By Richard P. Breed, III
On November 5, 1990 Congress enacted the Omnibus Budget Reconciliation Act of 1990 ("OBRA"). Included within the myriad provisions of OBRA was Section 11601 which retroactively repealed the "estate freeze" provisions of Section 2036(c) of the Code which, of course, had caused great concern to estate planners and their closely-held business clients since its introduction in late 1987. The Committee Reports accompanying the new legislation state that the complexity, breadth and vagueness of the old statute posed an unreasonable impediment to the transfer of family businesses.
Despite repealing Section 2036(c), Congress was still concerned about the potential estate and gift tax valuation abuse which can arise in the context of an "estate freezing" transaction. To prevent such abuse OBRA added a new Chapter 14 to the estate, gift and generation-skipping tax sections of the Internal Revenue Code. Chapter 14 provides special valuation rules for intra-family transfers of interests in closely-held businesses. See IRC Sections 2701-2704. While a discussion of each of these new Sections is beyond the scope of this article, it is important to understand the impact of the new law as it applies to a traditional tool for preserving or transferring control in a family business - the buy-sell agreement.
Since 1958, Regulations under Code Section 2031 have recognized that an agreement giving a person the right to purchase stock owned by a decedent at the time of his death, at a predetermined price, can fix the value of the stock in the decedent's estate. The Regulations required the agreement to be a bona fide business arrangement, and not a device to pass the decedent's shares to the natural objects of his bounty for less than full and adequate consideration. See Treas. Reg. Section 20.2031-2(h). In addition, the decedent must not have been free to dispose of the stock at other than the contract price during his lifetime. Congress became concerned that courts in recent years had been willing to extend the scope of that Regulation by allowing the price set forth in a buy-sell agreement to limit the fair market value of the decedent's interest in the business for estate tax purposes if 4 conditions were met: (a) the price was fixed or determinable, (b) the estate of the decedent was obligated to sell, (c) the agreement contained restrictions on the decedent's ability to make a lifetime transfer, (d) and there was a valid business purpose for the agreement. See Seltzer v. Comm., T.C. Memo 1987-568, and Estate of Bischoff v. Comm., 69 T.C. 32 (1977).
To limit the potential for abuse in the area and to prevent future decisions which followed Seltzer, OBRA adds new Section 2703. The general rule set forth in Section 2703(a) is that the value of any property (e.g., a decedent's interest in a closely-held business) shall be determined without regard to (a) any option, agreement or other right to acquire or use the property at less than its current fair market value or (b) any restriction on the right to sell or use such property determined without regard to any such option, agreement or other right. In short, OBRA adds a general rule that gives no weight to a buy-sell agreement or similar arrangement in establishing the fair market value of a decedent's interest in the business for estate tax purposes.
The exceptions to the general rule are, in certain cases, of greater significance that the rule itself. Section 2703(b) provides that the general rule will not apply (or, put differently, the agreement will be entitled to weight in valuing the decedent's interest) under 3 circumstances. The agreement must:
- be a bona fide arrangement;
- not be a device to transfer such property to the members of the decedent's family for less than a full and adequate consideration; and
- by its terms be comparable to similar arrangements entered into by persons in an arms' length transaction.
The Committee Reports recognize that buy-sell agreements are common business planning arrangements that are often used for legitimate business reasons unrelated to transfer tax consequences. However, the requirements added by Section 2703 reflect a Congressional attempt to distinguish between agreements designed to avoid estate taxes and those motivated by legitimate business reasons. Unfortunately, the new rules limit the scope of existing Reg. Section 20.2031-2(h), and add a new requirement of comparability in deciding whether a particular agreement was entered into for legitimate business reasons.
Requirements 1 and 2 set forth above are similar to those contained in Treas. Reg. Section 20.2031-2(h). However, the Committee Reports note that the "bona fide business arrangement" and "not a device" requirements are independent tests each of which must be satisfied. The mere showing that the agreement is a bona fide business arrangement will not result in recognition of the value for estate tax purposes if other facts indicate that the agreement is in fact also a device to transfer property to members of the decedent's family for less than full consideration. Under prior case law the maintenance of family control was held to be sufficient evidence of a bona fide business purpose and avoided any further IRS inquiry as to whether the agreement was a device to transfer wealth. In light of these now independent tests, estate planners must be careful to establish facts which show that both the business purpose and device test are met.
The last rule under Section 2703(b) requires that the taxpayer demonstrate that the agreement was one that could have been obtained in an arms' length transaction. The Committee Reports refer to several factors which can establish the requisite comparability of the agreement. Among the factors are (i) the expected term of the agreement, (ii) the present value of the property, (iii) its expected value at the time of exercise, and (iv) the consideration offered for the option. BY COMPARING THE PRESENT VALUE OF THE PROPERTY WITH ITS VALUE AT THE TIME OF EXERCISE OF RIGHTS UNDER THE AGREEMENT, IT WOULD APPEAR THAT THE IRS WILL NOT LOOK FAVORABLY ON A PREDETERMINED FIXED VALUE BUT, RATHER, WILL REQUIRE A FORMULA TO DETERMINE PRICE. It would also appear that a formula based on book value of the enterprise would not be binding on the IRS except perhaps in circumstances where valuation based on book value is the industry norm.
The test of comparability may prove to be the most troublesome largely because the IRS has yet to give any guidance on how the new rules will be interpreted. Section 11602(d) of OBRA directs the Secretary of the Treasury to conduct a study of the prevalence and types of options and agreements used to distort transfer tax valuation of property and other methods using discretionary rights to distort the value of property for such purposes. The results of the study are to be reported no later than December 31, 1992. However, at the very least it would appear that planners will need to place greater emphasis on recognized valuation techniques such as capitalization of earnings or discounted cash flows or other traditional valuation methodologies. An independent appraisal by a qualified professional may be necessary to establish comparability, not only of the valuation methodology, but also with regard to the other terms of the buy-sell agreement.
Reference in Section 2703(b)(2) to "members of the decedent's family" in connection with the "device" test described above may suggest that the new rules will only apply to buy-sell agreements among members of the decedent's family. However, the general rule of Section 2703(a) which gives no weight to a buy-sell agreement or similar arrangement in valuing the decedent's business interest is not expressly limited to intrafamily transfers. It would, therefore, appear that the new rules, especially dealing with comparability of the terms of the agreement within the industry, will even apply to agreements between unrelated shareholders. In such cases, the "device" test should not apply since each unrelated shareholder is presumably acting in his own best interest to obtain the highest price for his shares upon death, retirement or disability.
Finally, planners should note that the new rules of Section 2703 only apply to those agreements, options, rights or restrictions entered into or granted after October 8, 1990 or which are substantially modified after October 8, 1990. The statute does not define what constitutes a "substantial modification", but it would probably be advisable not to modify a pre-OBRA agreement which might otherwise be grandfathered under the new law until the IRS offers guidance on what is a "substantial modification."
In conclusion, it is apparent that, while OBRA eliminated many pitfalls for the unwary by repealing Section 2036(c), the addition of Chapter 14 will require careful planning and appropriate documentation to satisfy the new valuation rules. Buy-sell agreements or similar arrangements remain viable estate planning techniques, but they will need to conform to the rigorous valuation analysis of new Section 2703(b). In addition, under the new comparability analysis, the IRS can be expected to challenge those agreements, often between family members, in which the purchaser tenders his promissory note payable over a number of years in payment of the decedent's interest in the business. In this context, life insurance or disability buyout insurance as lump sum funding mechanisms may take on even greater importance in succession planning for family businesses.