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Formula Price of Family Buy-Sell Agreement Did Not Control for Estate Tax Valuation

Estate Planning Journal

In Estate of True, Jr., 1 the Tenth Circuit affirmed the decision of the Tax Court holding that a buy-sell agreement among family members did not control for estate tax valuation purposes because the buy-sell agreement was a substitute for a testamentary disposition.

Facts

H.A. True, Jr. and his wife established a number of companies involved in ranching operations (including a guest ranch) as well as oil and gas exploration, marketing, and transportation. Each company was governed by a buy-sell agreement that required the owners to buy the interest of any owner who either died, became disabled, ceased working in the business, or attempted to transfer an interest in the company. The purchase price for the interest was determined pursuant to a formula based on the tax book value of the company.

In 1971, each of the four True children acquired a 1% interest in one of the True companies, which they purchased from the corporation for its tax book value. True and his wife did not report the transaction on a gift tax return because the acquisition had been structured as a sale rather than a gift. In 1973, True and his wife gave to each of their four children an 8% interest in two other True companies. True and his wife reported these gifts on a gift tax return and valued the gifts at their tax book value.

The IRS determined deficiencies against True and his wife for the 1971 and 1973 transfers. The IRS asserted that the transfers were gifts equal to the difference between the fair market value (“FMV”) and the tax book value of the interests. True and his wife paid the deficiencies and brought refund actions in U.S. District Court. In both cases, the district court ruled in favor of True and his wife, 2 and held that there were no unreported gifts because the FMV of the interests was equal to the tax book value.

True and his wife also routinely made annual exclusion gifts to their children. Upon obtaining interests in True companies, the True children entered into the buy-sell agreements governing the True companies.

In 1984, Tamma, one of the True children, ceased being an active participant in the True companies. In accordance with the terms of the buy-sell agreements, Tamma's interests in the True companies were purchased by True, his wife, and their other children at tax book value. After Tamma's withdrawal from the True companies, True and his wife ceased making annual exclusion gifts to Tamma, and they amended their estate planning documents to remove any provision for Tamma. In one of his estate planning documents, True stated that Tamma's inheritance had been fully satisfied during his lifetime as a result of the sale of her interests in the True companies.

In 1993, True sold interests in several True companies to his wife and children (other than Tamma) at tax book value. True and his wife reported these transfers on a gift tax return but treated them as sales. The IRS issued a notice of deficiency with respect to the transfers, contending that the value of the transferred interests was higher than tax book value.

In 1994, True died. In accordance with the terms of the buy-sell agreements, True's remaining interests in the True companies were sold to his wife and children (other than Tamma) at tax book value. True's estate filed an estate tax return and reported the value of his interest in the companies as equal to their tax book value. The IRS issued a notice of deficiency against the estate, asserting that the value of True's interests in the True companies was higher than the tax book value at which the interests were sold.

After True died, his wife decided in 1994 that she wanted to retire from active participation in the True companies. In accordance with the terms of the buy-sell agreements, she sold her interests in the True companies to her children (other than Tamma) at tax book value. She filed a gift tax return reporting the transfers but treated them as sales. The IRS issued a notice of deficiency claiming that the value of the interests sold by Mrs. True was higher than tax book value.

True's estate and Mrs. True filed a petition in Tax Court challenging the IRS' determination. The Tax Court rejected the taxpayers' argument 3 that the tax book value formula and the other restrictive terms of the buy-sell agreements controlled the value of the transferred interests in the True companies for estate and gift tax purposes. The taxpayers appealed the decision to the Tenth Circuit.

Analysis

Reg. 20.2031-2(h) provides that one of the requirements for an option or contract price in a buy-sell agreement to control for estate tax purposes is that the agreement not constitute a testamentary substitute intended to pass the decedent's ownership interest for less than adequate and full consideration.

In ascertaining whether a buy-sell agreement constitutes a testamentary substitute, the Tenth Circuit held that the proper analysis examines the terms of the buy-sell agreement and the manner in which those terms were established in order to determine whether the buy-sell agreement was reached by the parties acting in an arm's-length manner. The appeals court concluded that it could be inferred from the evidence presented that the True buy-sell agreements were testamentary substitutes.

First, True sought only a limited amount of professional advice in deciding to use a tax book value formula in the buy-sell agreements. Second, True did not obtain independent appraisals to determine whether the formula in the buy-sell agreements constituted FMV. Third, the formula contained in the buy-sell agreements excluded valuable intangible assets. Fourth, the buy-sell agreements did not contain a mechanism by which to reevaluate the price terms. Fifth, there was no negotiation between True and his children as to the terms of the buy-sell agreements. Finally, in a document exercising a power of appointment, True stated that Tamma's potential inheritance had been fully satisfied when she severed her financial ties with the True companies.

Having concluded that the buy-sell agreements were testamentary substitutes, the appellate court next examined whether the price terms in the buy-sell agreements were adequate consideration for the ownership interests to be transferred. The taxpayers contended that the decision of the U.S. District Court in the 1971 and 1973 gift tax cases, holding that the book value price represented FMV for the transfers in those years, collaterally estopped the IRS from arguing that the price terms in the buy-sell agreements did not represent FMV. The Tenth Circuit rejected the taxpayers' argument and ruled that the issues in the district court case were not identical to the issues presented in this case because the district court in the gift tax analysis did not need to consider whether the buy-sell agreements served as testamentary substitutes. Therefore, the Tenth Circuit held that the IRS was not bound by the holding of the district court.

The appeals court then discussed whether the nonprice restrictions contained in the buy-sell agreements should be considered in determining whether the formula price constituted adequate consideration for the ownership interests to be transferred. The court held that, if the terms of the buy-sell agreement and the conduct of the parties with respect to those terms give rise to an inference that the buy-sell agreement was a testamentary substitute, it would not be proper to consider the nonprice restrictions contained in the buy-sell agreement in determining whether the formula price constituted adequate consideration for the ownership interests to be transferred. The appellate court held, however, that it was appropriate for the Tax Court to apply a discount for lack of marketability because such a discount gave sufficient weight to True's intent—as evidenced by the buy-sell agreements—to keep ownership of the True companies within his family.

The court noted that the deductions and rates of depreciation allowed for tax book accounting greatly reduced the book value of many of the True companies. In addition, the taxpayers did not present any evidence to prove that a valuation based on book value would be a method that unrelated parties would agree to use. In fact, the record indicated that when the True family invested in companies with nonfamily members, the book value pricing method was not used.

The Tenth Circuit next considered whether the price terms in the buy-sell agreements should control for purposes of valuing the 1993 and 1994 lifetime gifts by True and his wife. The court held that buy-sell agreements should not necessarily control for gift tax valuation purposes but that, at most, the terms of the agreements may serve as factors to be considered in making the valuation.

Finally, having decided that the price terms in the buy-sell agreement did not control for estate or gift tax purposes, the Tenth Circuit reviewed whether the Tax Court had properly valued the interests in the True companies. The taxpayers argued that the Tax Court should have considered the nonprice terms of the buy-sell agreements in determining the value of the interests in the True companies. The Tax Court, relying on Estate of Lauder, 4 held that the restrictive provisions of the buy-sell agreements were to be disregarded for estate and gift tax valuation purposes.

The Tax Court did apply a discount for lack of liquidity resulting from the terms of the buy-sell agreements that restricted ownership of the interests in the True companies to True family members. The appellate court held that the existence of a buy-sell agreement, and the bona fide reasons supporting it, should be considered in determining the FMV of the interests. The court of appeals found that the Tax Court properly considered the existence of the buy-sell agreements since it applied marketability discounts to take into account the restricted market that existed for the interests resulting from the terms of the buy-sell agreement. The Tax Court also considered the impact that state partnership law would have on the value of those True companies formed as partnerships. The Tenth Circuit therefore sustained the decision of the Tax Court with respect to the valuation of the True companies.

Comments

The True case is instructive on several points. First, a formula price of a buy-sell agreement among family members must be comparable to what unrelated persons would agree to. Second, appraisals and independent professional advice are very helpful, if not imperative, in determining a sustainable formula price. Third, although it may seem somewhat unnatural, it would be advisable for each family member to have independent counsel and for there to be some degree of negotiation among the parties to the buy-sell agreement. The buy-sell agreements at issue in True were not subject to Section 2703 because the agreements were executed prior to October 8, 1990.

1 94 AFTR 2d 2004-7039, 390 F3d 1210 (CA-10, 2004).

2 See True, 50 AFTR 2d 82-6246, 547 F Supp 201, 82-2 USTC ¶13503 (DC Wyo., 1982); True, No. C79-131K (DC Wyo., 10/1/80).

3 See Estate of True, TC Memo 2001-167, RIA TC Memo ¶2001-167, 82 CCH TCM 27

4 TC Memo 1994-527, RIA TC Memo ¶94527, 68 CCH TCM 985

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