Many family businesses use buy-sell agreements to ensure that control is maintained by the people who are active in managing the company, and to facilitate management continuity, as well as an orderly transition of ownership. Furthermore, buy-sell arrangements can create a private market for valuable, but otherwise unmarketable, shares in the family business, and can create liquidity for surviving family members. The survivors may need cash to pay estate taxes, and may prefer not to retain ownership in a nonpublic company in which they have no active role.
However, the owners and advisers who draft buy-sell agreements often overlook one additional, significant benefit. If the agreement contains certain required provisions, the stated purchase price will be binding on the Internal Revenue Service for federal estate tax purposes.
In this “safe harbor” arrangement, the family can swiftly and economically establish, with certainty, the estate-tax value of family business interests. Once established, this minimizes the guesswork and takes the worry out of figuring how much estate tax will someday be owed.
Five criteria to qualify
To reap these benefits, buy-sell agreements that were entered into prior to October 9, 1990, and that have not subsequently been amended in any material fashion, must meet five requirements. (I’ll address the status of more recently drafted agreements in a moment.)
First, the purchase price in the agreement must be a fixed dollar amount or must be determinable under a fixed formula.
Second, as of the date on which the agreement is entered into, the fixed price or the formula valuation price must equal the stock’s full fair market value. This must be the case even if, at a subsequent date when a shareholder dies, there has developed a substantial disparity between the price under the purchase agreement and fair market value.
Third, either the corporation or any other parties to the agreement must be obliged to purchase (and the shareholder’s estate must be obliged to sell) all of the decedent’s stock, or the corporation (or any other party to the agreement) must have an enforceable option to purchase all of the decedent’s stock.
Fourth, the agreement must be a bona fide business arrangement. If so, it will not be disregarded as merely a device to transfer interest in the family business, below fair market value, to family members.
Finally, the decedent must have been unable during his lifetime to dispose of any of the stock subject to the buy-sell agreement for any amount that is higher than the price that would have applied under the agreement. For example, if under the agreement the family business stock is valued at $1,000 per share, the decedent must have been prohibited from selling any stock to anyone at any time for more than $1,000 per share, without first offering to sell the stock to the other parties in the buy-sell agreement at the same $1,000 per share price.
Requirement for recent agreements
Agreements that were entered into, or substantially modified, on or after October 9, 1990, must meet all of the foregoing requirements. (Pre-existing agreements that do not qualify for the safe harbor can, of course, be amended to meet the requirements.) However, additional requirements under Chapter 14 of the Internal Revenue Code will also apply to such new or modified agreements.
Specifically, even if the agreement constitutes a bona fide business arrangement, the IRS may still challenge the valuation under the agreement, if the agreement is determined to be a device to transfer business interests to family members for less than full and adequate consideration.
Furthermore, the burden rests on the decedent’s estate to demonstrate that the terms of the buy-sell agreement are comparable to similar arrangements entered into by other business owners in arm’s-length transactions.
Two implications arise from the latter requirement. First, it is almost inconceivable that anyone negotiating at arm’s length would ever agree to a buy-sell arrangement establishing a fixed price that remains unchanged despite any alterations (for better or worse) in the income of the business or the value of the business’s assets. Therefore, a formula price must be used.
Second, the parties to the agreement should consult with a qualified business appraiser or investment banker to ensure that any formula is consistent with the practices of other businesses whose owners act at arm’s length in financial transactions.
Family business owners should also weigh heavily two other crucial considerations. First, if the family created a buy-sell agreement prior to October 9, 1990, that has not since been altered in any material fashion—and so is not subject to the more stringent standards of Chapter 14—it is important to consult with competent advisers before altering the agreement. The advisers should either ensure that the alteration does not subject the agreement to Chapter 14 conditions, or confirm that the alteration is so important to the parties that they should voluntarily relinquish protection from Chapter 14.
Second, many sensible owners object, for perfectly good business reasons, to one or more of the requirements needed to qualify for the estate-tax safe harbor. By far the most frequent reservation relates to the prohibition on selling family business interests during a shareholder’s lifetime for more than the formula amount that would be paid upon death. Owners often prefer that stock sales be permitted, subject only to a right of first refusal (exercisable either by the corporation or by other shareholders) to match the amount offered by an outside third party, even if the amount exceeds the price under the buy-sell agreement.
Such owners have decided to venture outside of the safe harbor available under the estate tax law. While such decision are often the result of good judgment, they should be made only with great caution. Once safe harbor protection is unavailable, the shareholder’s family faces the risk that his or her estate will be forced, under the buy-sell contract, to sell stock at the formula price, but that the IRS will assess estate taxes based on a far higher fair market value. In the worst possible case (if fair market value exceeds the formula price by more than 82 percent), the sale proceeds won’t even cover the estate tax bill, leaving no balance for the shareholder’s family.
Michael L. Fay is chairman of the private client department at Hale and Dorr in Boston and heads the law firm’s family business practice (michael.fay@haledorr.com).