Buy-Sell Agreements.

Impact for Family Corporate and Partnership Interests

The recent case of Estate of H.A. True, Jr. et al v. Commissioner, T.C. Memo 2001-167 (July 6, 2001) examined the role of a buy-sell (buyback) agreement in corporate redemptions among family members, as well as the buy-sell requirements in partnership agreements.

Case Specifics

In particular, the Tax Court considered the following items:

* Does a book value provision control for estate and gift tax purposes (in 1993 and 1994)?

* If it does not, what role do the other provisions of these agreements have on determining value?

* If there is a provision for delay in payment, how should it be treated? And,

* What would determine liability for underpayment penalties? The buyback agreements included not only buyback agreements for corporate stock but also the buyback provisions included in partnership agreements.

Henry True, Jr. died in 1994, and was survived by his wife, children, grandchildren and great-grandchildren. He had worked in the oil and gas business since 1938, and had formed more than 20 companies. These companies were in the oil and gas business, a drilling supplies wholesaler, an environmental cleanup firm, a bank holding company, a number of cattle ranches, and he co-owned a dude ranch with his wife, brother and sister-in-law. They were organized as corporations and partnerships.

The Trues used buy-sell provisions to restrict a related owner's ability to sell outside the True family. Furthermore, these agreements that were in existence for a long time, were adjudicated in a U.S. District Court as controlling in 1971 and 1973, and were used to effect an actual redemption in 1984.

Court's Analysis

The court went to great lengths to analyze when a buyback provision has a business purpose or is testamentary, immaterial of whether a corporation or partnership is involved, since both were at issue here. Following is a summary of the Tax Court's very lengthy--336-page--opinion:

* A buyback provision involving family members has a high standard to meet to qualify as a business purpose agreement rather than a testamentary disposition. In essence, the result controls, not the provision's form.

* If an agreement is found to be testamentary, any provision providing for redemption at less than fair market value will not control for estate or gift tax purposes and will be ignored in the valuation of the interest bequeathed.

* It has been argued that the existence of the buyback agreement would increase the lack of marketability by virtue of its existence (even ignoring the establishment of the price). The court found that if an agreement is found to be testamentary, its existence will be ignored in determining discounts such as lack of marketability or control. Note that the court provided extensive discussions on how it arrived at various lack of marketability and control discounts, which is unusual for the Tax Court, providing some insight into the court's thinking on these discounts.

* A provision that allows payment at some time in the future can be considered a below-market loan with the imputed interest considered a gift.

* Because the estate had not used a qualified appraiser, relying instead only on the buy-sell agreement, they were liable for underpayment penalties.

* The IRS asserted repeatedly the "swing vote" concept in which the block at issue could combine with another family member to control. In all cases, the Court ignored the concept.

Lessons Learned

While this is a "Memo" case, several lessons can be learned from it:

* When assisting in setting up, implementing or reporting values based on a buy-sell provision either for a corporation or partnership, the tests provided here can be used as a guide as to whether it is likely to be found to be a business purpose or testamentary agreement.

* Provisions for a buyback at other than FMV involving family members are highly vulnerable. It is essential to obtain a legal opinion if there is doubt whether a particular term would be considered a business purpose or testamentary provision. If there is any doubt, it is clear from this case that a purchase at fair market value at the time of execution should pass muster.

* Be careful of provisions that appear to be innocuous. Providing for an extended decision or payout time is typically found in most agreements. In this case, it generated an unintended gift with serious consequences. It is therefore necessary to be vigilant in considering the ramifications of any and all provisions particularly when family members are involved.

* Values determined by a buyback mechanism should be checked with a qualified appraisal. The estate was liable for extensive penalties because it relied only on the buy-sell agreement and did not rely on independent appraisals or professional guidance, so the Tax Court found that the estate did not exercise ordinary business care and prudence. While such an aggressive position may have some appeal, it is important to be aware of the potential consequences.

* If the IRS attempts to assert the swing vote concept in denying valuation discounts, this case provides an excellent rebuttal to that position.

Joseph Vinso, Ph.D., MCBA, FIBA, ASA is president of Financial Resources Management, Inc., a Palos Verdes appraisal firm and a member of CalCPA's Estate Planning Committee. Committee members can answer your questions at www.calcpaweb.org/estate.