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July 1989

The role of buy/sell agreements in personal planning - part II. (part two of two)

by Arcari, Virginia A.

    Abstract- Personal planning sometimes involves buy/sell agreements. Significant issues to consider include tax considerations and estate freeze limitations. It is believed that planning with buy/sell agreements will protect individuals, and financial planners attempting to work with clients must make sure to be aware of each client's personal goals.

Tax Considerations With a Buy/Sell Agreement

The selling owner (or his or her estate) will be concerned that a transfer of his or her interest pursuant to the Buy/Sell Agreement will be considered a sale for income tax purposes. Although capital gains and ordinary income are presently taxed at the same rates, in the case of a sale resulting in a capital gain, the owner may recover the tax basis on his or her ownership interest on a tax-free basis.

In the case of a business operated in partnership form, treatment as a sale for tax purposes is assured whether the Buy/Sell Agreement is in the form of an Owner Cross-Purchase Agreement or an Entity Redemption Agreement. In the case of a corporate business (including an S Corporation), the transfer pursuant to an Owner Cross-Purchase Agreement should also be considered a sale for tax purposes. In the case of a corporate business and an Entity Redemption Agreement, when the shares are transferred by the qualifying estate to the corporation pursuant to a Sec. 303 Redemption Agreement, it will involve a purchase from an estate of more than the redemption allowance. However, if during his or her lifetime the selling owner sells less than his or her entire ownership interest, or remains involved in the management of the corporate business, or has family members still involved in the business, there is a possibility that instead of sale treatment, the corporate payment would be treated as a dividend. Thus, the owner or the estate could be denied a tax-free return of basis.

With respect to the purchasers, in the case of an Owner Cross-Purchase Agreement, the owners would receive a step-up in the tax basis of their ownership interests equal to the price paid to the selling owner. Businesses operated by an S Corporation or partnership can offer the owners a basis step-up using either an Entity Agreement or an Owner Cross-Purchase Agreement. In the case of a C Corporation, however, the redemption of an owner's interest pursuant to an Entity Redemption Agreement would not permit the remaining owners to step-up the tax basis of their shares. Thus, such owners could ultimately be taxed on the additional value of their increased interest in the corporation.

Estate Freeze Limitations

As described above, one of the objectives of a Buy/Sell Agreement is to fix the value of an owner's interest in the business for estate tax purposes. Because of recent tax law changes, there may be some question as to whether this objective may be accomplished under all circumstances. Until 1987, an estate planning technique known as an "estate freeze" was often used to fix, or freeze, the value of the business owner's interest for estate tax purposes. The estate freeze was typically accomplished by having the owner divide his or her business interest into two separate ownership interests: 1) interest being entitled to all of the future appreciation in value of the business; and 2) interest entitled to the current value plus a large share of the income from the business. By making gifts of the "future appreciation" ownership right, the owner retained only his frozen interest in the current value of the business for inclusion in his taxable estate.

In late 1987, the estate tax provisions of the IRC were amended to prevent estate freezes. The owner's taxable estate is now required to include the value of any property transfer conveying a disproportionately large share of potential appreciation in the owner's business interest if the owner retains a disproportionately large share of the income or rights in the business. However, it was generally accepted that the adoption of the typical Buy/Sell Agreement (i.e., for a corporation with a single class of stock or a general partnership) would not be affected by the new estate tax freeze sanctions, since whatever potential appreciation in the value of the business the owner might have transferred, he or she did not retain any greater right to income from the business. Moreover, the legislative history under the 1987 tax law indicated that the estate tax freeze sanctions were designed only to make certain property includible in the estate and not to affect valuation.

Congress recently enacted TAMRA 1988 which includes several amendments to the new estate tax freeze rules. Among the amendments is the elimination of the requirement that the owner retain a "disproportionately large" share of the income or rights in the business in order for adverse estate tax consequences to result. Thus, the owner's retention of any continuing interest in the business following a transfer of a disproportionately large share of potential appreciation (i.e., the owner who continues to own the business interest even though the provisions of the Buy/Sell Agreement may result in a transfer of the potential appreciation of the owner's interest) would be subject to inclusion in the owner's taxable estate. The new tax law also adds a "safe harbor" indicating that an option or Buy/Sell Agreement with a price equal to fair market value at the time of the triggering event is excluded from the estate tax freeze rules. Thus, a Buy/Sell Agreement with a price determined by reference to an independent appraisal or a bona fide third-party offer at the time of the triggering event should be protected. Similarly, price determinations based upon the criteria generally used by the IRS to value closely-held business interests applied at the time of the triggering event should be permitted. In either case, however, although the existence of the Buy/Sell Agreement with a fair market value price determination may make it possible to avoid costly estate tax valuation disputes with the IRS, the value of the owner's business interest for estate tax purposes would not be less than full fair market value.

It is possible, although not clear from the new tax law or its legislative history, that other Buy/Sell Agreements may survive the amended estate tax freeze rules. These rules do not apply to transfers made to non-family members in exchange for full and adequate consideration in money or money's worth. Arguably, the adoption of an Entity Redemption Agreement or an Owner Cross-Purchase Agreement involving non-family members is supported by adequate consideration because of the reciprocal purchase and sale obligations and the owner's potential right to enjoy a greater interest in the business following the purchase of another owner's interest. For the same reasons, it might be argued that in the typical Buy/Sell Agreement, although an owner may give up a share of the potential appreciation in value of the business, his or her transferred share of appreciation is no greater than the share of potential appreciation he or she retains should another owner's interest be purchased first. In any event, whether or not the use of a Buy/Sell Agreement will fix the estate tax value of an owner's interest in a closely-held business is, at this time, uncertain at best. Future regulations and case law may be required to determine the extent to which Buy/Sell Agreements are affected by the new estate tax freeze rules.

Where an interest in a closely-held business is a substantial portion of an individual's net worth, planning with buy/sell agreements will protect the individual and "the natural objects of his affection." The client's personal goals and the application of professional techniques in this broad area present a challenge to the personal financial planner.

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