Substantial modifications of buy-sell agreements.

Buy-sell agreements or business continuation agreements are popular vehicles in a closely held business as a means of ensuring family control or continuity of management, or to provide liquidity in the event of a shareholder's untimely demise. In addition, buy-sell agreements may be used to establish the value of a business interest for estate tax purposes. In the past, some of these agreements have set artificially low values in an attempt to reduce estate and/or gift taxes. In response, Congress enacted Chapter 14 of the Internal Revenue Code, specifically Sec. 2703, in an attempt to reduce the perceived abuses of buy-sell and option agreements. The general rule of Sec. 2703(a) is that such agreements to acquire or use property at a price less than fair market value will be ignored for purposes of estate and gift tax. Only those agreements that meet the strict standards of Sec. 2703(b) will be upheld.

Buy-sell agreements entered into before Oct. 8, 1990 (the enactment date of Chapter 14) are exempt from the general rule of Sec. 2703(a). However, if these grandfathered agreements are "substantially modified" after Oct. 8, 1990, they will lose their exempt status. Under the regulations, a "substantial modification" is any discretionary modification of a right or restriction, whether or not authorized by the terms of the agreement, that results in other than a de minimis change to the quality, value or timing of the rights of any party with respect to the property subject to the right. For example, an addition of a family member to an agreement is a substantial modification, unless the addition is mandatory under the agreement or the added family member is assigned to a generation no lower than the lowest generation occupied by individuals already a party to the agreement (Regs. Sec. 25.2703-1 (c)).

In Letter Ruling 9620017, the Service dealt with two modifications to a pre-Oct. 8, 1990 agreement,in one situation finding the modification not substantial and in the other finding a substantial modification.

In the first situation, new shares were to be issued to new and existing shareholders not related to the majority shareholder. The shares were issued in consideration of services rendered to the corporation in the ordinary course of business. The newly issued shares were subject to the terms of the buy-sell agreement; when one of the shareholders left, his shares were purchased under the mandatory clause in the agreement. Under the circumstances, the IRS found that these changes (i.e., issuing shares to new and existing shareholders) did not constitute a substantial modification of the agreement.

However, in the second situation, under the same buy-sell agreement, the majority shareholder proposed to transfer shares to trusts for the benefit of his children. The shares would no longer be subject to the terms of the shareholder agreement. The other shareholders would consent to this transfer. The Service found this proposed transaction was a substantial modification, since it would result in a change in the quality, value and timing of the rights of the parties to the agreement. In addition, the transferee family members would be in a generation lower than the lowest generation under the agreements. As a result, this proposed modification would be substantial, and would result in the agreement losing its exempt status as a pre-Oct. 8, 1990 agreement.

Taxpayers who have buy-sell agreements that predate Oct. 8,1990 should exercise caution in either making changes to the agreements or issuing shares that might be construed as substantial modifications under the regulations. In close cases, taxpayers should consider a ruling request.

From Boyd D. Hudson, J.D., Martin & Hudson, Pasadena, Cal. (Not a DFK Affiliate)