Not Selling Your Business This Year?
Beginning shortly before the House Ways and Means Committee released its version of the President’s Build Back Better plan, several posts on this blog have explored the uptick in M&A activity as the owners of many closely held businesses have sought to sell them before the effective dates[i] of any new or increased federal income taxes.
In most cases, the individuals disposing of these businesses were already considering – if not yet committed to the timing of – their exit. Their concern over increased taxes,[ii] however, has accelerated the decision to sell for many; increased taxes translate into fewer net proceeds and a lower return on their years of investment.[iii]
Still, there are many other business owners who, for various reasons, have not disposed of their business. For example, some owners may believe their business needs to grow a bit more before it can demand a good price. In other cases, the business may sustain many members of a family; its continued ownership and operation by the family[iv] is more important than realizing the going concern value of the business by selling it and then dividing the proceeds.
Whatever the motivation for not selling, it is important that the owners of the business plan for certain not unlikely events that will require a degree of liquidity for which the business may not otherwise be prepared. For example, the death,[v] disability, or retirement of an owner; the divorce of another; the financial straits faced by yet another.[vi]
In each of these instances, the presence of a shareholders’ or partnership/operating agreement that provides a mechanism for the purchase and sale of at least a portion of an owner’s equity can go a long way toward reconciling an individual owner’s (or an estate’s) needs for liquidity with the preservation of the business and the protection of the other owners. A key consideration in such an agreement – especially in the case of a family-owned business – is the determination of the fair market value of an owner’s equity in the business; others include the mechanisms for providing this liquidity,[vii] and for getting it into the hands of the owner in question.
What follows is a discussion of a recent decision[viii] in which a surviving owner’s attempt at “fixing” the value of a deceased owner’s equity for tax purposes did not end well.
The Buy-Sell Agreement
Decedent and his Brother were the only shareholders in Corp, a closely held family business in which Decedent owned approximately 77 percent of the issued and outstanding shares of Corp stock. The two brothers and Corp signed a Stock Purchase Agreement (the “Agreement”) to maintain family ownership and control over the business and to satisfy certain estate-planning objectives. The Agreement provided that upon the death of one of the brothers, Corp would buy back (redeem) the deceased brother’s shares.
To fund its redemption obligation, Corp purchased $3.5 million in life-insurance policies on both brothers.[ix] The Agreement provided two mechanisms for determining the price at which Corp would redeem the shares. Under the first – which the brothers never followed – the brothers would jointly determine the agreed value per share of Corp stock at the end of every tax year. If they failed to do so, the brothers would determine the value by securing appraisals.
Death of a Shareholder
After Decedent’s death, Corp received $3.5 million in life-insurance proceeds from the policy on Decedent’s life. Corp used a portion of these proceeds to buy Decedent’s shares of Corp stock (the “Shares”) from Decedent’s estate (“Estate”).
In determining the purchase price for the Shares, Corp and Estate did not obtain appraisals for their value, as called for under the Agreement. Instead, they entered a purchase and sale agreement (the “Sale Agreement”) that provided for a price of $3 million. Aside from the life-insurance proceeds, Corp was worth approximately $3.3 million on the date of Decedent’s death; it also had an obligation under the Agreement to redeem Decedent’s Shares.
Brother, who was Estate’s executor, filed an estate-tax return which valued Decedent’s Shares at the $3 million price stated in the Sale Agreement.[x]
The IRS Disagreed
The IRS audited the estate tax return filed by Estate and challenged the $3 million reported as the date of death value for Decedent’s Shares. According to the IRS, the fair market value of Corp should also have included the $3 million in life-insurance proceeds[xi] used to redeem the Shares, thereby increasing their value.
Estate disputed the IRS’s position. It argued that the Agreement determined the value of Corp for estate-tax purposes. In the alternative, Estate argued that Corp’s fair market value did not include the $3 million of the life-insurance proceeds, because the Agreement created an offsetting $3 million obligation for Corp to redeem Decedent’s Shares.[xii]
The IRS argued that the Agreement did not set the value of Corp for purposes of the estate tax because it failed to meet certain statutory, regulatory, and judicially created requirements.[xiii]
The IRS issued a notice of deficiency in which it asserted additional estate tax. Estate paid the tax, following which it filed a claim for refund with the IRS; it subsequently sought a refund in District Court.[xiv]
The Court’s Analysis[xv]
The Court explained that the value of a decedent’s gross estate is the fair market value of the decedent’s property at the date of death. In general, the IRS determines the fair market value of such property without regard to any buy-sell agreement. However, certain buy-sell agreements fall under an exception to this general rule.[xvi]
Value Set by Agreement
According to the Court, a buy-sell agreement must meet three statutory requirements[xvii] if the agreement is to control the value of a decedent’s property for estate-tax purposes:
“(1) [i]t is a bona fide business arrangement[;]
(2) [i]t is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth[; and]
(3) [i]ts terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.”[xviii]
The Court noted that the buy-sell agreement must also meet certain additional, non-statutory requirements:
“(1) the offering price must be fixed and determinable under the agreement;
(2) the agreement must be legally binding on the parties both during life and after death; and
(3) the restrictive agreement must have been entered into for a bona fide business reason and must not be a substitute for a testamentary disposition for less than full-and-adequate consideration.[xix]
The IRS and Estate disputed whether the Agreement satisfied all the requirements necessary to determine the valuation of the Shares for estate-tax purposes. If it didn’t meet all the requirements, then general valuation principles would be applied. Estate urged that the Agreement met the requirements, while the IRS argued that “(1) the price of [Decedent’s] stock is not determinable from the Agreement; (2) the Agreement’s terms were not binding throughout [Decedent’s] life and after his death; (3) the [Agreement] is not a bona fide business arrangement and its terms are not comparable to similar arrangements that have been negotiated at arms’ length; and (4) the [Agreement] is an impermissible substitute for a testamentary disposition [that] transferred . . . wealth to [Decedent’s] family.”
The Court analyzed each of the above-referenced statutory requirements.[xx]
Bona fide business arrangement
The Court determined that the Agreement was a bona fide business arrangement, notwithstanding the shareholders’ disregard of the pricing mechanisms set out in the Agreement, because the brothers entered the Agreement to ensure continued family ownership over Corp and to satisfy certain estate-planning goals.
Device to transfer property to family for less than full-and-adequate consideration
The existence of a bona fide business purpose, alone, the Court stated, “does not exclude the possibility that a buy-sell agreement is a testamentary device.” Indeed, the Court stressed that “intrafamily agreements restricting the transfer of stock in a closely held corporation must be subjected to greater scrutiny than that afforded similar agreements between unrelated parties” to ensure that transactions between family members reflect full-and-adequate consideration and are not a substitute for a testamentary disposition.[xxi]
The IRS argued that the Agreement was such a device to transfer wealth for less than full-and-adequate consideration. The $3 million redemption price, the IRS asserted, was not full-and-adequate consideration because it did not account for the life-insurance proceeds, thus allowing Brother to obtain a financial windfall at Estate’s expense.
The Court concluded that the Estate had failed to show that the Agreement was not a device. It based this conclusion, in part, upon its determination that the $3 million redemption price was not full-and-adequate consideration: the price excluded the life-insurance proceeds from the valuation of Corp, the shareholders failed to obtain an outside appraisal or seek professional advice on setting the redemption price, and the shareholders disregarded the appraisal requirement in the Agreement.[xxii]
Comparability to similar arrangements
The IRS argued that the Agreement was not comparable to similar arrangements negotiated at arms’ length because Brother and Estate did not account for the insurance proceeds in the valuation of Decedent’s Shares and because the Agreement itself undervalued Decedent’s majority interest. The IRS claimed that an unrelated majority shareholder operating at arm’s length would not have allowed Corp to create a windfall for a minority shareholder at the expense of the majority shareholder’s estate.
The Court explained that a contractual restriction is treated as comparable to similar agreements if it “could have been obtained in a fair bargain among unrelated parties . . . dealing with each other at arm’s length.”[xxiii]
To show comparability, the Court continued, Estate had to produce evidence “that the terms of an agreement providing for the acquisition or sale of property for less than fair market value are similar to those found in similar agreements entered into by unrelated parties at arm’s length in similar businesses.”
Estate claimed the Agreement was comparable to similar arrangements negotiated at arm’s length simply because the $3 million redemption price was equal to what Estate claimed was the fair market value of Decedent’s Shares.[xxiv]
The Court concluded that Estate did not show the Agreement was comparable to similar agreements negotiated at arm’s length. The Court included the life-insurance proceeds in the fair market value of Corp and of Decedent’s Shares. It also observed that the Agreement’s prohibition of control premiums or minority discounts resulted in an undervalued majority interest for the Shares.[xxv]
Fixed and determinable offering price
The IRS contended that the price of the Shares was not fixed and determinable under the Agreement because Brother and Estate ignored the Agreement’s pricing mechanisms and came up with a valuation of their own.
The Agreement required the shareholders to establish the price-per-share every year; but in the 12 years the Agreement was in place before Decedent’s death, they never agreed on a value. Under the Agreement, their failure to do so triggered the obligation to obtain an appraised value. However, Brother and Estate did not follow that process; instead, they chose to come up with their own ad hoc valuation of $3 million.[xxvi]
The Court found that Corp’s share price was not “fixed and determinable” from the Agreement. The $3 million redemption price set forth in the Sale Agreement did not come from any formula or other provisions in the Agreement, thereby rendering Estate’s proposed share price, for estate-tax-valuation purposes, neither fixed nor determinable from the Agreement.[xxvii]
Binding during life and after death
The IRS next argued that the Stock Agreement’s terms were not binding throughout Decedent’s life and after his death because, as described above, Brother and Estate ignored their obligations under the Agreement.
Estate argued that it negotiated a fair redemption price for the Shares, based on the stipulation with the IRS affirming the $3.1 million valuation for Corp. But this was not relevant to whether the Agreement bound the parties. The supposed fairness of the price did not mitigate the failure to follow the pricing mechanism in the Agreement. Brother and Estate did not consider the Agreement to bind their behavior after Decedent’s death, so the Agreement could not control the value of Decedent’s Shares for estate-tax purposes.[xxviii]
Based on the foregoing, the Court concluded that the Agreement did not establish Corp’s or the Shares’ value for estate-tax purposes.
The Court Determines FMV
Having decided that the Stock Agreement did not control the value of Decedent’s Shares, the Court turned next to determining such value itself.
Fair market value, the Court stated, is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[xxix]
The Court explained that, in valuing the equity of a closely-held business for which no market exists, courts consider factors such as “the company’s net worth, prospective earning power and dividend-paying capacity, and other relevant factors.”[xxx] This valuation, the Court continued, includes the proceeds of life-insurance policies owned by the corporation: “consideration shall also be given to nonoperating assets, including proceeds of life-insurance policies payable to or for the benefit of the company, to the extent that such nonoperating assets have not been taken into account in the determination of net worth.”
The IRS claimed that those proceeds should have been included in Corp’s value, resulting in a $6.86 million fair market value. Estate urged that the fair market value of Corp did not include the $3 million in life-insurance proceeds at issue because those proceeds “were off-set dollar for dollar by the obligation to redeem [Decedent’s] shares” under the Stock Agreement.
The Court agreed with the IRS. Under the willing-buyer-willing-seller principle, it stated, a redemption obligation does not reduce the value of a company as a whole or the value of the shares being redeemed.[xxxi]
The owners of a closely-held business must appreciate that a carefully drafted agreement among its owners and/or the business can have a significant impact upon the valuation of the business for gift-and-estate-tax purposes.
However, they must also recognize that, to achieve this result, they are required to forfeit some degree of flexibility.
The purpose of such an agreement is to establish the “market value” for the business and for the owners’ respective interests in the business. The agreement achieves this result by, in effect, creating the relevant market.[xxxii] Thus, as indicated above, the price for the purchase and sale must be determinable by the terms of the agreement; the agreement must have a bona fide business purpose, it must be binding for all transfers and be comparable to similar agreements between unrelated parties.
If these requirements can be satisfied, the owners of the business should be able to better control their gift-and-estate-tax exposure. In turn, they can determine the most appropriate mechanism for effectuating and funding a buyout.
[i] Some were proposed to be effective beginning the date the legislation was proposed (basically, a retroactive application), others on the date of its enactment, and others for tax years beginning after December 31, 2021. Congress sought to moderate the immediate impact of the changes through various transition and grandfathering rules – small comfort to many.
[ii] For example, the sale before the end of 2021 of a business operated as a partnership or as an S corporation, the owners of which are taxed as U.S. individuals who are active in the business, would generate ordinary income taxable at a top federal rate of 37% and long-term capital gain taxable at 20%.
The same sale after 2021 would include, in addition to the foregoing taxes, the imposition of the 3.8% net investment income surtax on a partner’s or S corporation shareholder’s pro rata share of the entity’s taxable income (without regard to the individual owner’s involvement in the business), plus the 5% and 8% surcharges on income that exceeds certain threshold amounts.
[iii] The availability of cheap money and the willingness of private equity to spend it has been another motivating factor.
[iv] Along these lines, older owners may be thinking about utilizing some or all of their remaining unified gift/estate tax exemption amount to transfer equity to family members or to trusts for the benefit of such individuals.
[v] This burden has been one of the arguments advanced for years by the Republicans in favor of eliminating the estate tax. Many estates, they have asserted, are forced to sell the decedent’s business to raise the funds necessary to pay the tax. Hyperbole? Some.
Long ago, Congress recognized the bona fide nature of this concern, and enacted IRC Sec. 6166 and Sec. 303 to address it, at least in part.
Sec. 6166 allows certain estates to satisfy, over a 15-year period, that portion of their federal estate tax liability that is attributable to the value of a closely held trade or business (but not to the value of any “passive” assets held by such trade or business).
Sec. 303 allows an estate to treat the redemption of its shares in a corporation as a sale or exchange for tax purposes, notwithstanding it would otherwise be treated as a dividend distribution under IRC Sec. 302 and 301, if the amount redeemed does not exceed the sum of the estate taxes owing, and administration expenses incurred. Such treatment allows the estate to offset the distribution with the stepped-up basis in the stock being redeemed, essentially wiping out the income tax on the distribution.
[vi] Well-advised businesses will address many of these contingencies in advance. For example, some seek to create a “market” for their owners by offering to periodically buy back equity interests up to a predetermined value that is manageable by the business.
[vii] Life insurance has long been utilized as a tool for funding the buyout of a deceased owner’s equity in a closely held business. The estate obtains the cash proceeds in exchange for selling its equity back to the business. The estate may then use the proceeds to satisfy its tax liabilities and other expenses.
A significant issue presented by the case discussed in this post was the inclusion of the life-insurance proceeds in the valuation of the business that owned the policy on the deceased owner’s life.
[viii] Connelly. v. U.S., F.Supp.3d, (E.D. Mo. 2021).
[ix] Without these proceeds, Estate asserted, Corp would have had to sell some of its assets, borrow money, or both, to buy Decedent’s Shares.
[x] The Code imposes a federal estate tax on a decedent’s taxable estate. The tax is imposed on the taxable estate a decedent transfers at their death. A decedent’s taxable estate is the value of the decedent’s gross estate, minus all authorized deductions. The decedent’s gross estate includes the decedent’s “property, real or personal, tangible or intangible,” as of the decedent’s date of death. The value of the gross estate “shall be determined by including . . . the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.”
[xii] According to Estate’s expert, the Agreement created “an enforceable contractual obligation to use the life-insurance proceeds to purchase [Decedent’s] stock in [Corp]” upon Decedent’s death. The expert opined that the life-insurance proceeds used to redeem the shares should be excluded from the fair market value of Corp, asserting that the IRS improperly disregarded Corp’s obligation to redeem Decedent’s Shares. Thus, he concluded, that inclusion of the insurance proceeds in Corp’s fair market value resulted in an overstated value for Corp, as well as an inflated estate-tax bill for Estate.
[xiii] By contrast, the IRS’s expert stated that “[i]n a fair market equity valuation, the insurance proceeds would be included in the value of [Corp] as a non-operating asset.” He opined that allowing the corporation’s redemption obligation to offset the insurance proceeds “undervalues [Corp’s] equity, undervalues [Decedent’s] equity interest in [Corp], and violates well-established equity valuation principles because the resultant share price creates a windfall for a potential buyer that a willing seller would not accept.”
[xiv] The parties stipulated that, if Estate was due a federal estate tax refund, for the purpose of determining the amount of such refund, the fair market value of Decedent’s Shares was $3.1 million as of the date of death.
The stipulation expressly left aside the dispute over how to account for the life-insurance proceeds used to redeem Decedent’s Shares, so the stipulation only controlled the value of Corp exclusive of those life-insurance proceeds.
[xv] The Court began by explaining that, in a tax refund action, the district court must determine the plaintiff’s tax liability; it “must make a de novo determination as to whether the plaintiff is entitled to a federal-estate-tax refund.” The notice of deficiency, the Court continued, carries a presumption of correctness, requiring the taxpayer to demonstrate that the deficiency is incorrect; in other words, the taxpayer bears the burden of persuading the Court that the assessment is incorrect.
[xvi] IRC Sec. 2703(b).
[xvii] Set forth in IRC Sec. 2703 and the regulations promulgated thereunder.
[xviii] IRC Sec. 2703(b); 25.2703-1(b).
[xx] The Court began by observing that Estate’s arguments all turned on the same premise. Estate argued that the company sold Decedent’s Shares at fair market value, which in turn relied on the assumption that Estate’s valuation expert correctly valued the Shares. Estate’s valuation expert excluded $3 million in life-insurance proceeds from the valuation. And, even though the parties to the Sale Agreement did not value Decedent’s Shares using the valuation mechanisms set forth in the Agreement, Estate nonetheless argued that the very existence of the Agreement – the parties’ failure to adhere to it notwithstanding – provided sufficient basis for the Court to accept Brother’s and Estate’s ad hoc valuation as the proper estate-tax value of Decedent’s shares. The Court rejected this premise, but nonetheless analyzed whether the Agreement fits into the buy-sell-agreement exception to the fair-market-valuation rule.
[xxi] Despite the legitimate business purpose of the Agreement, Estate had the burden of proving the Agreement was not a device to pass Corp’s shares to members of the family for less than full-and-adequate consideration. Estate asserted that the Agreement was not a testamentary device because (2) the Agreement was binding, because Corp redeemed such shares, and (3) the brothers were in good health when they executed the Agreement.
[xxii] The Court observed further that the Agreement’s appraisal requirement was flawed because it directed that any appraisal not take premiums or minority discounts into consideration. These factors indicated that the price was not full-and-adequate consideration.
While the brothers’ good health when they executed the Agreement weighed in favor of Estate’s argument, the Court pointed to what it described as the parties’ “abject disregard” of the Agreement so as to undervalue the company and underpay estate taxes, as well as the Agreement’s lack of a control premium or minority discount, as evidence that the Agreement was a testamentary device to transfer wealth to family members for less than full-and-adequate consideration.
[xxiii] 25.2703-1(b)(4) (this determination considers factors such as “the expected term of the agreement, the current fair market value of the property, anticipated changes in value during the term of the arrangement, and the adequacy of any consideration given in exchange for the rights granted.”). The question is whether, “[a]t the time the right or restriction is created, the terms of the right or restriction are comparable to similar arrangements entered into by persons in an arm’s length transaction.”
[xxiv] In support of its position on the fair market valuation, Estate presented the calculation-of-value report from two appraisers. The Court did not find these persuasive. Their calculation of value relied on the premise that life-insurance proceeds used to redeem a stockholder’s shares do not count towards the fair market value of the company when valuing those same shares. Thus, the Court found, neither valuation answered the question of whether the $3 million price was below fair market value, and both valuations ignored the detailed valuation mechanism in the Agreement.
[xxvi] Estate argued that the mere existence of a pricing formula in the Agreement satisfied the requirement that the offering price be “fixed and determinable” by the preexisting agreement. But Estate did not ask the Court to apply one of the price-setting mechanisms set out in the Agreement; it wanted the $3 million price to control estate-tax valuation, even though that price had “no mooring in the [Agreement].”
[xxvii] Estate argued that the $3 million price “resulted from extensive analysis of Corp’s books and the proper valuation of assets and liabilities of the company. [Brother], as an experienced businessman extremely acquainted with [Corp’s] finances, was able to ensure an accurate appraisal of the shares.” Leaving aside Brother’s obvious self-interest in arriving at a below-market valuation, the Court found that this argument revealed the frailty of Estate’s position: Estate didn’t believe that the very specific valuation mechanism in the Agreement produced an accurate value that bound Estate, but the Court should treat it as if it did.
[xxviii] The Court observed that the more likely explanation for the parties’ scrapping the Agreement in favor of the after-the-fact Sale Agreement was that the latter allowed Brother to buy Decedent’s Shares at a below-market value and reduce Estate’s taxes.
[xxxi] The Court dedicated much of its opinion to this issue, but I have chosen instead to focus on the effect of the Agreement itself on the valuation of the Shares.
[xxxii] An analogous situation involves the valuation of non-traded stock that is granted to an employee in consideration for their services. According to Reg. Sec. 1.83-3, in determining the value of such stock, one may consider the effect of a “non-lapse restriction,” which is defined as a permanent limitation on the transferability of property which will require the transferee of the property to sell, or offer to sell, such property at a price determined under a formula, and which will continue to apply to and be enforced against the transferee or any subsequent holder (other than the transferor). For example, a limitation subjecting the property to a permanent right of first refusal in a particular person at a price determined under a formula is a permanent non-lapse restriction. See Reg. Sec. 1.83-5 for other examples of non-lapse restrictions (including one that ties the price to book value).