Buy-sell agreements also can establish a pricing and valuation formula for shares where there is no public market to do so. The formula often calls for a valuation to be completed by an accountant or appraiser and may include various adjustments to account for circumstances particular to the company, its assets and operations. It may take into account the relative shareholdings of each shareholder and build in a minority discount in recognition of the lower share value that may arise from a minority shareholder’s inability to influence or control management and operations.
The IRS will generally respect buy-sell agreement pricing and valuation formulas if certain conditions are satisfied. From an IRS perspective, the inquiry begins with application of the requirements established under Code Section 2703, which include the following: (a) the price must be fixed and determinable; (b) the agreement must be binding on the parties during life and after death; and (c) the agreement must be comparable to similar agreements entered into by persons at arm’s length and must have been entered into for a business purpose, and not as a substitute for a testamentary disposition.
A price is generally considered fixed and determinable if the agreement sets forth an agreed upon price which is based upon a fair market determination and subject to periodic review and adjustment to maintain a pricing reflective of such determination, or if it contains a formula or mechanism which can be applied objectively to establish a price. A provision in the agreement making it enforceable against the parties and their respective successors generally satisfies the second condition, provided none of the parties has unilateral authority to alter the agreement.
Valid business purposes include a desire to avoid disputes among shareholders, the need to provide for continuity in operations, and the need to avoid share transfers that might introduce uninvited shareholders to the company. However, such stated purposes may be set aside by the IRS if circumstances surrounding execution of the buy-sell indicate a testamentary objective. In that case, the share value determined under the agreement will be ignored. Circumstances that indicate a testamentary objective include dictation of terms without negotiation by the parties, establishment of a price without a fair market evaluation or without reliance upon professional advisors, and use of a pricing mechanism that omits or understates asset values or does not include reevaluation provisions.
A substantial part of our practice relates to advising closely-held businesses and their owners, and includes the drafting of buy-sell agreements. If you have any questions regarding such agreements, we encourage you to telephone us.