Buy-sell agreements and transfer tax valuation.

It is common for owners of closely held businesses to restrict the transfer of interests in such businesses through buy-sell agreements, and to rely on such agreements in determining value for estate and gift tax purposes. However, this reliance is often misplaced and may cause severe ramifications.

Sec. 2703(a) provides that the value of property for estate, gift and generation-skipping transfer tax purposes will be determined without regard to (1) any option, agreement or other right to acquire or use the property at a price less than fair market value (FMV), or (2) any restriction on the right to sell or use the property. Sec. 2703(b), however, provides an exception for any option, agreement, right or restriction that meets all of the following requirements:

[] It is a bona fide business arrangement.

[] It is not a device to transfer property to members of the decedent's family for less than full and adequate consideration in money or money's worth.

[] Its terms are comparable to similar arrangements entered into by persons in an arm's-length transaction.

A right or restriction will be regarded as meeting each of these requirements if more than 50% in value of the subject property is owned by individuals who are not members of the transferor's family and who are subject to the same right or restriction (Regs. Sec. 25.2703-1(b)(3)).

Sec. 2703 has an effective date of Oct. 8, 1990; any buy-sell agreement entered into or modified on or after that date will be subject to its provisions. Many commentators feel that Sec. 2703 merely codified existing law and that any buy-sell agreement that does not fall within the stated exception will be disregarded in determining transfer tax value.

A buy-sell agreement among family members that sets a value of less than FMV will almost certainly fail to come within the exception. Since the buy-sell agreement will presumably still be enforceable, an estate could pay a transfer tax on FMV while receiving a lesser amount for the stock or partnership interest. In certain situations, the cash received could be less than the tax on such stock or interest.

Also, if the stock or partnership interest is to pass to a surviving spouse or marital trust, the marital deduction will be limited to the buy-sell price. The excess of FMV over such price will reduce the amount of other assets passing to the credit shelter trust. An unexpected tax could also be produced if the amount of such excess exceeds the decedent's unused credit shelter amount.

The effect of Sec. 2703 must be considered when dealing with closely held business clients with buy-sell agreements currently in effect or under consideration.

From Frank L. Washelesky, CPA, J.D., Ostrow Reisin Berk Abrams, Ltd., Chicago, Ill.