When a major asset of one’s estate includes a closely held business, there are a number of “special” problems that arise. We discuss four problems in particular, and how the use of a “buy-sell agreement” may help to solve them.
First, upon the owner’s death, there is a problem of estimating the amount of taxes his or her estate will owe if any. Essentially, this is a valuation problem: It is difficult to determine the value of one’s business interest on the one hand and the value of your estate at death on the other.
By definition, if the business is “closely-held” there is likely no existing market to determine the “fair market value” of the business, and often this will result in a valuation discount for “lack of marketability.” Furthermore, if the owner’s interest is fractional—that is, less than 100%—further valuation problems arise because the interest is subject to a “minority interest discount.” This discount is justified on the grounds that a minority interests in closely-held business is often difficult to sell and generally worth less than a controlling interest or sole ownership would be. Basically, buyers are not willing to pay as much for an interest that lacks control over the underlying business or property (How much would you pay for an undivided one-third interest in a Jeep Grand Cherokee?). Courts do not always distinguish between these two discounts, but they are both common and well-established.
The larger the valuation discount taken, the less estate tax a business owner’s estate will have to pay. However, care must be taken in taking valuation discounts, because problems can arise if they are not respected by the IRS. Courts are constantly adjusting what is deemed a “reasonable” discount, varying between 15% and 40%. For this reason, it is best to work with both a valuation expert (a qualified appraiser) and an estate planning attorney who is familiar with the relevant case law permitting these discounts.
A buy-sell agreement helps minimize valuation problems. A properly drafted buy-sell agreement helps to fix the estate tax valuation of the business interest owned by the owner at his or her death by establishing an arm’s length valuation method via an advanced contractual agreement amongst a business’s various owners. In the absence of a buy-sell agreement, the deceased business owner’s interest is open to valuation by the taxing authorities, which prefer to see a higher valuation and thus generates greater estate taxes than a lower valuation would. Valuation problems can and should be avoided prior to the owner’s death, especially when his or her estate is illiquid.
Clients often ask if a valuation problem will ever become an issue if the owner plans to leave his or her business interest to a surviving spouse, while planning on electing the “unlimited martial deduction,” which allows a person to pass an unlimited amount of assets/money to one’s spouse estate tax free. In other words, it is asked, “When I die, I plan to leave my estate to my spouse—and thus there will not be any estate tax due, thus, I do not need a buy-sell agreement or to worry myself concerning the value of my business interest upon my death, correct?” In a sense, there is something correct with this statement. If one plans to give his or her entire business interest to the surviving spouse, then a buy-sell agreement does not confer any immediate major benefit to the business owner. However, at the second death (or if the surviving spouse dies first), the need to establish the value of a business interest cannot be overstated, and a buy-sell agreement will be helpful in this regard (however, certain requirements must be satisfied for buy-sell agreement to “fix” the value for estate tax purposes).
There is a second “special” problem that a business owner must address when planning his or her estate. Namely, when the business interest comprises a substantial portion of one’s estate, the estate may face a liquidity or cash flow problem where insufficient assets are available to pay an estate tax without the need to liquidate the business in order to pay the corresponding taxes arising from holding the business interest until his or her death, and the associated estate administration expenses. Additionally, the business itself may have a liquidity problem when it seeks to purchase the owner’s interest after his or her death. Typically, if the interest is to be purchased by the business itself or by the surviving business partners personally, estate planners will utilize some sort of life insurance to provide for the needed liquidity.
Stated plainly, a buy-sell agreement provides that on the death of an owner of a closely-held business, his or her interest will be purchased. If the purchasers are the surviving owners, then agreement is called a “cross-purchase agreement;” and if the business entity itself is the purchaser, the agreement is called an “entity agreement.” When the surviving owners purchase the interest under a buy-sell agreement, they help ensure a continuous and conflict-free succession of the business after the owner’s death—for the business itself may not be able or willing to distribute earnings to the decedent owner’s estate.
Third, if the business owner is essential to the business, there is the issue of the preservation of the business command and control structure after his or her death. Planning around this is often a business question, rather than an estate or tax matter—although creative solutions may arise from talking with your estate planning attorney. For example, your attorney might alert you to the possibility of a merger with another business, allowing the business to carry on as part of another entity.
Fourth, when the business owner is still actively employed in the business at his or her death, there may be the need to replace the owner’s salary, since his or her family will not have that salary to support them after the owner’s death. An estate planning attorney can help address this issue, as well. For example, the attorney may advise on setting up a defined contribution plan, a deferred compensation plan, a buy-sell agreement, or the use of insurance, to name just a few possible solutions.
A buy-sell agreement additionally provides a method whereby the decedent’s estate will receive cash (or other liquid assets), rather than an unmarketable interest in a closely-held business. This is particularly important where the surviving spouse and family would not know how the run the business after the owner’s death, or where the business interest is to be divided among the owner’s beneficiaries (spouse, children, family, etc.); for it is easier to divide cash (and other liquid assets) than a fractional interest of a closely-held business that is unmarketable.