Late in 1996, Blount became very ill. The Company’s controller determined the most the Company could afford to pay Blount for his shares was $4 million. Blount and the Company then entered into a new agreement (the “1996 buy-sell agreement”) whereby the Company was required to purchase Blount’s shares for $4 million upon Blount’s death. (The purchase price the Company would have been required to pay under the 1981 agreement was $7.6 million, the book value.) Blount died in 1997, and the Company purchased his shares for the agreed price of $4 million.
Upon the IRS’s review of Blount’s estate tax return, the IRS determined the fair market value of Blount’s shares was approximately $8 million. The case proceeded to the tax court, where the IRS contended the 1996 buy-sell agreement between the Company and Blount should not be binding on the issue of the value of Blount’s shares.
The tax court agreed with the IRS. First, the tax court determined that the 1996 buy-sell agreement must be disregarded because Blount had the unilateral right to amend the buy-sell agreement during his life. Because the agreement was not binding on Blount during his life, it would not control to establish the value of Blount’s shares upon his death. The tax court also held that the 1996 buy-sell agreement would be disregarded for the reason that the value purported to be established by the agreement was not fair market value, as there was no evidence that the agreement was negotiated at arm’s length and was comparable to similar arrangements entered into by similar companies. Because the estate was unable to do so, the tax court agreed with the IRS that Blount’s shares were worth $8.23 million. Blount’s estate was required to pay an additional $2.4 million in estate tax.
A buy-sell agreement plays a critical role in the relationship between a business and its owners. In addition to establishing the relative rights of the business owners with respect to management of the business, it sets forth the circumstances under which the company or the other shareholders must purchase – or have the right to purchase – the shares of another shareholder. Moreover, the determination of value established by a buy-sell agreement should be carefully described so as to avoid disputes between the shareholders and provide a defensible value with respect to estate taxes. Finally, the agreed value or the formula should be reviewed and updated regularly.
If you have a question regarding the preparation or review of your buy-sell agreement, please do not hesitate to contact the attorney in our firm with whom you regularly work.