Stock-purchase agreement and insurance proceeds disregarded in valuation of decedent's stock.

A recent Eleventh Circuit decision held that a corporation's fair market value (FMV), not a stock-purchase agreement, was the proper basis for valuation of the shareholder's stock at death. However, it also held that insurance policy proceeds used to purchase the decedent's stock under the agreement should not have been included in computing the company's FMV.

Facts

A and B were the only shareholders of E corporation. In 1981, they entered into a stock-purchase agreement requiring E to purchase the holder's stock on his or her death at a price agreed on by the parties. E purchased insurance policies to ensure that the business could continue operations while fulfilling its commitment to purchase stock under the agreement. The policies would provide roughly $3 million, respectively, for the repurchase of A's and B's stock.

After A's death in 1996, B executed an amendment to the stock-purchase agreement that bound B and E to exchange $4 million for the shares B would own at his death. In 1997, B's estate filed a return declaring $4 million as the shares' value. The IRS filed a deficiency notice.

FMV Exceptions

A taxable estate is generally the FMV of the decedent's property at the date of death; see Secs. 2031(a) and 2033. Regs. Sec. 20.2031-2 defines the FMV calculation. That guidance has been refined by the courts into an exception to the general rule for property subject to a valid buy-sell agreement; see True, 390 F3d 1210 (10th Cir. 2004). This exception has three requirements:

1. The offering price must be fixed and determinable under the agreement;

2. The agreement must be binding on the parties both during life and after death; and

3. The agreement must have been entered into for a bona fide business reason and not as a substitute for a testamentary disposition.

Under the Omnibus Budget Reconciliation Act of 1990 (OBRA), the agreement also must (1) have a bona fide business purpose, (2) not permit a wealth transfer to the natural objects of the decedent's bounty and (3) be comparable to similar arrangements negotiated at arm's length; see Sec. 2703 and Regs. Sec. 25.2703-1(b). The OBRA applies to all agreements created or substantially modified after Oct. 8, 1990.

Binding During Life

To qualify for the exception to the general FMV rule, the restrictive agreement must be binding during the decedent's life; see Regs. Sec. 20.2031-2 (h). Here, the 1981 agreement could only be modified by the "parties thereto." By the time the 1996 agreement was consummated, the only remaining parties were E and B. B owned an 83% interest in E. He was the only person on E's board of directors and was the president of the company. He essentially had the unilateral ability to modify the 1981 agreement during his life. Thus, the court determined that the 1981 agreement did not meet the exception to the general rule, and the shams' value must be determined using FMV under Sec. 2703.

Comparability

The Eleventh Circuit agreed with the Tax Court's determination that the 1981 agreement was substantially modified in 1996, thereby making it subject to OBRA. As an alternative grounds for its decision, the Tax Court examined whether the agreement was comparable to similar arrangements entered into at arm's length under the Sec. 2703(b) OBRA requirements and Regs. Sec. 25.2703-1(b)(4)(i). The court noted that E's witness did not factor anything other than price into his equation of comparability, rejected the conclusion that industry values were comparable and concluded that the agreement price was not sufficiently close to the other experts' determinations, to satisfy the statutory comparability exception.

Insurance

To establish the FMV, the Tax Court blended the analyses of the experts to arrive at a value of $6.75 million. The Eleventh Circuit upheld this determination, but held that the Tax Court erred when it added the insurance proceeds that E would receive on B's death to the company's value, concluding that the value would have been $9.85 million.

In valuing the corporate stock, "consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent that such nonoperating assets have not been taken into account in the determination of net worth" (Regs. Sec. 20.2031-2(f)(2)). However, the limiting phrase, "to the extent that such nonoperating assets have not been taken into account," precludes the inclusion of the insurance proceeds in this case. To the extent that the $3.1 million insurance proceeds cover only a portion of the estate's 83% interest in the $6.75 million company, they are offset dollar-for-dollar by E's obligation to satisfy its contract with the decedent's estate. Thus, the insurance proceeds should not have been included in the computation of the company's FMV.

ESTATE OF GEORGE BLOUNT, 11th Cir., 10/31/05, aff'g in part, rev'g in part TC Memo 2004-116.

David O'Driscoll, J.D., LL.M.