Law firms are always looking for creative ways to maintain the firm’s continuity if one of the major partners dies. Many enter into buy-sell agreements, which sell the interests of a deceased or departing owner to the remaining partners using a predetermined price or formula.
The 11th Circuit Court of Appeals gave companies another buy-sell continuation strategy with its favorable 2005 ruling regarding the use of life insurance purchased by the corporation to buy back the insured’s interest in the event of death.
Facts of the Case
George C. Blount owned the majority of shares of a Georgia construction company. He entered into a buy-sell agreement with the other owner, his brother-in-law.
In spite of the earlier positions taken by the IRS and the Tax Court, the Court of Appeals ruled that the amount of the policy proceeds should not be included in the calculations to determine the corporation’s fair market value. (Estate of Blount v. Commissioner, No. 04-15013, 10/31/05)
In the decision, the court stated that even though the company did receive the death benefit, it shouldn’t be included in the corporation’s net worth because, in effect, the money was already spent as the life insurance was purchased for the express purpose of buying back the insured’s shares upon his death. The decision also included a “dollar for dollar” offset for life insurance proceeds that must be used when these proceeds are designated to purchase stock.
The ruling is a definite shot in the arm for business continuation planning structured around stock redemption arrangements. These plans offer some distinct advantages over the more commonly used cross purchase agreements. The cross purchase sidesteps the issue of insurance proceeds being part of a corporation’s net worth because the policies are owned by the individual partners. However, cross purchase plans lead to difficulties when a company is trying to cover shareholders with different ownership levels, wide age differences, or unfavorable health conditions. Stock redemption plans allow the company to pool premiums, which is a more equitable way to deal with diverse shareholders, as well as reduce the number of policies to be purchased.
The Blount decision also stated that the stock redemption agreement didn’t “peg” the value of the business for federal estate tax purposes. The court disregarded the amount listed in the agreement because, as the majority stockholder, Blount could unilaterally change it at any time while he was alive. In fact, he had changed it a few months before his death.
According to the U.S. Treasury, a buy-sell agreement can only set the value of a business for tax purposes if:
- The agreement price is fixed and determined by a formula.
- The estate is obliged to sell under a valid and enforceable agreement.
- The obligation to sell must be binding during one’s lifetime.
The agreement constitutes a bona fide business agreement and is not merely a ruse to pass shares to beneficiaries without full and adequate consideration.
The IRS also has similar statutory requirements for determining a business’ value for estate tax purposes. Known as the three-point “safe harbor” test, it applies to any agreement entered into or materially modified after 1990.