This is a very good question, particularly when the parties to the buy-sell agreement involve family members. For it is one thing for the agreement to be respected for contract law purposes between the parties; it is another thing for it to be respected for tax purposes (for purposes of the IRS). As explained elsewhere in another Q&A on this site, a buy-sell agreement will be respected for tax purposes only if seven (7) factors are present. Two of these factors are that buy-sell agreement is (i) bona fide and (ii) not a “device” to transfer assets to family members for less than full and adequate consideration in money or money’s worth.
As a result, there is sometimes a tension between these two goals. To see this, consider a parent who seeks to transfer his 60% interest in a business to his son under the terms of a buy-sell agreement. As family, he wants to transfer the business for a lower value, thereby achieving a lower transaction cost. However, to be respected for tax purposes, the transfer under the buy-sell agreement must be “bona fide” and not a “device” to transfer the business to his son for less than full and adequate consideration. In other words, it must not be a wink-wink, nod-nod bargain sale.
What are the business owner’s options, then? In general, there are three methods for an owner of a closely-held business to set the price under a buy-sell agreement for the purchase of a decedent’s interest. Each has virtues and vices.
(1) Valuation set by annual agreement. First, the parties can agree upon a price right now (while the business owner is still alive), and review that figure each year to see whether it is reasonable in light of the growth on the business—for example $25 per share. There are two main drawbacks to this method, however.
The first is its practical implementation is unlikely. That is, it is not likely that busy business owners would pause each year to determine the purchase price. They are focused on growing the business and turning a profit, as they should be. Moreover, this method may also prove difficult in practice because the overall valuation of the business will fluctuate with time. The second main drawback is that some of the business owners may bargain with less than good faith, urging for a lower valuation, particularly if one of the shareholders has a serious illness (e.g. cancer).
(2) Valuation set by formula. Second, the price can be set by a formula upon the owner’s death. There are various formulae that practitioners use. Sometimes a multiple of the book value of the business at the owner’s death is used. One problem with this approach is that book value often departs from the business’ true, fair market value. Essentially, book value is the historical cost of the business, taking into account depreciation. Unlike fair market value, book value does not show the goodwill of the business, as it is not an asset on the balance sheet. Another problem with this method is that it might not actually achieve the twin goals of the business owner (being binding on the parties and respected for tax purposes), as the valuation might not be respected for tax purposes. Book value was rejected as a proper valuation for estate tax purposes by some courts (see, e.g., Estate of True, T.C. Memo 2001-167 (2001)). Other formula methods employ a multiple of the capitalization of the earnings, divided by an appropriate capitalization rate (or “cap rate”). This method is good when the business still has earning capacity at the owner’s death. But if the primary value of the business at the owner’s death is derived from its assets, rather than its earning capacity, then this method would be less appropriate. A third formula method combines a valuation that is partly due to the value of the business assets and partly due to the income potential of the business.
(3) Valuation set by appraisal or arbitration. Finally, the price can be set by an appraisal or by arbitration when the business owner passes away. There is simplicity to this method, but its simplicity also results in uncertainty. In particular, because the valuation is performed only at the death of the departing business owner, the other owners (or the business itself) cannot plan for the purchase of his interest because the purchase price is unknown and unascertainable. It thus would thus be difficult to know how much tax to expect, and how much insurance to purchase.
In sum, buy-sell agreements are important, and determining the price of the agreement is not an easy thing. Each method described above has its drawbacks. Fortunately, not all are fatal. A good attorney may draft into the buy-sell agreement a number of “failsafe” provisions to help prevent certain valuation inaccuracies. For example, if the parties chose the first method above to value the decedent’s interest and there was concern, even if remote, that the other business owners would try to force a lower valuation upon the owner in poor health, the buy-sell agreement could provide that upon the discovery of a terminal disease, the valuation method would switch to an appraisal by a qualified expert. In addition, upper and lower bounds may be established using the book value or the income capitalization method. These are important questions for the business owner to weigh through with his attorney and his advisors.