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By Lawrence Palaszynski, CPA

Buy/sell agreements are an overlooked or downplayed factor when valuing a closely held business. The primary purposes of these agreements are to 1) provide liquidity and create a market to sell shares, 2) set a price for the shares, and 3) provide for a continuity protecting against unwanted new partners.

A legally enforceable buy/sell agreement may set a price that may not approximate the fair market value of the business. For example common methods and problems include--

* Net Book Value--No relevance to current value of assets and does not consider earnings,

* Adjusted Net Book Value--Adjusts the balance sheet to fair market value however still does not consider earnings,

* Adjusted Net Book Value plus an earnings multiple--Adjusts the balance sheet to fair market value and then adds a multiple of average of earnings or cash flow. This last formula is the most commonly used method due to ease of understanding and apparent concreteness of the factors to be employed.

Everyone agrees that every business is unique yet most use the same basic formulas. But these formulas bring problems with them.

First, they do not allow for earnings trends. For example, a company with annual earnings of $100,000, $50,000, and $0 in consecutive years would be valued the same as a company with the total opposite earnings trend of $0, $50,000, and $100,000. Obviously, the company that has the increasing earnings trend has more value.

Other common problems using formulas include the following:

1. Not taking into account changes in--

* regulation

* the product's market

* technology

* local economic conditions

* covenants and restrictions posed by new bank financing

* changes in tax statutes (sub S to C or LLP)

* the company's ability to borrow

2. Definition of earnings may be disputable--for example when the valuation formula calls for adjusted book value plus five times earnings, does earnings mean--

* before tax or after tax

* tax or book

* cash or accrual

* income before extraordinary items or adjusted for accounting changes (LIFO vs. FIFO, changes in reserves for bad debts)

* earnings before any normalization adjustment? If not, what adjustments should be made for the owners' salaries, rents, interest, and other perks

* using the last ending accounting period before or after the triggering event.

It is sometimes assumed the buy/sell agreement will automatically set value in the estate and gift tax arena. While the agreement may set a legally enforceable price that must be paid by the parties, the tax court may set it aside as a tax avoidance device. For example, a company's buy/sell formula sets an exchange value of $1 million. The tax court deems the buy/sell agreement a tax avoidance device, sets the formula aside and values the interest at $3 million. Two problems then arise; first, the estate does not receive full value for the stock; second, the higher-than-anticipated estate tax paid by the estate on $3 million may cause the beneficiaries to receive much less than planned and possibly not have enough cash to pay the estate tax.

A buy/sell agreement can establish the estate tax value of closely held stock only if it satisfies specific conditions prescribed by Reg. section 20.2031-2(h) and IRC section 2703. The regulation provides that agreements entered into before October 9, 1990, and not substantially modified thereafter will be considered in valuing the decedent's stock for estate tax purposes if both of the following conditions are met:

1. The agreement is a bona fide business arrangement.

2. The agreement is not a device to pass the decedent's shares to the natural heirs for less than adequate consideration.

Modifications that are not substantial include--

1. those required by the agreement.

2. discretionary (does not change rights or ownership) changes such as a change in the company's name.

3. modification of capitalization rates due to specified market interest rate changes.

4. modification to produce a closer approximation to fair market value.

Section 2703 added to the IRC in 1990 as part of the anti-estate freeze provisions of Chapter 14, added a third requirement for certain related parties. It states that the terms must be comparable to similar arrangements reached by persons in an arm's length transaction, a tough thing to prove. This rule seems very open to speculation; however setting a fair market price is obviously the intent.

It may be wise to avoid modifications to an agreement that is grandfathered or was made before October 9, 1990. The old rules without the comparability test are easier to satisfy. However, the Estate of Lauder case suggests that all agreements may fall under the 1990 change.

There are several ways to add support to the position that the buy/sell agreement is a bona fide business arrangement and not a tax avoidance device:

1. Show the parties' intentions in the document itself. For example, courts have found that restrictions on ownership or transfers of stock to maintain a particular ownership or continuity of management are legitimate reasons for entering into a buy/sell agreement. In Rudolph, DC Ind., 2/5/93 the court found where a valid business purpose had been established; the IRS bore the burden of proof that it was testamentary intent.

2. The stock price as well as restrictions must bind both shareholder and the shareholder's estate. Two separate calculations will show the wrong intentions.

3. The agreement may be set aside if it was ignored in the past by the owners. For example, if the stock was sold not at formula prices or was not first offered to the corporation as required by the agreement, the courts may set the agreement aside.

4. Release clauses that release the estate from its obligation to sell if the IRS rejects the agreement's valuation for estate tax purposes may prove fatal.

5. If the agreement was reasonable when it was reached, subsequent events may not invalidate the agreement. However if the original formula, due to changes in economic or operating conditions, is no longer an appropriate means of determining FMV, courts have set the agreement aside citing the parties' failure to provide for a reassessment of the formula.

6. An agreement's intent is highly suspect when it is entered into when one of the parties is in poor health.

7. Another way to rebut the tax avoidance device issue is to show that the decedent's heirs did not benefit from the buy/sell agreement.

8. Factors suggesting arm's length transaction include use of independent counsel, outside appraisers, and evidence of a negotiation process.

Closing Thoughts

Nearly all buy/sell agreements allow for death or retirement as a trigger. But important events to be also considered are disability, divorce, firing of a minority owner, or the personal bankruptcy of an owner; these will affect the buy/sell agreement and related value computations.

It must be noted that not all shareholder agreements that discuss a transaction price are bona fide buy/sell agreements. If the document contains no triggering event such as death, it would not be construed as an enforceable buy/sell agreement in the event of death of the shareholder.

Recently the issue of a contingent liability that triggers a buy/sell agreement has arisen. Two problems can arise. First, as shown previously, the formulas used can provide many buy back prices, thus creating room for argument. Second, does a mandatory company stock buy back have a significant impact on the company's operating cash flow thereby increasing risk to an investor and thus impairing the firm's value?

Buy/sell agreements should be part of every company's initial setup and planning. It is surprising how many companies do not have one. What is even more surprising is the relatively little weight given in planning and monitoring a document that may dictate the company's future. *


By Susan R. Schoenfeld, Esq., CPA

How does a testator make provision for a surviving pet after the decedent's death? This situation can arise in a number of circumstances, although typically, it involves a single person living alone, or a married couple with no children, for whom the animals are the family.

Until recently, New York clients with beloved animals had no legally effective way to make sure their pets would continue to be properly cared for. Usually, the Will would be drafted to provide that the pet would be left to a certain person, together with a sum of money, with a precatory request that the pet be cared for. Or alternatively, a sum of money would be left to a certain person contingent on their agreement to care for the pet. Neither of these provisions was legally enforceable.

New EPTL section 7-6.1 (effective June 1996) permits honorary trusts in New York for the care of a designated domestic or pet animal, enforceable at law. The practice commentary to the statute notes that prior to this new rule, trusts for the benefit of animals were not legally enforceable because a trust must have a beneficiary able to compel enforcement of the trust, and also because the perpetuities period is measured by only human lives. Under the new law, a person is designated to enforce the trust terms. Further, the trust terminates when no living animal is covered by the trust, or after 21 years, whichever comes first, thereby solving the perpetuities objection.

The trust may be set up as an inter-vivos instrument, although typically it would appear in the pet owner's Will. The trust should name and describe the animal to be benefited by the trust and describe the intended use of the income and principal for the pet's benefit. Unless expressly permitted in the trust document, the trustee may not use trust funds for any purpose other than the benefit of the covered animal.

Upon termination of the trust, whether upon death of the covered animal or the passage of 21 years, any unexpended trust property would pass as directed in the trust instrument or, in the absence of direction, to the estate of the grantor.

A testator should not use this new provision as an opportunity to grossly overfund a pet trust. If a court determines that the amount of property in the trust substantially exceeds the amount necessary for the stated purpose of caring for the animal, it may reduce the principal of the trust. The excess would pass as unexpended trust property as directed in the trust instrument, otherwise, to the grantor's estate.

The testator should name a trustee to carry out his or her wishes on behalf of the pet. Ideally, the testator should discuss his or her plans for the pet trust with the named trustee, to make sure the intended trustee is willing and able to act in that capacity. The court may appoint a trustee on behalf of the animal if there is no designated trustee willing to act as such. The court is also given discretion to make any other determinations it sees fit to carry out the transferor's intent in providing for the animal.

All seriousness aside, this provision lends itself to some fun questions. Does the trust get an income distribution deduction, and if so, should Fido (or Socks) now file an income tax return to pay tax on the income? Is this trust property referred to as a Qualified "Domestic" Trust? And, would a notarized pawprint be sufficient for the pet to disclaim its interest in the trust? *

Marco Svagna, CPA
Lopez Edwards Frank & Company

Lawrence Foster, CPA
KPMG Peat Marwick LLP

Contributing Editors:
Richard H. Sonet, CPA
Marks Shron & Company LLP

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Eric Kramer,JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

James McEvoy, CPA
Chase Manhattan Bank

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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