Family business owners may wish to exclude outsiders from ownership. A buy-sell agreement is a contract between shareholders or partners which restricts the transfer of closely-held stock in the event of the shareholder’s retirement, death, or receipt of an outside offer. The agreement creates a market for the stock by requiring or (granting an option to) the remaining shareholders or to the corporation to purchase the shares in the event of the specified contingency. The buy-sell agreement may succeed in fixing the value of stock for estate tax purposes. However, because of perceived abuses in the use of buy-sell agreements to freeze values of family businesses, IRC § 2703, discussed below, was enacted.

Either the corporation or the shareholders may be required to purchase the shares. Under a cross-purchase agreement, the remaining shareholders are either obligated or granted an option to purchase the ownership interest of the withdrawing or deceased shareholder. Under a redemption agreement, the entity itself is either obligated or granted an option to purchase that interest. Under a hybrid agreement, the entity has either an option or obligation to purchase, but may assign that obligation to the remaining owners. The cross-purchase agreement is often preferred since it suffers from the least troublesome tax and nontax constraints.

Some income tax considerations  discourage the use of redemption agreements. Since a corporate redemption distribution that fails to meet the requirements of IRC § 302(b) (after the application of attribution rules found in IRC § 318) will be taxed as a dividend to the redeemed shareholder, no recovery of basis will be permitted. By contrast, a sale to another shareholder pursuant to a cross purchase agreement will always result in capital gain. Furthermore, the basis of the shares of remaining shareholders will not be increased as a result of a corporate redemption. Again, by contrast, where a cross-purchase agreement is utilized, each remaining shareholder receives a cost basis in the new shares. (If the shares are expected to be held in the family until death, the basis of the shares themselves is less important.) Basis considerations are not relevant in the context of a redemption by an S Corp or by an LLC — both pass-thru entities — since the remaining shareholders will necessarily receive a basis increase.

Some income tax factors favor redemption agreements. Interest paid by a C corporation to redeem shares will be fully deductible by the corporation. Conversely, interest paid by corporate shareholders under an installment note purchase pursuant to a cross-purchase agreement will constitute investment interest subject to limitations on deductibility. In the case of an LLC and a cross-purchase agreement, interest paid by the owners will be classified as either deductible business interest, investment interest, or passive interest, depending on whether the assets of the entity are used in the conduct of a trade or business, and whether the owner materially participates. Where an LLC itself redeems its shares, the interest deduction and its characterization would pass through to its members.

Local law considerations must also be considered when drafting the agreement. For example, state law may effectively preclude or discourage the use of a redemption agreement, by prohibiting a corporation from redeeming its shares unless sufficient capital surplus or retained earnings exist for the redemption. This problem might be surmounted by including a provision in the redemption agreement requiring shareholders to take action to cause the redemption to satisfy capital requirements under state law. For example, the agreement might require the corporation to increase the capital surplus by reducing stated capital, or to revalue appreciated assets to obtain a more accurate estimate of their FMV.

Financial considerations also impact on which type of buy-sell agreement will be chosen. Loan agreements must be reviewed, since restrictive covenants therein may prohibit an entity from redeeming its own shares. Even if the lending institution is indifferent, the obligation to redeem the interest of the deceased owner may adversely affect the entity’s ability to borrow funds in the future. This problem could in theory be solved by the owners’ becoming personally liable on future loans. However, the owners may be unwilling or unable to undertake such a commitment, with good reason.

The buy-sell agreement must also provide for the purchase or redemption of the shares. Money must be available either to the remaining shareholders or to the corporation to purchase the departing or deceased owner’s shares. Life insurance is sometimes an attractive funding mechanism in testamentary situations because amounts received by beneficiaries are excludable under IRC § 101. Yet life insurance may be cumbersome when many owners are involved, since each owner would be required to purchase a policy on every other owner. Moreover, premium payments for insurance purchased to fund a buy-sell agreement are not deductable either by the corporation or by the shareholders, and must therefore be paid with after-tax dollars, an expensive proposition. Nevertheless, since C corporations may reduce earnings by paying reasonable salaries, it may be feasible for a corporation in a 15% tax bracket to forego the deductibility of the premiums.

Life insurance may fund the agreement in the event of the death of a shareholder. However, other contingencies may trigger obligations under the agreement that cannot be funded with life insurance. For example, the corporation or shareholders may be required to purchase or redeem shares from a retired or disabled shareholder. Disability insurance could be obtained, but it would be quite expensive. In this situation (or as an alternative to the use of insurance in general), the corporation may simply set aside a reserve in order to fund obligations arising under the buy-sell agreement. In that case, tax counsel must ensure that the corporation does not become subject to the accumulated earnings tax under IRC § 531, which would apply if the accumulation were not considered to be for “reasonable needs of the business.” However, a strong argument could be made that funding a buy-sell agreement constitutes a reasonable need.

Estate Tax Considerations

The agreement must formulate the manner in which the purchase price will be determined. Under the fixed price method, the owners would agree to a price after financial statements have been issued on an annual or other basis. The agreement could instead employ book value and adjusted book value to determine price. A third alternative would require appraisal of the business when the interest is sold. Finally, a capitalization of earnings method may be used. Each method of determining price has its own distinct advantages and disadvantages. In addition to determining price, the agreement must also set forth whether the purchase price will be paid in cash or in installments.

To depress the estate tax value of closely held businesses, buy-sell agreements often contained significant rights or restrictions that were never intended to be exercised. Congress sought to stem this perceived abuse by enacting § 2703, under which options, agreements and rights to use or acquire property at less than FMV are ignored in determining estate or gift tax value, as are restrictions on the right to sell or use property. However, § 2703(b) provides an exception for an option, agreement, right or restriction which (i) is a bona fide business arrangement; (ii) is not a “device” to transfer property to family members at less than FMV; and (iii) contains terms which are comparable to those which would have obtained in an arm’s-length transaction. Earlier case law which survived the enactment of §2703 adds that the estate must be obligated to sell the stock at the price determined under the agreement at death, and that the deceased must have been unable to sell the stock during his or her lifetime without first having the right to put (i.e., sell) such stock to the corporation.

A primary tax objective is therefore to come within the statute’s exception. Courts have traditionally found an agreement bona fide if the price determined thereunder was equal to the value of the interest at the time of execution of the agreement. However, since §2703 imposes an independent “device” requirement, the buy-sell agreement must also possess an independent legitimate business purpose. Establishing that the right or restriction was the result of an arm’s length transaction requires, according to legislative history, consideration of factors such as (a) the expected term of the agreement; (b) the current FMV of the property; (c) anticipated changes in value; and (d) the adequacy of consideration.

An agreement which sets the estate tax value at a price established by an independent appraisal at the death of the shareholder would likely withstand IRS challenge, yet it would also provide little in the way of freezing estate tax values. Alternatively, the agreement could require periodic determination of purchase price using a formula. §2703 would appear to require the expertise of a professional business appraiser in establishing that formula.