By: Boyd D. Hudson, Esq.
In the Spring 1997 issue of Dealer Buy-Sell, we discussed the main types of business continuation agreements, and when they were used. Business continuation agreements help owners protect the continuity of the business’s ownership, to establish a value for federal estate tax purposes, to provide the business a source of cash, and to create a market for the company’s stock. There are two principal types of business continuation agreements. In “cross-purchase” agreements, the shareholders agree to sell their interests to each other in case of death, disability, retirement or some other event. In “redemption” agreements, the business itself agrees to buy out the departing shareholder. In this article, we will focus on the income and estate tax effects of these agreements.
A. INCOME TAX EFFECTS
1. Cross-Purchase Agreements: In a cross-purchase agreement, the shareholder or his estate sells the stock to the other shareholders under the terms of the agreement, upon the occurrence of a triggering event. The buyers receive a tax basis in the stock equal to what they pay for it. The seller has capital gain or loss depending upon his or her tax basis in the stock. The estate will receive a “stepped-up” basis in the stock. In other words, the estate will receive a basis equal to the fair market value of the stock at death.
2. Redemption Agreements. In “redemption-type” agreements, where the agreement is between the business itself and the owners, the income tax issues are more complicated. For a selling shareholder, the goal is to make sure the transaction qualifies as redemption under the Internal Revenue Code. Failing to qualify the transaction as a redemption frequently makes the transfer a dividend, which will be taxed as ordinary income.
a. Selling Shareholder Issues. If the redemption falls into one of four categories, the selling stockholder will be considered to have sold his stock to the corporation, realizing either a gain or loss equal to the difference in the amount of proceeds and his tax basis in the stock; i.e. capital gain treatment. Of the four categories which give rise to sale-or-exchange treatment, only two are frequently encountered:
1. Redemptions that are “substantially disproportionate”. A redemption is “substantially disproportionate” if the shareholder owns less than half of the voting stock immediately after the redemption, and if the percentage owned decreases by at least 20 percentage points. In other words, a shareholder will receive capital gain treatment where his or her percentage interest in the business has decreased significantly.
2. Redemptions that cause a complete termination of the shareholder’s interest. The shareholder may also obtain sale-or-exchange treatment by transferring his or her entire interest.
Significantly, the Internal Revenue Code “attribution” rules affect the determination of sale-or-exchange treatment. Therefore, the IRS will consider a living shareholder to own not only his or her own stock, but also the stock held by the shareholder’s spouse, children, grandchildren, and parents. In addition, stock owned by a beneficiary of a decedent’s probate estate is considered to be owned by the estate. Stock owned by an estate is considered owned proportionately by its beneficiaries.
Because of the attribution rules, a seller will often receive dividend treatment when the corporation redeems related shareholders while the family still owns all of the stock. For example, if Mom, Dad and their two children each own 25 percent of the stock of Dealer Corp., and Dad’s stock is redeemed, the distribution to him will be a “dividend” even though 100 percent of his stock was redeemed. Through the attribution rules, the family owns 100 percent of the stock both before and after the redemption. However, under some special conditions, the attribution rules will not apply fully, and the redemption can still receive capital gains treatment.
b. Tax consequences to Corporation of Redemption. The corporation does not recognize gain or loss, from a distribution, related to (i) its own stock or rights to acquire its stock, or (ii) other property. The corporation reduces its earnings and profits upon the distribution of property. However, if the distributed property is appreciated property, the corporation first recognizes gain. Such gain results in an increase to the earnings and profits of the corporation. Earnings and profits are then reduced by the fair market value of the property distributed.
B. ESTATE TAX ISSUES OF BUSINESS CONTINUATION AGREEMENTS
1. In General. One of the objectives of a business continuation agreement is to establish the value of the business for federal estate tax purposes. Principally, shareholders want a valuation mechanism that the IRS will recognize. Often, the IRS will challenge stock valuations as artificially low and as not reflecting the true value of the shareholder’s interest. Further, in 1990, Congress passed a law establishing specific guidelines that shareholders must meet for the IRS to recognize a business continuation agreement for estate tax purposes.
2. Statutory Requirements. Under the 1990 law, the IRS will recognize the value for the business established by a business continuation agreement if:
a. It is a bona fide business arrangement;
b. It is not a device to transfer property to members of the decedent’s family for less than that property’s value; AND
c. Its terms are comparable to agreements between unrelated shareholders.
3. Meaning. As a result of the new law, the IRS will uphold business continuation agreements that meet these three tests, even if the resulting purchase price is lower than the current fair market value. Otherwise, the IRS will ignore the agreement and value the stock at the full fair market value.
4. Meeting the Three Tests.
a. Bona Fide Agreement. The agreement has to have a bona-fide business purpose, other than the reduction of estate taxes. The courts and the IRS have upheld agreements that were designed to ensure continuity of management. The IRS also accepts the preservation of family control as a valid business purpose.
b. Not a Device. If the parties have followed the terms of the agreement at all times, the IRS will not consider it a “device” for shifting the business to the family at a reduced price. In one case, the IRS ignored the terms of an agreement that tried to set the value of interests in a family partnership. Essentially, on three separate occasions, the partners had failed to exercise their options to buy partnership interests, which allowed one partner to transfer his interest to his family at a reduced value. Another factor is whether the shareholder-decedent would have been bound to the price as reflected in the agreement while alive. In other words, did he have the right to dispose of the stock at whatever price he chose while he was alive.
Even if the arrangement is not between family members, and meets the device test, it still must satisfy the other two tests. However, usually, shareholders do not want to transfer assets to people outside their family for less than adequate consideration. Shareholders normally want to protect their own families by avoiding agreements that effectively transfer assets for less than their full value.
c. The “Similar Arrangement” Requirement. This provision requires the shareholder to show that the agreement was one that could have been obtained in an “arm’s length,” negotiated agreement among unrelated parties in the same business. Among other factors, the IRS will consider the expected term of the agreement, the present value of the property, its expected value at the time exercised, and the price offered.
The taxpayer has the burden of proving that his particular method is a similar arrangement. Generally, isolated comparables will not be evidence of general business practice. However, if more than one valuation method is used in a particular business or industry, a right or restriction will not fail to show general business practice merely because it uses only one of the recognized methods.
The estate should adopt one of two approaches in order to meet this requirement. The estate can value the shares through an independent appraisal. Although it does not freeze the stock’s value, independent appraisal meets the “similar arrangement” requirement. Alternatively, the agreement can use a formula for determining the purchase price periodically. This formula should be comparable to those used in the same industry as the business. The parties can review and change the formula if the circumstances of the business change.
Please note that a business continuation agreement does not have to meet these three tests above if non-family members own more than 50 percent of the business. Generally, when the transferor is a minority interest holder, it is less likely that a shareholder will use the restrictions to transfer the business to his or her family for less than its fair market value.
CONCLUSION
If you are concerned about the continuity of your dealership’s management and about protecting your family after you die, then a business continuation agreement can ease your concerns. However, you need to have your agreement drafted carefully and reviewed regularly to assure that it complies with current income and estate tax laws. We recommend that dealers and their advisers review their existing agreements to determine if they meet all income and estate requirements.
(Mr. Hudson is formerly of Counsel to the law firm of Manning, Leaver, Bruder & Berberich.)
This article was written in 1998.