Buy-sell agreements cannot be relied on to determine the value of a business for the purposes of estate tax or gift tax.
If the IRS believes that a closely held business, or an interest in it, has a higher fair market value (FMV) than the one determined by a buy-sell agreement, it may use that higher value to determine the tax liability. This is to prevent business owners from artificially lowering the value of a company for the purpose of reducing or evading taxes.
If you’re part owner in a closely-held company – particularly a family-held company – here’s what to know.
How Buy-Sell Agreements Can Affect Sales Price and Company Value
It’s the same old story: Business owners want to protect their assets and pay as little as possible in taxes to the federal government, while the IRS wants to get all the money it’s entitled to under the law.
One way some business owners have tried to reduce the amount taxes owed to the IRS is by artificially reducing the value of a closely held company, or interest in that company, through certain provisions in the company’s buy-sell agreement.
For example, terms in a buy-sell agreement might:
- Set a fixed price for sale that’s significantly below FMV
- Set a formula to determine price that’s below FMV
- Restrict sale back to the company at a particular price
- Restrict sale to family members only, which lowers value by reducing marketability
- Give right of first refusal for purchase to existing owners at below FMV prices
When the owner eventually dies, the value of the business or business interest is reported as the value determined by the buy-sell agreement and not an objective appraiser. This may mean a lower – sometimes substantially lower – tax liability.
The IRS Will Disregard Such Terms
Terms like those above can lead to the under-valuing of a company which could mean less taxes for the IRS to collect. Under Section 2703(a) of the Internal Revenue Code (IRC), the IRS will disregard such terms in buy-sell agreements:
“(a)General rule For purposes of this subtitle, the value of any property shall be determined without regard to—
- “any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or
- “any restriction on the right to sell or use such property.”
If the IRS rejects the valuation of a business based on a buy-sell agreement, then it will use the value determined by a qualified appraiser or other method.
However, such terms are not necessarily illegitimate. The IRS will not disregard these kinds of terms if certain conditions are met.
The Three “Safe Harbor” Conditions for Buy-Sell Agreements
Exceptions to the general rule above are found in the “Safe Harbor” provisions of Section 2703(b) of the IRC. The IRS will respect the valuation in a buy-sell agreement if all three of the following conditions are met:
(b)Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
- “It is a bona fide business arrangement.
- “It 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. [the “device test”]
- “Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.” [the “comparability test”]
More on the “arms’ length” standard below.
The “Arms’ Length” Standard
IRC Sections 2703(a) and (b) apply to all closely held businesses, but in practice, they most commonly apply to family-held businesses. The IRS is more likely to scrutinize family-held companies and transfers between family members, as family members are more likely to want to give each other the most favorable terms possible.
This is where the “arms’ length” standard comes in. A buy-sell agreement’s terms should reflect the reality of doing business with unrelated parties, not family members. When business is done at arms’ length, all parties involved act in their own self-interest; the transaction is free from manipulation, duress, and favoritism; and transfers occur at fair market value. A transfer between family members at below-market value is a big red flag to the IRS.
Other red flags to avoid:
- Terms in the buy-sell agreement that are not supported with sound business reasons
- Fixed sales price or price formula in the buy-sell agreement that doesn’t reflect the current market
- Evidence the company’s purpose is more for estate planning than conducting business
As a business owner, one proactive step you can take is to have your buy-sell agreement reviewed by a business attorney and updated as needed to ensure it reflects the current market and aligns with the arms’ length standard.
Strategic Legal Advice to Protect and Grow Your Business
When was the last time your buy-sell agreement and other corporate governance documents were reviewed? Laws and circumstances change, and it’s smart to make sure your company’s documents reflect those changes. Business attorney Gem McDowell and his team can help.
For strategic legal advice and help with contracts, corporate governance documents, and starting, buying, or selling a business in South Carolina, contact Gem. Gem has over 30 years of experience helping individuals and business professionals across the state protect their interests, avoid mistakes, and plan for the future. Call the McDowell Law Group, with offices in Myrtle Beach and Mt. Pleasant, SC, at 843-284-1021 today to schedule a free consultation.
