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Buy-sell agreement with a twist.

There is little doubt that good business planning includes planning for the death of the business's owners. A well-structured buysell agreement is often important to the planning process. But how the buy-sell is structured can have a major impact on the seller's estate tax.

There are two basic types of buy-sell agreements. The more typical arrangement is a redemption, in which the corporation buys the stock from the shareholder's estate at a price determined by the buy-sell documents. In nonfamily situations, to be honored by the IRS, the price must reflect the stock's fair market value {FMV) at the time of the agreement and must be binding on the parties during lifetime and at death. At the same time, a significant amount of flexibility exists.

Such arrangements are generally funded by insurance, with the corporation named as the insured and paying all the premiums. While a redemption has the advantage of simplicity, it is not without problems.

[] Any build-up of cash value in the policy is subject to the claims of corporate creditors.

[] The life insurance proceeds may cause the corporation to be subject to the alternative minimum tax.

[] The value of the stock may be increased by its proportionate share of insurance proceeds.

To avoid these pitfalls, many corporations are switching to the second type of buy-sell agreement-the cross-purchase agreement. In this arrangement, the corporation is not a party to the agreement at all. Instead, each shareholder agrees to buy a proportionate share of each other's stock in the event of a shareholder's death.

Cross-purchase agreements are not simple. For example, a corporation with five shareholders would need 20 separate insurance policies to accomplish their goals. leach shareholder needs four policies.) But this method does eliminate the problems identified with redemptions.

One of the most difficult aspects of the buy-sell agreement is determining a way to value the stock that reflects its true worth. Remember, when the buy-sell agreement is drafted, the parties do not know who among them will be the buyers and who will be the sellers. Assuming an arm'slength relationship {special rules under Chapter 14 may apply to related parties) and a methodology that clearly reflects FMV, a formula stated in a buy-sell agreement should suffice to fix the stock's FMV for estate tax purposes.

One company went a step beyond just fixing the value in the buy-sell agreement. In Mitchell, 37 BTA 1 {1938), the price was negotiated after the death of a shareholder and the estate tax value was reduced by the amount of insurance proceeds owned personally by the decedent. Facts of the case

en and Mitchell each owned 50% of a corporation. They agreed in a cross-purchase buy-sell arrangement to purchase the other's stock at a price determined by mutual agreement on either's death. The cross-purchase was funded in part by $200,000 of insurance on each of them owned by the insured and payable to his estate. Each shareholder paid one-half of the total premiums on the policies. When Mitchell died, his estate negotiated with Lennen and agreed on a value of approximately $300,000 for the stock.

Up to this point, this situation is very typical. However, the Lennen & Mitchell buy-sell agreement obligated the estate to apply the insurance proceeds I$200,0001 to the sales price of the stock. In other words, Mitchell's estate received $100,000 from Lennen and $9,00,000 from the insurance policy as total payment for stock worth $300,000.

Predictably, the IRS asserted that Mitchell's gross estate included $200,000 of life insurance the policy was payable to his estate and he had the right to change beneficiaries) and $300,000 of stock {the arm's-length negotiated sales price), while the estate argued that the stock was only worth $100,000 {the actual cash received from Lennen). The Board of Tax Appeals agreed with the estate. The stock owned was subject to a binding agreement that limited the stock's value to $100,000, the excess of the negotiated value over the amount of insurance proceeds.


As well as things turned out for the Mitchell estate, they could have turned out better. Suppose Mitchell did not retain any rights to the insurance policy and did not have proceeds payable to his estate. The following is a possible planning technique.

An insurance trust is established to own life insurance on a shareholder's life; the trust retains all rights and incidents of ownership and the insurance proceeds are payable to the trust. A crosspurchase buy-sell agreement binds the shareholder's estate to sell the stock at a formula price reduced by the proceeds of insurance held by the trust, even though not payable to the estate. The result should be a reduced stock value for estate purposes and the insurance proceeds should not be includible in the estate. This greatly increases the decedent's after-tax proceeds while reducing the survivor's obligation. In addition, a properly worded agreement can be self-adjusting, so that if the buyout occurs during lifetime, the full FMV is paid and no shareholder receives a windfall.

From Valerie C. Robbins, CPA, Beers & Cutler, Washington, D.C.
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Robbins, Valerie C.
Publication:The Tax Adviser
Date:Aug 1, 1992
Previous Article:Amortization of life estates and term interests.
Next Article:Assets includible in a transferor's estate.

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