It would be wonderful if the future just took care of itself. But in the case of buy-sell agreements, the future depends on what’s done today. For businesses, an unforeseen event such as the death of an owner can quickly turn into a crisis that could lead to a transfer of ownership.
Businesses with more than one owner, therefore, need a buy-sell agreement to provide both liquidity and an orderly ownership transition in the face of an owner departure — whether unexpected or planned. But it’s not enough to have a buy-sell agreement in place. Its provisions related to the business’s value and the pricing of shares also must be properly thought out.
Valuation can solve problems
There’s a good reason owners turn to professional appraisers to value their businesses for buy-sell agreements. Shareholders must agree on a valuation firm’s qualifications and independence, so the resulting valuation under the agreement is likely to be objective. Independent valuation can also help owners avoid legal battles and ensure values stand up well under legal challenge.
There’s no single, surefire method of determining an appropriate share price in buy-sell agreements— nor is the price necessarily the same in all situations. Owners can set a price in a number of ways. Most buy-sell agreements specify one or a combination of the following approaches:
Formula approaches imply that some “black box” exists from which to derive a credible value. But a formula approach is unlikely to enable the buy-sell agreement to both facilitate estate planning and provide liquidity at a fair market value during the owners’ lifetimes.
Similarly, mutual agreement may not be the best price-setting mechanism because owners can be blind to their own self-interests. They tend to think that their co-owners will leave the company first. Thus, they may agree to a “conservative” buy-sell value with the hope of exercising a purchase option (or obligation) at a favorable price. But of course such a price may understate the value of the shares.
The IRS scrutinizes buy-sell valuations, especially those involving family businesses, leading to disputes that often end up in court. Valuation is at the heart of most disputes the IRS has with an estate that contains a substantial closely held business interest. If the IRS determines that fair market value is higher than the amount calculated under a buy-sell agreement, the estate could owe tax on an amount it never received, leaving heirs much less than anticipated.
Under Chapter 14 and Internal Revenue Code Section 2703, which addresses the buy-sell agreement in a family setting, the IRS generally will accept the value prescribed by a buy-sell agreement only if:
Courts tend to rule that buy-sell agreements establish value for estate tax purposes if:
Courts also are more likely to uphold a value if the agreement effectively limits lifetime sales at more than the agreed price — usually through rights of first refusal granted to co-owners or the company itself.
Failing to clearly define how value is to be determined, and how often, can lead to disputes that may undo the benefit of having a buy-sell agreement. A poorly thought-out one can cause more problems than it solves — for example, owners may overlook or ignore the agreement, leading to disputes. Fortunately, most of these problems can be avoided by employing experienced advisors to address share price and funding issues.
Sidebar: Uncommon events that could trigger a buy-sell agreement
Most people are familiar with having a shareholder’s death or voluntary departure trigger a buy-sell agreement. But they often fail to consider other events that can affect the future of the business, such as when:
Another triggering event can be conviction for committing a crime or involvement in a scandal. Buy-sell agreements are often structured to force an owner guilty of such an indiscretion to sell at a lower price.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.