Establishing the estate value of stock by using a buy-sell agreement.

Facts: Arthur Freed owns half of Arthur, Inc.; Henry James owns the other half. Henry and Arthur are not related. The value of each owner's stock is $200,000.

Arthur has conducted extensive estate planning during the last year and his assets (net of liabilities secured by or related to the assets) currently include:

Stock in Arthur, Inc.                          $200,000
Farm (special use valuation)                    400,000(*)
Other assets                                    150,000
Total net assets includible in the estate      $750,000

(*) The actual fair market value of the farm is $700,000.

Arthur's only son, Jason, will inherit all of the property when Arthur dies. Jason is not interested in working for the corporation after his father's death, and Henry is afraid Jason will sell the stock to an outside party when he inherits it. Henry has proposed that he and Arthur enter into a buy-sell agreement. Under the terms of the proposed agreement, the stock of the first to die (Arthur or Henry) would be bought from his estate. Henry has proposed the sales price be $200,000 (the stock's current value). Both Arthur and Henry are aware that the value of the stock could increase in the future, although this possibility is considered unlikely.

Arthur wants to establish the current value of his stock as the value to be included in his estate, to avoid having to include any potential appreciation. He has asked his tax adviser whether a buy-sell agreement is an effective way to do this. Issue: Will a buy-sell agreement establish the estate value of the stock?

Analysis

Property generally is valued for estate tax purposes based on its most profitable use. Often the most profitable use of farmland is not farming, especially if the farm is near an urban area. It might be much more profitable to sub-divide the land for construction of homes. Valuation based on that use of the property can result in estate taxes so high the heirs are forced to sell the land rather than continuing farming. By electing special use valuation under Sec. 2032A, an estate can value qualifying property based on its actual (rather than on its most profitable) use.

To qualify for special use valuation, the value of the farm must be at least 50% of the estate's total net assets (i.e., gross assets minus liabilities secured by or related to the assets), and at least 25% of the adjusted gross estate must be qualified real property. Arthur is aware of the special use election and knows, based on current values, the farm is worth at least 50% of his total net assets and at least 25% of his estate will be comprised of qualified real property. Thus, his estate is eligible for the special use valuation.

An asset's estate tax value generally is its fair market value (FMV) at the date of death. This value becomes the basis of the asset in the hands of the estate and its successor, and is used in calculating gain or loss in a subsequent disposition. Thus, the impact of stock's FMV at a shareholder's death can be significant. Determining the FMV of stock in a closely held corporation can prove difficult due to the subjective factors involved. Buy-sell agreements and recapitalizations are used to avoid some of the problems.

Buy-sell agreements are often used to guarantee a shareholder that, on his death, his estate will have a buyer for his stock or to guarantee surviving shareholders they will have first right to purchase the decedent's stock. However, the sales price in a buy-sell agreement does not automatically become the stock's estate value at the shareholder's death. Whether the buy-sell agreement sets the stock's value for estate tax purposes, the agreed-to price generally will be legally enforceable as the sales price. Shareholders should keep this in mind when entering into buy-sell agreements, especially if the value of the stock is expected to increase substantially before the agreed-on sale date.

If a buy-sell agreement sets a non-FMV purchase price for stock or restricts the shareholder's right to sell the stock, Sec. 2703 generally values the stock (for gift, estate and generation-skipping tax purposes) by ignoring the agreement. Sec. 2703 is effective for agreements entered into or substantially modified after Oct. 8, 1990. Regs. Sec. 25.2703-1(c) contains a detailed definition of the term "substantial modification." (The rules for agreements not affected by Sec. 2703 are addressed in Regs. Sec. 20.2031-2(h).)

If a buy-sell agreement is entered into or substantially modified after Oct. 8, 1990, the general rule of Sec. 2703 is avoided if the following requirements are met:

1. The agreement is a bona fide business arrangement.

2. It is not a device to transfer the stock to a family member for less than FMV.

3. The terms of the agreement are comparable to those entered into in arm's-length transactions.

Each of the three requirements must be independently satisfied. Therefore, even if an agreement has a bona fide business purpose, it is still necessary to prove the agreement is not a device to transfer property for less than FMV. However, if an agreement is among persons who are not the natural objects of each others' bounty (i.e., unrelated persons), it is presumed to meet the three tests. Therefore, an agreement between Arthur and Henry should meet the requirements of Sec. 2703, regardless of whether the three tests are actually met.

However, certain requirements must still be satisfied for a price established by a buy-sell agreement to be recognized for estate tax purposes, regardless of whether the agreement is between family members or unrelated parties. The agreement must:

1. Establish a reasonable and determinable price for the interest;

2. Obligate the decedent's estate to offer to sell the interest at the agreement price;

3. Prohibit the lifetime transfer of the interest at a price in excess of the agreement price; and

4. Be a bona fide business arrangement and not a device to transfer the interest to family members for less than adequate consideration.

If a buy-sell agreement in effect at a shareholder's death does not meet these conditions or the exception for unrelated parties, the agreement could do more harm than good. As an example, if the price in a buy-sell agreement is considered unfair (e.g., it is less than FMV), the sale required by the agreement may result in the estate being forced to sell stock at a low price, but paying estate tax on a higher value. In other words, the agreement may be binding on the parties under state law and the estate may be forced by law to sell the stock at the lower price specified in the agreement.

While a buy-sell agreement can help eliminate valuation problems for an estate, the valuation problems associated with determining the sales price to be included in the agreement still exist.

Conclusion

The tax adviser should recommend Arthur execute a buy-sell agreement with Henry, using the current FMV (determined by an appraisal) as the agreement's sales price. This should establish the current value of his stock as the estate value. Arthur should also monitor the value of his other assets to ensure their total value (other than the farm) does not equal or exceed, along with the stock value, 50% of the value of his estate. If the other assets appreciate substantially, Arthur can make gifts of some of the assets so the farm will continue to qualify for special use valuation.