943 / What special valuation rules apply to certain agreements, options, rights, or restrictions exercisable at less than fair market value under Chapter 14?

To determine whether a buy-sell agreement or other restrictive agreement has terms comparable to those entered into by persons in an arm’s length transaction, the following factors are to be considered: (1) “the expected term of the agreement, (2) the current fair market value of the property, anticipated changes in value during the term of the agreement, and (3) the adequacy of any consideration given in exchange for the rights granted.”⁴ The terms of a buy-sell agreement or other restrictive agreement must be comparable to those used as a general practice by unrelated persons under negotiated agreements in the same business. Isolated comparables do not meet this requirement. More than one recognized method may be acceptable. Where comparables are difficult to find because the business is unique, comparables from similar businesses may be used.⁵

In the case of a partnership (or LLC) created on a decedent’s deathbed, the IRS has stated that the partnership was the agreement for purposes of IRC Section 2703, and the partnership should be ignored because the partnership was not a valid business arrangement and the partnership was a device to transfer the underlying property to the family members for less than adequate consideration. Even if the partnership was not ignored, the Service stated that it would ignore the restrictions on use of the property contained in the partnership’s agreement; such restrictions also would fail IRC Section 2703.⁶ Courts have also rejected the idea that the partnership can be ignored for purposes of IRC Section 2703.⁷

The Tax Court has applied IRC Section 2703 to certain gifts of family limited partnership interests.⁸

Certain restrictions on the sale or use of property in a restricted management account are disregarded for transfer tax purposes under IRC Section 2703.⁹

For more information on valuing a closely held business interest, see Q 927, Q 929.

Effective Date and Transition Rules

This provision applies to agreements, options, rights, or restrictions entered into or granted after October 8, 1990, and agreements, options, rights, or restrictions substantially modified after October 8, 1990.¹⁰ Any discretionary modification of an agreement that results in other than a de minimis change in the quality, value, or timing of the agreement is a substantial modification. Generally, a modification required by the agreement is not considered a substantial modification. However, if the agreement requires periodic modification, the failure to update the agreement is treated as a substantial modification unless the updating would not have resulted in a substantial modification. The addition of a family member as a party to a right or restriction is treated as a substantial modification unless (1) the addition is mandatory under the terms of the right or restriction, or (2) the added family member is in a generation (using the generation-skipping transfer tax definitions of generations) no lower than the lowest generation of any individuals already party to the right or restriction. The modification of a capitalization rate in a manner that bears a fixed relationship to a specified market rate is not treated as a substantial modification. Furthermore, a modification that results in an option price that more closely approximates fair market value is not treated as a substantial modification.¹¹

Effect on Options and Buy-sell Agreements

In order to help fix values for estate, gift, and generation-skipping transfer tax purposes, newly executed or substantially modified options and buy-sell agreements exercisable at less than fair market value between persons who are the natural objects of each other’s bounty will generally have to meet all three of IRC Section 2703’s requirements. Otherwise, such agreement will be disregarded in valuing the property. Old options and buy-sell agreements which are not substantially modified after October 8, 1990 are not affected by IRC Section 2703. IRC Section 2703’s provisions apply to agreements involving either business or nonbusiness property.