity needs of the decedent’s estate is considered a bona fide purpose (Estate of Amlie, T.C. Memo. 2006-76). However, the Tax Court (affirmed by the Eighth Circuit) held that an entity consisting entirely of marketable securities was not a bona fide business arrangement (Holman, 130 T.C. 170 (2008), aff’d, 601 F.3d 763 (8th Cir. 2010)).

Not a device to transfer property for less than full consideration

This requirement is often referred to as the nondevice test. Its purpose is to ensure the agreement is not simply a device to reduce the estate tax value. The statute and regulations do not provide guidance on this requirement’s specifics. The committee reports suggest only that the client’s desire to maintain family control, standing alone, does not assure the absence of a device to transfer wealth (following the appellate court decisions in St. Louis County Bank, 674 F.2d 1207 (8th Cir. 1982), and Estate of True, T.C. Memo. 2001-167, aff’d, 390 F.3d 1210 (10th Cir. 2004)).

In Estate of Lauder, however, the Tax Court provided insights into how this test is applied. The Tax Court found that a buy/sell agreement was merely a device to reduce estate taxes when (1) testamentary considerations influenced the parties involved, and (2) the formula in the agreement did not reflect full and adequate consideration because it did not set a fair price for the interest. The formula used was an adjusted book value formula, which the court may have found arbitrary in nature. Because the agreement did not pass the nondevice test, the terms of the agreement did not control the estate tax value of the interest.

When involved in drafting a buy/sell agreement, a practitioner should recommend that an independent appraiser be consulted to verify that the valuation method used establishes an FMV for the business interest or other property valued under the agreement. A valuation formula established using the services of an unrelated professional appraiser will be more readily accepted by the IRS than one based on book value or some other arbitrarily determined factor.

Terms are comparable to third-party arrangements

A buy/sell agreement is comparable to similar arm’s-length arrangements if the agreement is one that could have been obtained in a fair bargain among unrelated parties in the same business, dealing with each other at arm’s length (Regs. Sec. 25.2703-1(b)(4)). An agreement is considered a fair bargain if it conforms to the general practice of unrelated parties under negotiated agreements in the same business. Terms that mirror state law default provisions may also be considered comparable or arm’s-length. This requirement creates a standard of commercial reasonableness that did not exist prior to the adoption of Sec. 2703.

Factors to be considered in determining whether the fair-bargain standard is satisfied include:

• The expected term of the agreement;
• The property’s current FMV;
• Anticipated changes in value during the term of the agreement; and
• The adequacy of any consideration given in exchange for the rights granted.

In determining whether the agreement is comparable to third-party arrangements, the agreement must demonstrate that the general business practice of the industry is followed. The following rules determine whether the agreement follows general business practice:

• Isolated comparables are not sufficient to establish general business practices;
• If more than one valuation method is commonly used in a business, the buy/sell agreement will not fail the general business practice requirement merely because it uses only one method;
• It is not necessary that the terms of the buy/sell agreement parallel the terms of any one particular agreement; and
• If comparables are difficult to find because the business is unique, comparables from similar businesses may be used.

Planning tip:Obtain an expert opinion on whether an agreement is comparable to industry standards. The taxpayer bears the burden of proving that an agreement meets this standard.

Warning:If a buy/sell agreement between related parties sets a formula purchase price for a deceased member’s interest, resulting in a value less than that ultimately allowed for estate tax purposes (because the Sec. 2703 requirements were not met), the heirs will receive the lesser amount for their interest, while the estate tax value will be based on the greater amount.

Grandfathered agreements

The Sec. 2703 provisions do not apply to any buy/sell agreement entered into before Oct. 9, 1990, that has not been substantially modified since that date (Regs. Sec. 25.2703-2). The IRS has ruled that changes to the quality, value, or timing of the parties’ rights for pre—Oct. 9, 1990, agreements were de minimis and not considered substantial modifications (IRS Letter Rulings 9652009, 9652010, and 9711017). Clarifying provisions have also been ruled not to be substantial modifications (IRS Letter Ruling 200625011).

Forms of buy/sell agreements

A buy/sell agreement is generally structured in one of two ways — as a cross-purchase agreement or as a redemption agreement.

Cross-purchase agreements

A cross-purchase agreement is an agreement between individual members. In a funded cross-purchase agreement, each member purchases a life insurance policy on the life of every other member. When a member dies, the proceeds of the life insurance policy are paid to the member purchasing the policy. The proceeds are then used to purchase the LLC interest from the estate according to the terms of the cross-purchase agreement. This method can be cumbersome and expensive if there are several members or if there is a wide disparity in the members’ ages or insurability.

One advantage of using a cross-purchase agreement is that the surviving members (purchasers) increase their basis in the LLC by the amount of money paid for the additional interest in the LLC. The reliance on each member’s ability to maintain the financial stability required to make premium payments and protect the policy’s cash value is a significant drawback of cross-purchase arrangements. Another drawback is that the cash surrender value of the policies could be part of a member’s bankruptcy estate if the member declares bankruptcy. This could pose a problem in trying to collect on the policy.

Redemption agreements

A redemption agreement is an agreement between the members and the LLC. These agreements generally provide that when a member dies, the LLC agrees to redeem the decedent’s interest. Redemption agreements can also be used to liquidate a member’s interest in the event of the member’s disability.

Funding a buy/sell agreement

Funding the agreement with life insurance will, when the owner dies, provide the immediate cash needed to purchase the owner’s interest. Often, insurance is the only way that a remaining owner can raise the cash needed to purchase the deceased member’s interest. A buy/sell agreement should be evaluated periodically to ensure the valuation clause and amount of insurance is updated. The agreement should provide that any difference between the FMV of the LLC interest and the amount of insurance can be funded with cash, other assets, or a note payable to the estate.

If life insurance is not available due to the age or health of a member, it is possible to fund the buy/sell agreement entirely with a promissory note payable over an extended period of time. The note should be secured with assets and/or personally guaranteed by the remaining members. This approach reduces or eliminates the cost of carrying insurance, but it also increases the existing members’ risk and negatively affects the entity’s balance sheet.

Tax-related buy/sell provisions

Clients should consider including the following provisions (either in the buy/sell agreement or the LLC’s operating agreement) when considering a buy/sell agreement for LLC members:

• Establish a predetermined valuation methodology or formula;
• Identify the method and source of funding, such as cash, life insurance, or an installment note;
• Require an interim closing of the LLC’s books to allocate items of income and loss to a member that disposes of his or her entire interest in the LLC;
• Require minimum distributions to all members equivalent to the tax payable on each member’s distributive share of LLC income or gain (this provision is particularly beneficial to the LLC’s minority interest holders);
• Require that the LLC consider a Sec. 754 election — however, this election may not be appropriate if the value of the LLC property has decreased (or is likely to decrease in the future); and
• Address when or whether a third-party purchaser can become a member, versus an assignee.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 25th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).