The brothers M owned 77% and T owned 23% of the stock of C. The brothers and C signed a Stock Purchase Agreement, the “Stock Agreement”, in 2001. The Stock Agreement provided that upon one brother’s death, the surviving brother had the right to buy the decedent’s shares, but the Stock Agreement required C itself to buy the shares if the surviving brother chose not to buy them.
To fund its redemption obligation, C bought $3.5 million in life insurance policies for both brothers. Article VII of the Stock Agreement provided two mechanisms for determining the price at which C would redeem the shares. It specified that the brothers “shall by mutual agreement, determine the agreed value per share by executing a new ‘Certificate of Agreed Value’ at the end of every tax year.” If the brothers failed to execute the Certificate of Agreed Value, the brothers would determine the “Appraised Value Per Share” by securing two or more appraisals. The brothers never signed a single Certificate of Agreed Value under the Stock Agreement.
Upon M’s death on Oct. 1, 2013, C received about $3.5 million in life insurance proceeds. C used a portion of the proceeds to buy M’s shares from M’s estate. C and the estate did not obtain appraisals for the value of M’s shares under the Stock Agreement, instead entering a Sale and Purchase Agreement, the “Sale Agreement”, for the price of $3 million.
Through the Sale Agreement, the estate received $3 million in cash; M’s son secured a three-year option to purchase C from T for $4.16 million; and n the event T sold C within 10 years, T and M’s son agreed to split evenly any gains from the future sale. T, as executor of M’s estate, filed an estate-tax return valuing M’s C shares at $3 million. The IRS determined that as of Oct. 1, 2013, the fair market value of C should have included the $3 million in life-insurance proceeds used to redeem the shares.
Congress imposes a federal estate tax on a decedent’s taxable estate. The decedent’s gross estate includes the decedent’s property, real or personal, tangible or intangible, as of the decedent’s date of death.
The parties dispute the value of C, and of M’s shares, as of the date of M’s death. The estate argues that the Stock Agreement determines the value of C for estate-tax purposes. The estate also argues, alternatively, that C’s fair market value does not include $3 million of the life insurance proceeds, because the Stock Agreement created an offsetting $3 million obligation for C to redeem M’s shares.
The IRS generally determines the fair market value of any property without regard to a buy-sell agreement, but certain kinds of buy-sell agreements fall under an exception to this general rule.
To control the value of a decedent’s property, a buy-sell agreement must meet the statutory requirements of section 2703(b):
- It is a bona fide business arrangement;
- It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration; and
- Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction.
A buy-sell agreement must also meet several additional requirements:
- The offering price must be fixed and determinable under the agreement;
- The agreement must be legally binding on the parties both during life and after death;
- The restrictive agreement must have been entered into for a bona fide business reason; and
- The restrictive agreement must not be a substitute for a testamentary disposition for less than full and adequate consideration.
The IRS argued that the Stock Agreement is not a bona fide business arrangement. To establish that the Stock Agreement was a bona fide business arrangement, the estate needed only to show that the brothers entered the Stock Agreement for a bona fide business purpose. The parties here have stipulated that the brothers entered the Stock Agreement for the purpose of ensuring continued family ownership over C. The District Court deems the Stock Agreement a bona fide business arrangement.
The estate failed to show that the Stock Agreement was not a device to transfer wealth to M’s family members for less than full and adequate consideration. First, the $3 million redemption price was not full and adequate consideration. The $3 million redemption price is only equivalent to the fair market value of the shares if the court were to find that the $3 million in life insurance proceeds are not included in C’s value. Even though C fulfilled the purpose of the agreement by redeeming M’s shares, T and the estate’s process in selecting the redemption price indicates that the Stock Agreement was a testamentary device. T and the estate excluded a significant asset from the valuation of C, failed to obtain an outside appraisal or professional advice on setting the redemption price, and disregarded the appraisal requirement in Article VII of the Stock Agreement. Additionally, the Stock Agreement’s lack of a control premium for M’s shares undervalues M’s shares. The lack of a control premium for M’s majority interest indicates that the price was not a full and adequate consideration. The Stock Agreement was a testamentary device.
The estate does not show that the Stock Agreement is comparable to similar agreements negotiated at arm’s length. The estate failed to provide any evidence of similar arrangements negotiated at arm’s length. That closely-held family corporations generally use life insurance proceeds to fund redemption obligations does not establish that this particular Stock Agreement was comparable to an arm’s-length bargain, particularly when the $3 million valuation was so far below fair market value.
The Stock Agreement required M and T to agree on and sign “certificates of agreed value” every year to establish the price per share, but they never created or signed such certificates. Under the Stock Agreement, the failure of the shareholders to do so triggered the obligation to obtain the appraised value per share through a very specific process involving multiple professional appraisers. But T and the estate never followed that process. Instead, they chose to come up with their own ad hoc valuation of $3 million.
The court found that C’s share price was not “fixed and determinable” from the Stock Agreement. The $3 million redemption price set forth in the Sale Agreement did not come from any formula or other provisions in the Stock Agreement, rendering the estate’s proposed share price neither fixed nor determinable from the Stock Agreement.
The Stock Agreement required M and T to agree on and sign “Certificates of Agreed Value.” They never created or signed such certificates. During life, the parties did not treat that aspect of the Stock Agreement as binding. The Stock Agreement was not binding after M’s death. T and the estate failed to determine the price per share through the formula in the Stock Agreement. T and the estate did not consider the Stock Agreement to be binding or enforceable on them; they ignored the price mechanism in Article VII and sold M’s shares for $3 million without first obtaining any appraisals for C. T and the estate utterly ignored the mandatory terms, demonstrating that the Stock Agreement was not binding after M’s death. The Stock Agreement does not establish C’s value for estate-tax purposes.
Life Insurance Proceeds
Courts determine the fair market value of property based on the “willing buyer-willing seller” test. The estate urged that the fair market value of C did not include the $3 million in life-insurance proceeds at issue, because those proceeds “were offset dollar for dollar by the obligation to redeem M’s shares” under the Stock Agreement. The parties agree that the facts of this case present the same fair market value issue as Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005). The Eleventh Circuit held that the fair market value of the closely held corporation did not include life insurance proceeds used to redeem the shares of the deceased shareholder under a stock purchase agreement. The Eleventh Circuit reasoned that the Stock Agreement created a contractual liability for the company, offsetting the life insurance proceeds.
The IRS contended that the Eleventh Circuit’s approach violates customary valuation principles. Life insurance proceeds are non-operating assets that generally increase the value of a company. To determine the fair market value of M’s shares, the court analyzed whether C’s redemption obligation was a corporate liability. As the Tax Court observed in Estate of Blount, a redemption obligation is not a “value-depressing corporate liability when the very shares that are the subject of the redemption obligation are being valued.”
A willing buyer purchasing C on the date of M’s death would not demand a reduced purchase price because of the redemption obligation in the Stock Agreement, as C’s fair market would be the same regardless. The willing buyer would buy all 500 of C’s outstanding shares for $6.86 million, acquiring C’s $3.86 million in estimated value plus the $3 million in life insurance proceeds at issue. If C had no redemption obligation, the willing buyer would then own 100% of a company worth $6.86 million. But even with a redemption obligation, C’s fair market value remains the same. Once the buyer owned C outright, the buyer could either cancel the redemption obligation to himself and own 100% of a company worth $6.86 million, or let C redeem M’s former shares. Under this option, the buyer would receive roughly $5.3 million in cash and then own 100% of a company worth the remaining value of about $1.56 million, leaving the buyer with a total of $6.86 million in assets. Therefore, with or without the redemption obligation, the fair market value of C on the date of M’s death was $6.86 million.
Construing a redemption obligation as a corporate liability only values C post-redemption (i.e., excluding M’s shares), not the value of C on the date of death (i.e., including M’s shares). A redemption obligation is not the same as an ordinary corporate liability. C’s redemption obligation simply bought M’s shares. The redemption did not compensate M for his past work, so it was not an ordinary corporate liability. Redemption obligations are different from other types of corporate obligations in that a redemption obligation both shrinks the corporate assets and changes its ownership structure. A redemption does not change the value of the company as a whole before the shares are redeemed. A stock redemption results in the company (and more specifically its remaining shareholders) getting something of value for the cash spent, i.e., the decedent’s share of ownership in the company; the exchange increases the ownership interest for each of the company’s outstanding shares, i.e., the surviving shareholders’ shares.
The $3 million in life insurance proceeds used to redeem M’s shares must be included in the fair market value of C and of M’s shares. The court grants the IRS’s motion for summary judgment and denies the estate’s motion for summary judgment. See Connelly et al. v. United States et al., F.Supp.3d, (E.D. Mo. 2021).
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.
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