Buy-sell agreements and estate planning.

For owners of a closely held corporation, a buy-sell agreement may be the most basic and the most important element in their estate planning arrangements. Such an agreement, can help avoid many of the problems that may arise when one of the shareholders dies.

DEFINITION

Basically, a buy-sell agreement is a contract, either between a closely held corporation and its shareholders, or among the shareholders themselves, to buy and sell stock at a predetermined price when a specified event occurs, such as the death of a shareholder.

These agreements provide several advantages for the parties involved:

1. They assure a continuity of ownership and management by keeping the stock in the hands of those active in the corporation's business and out of the hands of relatives and other outsiders who may not be so interested.

2. They prevent problems in the sale of a deceased shareholder's interest. By designating a purchaser for what may be unmarketable stock (or stock that may not have an easily determined value), they help assure hquidity.

3. They help with stock ownership problems. Some regulated corporations (such as professional corporations) are limited as to who may be shareholders, and S corporations are limited as to types and number of owners.

4. Most important, if properly structured, these agreements can fix the stock's value for estate tax purposes, providing some much-needed certainty.

SETTING A VALUE

In general, for estate tax purposes, the value of property will be determined, at the owner's death, without regard to any restriction on the right to sell or use it. There is an exception, however, that will allow establishment of an estate tax value for closely held stock, if certain requirements are contained in the contract:

1. The agreement must obligate the estate to sell the stock on the shareholder's death. This obligation, either by a mandatory purchase or an option held by the business or the surviving shareholders, must be binding on the part of the estate.

2. The agreement must fix the price of the shares or must contain a formula or method for determining it. This price must have been arrived at according to some reasonable valuation technique and must bear some relationship to the business value.

3. The agreement must operate at all times, not just on the shareholder's death. The shareholder cannot dispose of company stock during his or her life without first offering it to the other parties at no more than the specified agreement price (for example, a right of first refusal). In other words, the parties obligated to buy the stock at death (whether the corporation or the other shareholders) must also have the opportunity to purchase the shareholder's stock while he or she is alive, before it is offered to outsiders.

4. The agreement must be a good faith business arrangement and must have a valid business purpose. Keeping a business within a family or maintaining existing management control may be legitimate purposes.

5. The agreement cannot be a device to transfer property to members of the decedent's family for less than full and adequate consideration. This requirement will be satisfied if the price under the agreement is equal to the interest's fair market value when the agreement is made.

This requirement also will be considered met if more than 50% of the value of the stock is owned by individuals who are not members of the transferor's family and who are subject to the same restrictions as the decedent.

6. The terms of the agreement must be comparable to similar arrangements entered into by others length transactions.

FAILURE TO SET VALUE

If a buy-sell agreement does not meet the tests of this exception, the Internal Revenue Service may disregard it when determining the stock's value for estate tax purposes. The estate could then find itself in a no-win situation. Since presumably the buy-sell agreement would still be valid and enforceable, the estate would receive a certain amount for the deceased shareholder's stock. If the Internal Revenue Service determined that the appropriate value for this stock was higher, the estate would then be taxed at the higher value, while receiving the lower amount.

For a discussion of buy-sell agreements and other current developments, see the Tax Clinic, edited by Alan Witt, in the October 1995 issue of The Tax Adviser

Editor's Note

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.