When Wyoming oilman Dave True decided to use buy-sell agreements to make sure his various businesses stayed in the family and to secure some estate tax relief to boot, little did he realize that the end result would be a Tax Court assessment of almost $76 million in estate tax deficiencies and $21 million more in penalties. Fortunately, an appeal to the 10th Circuit cut that bill by $80 million and gave some future guidance to family businesses as well. With the 10th Circuit's opinion and a copy of IRS Code Section 2703 at your side, you should be in a good position to help your clients use buy-sell agreements to their advantage without getting their hand slapped--hard--by the IRS. However, be aware: "Today, it is much more difficult to accomplish any significant tax advantages with a buy-sell agreement," says Bill Mureiko, partner in the Dallas law firm Thompson & King LLP.
The True story began in the early 70s, when True and his wife started gifting and/or selling partial interests in a variety of family businesses to their adult children. Each interest was subject to certain restrictions. Among other things, "failure to work in the business, any attempt to transfer an interest in the business, death, and disability were each treated as if the holder of the interest had notified the other owners [all family] of his or her intent to withdraw from ownership" (Estate of True v. Commissioner). The buy-sell agreements also said that the so-called formula value for each of the businesses would be "derived from a calculation of the tax book value" of those businesses.
The agreements apparently were not mere window dressing. The court pointed out that the parties regularly enforced them. In fact, in 1984 when True's daughter Tamma and her husband withdrew from the businesses to start their own ranch, the family bought them out at tax book value. In addition, Dave and his wife amended their estate plan to remove Tamma as a beneficiary, noting that she had "severed her financial ties with the True companies, and thus her potential inheritances had been fully satisfied (Estate of True)." As we'll see later, the Trues may wish they could take a Mulligan on that decision. "Dave should have left her in his will," says Mureiko. "Had he left her in, it would not have looked like the buy-sell agreement was a testamentary substitute," intended, among other things, to pass property to heirs at less than fair market value.
All the True family agreements had been executed prior to 1990, a critical point because effective October 8, 1990, the rules governing the use of such agreements to establish value for estate tax purposes were changed by the enactment of IRS Code Section 2703. "If an agreement was entered into prior to that date and not substantially modified since 1990, then theoretically, Section 2703 doesn't apply, and you would use the analysis used by the True court," explains attorney Louis Mezzullo, a partner in the Richmond, Va. firm McGuire Woods LLP. "However, if it applies, then you must go through the 2703 analysis."
Section 2703 analysis begins by asking whether the decedent is exempt under a so-called regulatory exception. If he owned more than 50 percent of the partnership or corporation subject to the agreement, he is not exempt, and the agreement must meet the three requirements of Section 2703(b) that the agreement must be
1) a bona fide business transaction that is
2) not a testamentary device to transfer property to "members of the decedent's family for less than full and adequate consideration," and
3) whose terms are "comparable to similar arrangements entered into by persons in an arms' length transaction."
"If 2703 doesn't apply, either because the agreements satisfy those requirements or because of the regulatory exception, then you have two additional requirements under pre-1990 law used in True," Mezzulo continues.
First, under the court's analysis in True, the agreement must be binding during the decedent's lifetime and at his death. The recent Smith III v. U.S. case gives us some idea of what that means since the Magistrate ruled that the agreement was not binding because one party could amend or modify the agreement unilaterally because he owned "2/3 of the general partnership and more than 50 percent of the limited partnership interest," says Mezzulo.
Second, the True analysis says that the so-called price term of the agreement must be "determinable from the agreement." However, apparently it's how the price is determined from the agreement that is important. There is no disputing that the tax book value the True family used in all of their buy-sell agreements satisfied the "determinable" part of the test. What concerned the court was that the formula used resulted in a lower than fair-market value for most, if not all of the subject properties, leading the court to examine whether the agreements were negotiated at arms' length or were intended as testamentary substitutes--a no-no under the True analysis and Section 2703 for that matter. In fact, Mureiko argues that the principal value of the True case in both pre- and post-2703 cases is that "it is instructive as to what the courts will look for in terms of a buy-sell agreement that is a testamentary substitute."
So what did the True court look at? Well, in addition to the arms' length issue, the court listed a host of other factors from which it could "draw an inference" as to whether the agreements were testamentary. For example, it considered the health and age of the decedent when the agreements were executed. It examined whether the parties were equally bound and whether significant assets were excluded from the agreement, among other things. However, it focused primarily on how the price term was selected, including whether the parties sought appraisals or other professional help in choosing the formula they settled on. Of course, the court was also troubled by the fact that Dave True and his wife had essentially disinherited his daughter Tamma after she moved on to greener prairies, saying that she got her share of his estate pursuant to the buy-sell agreements. If the agreements were not intended as substitutes for a will, the court reasoned, she "likely would have been excluded only from that [part] of his estate relating to his interests in [his companies]."
The court was likewise unimpressed that the price-term formula was rather arbitrary and applied across the board to all business entities--ranches, oil and gas companies, and trucking companies--regardless of their differences, resulting in values that were below fair market. "I think that really caused the tax court to stumble and say that this just doesn't look like something unrelated third parties would do," Mureiko says.
Given that these were family businesses, it didn't help that there was no evidence that the parties to each agreement--the children--sought professional counsel before they signed on the dotted line. Nobody hired an attorney to review the documents; nobody hired a CPA to determine values. Instead, they simply signed. According to the court, "they were presented with a business opportunity crafted by their father, which they could accept or reject." In other words, Mureiko explains, "the absence of independent attorneys and CPAs advising each family member was a significant negative factor."
In sum, the court ignored the buy-sell agreements because the only inference they could draw from the facts was that the agreements were testamentary substitutes. "The agreements allowed them to transfer more property than it looked like they were," says Langdon Owen, a shareholder in the Salt Lake City firm of Parsons Kinghorn Harris. "And that's the kind of thing a third party probably wouldn't want."
Though the True agreements were executed prior to 1990, the True case was decided in 2004--four years after Section 2703 went into effect. Consequently, the Trues argued that the court was incorrect in applying 2703's "arms' length standard"--what many call the comparability standard--to their case. The court countered that other courts had consistently applied that standard to buy-sell agreements, long before 1990. "In short, I think the True case makes the same analysis that would be made under 2703," Mezzulo states.
That said, is there any benefit to not substantially modifying pre-1990 agreements? Mureiko thinks there is--if your client's facts stack up well with the True facts. The strict comparability requirement under Section 2703(b)(3) for all practical purposes eliminates the possibility of getting any estate tax leverage out a buy-sell agreement, he says. "However, the old law is not as strict; it doesn't set the bar as high," he says. "So it's possible that an old agreement could get you some estate tax leverage."
On the other hand, given the court's warning that intra-family agreements are subject to greater scrutiny than agreements between unrelated parties, families with pre-1990 agreements that suffer from True-like defects should amend their agreements to bring them in line with Section 2703, as should families drafting agreements in a post-2703 world. Once again, the True case provides excellent guidance. "The court basically interpreted old case law and the older [regulation] as being essentially consistent with 2703," Owen explains. "So the case remains relevant in applying that provision."
And what the case teaches us is that formulas are out the window, particularly if the agreements are intra-family and if they would result in a lower than fair-market value. There are a couple of ways to make sure that doesn't happen, Owens says, and both of them involve appraisals. For instance, the parties could use appraisals as a back-up mechanism in the event the parties can't agree on a value or where the formula hasn't been revised in some time. Or the parties can agree to use an appraisal for establishing value when someone leaves the business or dies. "What I advise parties to do is use an appraisal process whenever the buy-sell gets triggered," he continues. "That's really the only safe way to go. If you don't do that, then in a family deal, you're going to have the courts and the IRS second-guessing you."
Estate planning is something you should not do on the cheap, especially when you have the bucks, and much bigger bucks are at risk. Dave True, like many otherwise sophisticated people, apparently tried to go the poor-boy route, preferring to take the risk rather than pay $3,000 to $5,000 for an appraisal. In fact, the Tax Court penalized the True estate because Dave took that risk with his eyes wide open. "Their accountant had at one time warned him that the [IRS] might not accept the formula value, and he went ahead without an appraisal anyway," Owen says. Thus the IRS picked up the dollar, and the True estate got the dime.
Gregory Taggart (email@example.com), a former attorney who has worked in insurance and financial planning, teaches writing at Brigham Young University.