BUY-SELL AGREEMENTS
ESTABLISHING A VALUE
FOR A CLOSELY HELD BUSINESS INTEREST
LAKE COUNTY ESTATE PLANNING COUNCIL
BARRY P. SIEGAL
Barry P. Siegal
Stahl Cowen Crowley Addis LLC
55 W. Monroe, Suite 1200
Chicago, IL 60603
312-377-7860
312-423-8178 (fax)
633 Skokie Boulevard
Suite 480
Northbrook, Illinois 60062
Tel: 847-480-4638
Fax: 847-509-9263
bsiegal@stahlcowen.com
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A.
INTRODUCTION
1.
Business Succession Planning is a critical element to the survival of
closely-held businesses. It is estimated that fewer than one-third (1/3rd) of familyowned businesses survive through the second generation and less than ten percent
(10%) through the third. One of the primary reasons for this is inadequate planning
for the owner’s death or retirement.
2.
One of the principal tools which is utilized in insuring the
continuation of the closely-held business in the Shareholders Agreement, in the
case, of a corporation, or the operating agreement, with buy-sell provisions, in the
case of a limited liability company.
3.
Why is the need for a buy-sell agreement as an integral part of a
succession plan so obvious? A buy-sell agreement, if it is openly and intelligently
negotiated provides a framework for determining the manner in which an
ownership interest in a closely held business is transferred to family members or
co-owners in the event of a triggering event. If there is a “buy-in” by all interested
parties, then it will minimize any wrangling or arm twisting upon the occurrence of
a “triggering event.” “Triggering Events” can include death, disability, retirement
or termination of employment of an owner or a proposed voluntary or involuntary
transfer of an ownership interest.
B.
ESTABLISHING A PURCHASE PRICE
1.
Once the parties to the buy-sell agreement agree that some form of
buy-out of an owner’s interest is required, the most difficult issue which they face
is determining the purchase price for the owner’s shares.
2.
Business owners, especially in family-owned business settings have in
the past attempted to use buy-sell agreements as a means of transferring a
controlling interest in the business to younger family members by establishing an
arbitrarily low buy-out price upon the death of the senior family member.
3.
Historically, the purchase price established by a Shareholders
Agreement with respect to the purchase of shares from a deceased Shareholder’s
estate established the market value for Federal Estate Tax purposes if certain
conditions were met.
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a.
If the Agreement restricted the sale of stock during lifetime and
at death and was between unrelated individuals, the agreed
purchase price was normally binding on Internal Revenue
Service. See Broderick v. Gore (55-2 USTC ¶ 11, 555).
b.
Treasury Regulations (§ 20.2031-2(h)) also provide that the
agreement must be a bona fide business arrangement and not a
device for passing the decedent’s shares to the natural object of
his bounty for less than adequate and full consideration.
c.
In St. Louis County Bank v. U.S., (82-1 USTC 13,459) the
shares of a closely held corporation were owned by Mr. Sloan
(265 shares) and his children (201 shares). The agreement
provided for a right of first refusal in the event of a voluntary
lifetime transfer as well as an option to purchase the shares of a
deceased Shareholder at a formula price equal to ten times the
average annual net earnings for the previous five years.
At the date of Mr. Sloan’s death, the average annual net
earnings for the prior five years was $0. The Corporation
exercised its option to repurchase the Shares for $0. Although
the District Court held that the Agreement had a valid business
purpose and provided for a reasonable price, the Court of
Appeals held that under the circumstances presented, including
the health of the testator at the time of the agreement and the
discrepancy between the purchase price and book value, “a
reasonable inference could be drawn that the agreement was
testamentary in nature and a device for the avoidance of estate
taxes.” The decision was, therefore, reversed and remanded.
4.
Applicability of IRC Section 2703.
a.
Purpose of this provision was to prevent a business owner from
creating an artificially low value for estate tax purposes by
providing for a purchase price in the Shareholders Agreement
that was lower than the actual market value.
b.
Section 2703 will apply (and buy-sell value will be disregarded)
unless the agreement:
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(i)
(ii)
(iii)
is a bona fide business arrangement;
is not simply a device to transfer stock to natural objects
of bounty for less than full and adequate consideration;
its terms (including valuation determination) are
comparable to similar arrangements entered into by
persons in an arms-length transaction.
c.
Bona fide business arrangement. To satisfy the “bona fide
business arrangement” test, the arrangement must bear some
nexus to a business and not be motivated simply by estate tax
transfer savings. Courts have held hat maintaining control and
management of the business in the existing owners is a
legitimate business purpose.
d.
Device to transfer business. (i) The second test is related to the
first test and depends on the circumstances surrounding the
execution of the agreement.
Clearly, this test applies
predominately when the parties to the agreement are related and
the purchase price and/or terms of payment for the older parties
shares in the event of death are more favorable than what
unrelated parties might agree upon.
(ii) The lead case on the topic is Estate of Lauder v. Comm. TC
Memo 1992-736(1992). There the decedent, Joseph Lauder,
who along with his wife, Estee Lauder, and founder of the
world famous cosmetic company, was subject to a Shareholders
Agreement which restricted the transfer of shares during
lifetime and required the estate of a deceased Shareholder to
sell his or her shares back to the Company at a price set by a
formula based on book value, with certain adjustments, in
particular the exclusion of any factor for intangibles, including
the company name. When the taxpayer died the estate valued
his shares on the basis of the Agreement which resulted in a
date of death value of $29,000,000. The IRS disagreed on the
basis that the Agreement was not binding and established a
value of $89,500,000. The Tax Court agreed with the Service
and held that the Agreement was a device for transferring the
business to family members at a discount. Critical to the
court’s decision was the fact that the purchase price was arrived
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at without any negotiation (and indeed, by one of Joseph’s sons
without Joseph’s input) and without a formal appraisal.
e.
Comparable to arms length transaction. (i) A right or restriction
is treated as comparable to similar arms-length transactions if
“the right or restriction is one that could have been obtained in a
fair bargain among unrelated parties in the same business
dealing with each other at arms length.” Treas. Reg. §25.27031(b)(4). Whether the agreement is comparable requires
consideration of such factors as the term of the agreement,
market value, and adequacy of any consideration given in
exchange for the rights.
(ii) Perhaps it can be said, where Shareholders are not related,
the terms of a buy-sell agreement can be presumed to constitute
a bona fide business arrangement and to be the result of armslength negotiations, if the methodology for determining the
purchase price is reasonable.
(iii) In Estate of Blount v. Comm. TC Memo, 2004-116 (May
12, 2004) the Tax Court rejected the purchase price established
under a Shareholders Agreement entered into by two brothersin-law, each of whom owned 50% of a closely-held business.
The Agreement provided for a right of first refusal during
lifetime and required a purchase of the shares of a deceased
shareholder at a price set by the Agreement. The decedent
during his lifetime had acquired a controlling interest in the
Company and had along with the Company changed the price
and terms of a redemption at death. The Eleventh Circuit Court
of Appeals affirmed the Tax Court decision in rejecting the
testimony of an independent appraiser since he failed to take
into consideration “non-economic factors that would lead to
truly comparable transactions.”
(iv) In the Estate of Amlie V. Comm, TC Memo 2006-76 (April
17, 2006) the decedent left her estate equally to her daughter
and her two sons, but allocated a certain portion of her stock in
First American Bank Group to a trust established for her son,
Rod. In addition, Rod’s trust was given the right to buy the
balance of the bank stock. The taxpayer became incapacitated
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and in 1991 her conservator entered into a Shareholders
Agreement, prohibiting a lifetime sale to a third party without
offering the shares to the Company. The Agreement also
established: (i) put options so the Shareholder at death at book
value and (ii) call options in the company for one year after
death at the same price. Subsequently, in 1995 the Agreement
was modified and an adjustment to the price was established by
the Court in a Family Settlement Agreement at $118 per share.
However, a subsequent Agreement between Rod’s trust and the
Company obligated the Company to buy the trusts shares for
$217.50 share upon the death of a Shareholder.
Upon the decedent’s death, the estate reported the stock at a
value of 118 per share or $993,000. The shares were, in fact
sold back to the Company for $1,447,000. The balance of the
funds received by Rod’s trust was reported as a capital gain.
The Tax Court held that the 1995 Agreement established the
fair market value for the shares. It stated that it met the
requirements of Section 2703, and in particular, its terms were
comparable to similar arrangements entered into by person’s in
an arms length transaction. Although the estate’s expert merely
pointed to an earlier “arms length” agreement between the
decedent’s conservator and the Bank, the court held that this
was sufficient. It stated that the terms reached in the earlier
agreement was based on a survey of comparables and that the
conservator had sought professional advice from a valuation
specialist.
C.
APPROACHES FOR DETERMINING PURCHASE PRICE.
1.
No one valuation formula is equally appropriate for all businesses.
2.
Appraised Value (as of the triggering event).
a.
This approach may eliminate future disagreement regarding the
methodology the determining value but lacks predictability.
Therefore, it is difficult to prefund the purchase price.
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b.
If this approach is utilized, it is important to carefully set for the
parameters for determining value; i.e.: how many appraisers,
qualifications, what factors to consider, etc.
3.
Periodic Agreed Value.
a.
Under this approach the Shareholders agree on a set price,
either as a result of an independent appraisal or some enunciated
formula, and agree to meet annually to redetermine value of shares.
b.
This approach allows for a meeting of the minds, provided that
parties actually review the value on a periodic basis.
c.
If the parties are related, it is imperative that the basis for the
valuation be set forth in writing.
d.
Main problem is when owners either don’t meet or fail to agree
on a new value. If there is no fall-back position, then most recent
value applies which probably doesn’t reflect the true value of the
Company.
4.
Formula Approach. This is most practical approach if the formula
used is realistic.
a.
Book Value
(i)
Book value per share is determined by dividing the
entity’s net worth (assets less liabilities) into the number
of outstanding shares or units;
(ii)
Book value approach has limited appeal since “book
value” is a historic not actual figure, unless assets are
adjusted to current value (e.g. marketable securities and
real estate should be adjusted to actual value);
(iii)
Book value normally does not take into consideration
good will;
(iv)
Book value is normally not a realistic approach for S
corporations and limited liability companies since
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earnings may be distributed to owners and book value
remain static even with growing company.
b.
5.
Capitalized Earnings or Cash Flow.
(i)
Determined by multiplying the average earnings or cash
flow for a given period by a specified capitalization rate;
(ii)
Adjustments to earnings are necessary for extraordinary
items and excess compensation to owners;
(iii)
Formula is usually based on a weighted average of cash
flow to take into account trend of increased or decreased
earnings;
(iv)
Abnormal or non-recurring items such as changes in
accounting methods, unusual gains or losses, or heavy
retirement plan contributions must be considered.
(v)
The capitalization rate is the most important aspect of
this approach. It is based on the rate of return a
hypothetical investor would expect. Typically, the best
guide to determining a cap rate is the sales price for
comparable companies.
This may be difficult to
determine.
Combination Approach.
a.
one alternative is the last agreed value unless there has been no
agreement for given period of time (e.g.: 12 months), then use last value plus
or minus change in Company’s net worth as fall-back to formula approach.
b.
another possibility is a hybrid of the above methods, such as
book value plus X times average cash flow for the prior five years.
D.
IMPORTANCE OF PERIODIC APPRAISALS.
1.
The owner of a business typically does not have adequate information
to provide realistic value.
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2.
If shareholders are unrelated and they can agree on a valuation
approach, appraisal may not be necessary, although appraisal provides an objective
approach to fixing the purchase price or setting the formula.
3.
realistic.
Appraisal need not be done every year – 3-5 years usually more
4.
Use of periodic appraisal may help satisfy the requirements of Sec
2703(b)(1).
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