By Marc Newman, Associate Managing Partner,
Anchin, Block & Anchin LLP
It would be wonderful if the future just took care of itself. But in the case of buy-sell agreements, the future depends on what’s done today.
For businesses, an unforeseen event such as the death of an owner can quickly turn into a crisis that could lead to a transfer of ownership.
Businesses with more than one owner need a buy-sell agreement to provide both liquidity and an orderly ownership transition in the face of an owner departure, regardless of whether or not it was expected.
However, it’s not enough to have a buy-sell agreement in place; its provisions related to business value and pricing of shares must also be properly thought out.
There’s a good reason owners turn to professional appraisers to value their businesses for buy-sell agreements.
Shareholders should agree on a valuation firm’s qualifications and independence, so the resulting valuation is likely to be objective. Independent valuation can also help owners avoid legal battles and ensure values stand up well under legal challenge.
There’s no single, surefire method of determining an appropriate value in buy-sell agreements nor is the price necessarily the same in all situations. Owners can set a price in a number of ways.
Most buy-sell agreements specify one or a combination of the following approaches:
• A predetermined formula that refers to book value, capitalized earnings, or other readily identifiable measures,
• Mutual agreement as to the shareholders’ judgment of value, or
• Independent appraisal.
Formula approaches imply that some “black box” exists from which to derive a credible value. But a formula approach is unlikely to enable the buy-sell agreement to both facilitate estate planning and provide liquidity at a fair market value during the owners’ lifetimes.
Similarly, mutual agreement may not be the best price-setting mechanism because owners can be blind to their own self-interests. They tend to think that their co-owners will leave the company first.
Thus, they may agree to a “conservative” buy-sell value with the hope of exercising a purchase option (or obligation) at a favorable price. But of course such a price may understate the value of their shares.
The IRS scrutinizes buy-sell valuations, especially those involving family businesses which lead to disputes that often end up in court.
Valuation is at the heart of most disputes the IRS has with estates that contain substantially close- held business interests. If the IRS determines that fair market value is higher than the amount calculated under a buy-sell agreement, the estate could owe tax on an amount it never received, leaving heirs much less than anticipated.
Under Chapter 14 Internal Revenue Code Section 2703, (addresses the buy-sell agreement in a family setting) the IRS generally accepts the value prescribed by a buy-sell agreement only if:
• It’s a bona fide business arrangement,
• It’s not simply a device to transfer stock to family members for less than full and adequate consideration, and
• Its terms are similar to arrangements entered into by persons in an arm’s-length transaction.
Courts tend to rule that buy-sell agreements establish value for estate tax purposes if:
• The value appears fair and adequate when the parties agree,
• The agreement has a well-defined price-setting mechanism, and
• The agreement obligates an estate to sell.
Courts are also more likely to uphold a value if the agreement effectively limits lifetime sales at more than the agreed price — usually through rights of first refusal granted to co-owners or the company itself.
Failing to clearly define when and how value is to be determined can lead to disputes that may undo the benefit of having a buy-sell agreement.
A poorly thought-out agreement can cause more problems than it solves. For example, owners may overlook or ignore the agreement ultimately leading to disputes.
Fortunately, most of these problems can be avoided by working with experienced advisors to address share price and funding issues.