A Qualified Appraisal is a Must for Buy-Sell Agreements

 
Businesses with more than one owner should create and maintain a written buysell agreement specifying what happens in the event of an owner’s death, disability, divorce or retirement. A buy-sell agreement (“BSA”) is a contract between the owners (or the owners and the business entity itself) that establishes rules and restrictions when there is a change in ownership brought about by a “triggering event”. Triggering events are specified in the contract and generally include any circumstances that cause an owner to dispose of an ownership interest.

The typical BSA provides that an owner’s interest in the business will be sold at a specified price to the other owners or to the business itself, upon occurrence of specified events. Common methods for determining the purchase price under a buy-sell agreement include: establishing a fixed price in the contract, specifying a formula such as a percentage of book value or sales, or requiring an independent appraisal.

A BSA prevents unwanted persons from becoming members of the ownership group and ensures a ready market for closely held ownership interest. In the case of an owner’s death, it provides liquidity to a deceased owner’s family and assures any co-owners that they will have the option of continuing the business without interference from the family of the deceased owner. In some cases (provided the agreement is drafted in accordance with the Internal Revenue Service Regulations), BSAs also offer estate planning benefits by establishing a value for the business.

The most crucial aspect of a well structured BSA is the provision establishing the purchase price. Most owners seek fairness and, accordingly, want the transfer of ownership interest to be based on a price that approximates fair market value.

If the owners anticipate using the BSA for tax purposes (i.e. establishing a price for estate tax purposes), there are specific tax guidelines that must be followed for the BSA to be acceptable to the Internal Revenue Service. Generally speaking for a BSA to be acceptable to the IRS, it must:

• Be a bonafide business arrangement
• Not be a device to transfer interest to family members for less than full and adequate consideration, and
• Have terms comparable to similar agreements entered into by persons in an arms length transaction.

In addition to the Tax Court, civil courts have also favored BSA’s that meet this three prong test.

The first and last tests are easily met. The second test is the more difficult to meet and has been subject of a plethora of litigation.

The best way for to avoid rejection of the BSA by the IRS and civil courts is to ensure fairness to all parties by establishing a fair market value price at the time the agreement is entered. Furthermore, the agreement should also provide a mechanism to track changes in value over time so that at any point in time the fair market price is readily available.

There are two ways to attain the fair market value:

1. Independent appraisals on a regular basis
2. Periodic appraisals in combination with a formula

An independent appraisal on a regular basis, while the most accurate method, can be expensive and time consuming and it does not measure value between appraisal periods.

Periodic appraisals in combination with a formula provides for better practicality without compromising the integrity of the appraisal. With this approach, typically an appraisal is done at the time the BSA is established, and subsequent appraisals are done either every five years or every time there is a major change in business operations. Between appraisals dates, value is determined via a formula which incorporates financial data as well as industry economic measures.

The appraiser assisting in the preparation of the BSA needs to understand the company and the industry “value drivers” which are generally obtained in the process of preparing the initial valuation. The appraiser will structure a customized buy-sell pricing mechanism designed to track future changes in value without the cost of a valuation. A well drafted pricing mechanism will consider future changes in the company’s financial position, earnings and cash flow as well as non-financial matters such as the industry, market position and competition.

Failure to draft a BSA that properly measures fair market value can prove to be very costly, as demonstrated in the following cases. Estate of H.A.True, Jr. and Jean D. True v. Commissioner, July 6, 2001, T.C. Memo 2001-167. This tax court case was decided less than two years ago and sent a clear message to the legal community that the sale price of stock exchanged in accordance with the BSA must reflect fair market value.

For over 20 years, the True family abided by the BSA that stated that shares were to be exchanged at book value. The tax court concluded that, even though the family amicably agreed to a value, the BSA was unacceptable for tax purposes because it did not reflect the company’s fair market value. The opinion stated that: “The court is troubled by the fact that the accountant hired by the family has no technical training or practical experience in valuing closely held businesses”.

As a result, the court assessed an additional $75 million in tax plus a $30 million penalty for valuation understatement.

Estate of Lauder v. Commissioner.The tax court ruled that the buy-sell agreement could not be used to measure the value of the holdings of Estee Lauder in part because the estate made no effort to retain qualified appraisers to set a price for the stock. The opinion stated: “The court is troubled by the fact that the defendant’s son settled on a book value formula after having consulted only with a close family advisor, not a valuation expert”.

BSA’s are useful and enforceable devices as long as fairness is the objective. The best method for ensuring that the buy-sell agreement is based on fair market value is to engage an experienced and qualified appraiser, otherwise you run the risk of severe tax penalties or having the court reject the BSA.

FWIW - Summer 2003

FWIW is intended to inform readers of developments in the field of valuation. The articles written may, or may not, reflect the opinion of the authors. Please note, any advice contained in this publication was not intended, or written, to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This publication is distributed with the understanding that the publisher and distributor are not providing legal, accounting or other professional advice and assume no liability whatsoever in conjunction with the information contained within this publication.