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Buy-sell agreements - a valuable estate planning tool.

At present, the marginal federal estate tax rate imposed upon an estate can run as high as 50%. [1] A critical element in determining a federal estate tax is the value of the decedent's gross estate. The value of such gross estate is the fair market value of items includible in the decedent's estate (pursuant to IRC Section 2033-2044) at the time of the decedent's death, unless the executor of the estate validly elects to utilize the alternate valuation method, in which case the value of the decedent's gross estate will be determined pursuant to IRC Section 2032.

Many estates are able to avoid taxation through utilization of the unified credit and/or marital deduction. Unfortunately, however, a significant number of estates may still be liable for estate taxes. This could arise for example, where there is no surviving spouse and the unified credit (and other credits) remaining at death is inadequate to offset the tentative tax on total transfers included in the computation of the decedent's federal estate tax. Subjection to an estate tax can pose a severe dilemma, particularly where such tax is high and the estate lacks liquidity. To avoid such a situation, it is often desirable to attempt to minimize the value accorded property included in one's estate and establish a market for such property. One valuable technique for meeting these objectives is through a buy-sell agreement. Utilization of a buy-sell agreement is particularly appealing with regard to interests held in a family run business by the decedent, as it not only can provide the estate with liquidity and help to establish the value of items within the decedent's estate but can also prevent the decedent's interest from passing to someone outside of the family group.

Typically buy-sell agreements require the seller to sell an item for a determinable price to a particular buyer who has a responsibility to buy the item upon the occurrence of a designated event, e.g., death. Generally, where a buy-sell agreement is used as an estate planning instrument, it is entered into between family members. When the subject matter of the arrangement is an interest in a business, frequently the business and the interest holder will be parties to the agreement.

Regardless of the parties to the transaction, an examination of case law and Service pronouncements indicates that four factors are of paramount importance in determining if the value set by a buy-sell agreement will be accepted for estate tax purposes:
1) Whether the price is determinable
 under the terms of an agreement;
2) Whether the shareholder must
 sell at the contract price or other
 interest holders must purchase
 the interest at that price;
3) Whether the obligation to sell at
 the contract price is binding upon
 the owner of the interest during
 his(her) lifetime or upon the
 owner's estate at his(her) death;
4) Whether the arrangement is a
 bona fide business arrangement
 and not a device to pass the decedent's
 interest to the natural objects
 of his bounty for less than
 adequate and full consideration. [2]


The sale price of a buy-sell agreement must be determinable in the written agreement. The price may be based upon a formula or stated in a conventional fixed dollar amount. Courts have generally upheld the value set by a buy-sell agreement if the price or formula was reasonable and based upon facts and circumstances existing at the time of the agreement. [3] Caution must be used, however, because if the nature of the item changes drastically after the date of the agreement the value set by the agreement may be disregarded [4] (for example, where the agreement concerns an interest in an entity and the entity's structure or business undergoes substantial change after the agreement is entered into).

Obligation to Sell or Buy

In order for the value (price) set by a buy-sell agreement to be recognized, the agreement must require the decedent's estate to offer the item for sale to a designated party. While typically the designated party is also required to purchase the offered interest for a previously agreed upon price, such is not a requisite for a valid agreement. The courts and regulations make clear that it is the decedent who must be bound to offer an item for sale for the agreed upon price, rather than any potential purchaser. [5] In addition, for the agreement price to be controlling for estate purposes, the decedent's ability to transfer the interest during his (her) lifetime must have been subject to restriction, e.g., a right of first refusal by others, or conditions preventing the transferability of the interest.

Device Test

Buy-sell agreements between related parties arc subject to substantial scrutiny by the Service to determine if such arrangements are merely devices for avoiding gift or estate taxation. Despite numerous attacks made by the Service upon valuation under a device theory, the courts have generally been reluctant to characterize a related party buy-sell agreement as a device. This treatment is illustrated by the recent Tax Court case of hall v. Commissione [6] concerning the value of closely held stock included in the decedent's estate. The decedent, the founder and chairman of the board of Hallmark Cards, Inc., held the stock in Hallmark Cards pursuant to restrictions on transferability and a buy-sell agreement. According to the executor, the restrictions and agreement were entered into by the decedent out of desire to keep ownership of the company solely within his family's hands. The value of the stock included in the decedent's gross estate was based upon the stock's adjusted book value (the sales price as set by the buy-sell agreement). The Service contended that such value was extremely low, giving rise to an alleged estate tax deficiency of $201,776,276.84 and that the agreement was merely an estate planning device. The court ruled in favor of the taxpayer, suggesting that the desire to keep the business within the family was a bona fide business purpose and that the value as set by the estate was the most reliable measure of value.

Income Tax Considerations

Buy-sell agreements concerning property in a decedent's estate have significance not only for estate tax purposes, but for income tax purposes as well. Where the sales price set by such an agreement is considered determinative of estate valuation, there will generally be no income recognized by the estate as a result of the sale because the value of the property included in the gross estate serves as the basis of such property to the estate. Thus, when the property is sold for an amount equal to such value (basis) no recognized gain or loss is produced. Concurrently, the purchaser of such property will obtain a cost basis in it.

Special income tax problems can arise, however, from a buy-sell agreement where the parties to such are a regular C corporation and its shareholder (decedent), and the subject matter of the agreement is stock within the corporation. Pursuant to IRC Section 302(a), a redemption of corporate stock will generally be treated as a dividend distribution unless falling within the purview of a Code provision which accords the redemption sale or exchange treatment.
 The following Code provisions enable
acquisition of sale or exchange
treatment in this regard:
1) Section 302(b)(1), which pertains
 to redemptions which are
 not essentially equivalent to a dividend;
2) Section 302(b)(2), pertaining to
 distributions substantially disproportionate
 with respect to the
3) Section 302(b)(3), concerning
 redemptions which completely
 terminate the shareholder's equity
 interest in the corporation;
4) Section 302(b)(4), concerning
 redemptions of stock held by non-corporate
 shareholders which are
 made in partial liquidation of the
 corporation; and
5) Section 303, pertaining to qualified
 redemptions of a decedent's

Among these provisions, the most useful in garnering sale or exchange treatment are those of Sections 302(b)(2) and 302(b)(3). The other provisions each suffer from some significant shortcoming. Section 302(b)(1) lacks appeal in that it is ambiguous and does not contain any mechanical test for sale or exchange treatment.

Section 302(b)(4) requires the redemption to be made pursuant to a plan of partial liquidation within either the year such plan was adopted or the succeeding year. In addition, such redemption must generally result in a contraction of the corporation's business. Thus, obtaining sale or exchange treatment under Section 302(b)(4) is often difficult or undesirable for a taxpayer because it may well be beyond the taxpayer's control (e.g., the need for a plan) or signify a reduction in potential business activity. This second problem is a most important drawback for buy-sell arrangements, as often the objective of the arrangement is retention of continuity and control of the business by family members.

Section 303 is of limited benefit because the amount which qualifies for sale or exchange treatment on a Section 303 redemption is limited to the amount needed to pay death taxes (including estate, inheritance, legacy and succession taxes) and funeral or administration expenses with regard to the decedent shareholder.

In contrast to the redemptions prescribed by Sections 302(b)(1), 302(b)(4) and Section 303, those made under Sections 302(b)(2) and 302(b)(3) are attractive in that they contain mechanical tests (safe harbors), have requirements which are typically within the shareholder's control, and enable the amount realized to qualify as received in sale or exchange of stock without being subject to a necessary limitation.

For a redemption to qualify for sale or exchange treatment under Section 302(b)(2), the following requisites must be satisfied:
1) immediately after the redemption,
 the shareholder must have
 less than 50% of the total combined
 voting power of all classes
 of stock entitled to vote; and
2) The shareholder must have less
 than 80% of each class of stock
 (voting and nonvoting) in which
 he (she) had an interest prior to
 the redemption.

In determining if the criteria of Section 302(b)(2) are satisfied, Section 318 constructive attribution rules are generally applied. [7] In addition to an examination of the impact of constructive attribution upon qualification, it should be noted that according to the regulations a redemption apparently meeting the mechanical tests of Section 302(b)(2) will still fail if such is but part of a series of steps to redeem other shares of outstanding stock and, after all such steps are undergone, the redeeming shareholder does not satisfy the Section 302(b)(2) requisites."

Section 302(b)(3) provides that a redemption will be treated as a sale or exchange if such constitutes a complete redemption of all of the shareholder's stock in the corporation. In determining whether a complete redemption has taken place, Section 318 constructive attribution rules are applicable. The Code, however, will not treat the redeeming shareholder (in a purported Section 302(b)(3) redemption) as owning stock held by members of his (her) family if the elements of Section 302(c) are satisfied. Nevertheless, even if qualifying for such nonattribution, the redeeming shareholder may still be attributed constructive ownership of corporate stock through an entity. Caution must also be exercised by the redeeming shareholder with regard to the nature of consideration received from the corporation in the redemption. If such consideration, e.g., a note or bond, could result in the transferor obtaining an equity interest in the corporation, the redemption may fail Section 302(b)(3) requirements.

To avoid potential subjection to dividend treatment on the redemption of corporate stock, consideration should be given to entering into a buy-sell agreement with someone other than the corporation.

Financing the Purchase

A major problem faced in buy-sell agreements is how to fund the purchase price. One means often used is for the purchaser to take out a life insurance policy on the seller's life. Typically, the party taking out such insurance is also the named beneficiary. Thus, there is no deduction available for payment of the premiums on such policy. In most instances, the beneficiary of the policy will not be subject to an income tax as a result of receiving the insurance proceeds. Where a corporation is the beneficiary, however, potential subjection to tax due to such receipt can arise because of the resulting book-tax difference which has an impact upon the corporation's alternative minimum tax computation. [9]

Utilization of life insurance may also give rise to interesting tax issues when used by a flow-through entity to fund an interest held in it by a decedent. For example, where a life insurance policy is taken out by a partnership on the life of the partner, would the policy be includible in the decedent partner's estate if he is deemed to have sufficient incidents of ownership through the partnership? In Revenue Ruling 83-147, the Service indicated that such policy should indeed be included in the decedent partner's estate. To avoid the possibility of life insurance used to fund a buy-sell agreement producing an undesirable inclusion in a decedent investor's estate, steps should be taken to exclude the decedent partner from any potential beneficial interest in the policy either during life or at death. To do this it may be necessary to make certain adjustments to partnership allocations.

As in the case of a buy-sell agreement of a regular corporation, this potential pitfall can generally be avoided by having other investors, rather than the entity, enter into the buy-sell agreement and take out the policy.

According to the Service, the amount of insurance may also have repercussions upon the treatment accorded a buy-sell agreement. In TAM 8710004, for example, a buy-sell agreement concerning an interest in a family run closely-held corporation was funded by related parties taking out a life insurance policy on the life of a major shareholder. Upon the death of such shareholder, the purchase price set by the agreement was claimed as the value of the stock in the corporation included in his estate. In the Service's view, because the amount of the policy substantially exceeded the purchase price of the stock (which was the purported purpose of the policy), a lack of a bona fide business purpose was deemed to exist, and the price set by the agreement was considered not controlling of the stock value for estate tax purposes.


One method of reducing federal estate taxes while assuring liquidity of an estate is through utilization of a valid buy-sell agreement. When used with regard to an interest in a family run business, such an agreement can also enable control and ownership of the enterprise to remain within the family.

To garner these benefits, buy-sell agreements should be structured so that tax law requirements are satisfied. In addition, to maximize the financial benefits attainable from a buy-sell agreement, care should be taken to assure that the manner and funding of any purchase pursuant to the agreement are made in the most financially advantageous manner.


[1] IRC Section 2001(c).

[2] IRC Section 2031, Reg. Sec. 20.2031-2(h), Estate of Seltzer v. Commissioner TC Memo 1985-519(1985), and Slocum v. US, 256 F. Supp. 753 (S.D. N.Y. 1966).

[3] See Estate of Winkler TC Memo 1989-231 (1989), Estate of Harrison, TC Memo 1987-8 (1987), and Estate of Bischoff, 69 T.C. 32 (1977).

[4] St Louis County Bank v. U.S, 674 F.2d 1207 (8th Cit 1982).

[5]Broderick v. Gore, 224 F.2d 892 (10th Cir. 1955). Note that consideration should be given to providing some consideration to the seller for incurring restrictions on transferability and obligation to sell without there being a commensurate obligation to buy. Citizens Fidelity Bank and Trust Co. v. U. S, 209 F.Supp. 254 (WD. Ky. 1962).

[6] Estate of Hall, 92 T.C. No. 14 (1989). Note that as reflected in Hall, the desire to retain continuity of ownership and management will generally be considered a valid business purpose.

[7] Note attribution from certain parties may be avoided by establishing that bad blood exists between the parties and the unlikelihood of their acting in concert. Robin Haft Trust v. Commissioner, 62 T.C. 145 (1974), rev'd on other grounds 510 F.2d 43 (1st Cir. 1975).

[8] Reg. Sec. 1.302-3(a).

[9] IRC Section 56(f).
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Publication:The National Public Accountant
Date:Feb 1, 1990
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