U.S. Supreme Court Agrees to Decide Valuation Dispute Involving “Buy-Sell” Agreements
Shareholder “Buy-Sell” Agreements (or similar terms contained in the Operating Agreement of an LLC or Partnership Agreement) are a common key element of the business plan for owners of closely held entities. These agreements generally restrict transfer of interest outside of a close group and are often used as part of a business succession plan upon the death of one of the parties. The Supreme Court decision will address the valuation of the interest as a result of these contractual obligations. Connelly v United States, 70 F. 4th 412 (8th Cir. 2023), cert. granted No. 23-146 (December 13, 2023).
The “buy-sell” terms of an agreement among owners of a closely held entity are a useful tool that allows parties to purchase the interest of another member upon a variety of “triggering” events. These triggering events can include termination of employment, bankruptcy of the party, divorce of a party or to a proposed transfer outside an immediate group. However, a very common triggering event occurs upon the passing of one of the parties. By structuring a “buy-sell agreement” to incorporate a mandatory purchase by the survivors, the selling party can be assured of having the ability to liquidate closely held business interests which might otherwise have little or no value on the open market. The ability to purchase the shares by the surviving parties can allow the survivor(s) to continue the business unimpeded by the wishes of other third-party heirs to the estate of the deceased. In structuring the terms of a buy-out plan at death, the parties must be mindful that the purchase price, if too significant, can jeopardize the continuing ability to operate the business due to the cash flow strains resulting from the payments. As a result, many of these buy-sell agreements are funded by a life insurance death benefit.
There are three basic structures for Buy-Sell agreements. The first will contain provisions that allow the shareholders to acquire the interest of each other, a so-called “cross purchase” form. This form is generally preferred because it gives the buying party a “basis” in the acquired shares equal to the amount paid. The second will call for the entity to acquire the interest of the deceased individual by redeeming the deceased party’s interest. The third will contain a series of options for either the shareholders or the entity to acquire the interest.
The Connelly case involves two brothers, Thomas and Michael, who owned a company called Crown C Supply, Inc. in which Michael owned 77% and Thomas owned 23%. In order to satisfy the buyout plan, the corporation had acquired a $3,000,000 life insurance death benefit to effectuate a redemption. Michael passed away and it seemed that the entity was worth $3,890,000 upon the date of his death. Accordingly, Thomas, as executor of Michael’s estate, sold Michael’s 77% interest in the company to the corporation in exchange for $3,000,000 in cash that was received through the policy.
The parties had entered into a stock purchase agreement as a ‘cross purchase’ and, if not exercised by the survivor, the agreement required the company to buy back the brothers’ shares. Because the life insurance death benefit was paid to the corporation and not to Thomas individually, the corporation held the cash to acquire the interest from Michael’s estate. While the agreement required the brothers negotiate an “agreed value” each year to determine the purchase price, if they did not, the purchase price was to be decided by appraisal. The brothers had never agreed to an ‘agreed value’ and instead of obtaining two (or more) appraisals as was required by the agreement, the company and Thomas, both as purchaser and surviving brother and as executor of Michael’s estate, determined the price should be $3,000,000, about 77% of $3,890,000.
The Connelly case[1] addressed the question, what value should be assigned to Michael’s estate for the shares he held at his passing. Would the value for his shares be $3,000,000- the amount paid- or, considering the fact that the corporation had acquired $3,000,000 life insurance death benefit should his value be determined to be 77% of $6,890,000 reflecting the fact that the corporation had acquired the life insurance death benefits (i.e., $3,890,000 plus the $3,000,00 death benefit). The IRS had taken the position that the value in his estate for estate tax purposes would be 77% of $6,890,000 and thus, imposed an estate tax on the value of his estate.
A provision of the Internal Revenue Code, IRC Section 2703, provides as a general rule that buy-sell agreement values are to be disregarded in determining the value of the decedents shares. However, IRC Section 2703(b) give a safe harbor that provides that the buy-sell agreement can be binding upon the IRS in the event the three tests are met. First, the arrangement must be a bona-fide business arrangement. Second, the arrangement cannot be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money (or money’s worth value). Third, the agreement terms need to be comparable to similar arrangements entered into by persons at arm’s length to transactions. Michael’s estate conceded that it did not meet the safe harbor of IRC Section 2703(b) because an appraisal was not used to determine the value.
By contrast, for New Jersey inheritance tax purposes, this provision of the federal Internal Revenue Code does not apply. The New Jersey inheritance tax does not apply on transfers to many immediate family members; however, for a buy-sell agreement among unrelated parties, an excess value provided to a non-family member because a price is too low can be treated as a ‘transfer’ subject to a New Jersey inheritance tax at 15%[2]. An important point to remember is that, for New Jersey residents, the Will of the decedent should make sure that the decedent’s Last Will and Testament directs that any inheritance tax be paid by a party who acquires the shares for less than fair value. It is also worth noting, that buy-sell terms are binding in New Jersey, even if the value is less that fair value. A binding contract that is entered into by the parties while living must be respected by the estate of a deceased owner. See Estate of Cohen v. Booth Computers, 421 N.J. Super 134, 22 A.3d 991 (App. Div. 2011).
In Connelly, the estate argued that the life insurance should not increase the value of Michael’s interest because, while the corporation had received the life insurance death benefit, the corporation was also simultaneously legally bound by the terms of the agreement to use the proceeds to acquire Michael’s interest. Thus, the estate argued that there was an obligation, akin to a legal debt, that would reduce the value to the original $3,890,000 figure. This position had been established in an 11th Circuit case Blount v Commissioner.[3] The Eighth Circuit in Connelly agreed with the IRS and disagreed with the Blount decision. The court found that the tax code required that a non-operating asset, like the death benefit, must be included in the value of the company. The court concluded that the life insurance proceeds received by the company on the death of the first brother must be included in the value of the company at death and found for the IRS. Now, as a result of the split in authority among the federal Circuit Courts, the Supreme Court has agreed to settle the differences in a decision expected next year.
Some of the key takeaways from Connelly are that i) buy-sell agreements are always important tools for members of a closely held entity, ii) a cross purchase agreement is a better approach than a redemption plan for buy-sell agreements, iii) if family members are involved, a formula valuation agreement provision should be used to set the purchase price so amount paid is reflective of fair market value and the safe harbor provisions of IRC 2703(b) can apply, and iv.) for New Jersey taxpayers, where non-family members are involved, consider the potential impact of the New Jersey inheritance tax.
[1] 70 F 4th 412 (8th Cir. 2023).
[2] As a “Class D” beneficiary for New Jersey inheritance tax purposes. See, N.J.S.A. 54:34-5; See Grell v. Kelly, 132 N.J. Eq. 593 (N.J. Prerog. 1944). See also, Schroeder v. Zink, 4 N.J. 1 (1950).
[3] 428 F.3d 1338 (11th Cir. 2005)