Buy-Sell Agreement Disregarded for Estate Tax Valuation Purposes
A buy-sell agreement was disregarded for federal estate tax valuation purposes because the decedent had the unilateral ability to amend the agreement in Estate of Blount.1 In addition, the Tax Court held that the buy-sell agreement must be disregarded under Section 2703 because the estate failed to prove that the agreement was comparable to similar arrangements entered into in arm's-length transactions.
In 1981, George Blount and his brother-in-law, James Jennings, each owed one-half of the stock of Blount Construction Company (“BCC”). They entered into a buy-sell agreement with BCC that prohibited a shareholder from transferring or encumbering his stock without the written consent of the other shareholders (“the 1981 Agreement”). The 1981 Agreement also required a shareholder's estate to sell, and BCC to buy, the shareholder's stock at a price that was to be established by the shareholders annually. In the absence of such a redetermination, the redemption price would be based on the book value of BCC. BCC obtained approximately $3 million of life insurance each on the lives of Blount and Jennings.
In 1992, BCC adopted an employee stock ownership plan (“ESOP”). An independent appraisal was performed annually to establish the per share price of BCC stock. The ESOP appraisal was used when the ESOP purchased BCC stock using cash contributed to the ESOP by BCC, and when BCC redeemed the stock distributed to ESOP participants upon their retirement from BCC.
In January 1996, Jennings died and, in accordance with the 1981 Agreement, BCC purchased his stock based on the book value of BCC. After the redemption of Jennings' shares, Blount owned 83.2% of the outstanding stock of BCC and the ESOP owned the remaining shares. After Jennings' death, Blount was the sole member of BCC's board of directors and its president.
In October 1996, Blount discovered that he was gravely ill and he asked BCC's controller to prepare an analysis showing the impact on BCC of the redemption of his stock at different prices. After preparing this analysis, BCC's controller concluded that the most BCC could pay for Blount's stock was $4 million, taking into account BCC's receipt of $3 million of life insurance proceeds and the cash needs of BCC following redemption of Blount's stock.
After this analysis was complete and without consulting an attorney, Blount and BCC executed an agreement requiring BCC to redeem Blount's shares for $4 million (“the 1996 Agreement”). The 1981 Agreement would have provided that the redemption price for Blount's shares would have been approximately $7.6 million. The redemption price for Blount's shares would have been approximately $6.7 million if the independent appraisal prepared for purposes of the ESOP was used. The 1996 Agreement did not make any reference to the 1981 Agreement, addressed only the redemption price of Blount's stock at death and, unlike the 1981 Agreement that allowed for payments in installments, required the redemption price to be paid in a lump sum.
Blount died in 1997, and BCC redeemed his stock for $4 million. On the federal estate return, Blount's stock in BCC was reported at $4 million. In determining the value of Blount's stock, the Service ignored the buy-sell agreement and asserted that Blount's stock had a fair market value of approximately $8 million.
The issue before the Tax Court was whether the valuation set forth in the buy-sell agreement should be respected for federal estate tax purposes. A buy-sell agreement will determine valuation for estate tax purposes if the agreement meets certain requirements. One of those requirements is that a buy-sell agreement must contain binding restrictions that apply to transfers both during life and at death. A buy-sell agreement that fails to meet these requirements is disregarded for estate tax valuation purposes.
The Service argued that the 1996 Agreement was a novation of the 1981 Agreement, and therefore the 1996 Agreement terminated the 1981 Agreement in its entirety. If the 1996 Agreement was the sole operative agreement, it would be disregarded for estate tax purposes because it did not contain restrictions on lifetime transfers. The court, however, rejected the Service's argument and held that Blount intended that the 1996 Agreement be an amendment to the 1981 Agreement, and therefore the two agreements must be read together (“the Modified 1981 Agreement”).
The court next considered whether the Modified 1981 Agreement satisfied the requirement that a buy-sell agreement must contain binding provisions that apply to transfers during life as well as to transfers occurring at death. The 1981 Agreement required Blount to obtain the consent of the other shareholders in order to transfer his shares during his life. The court found that although the ESOP was not a party to the 1981 Agreement, Blount would have been required to obtain its consent to a lifetime transfer of his shares because the ESOP was a shareholder of BCC.
However, citing Bommer Revocable Trust 2 and Estate of True, 3 the court noted that a buy-sell agreement is disregarded for federal estate tax purposes if the decedent had the unilateral ability to amend the agreement during his life. The Modified 1981 Agreement provided that it could be amended only upon the written consent of the “parties thereto.” After the death of Jennings, the remaining parties to the Agreement were Blount and BCC. The court stated that since Blount controlled BCC through his 83.2% stock ownership in BCC, he could unilaterally amend the agreement. Accordingly, the court held that the Modified 1981 Agreement was not binding on Blount during his life and thus must be disregarded for estate tax purposes.
The court also ruled that even if the Modified 1981 Agreement was binding on Blount during his life, the agreement would be disregarded under Section 2703. That section, enacted in 1990, provides that any agreement to acquire property at less than fair market value will be disregarded. The court noted that it was clear from an examination of the legislative history of Section 2703 that the pre-Section 2703 requirements (including the requirement that a buy-sell agreement contain binding restrictions on lifetime transfers) continue to apply to buy-sell agreements to which Section 2703 applies. Section 2703 applies to agreements entered into or substantially modified after 10/8/90. The court held that the 1996 Agreement made substantial modifications to the 1981 Agreement, and because the amendments were made after 10/8/90, the Modified 1981 Agreement was subject to Section 2703.
Section 2703(b) sets forth an exception to the applicability of Section 2703 for buy-sell agreements that (1) are bona fide business arrangements, (2) are not a device to transfer property to members of the decedent's family for less than full consideration, and (3) are comparable to similar arrangements entered into in arm's-length transactions. Quoting from the legislative history and the Regulations under Section 2703, the court said that an estate must present evidence of agreements actually negotiated by persons at arm's length under similar circumstances and in similar businesses that are comparable to the terms of the challenged agreement.
While recognizing that it is possible for a buy-sell agreement to provide for an arm's-length redemption price that is less than fair market value, the court held that the estate's experts failed to provide any evidence of similar arrangements entered into at arm's length. The court stated that the only evidence of an arm's-length redemption price contained in the record is the book value redemption price contained in the 1981 Agreement. Therefore, the court determined that the Modified 1981 Agreement establishing a redemption price of $4 million must be disregarded under Section 2703.
After determining that the Modified 1981 Agreement did not establish the value of Blount's stock, the court examined the valuation reports prepared by the experts for the estate and the Service, and made adjustments to the valuation reports of the experts. The court held that the life insurance proceeds received by BCC upon the death of Blount must be included in determining the value of BCC. In addition, the court ruled that BCC's obligation to redeem Blount's shares should not be considered in determining the value of BCC. The court concluded that the value of BCC was approximately $9.9 million, and consequently, the value of Blount's 83.2% interest in BCC was approximately $8.23 million.
The Blount case reminds practitioners of the continuing relevance of the requirement that a buy-sell agreement must be binding upon the decedent in order to be respected for estate tax valuation purposes. It is customary for a buy-sell agreement to require the consent of a specified percentage of the ownership interests in order for the agreement to be amended. When the buy-sell agreement is executed among several parties, it would be unusual for any one person to have a sufficient ownership interest to unilaterally amend the agreement.
Nevertheless, Blount illustrates that subsequent events may occur (such as the redemption of the ownership interests of a deceased owner or the purchase of additional ownership interests by an existing owner) that may result in an owner having the unilateral ability to amend the agreement. When an estate plan is being prepared or reviewed, this is an issue that should not be overlooked. In addition, Blount illustrates the difficulties that a business owner with a majority (or greater) ownership may encounter in attempting to put a buy-sell agreement into place that will withstand IRS scrutiny.
The consequences to the Blount estate of the court's decision were particularly harsh. The estate received only $4 million from BCC as a result of the redemption of Blount's stock while the court upheld the Service's determination that the value of Blount's stock was approximately $8 million. Depending on other factors not set forth in the opinion, it is possible that the estate taxes attributable to the revalued BCC stock may have consumed the entire redemption price received by the estate. This result could have been avoided if Blount had sought the advice of competent legal counsel before amending the 1981 Agreement.
Finally, Blount illustrates the importance of expert testimony. The estate might have qualified for the Section 2703(b) exception if the estate's expert had introduced evidence regarding similar arm's-length arrangements. The court recognized that generally a buy-sell agreement may provide for a redemption price that is less than fair market value. Other points could have been made to the court. For example, was there any sort of fiduciary obligation to the ESOP? In addition, a redemption price paid in full at redemption may well be less than a redemption price paid over time since in the former situation there is no risk of nonpayment. These factors may have assisted the estate in establishing that the terms of the Modified 1981 Agreement were comparable to similar arrangements entered into in arm's-length transactions.
1 TC Memo 2004-116, RIA TC Memo 2004-116, 87 CCH TCM 1303.
2 TC Memo 1997-380, RIA TC Memo 97380, 74 CCH TCM 346.
3 TC Memo 2001-167, RIA TC Memo 2001-167, 82 CCH TCM 27.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.