Let’s say that you and two of your best friends have a small, but increasingly successful business.  Your plan is to continue to grow the company, and each of you is planning to remain in the business until retirement.  Recently, you have discussed the welfare of your families if any of you should die or become disabled.  Each of you has life and disability insurance, but what happens to the business when you die, and your wife and children inherit your stock?  A buy-sell agreement can help smooth-over the transition in ownership caused by such disruptive events as the death, disability, or retirement of an owner.  However, knowing how to structure the buy-sell agreement is extremely important in determining the fair market value of your corporate stock for gift, estate, or generation-skipping tax purposes.

When drafting your buy-sell agreement, you need to consider Section 2703 of the Internal Revenue Code.  That section is brief, but may have a dramatic impact on you and the other co-owners.  The general rule of Section 2703 says that the value of any property, in this case, your corporate stock, shall be determined without regard to:  (1) any option, agreement or other right to acquire or use your corporate stock at a price less than fair market value when determined without regard to the option, agreement, or right, or (2) any restriction on the right to sell or use your corporate stock.  However, an exception to the general rule is provided if the following three requirements are met:  (1) the agreement is a bona fide business arrangement, (2) the agreement is not a device to transfer your corporate stock to family members for less than full and adequate consideration, and (3) the terms of your agreement are comparable to similar agreements entered into by persons in an arm’s-length transaction.

The regulations under Section 2703 indicate that in order for the exception to the general rule to apply, each of the three requirements mentioned in the preceding paragraph must be independently satisfied for a right or restriction to apply.  Accordingly, the mere showing that a right or restriction is a bona fide business arrangement is not enough to satisfy the provisions of the exception, and that right or restriction will be ignored when determining the fair market value of your stock.

A right or restriction in your agreement is treated as comparable to similar agreements entered into by persons in an arm’s-length transaction if the right or restriction is one that could have been obtained in a fair bargain among unrelated parties in the same business dealing with each other at arm’s-length.  A right or restriction is considered a fair bargain among unrelated parties in the same business if it conforms with the general practice of unrelated parties under agreements negotiated in the same business.  The regulations indicate that the determination will generally entail consideration of such factors as:  (1) the expected term of the agreement, (2) the current fair market value of the property, (3) anticipated changes in value during the term of the arrangement, and (4) the adequacy of any consideration given in exchange for the rights granted.  

Using isolated comparables does not evidence general business practice.  The comparables have to be the norm rather than the exception.  However, in determining the norm, the regulations indicate that a right or restriction will not fail to evidence general business practice because it uses one valuation method when that valuation method is one of several methods commonly used to value a business in that industry.  If comparables are difficult to find because of some unique characteristic of the business, comparables from similar businesses may be used.

Your stock may be subject to multiple rights or restrictions under the buy-sell agreement.  If this is the case, the failure of one of the rights or restrictions to satisfy the requirements of the exception under Section 2703, will not cause any other right or restriction to fail to satisfy those requirements as long as the other right or restriction otherwise meets those requirements.

Buy-sell agreements are useful tools available to business owners to ensure an orderly transition of ownership.  However, care must be taken to draft the agreement in accordance with the provisions of Section 2703 so that there are no surprises concerning the fair market value of the corporate stock for gift, estate or generation-skipping tax purposes. 

It should be noted that the information in this article is also pertinent to a business organized in partnership form.