Corporate Governance for Estate Taxes of the Deceased

Will the amount paid under the agreement to heirs of a deceased shareholder govern for estate tax purposes?

Not necessarily. It is possible that the internal revenue service could determine that the actual fair market value of the stock for tax purposes is greater than the price paid under the agreement. This could be a disaster for the owner’s family, particularly in situations where the business is the largest asset in the estate and the asset is expected to provide family support following the owner’s death.

A buy-sell agreement often can be structured to lock-in the value of stock for federal estate tax purposes. The IRS perceives buy-sell agreements as potential tools to abuse the valuation process, particularly in situations like that of ABC Inc. where the bulk of the stock is owned by members of the same family. For this reason, section 2703 of the Internal Revenue Code was added in 1990 to specify certain criteria that must be satisfied in order for a buy-sell agreement price to control for estate tax purposes when over half of the stock of a company is owned by a single family.

Section 2703 imposes a three-part test. First, the agreement must be a legitimate, arm’s length business arrangement. Second, the agreement must not be a device used to transfer property to members of the deceased’s family for less than full value and adequate consideration in money or money’s worth. And finally, third, the terms of the agreement must be comparable to similar arrangements entered into by persons in an arm’s length transaction. Each of these three requirements must be satisfied.

Now, in most cases the third requirement will prove to be the most difficult, really the ball game. The comparable arm’s length determination is made at the time the agreement is entered into, not when the rights under the agreement are exercised. This third requirement will be satisfied if the agreement is comparable to the general practice of unrelated parties under negotiated agreements in the same industry. An effort needs to be made to determine what others in the same industry are doing. Usually, this will require the services of an expert appraiser at the time of the agreement. If multiple valuation methods are used in the industry, the requirement can be satisfied by showing that it is comparable to one of the commonly used methods.

If there are no industry standards because of the unique nature of the business, standards for similar types of businesses may be used to establish the arm’s length terms of the agreement. In the case of the ABC Inc., great care would need to be exercised to ensure compliance with these 2703 requirements. Because section 2703 is targeted at abuses among family members, the regulations to the provision offer a special exception in those situations where over 50% of the stock in the business is owned by non-family members.

In order for this exception to apply, the stock owned by the non-family members must be subject to the same restrictions and limitations as the stock held by family members. If in the case of ABC Inc., for example, Roger and Joyce, the non-family shareholders collectively own, say, 55% of the outstanding stock, the requirements of section 2703 would be deemed to have been satisfied and the value determined under the agreement would govern for estate tax purposes if three easier criteria are satisfied. One, the price must be specified or readily ascertainable pursuant to the terms of the agreement and the value must have been reasonable when entered into. Two, the dissident’s estate must be obligated to sell at death at that price. And three, the dissident owner must have been restricted from selling or transferring the stock during life. This condition is not satisfied if for example the dissident had the right to transfer an interest in the stock by gift during his or her life to a person who would not subject to the same restrictions.

So if the 50% non-family ownership test is satisfied, it is relatively easy to structure the agreement to ensure that the price paid at death under the agreement will control for estate tax purposes. If the 50% test is not satisfied, then an effort must be made to determine an industry standard and then to carefully structure the agreement to conform to that standard.

As always, this is not CPA, accountant, legal or investing advice. Please consult with knowledgeable professionals when making business and investing decisions. 

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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