Estate & Gift Tax Valuations: Can the IRS Disregard an Agreed Upon Value for Shares in a Buy-Sell Agreement?
Section 2703 of the Internal Revenue Code enacted in 1990 states that buy-sell agreements are disregarded for valuation purposes, unless the agreement satisfies the following tests.
Test One: The Agreement Must Constitute a Bona Fide Business Arrangement
The buy-sell agreement (Agreement) cannot be a ploy to transfer shares to members of the family at a price that is less than full and adequate consideration.
Test Two: Formula Clauses Must be Fair and Reasonable
If the Agreement includes a formula, it may not result in a transaction price that is lower than what would be agreed upon in an arm’s length negotiation.
Test Three: Terms and Conditions Comparable to Those in a Contract between Unrelated Parties
The covenants, restrictions and conditions in the Agreement must be consistent with practices incorporated in a business contract between unrelated shareholders.
Prior to the enactment of Section 2703, Treasury Regulation 20.2031-2(h) (Regulation) governed the manner in which a buy-sell agreement should be interpreted for estate and gift tax valuation purposes. This Regulation sets forth additional tests that are still considered relevant by most commentators.
Test Four: Agreement Must Include Valuation Methodology
The Agreement must include an explanation of the manner in which the value of the shares is determined.
Test Five: Shares Must be Sold Upon the Death of a Stockholder
In the case of an estate, upon the death of a shareholder, the Agreement must obligate the personal representative to sell the decedent’s stock.
Test Six: Shares Must be Offered to the Remaining Shareholders or Corporation Upon the Death of a Stockholder
When reporting the market value of a decedent’s shares, the agreed upon transaction price in the Agreement can be relied upon only if the contract includes a right of first refusal provision that vests the corporation, remaining stockholders, or a third party with the right to acquire the shares at a price which exceeds the stipulated sale price in the Agreement.
Make sure your buy-sell agreement satisfies the tests presented in Section 2703 and Regulation 20.2031-2(h).