Valuation and Buy Sell Agreements

Independent Council

If each side to the transaction had his or her own independent attorney the weight the IRS will attribute to the particular valuation methodology is greater. Estate of Joseph H. Lauder, T.C. Memo 1992-736. But the same concept also applies to your use of any "appraisal." If the appraisal was completed for a family for gift tax purposes the bias is obviously lower and even if in the range of what is fair value may warrant further analysis before use for a different purpose. The Lauder case pointed out a number of other fundamentals practitioners must consider in evaluating the strength of any valuation for tax purposes. Was an independent professional used? Was the value used in transactions prior to death? Was there arm's length bargaining (e.g., one child receiving the business and another child receiving another asset)?

Non-Tax Use

Economic or business use of the buy sell agreement will strengthen its import on a tax audit. For example, if the buy sell agreement was used as part of the applications for lenders or bonding to demonstrate corporate responsibility that would support the figures or formula used. Estate of Marlin Rudolph v. U.S., U.S. D.C. So. Dis. Indiana, No. 91-151-C, February 5, 1993. Also, if the owners obtain life insurance that can corroborate that the buy sell was not set in contemplation of death

Insurance Reliance Misplaced

Insurance is a tremendous tool to fund buy sell agreements, but be wary of relying on insurance as foolproof. If the insured commits suicide and the policy coverage is void, how will the buy out be concluded? PLR 9315005. Also be wary of indirect gifts if a controlled entity redeems shares.

Excessive Insurance

For many buyouts, the price is set with consideration of the cost of insurance coverage. Since term insurance is so inexpensive they might purchase a larger amount of coverage than the actual value. For young business owners this can be a dangerous mistake. This could create an inappropriate inference as to the insured amount being argued to be the real value in the event of a divorce or estate tax audit. It would be preferable to state what the current value is believed to be and what should happen with the excess insurance coverage.

Premium Values Should Not Govern

If a price is paid to buy out a minority shareholder to gain control, or if a partner is going through a divorce and the other owners or entity repurchase the divorcing owners shares to avoid the disruptions and difficulties of the divorce litigation, document that a premium was paid at the time of such a transaction and why, to provide some corroboration at a later date if a lower value is later used in a gift or estate planning transaction. If not, the IRS would likely argue that the third party transaction actually set the fair value for the business, rather than recognizing it as a unique special purchase that should not be used to infer arm's length value.

Ancillary Steps Critical

Too often practitioners focus almost exclusively on the valuation aspects of gift planning transactions. Ancillary issues are often as or more vital to address, so think and plan broadly. For example, if the client engages in a sale for a private annuity (typically structured to a defective or grantor trust) the client should have a greater than 50% opportunity to survive more than a year. There is a rebuttable presumption that if the client survives 18 months that the test is passed. Consider obtaining letters from two physicians indicating a two year survival period or even having a formal life expectancy analysis completed. While valuation remains critical to the success of such a transaction, it is not the sole factor.

Divorce Valuations

If stock in a closely held business is repurchased in a divorce the IRS may view the entities payment for the ex-spouse's equity as a payment of a divorce obligation and tax the spouse retaining the business. Thus, the structure of the transaction, not only the value, must be planned. John A. Arnes, 981 F.2nd 456, aff'g DC Wash.

What is Being Valued?

In a recent case the taxpayer formed a one member LLC and transferred assets to the LLC. Gifts were then made to heirs and portions of the LLC were sold to family trusts. What was appropriate to value? The underlying assets or the minority interests in the LLC that were given or sold? The IRS argued that since the LLC was a single member disregarded entity for tax purposes under the check the box regulations it should be disregarded for gift tax purposes. The court, however, held that the fact that the entity was disregarded for income tax purposes does not mean it should be disregarded for gift tax purposes and discounts were permitted. Pierre v. Commr., 133 TC No. 2 (2009). Similarly, when clients consummate a series of transactions it may be possible that the entity will be disregarded in the valuation process. In a number of different tax cases the courts have sided with the IRS that a purported transfer of assets to an entity followed by a contemporaneous, or even just a too rapid, transfer of entity interests would be deemed a transfer of the underlying assets, not merely the entity. Linton v. U.S. 2—9 WL 1913255; Shepherd v. Commr., 283 F.3d 1258 (11th Cir. 2002), Senda v. Commr., 433 F.3d 1044 (8th Cir. 2006). Practitioners should be wary of first determining what is proper to value before focusing on the nuances of the valuation itself.

Related Party Transactions

When valuing a closely held business, care should be taken to assure that all loan transactions are properly documented and that other intercompany transactions are supported by appropriate contractual arrangements. Too often, family and related-party transactions are treated with informality. You should not lightly value a cash transfer as a loan instead of equity if there is no written loan agreement. Similarly, intercompany transfers and management fees must be properly confirmed and documented. If the prices involved are not arm's length, it is often not only a matter of making an adjustment for purposes of an appraisal, but also assuring that sufficient documentation and proper pricing exists so that not only the IRS, but courts and credits as well, will respect the transactions.

Consider all Valuations

For closely held business provisions for buy sell purposes for retirement, death, disability, partial disability, and perhaps others must be addressed. Agreements often include "bad boy" provisions that provide a reduced payout if the equity owner being terminated had lost a license essential to participate, committed theft of business/entity assets or opportunities, etc. Each of these "buy out" prices or formula often has an objective different than that of determining the fair value of an interest in the entity. For example, the "bad boy" provisions are designed to penalize, death provisions may be based on the cost and availability of life insurance, retirement payments may be intentionally reduced to permit business succession and on the premise that equity owners should save for their own retirement. Each of the various "valuation" approaches should be evaluated as part of a valuation and identified or labeled for its intended purpose

References Should Work

If you refer to tax definitions or incorporate the definition of disability from an insurance policy, be sure to clarify the intent and provide for backup in case the tax rules change or the policy lapses.