Buy-Sell and Other Restrictive Agreements:
Weaving the Fine Line Between Business Objectives and Estate Tax and the Importance of Consistency

by Keith Schiller, Esq.
Schofield & Schiller
Walnut Creek, California

Buy-sell agreements are at the center of many business succession plans. With the advent of Chapter 14, and §2703 in particular, these agreements have come under increased scrutiny with respect to their role in fixing the value of business interests. This article reviews the law applicable to valuation of closely held business interests before and after Chapter 14 and Offers practical suggestions for drafting and planning in the area of buy-sell agreements. For further analysis see T.M. 835, Estate Freezes (Chapter 14). © Keith Schiller, 1998. This article was published in BNA's "Estates, Gifts and Trusts Journal" (1998).

INTRODUCTION

Restrictive agreements come in many forms - buy-sell, shareholder, partnership, limited liabililty company (LLC) and the like - supporting the continuation of the business, enhancing control, and establishing the purchase and sale price. Setting the price may be the most financially critical, as well as the goal fraught with the greatest peril, when the business deal and tax law are not in harmony. Whether the agreement will be recognized as determining the value of the business is governed by traditional estate and gift tax valuation principles, §§2703 and 2704,¹ and the Internal Revenue Service's expansive (and likely overly aggressive) interpretation of these Code sections.

Consider the following scenario:

H owns 90% of the shares of a light manufacturing business (TexCorp.), which includes depreciable property and an excellent customer base. H and his wife (W, who died a few years ago) have three children: Carol, Dave and Eve. Only Carol is actively involved in the business, as Dave and Eve have chosen other pursuits. TexCorp. has 50 employees, $30 million in annual sales, and two key employees in addition to H and Carol. Carol owns the other 10% of the shares. The existing shareholder agreement allows the surviving shareholder to purchase stock at its book value, which is currently $1 million. H and Carol feel comfortable that TexCorp. could be sold for $6 million on the open market, given goodwill and adjustment of assets to fair market value. On H's death, Carol purchases all of H's shares for $900,000. H's Will allocates estate tax to the residue of the estate. H has a net taxable estate of $3 million apart from the 90% shares of TexCorp.

After Carol pays $900,000 to H's estate for the stock, the estate has assets of $3.9 million in value before estate tax. Unfortunately, the IRS does not accept the shareholder agreement price and is successful in establishing a value of $5.4 million for the business, after taking into account the lack of marketability discount and the control premium.² As adjusted, H's taxable estate is now $8.4 million, which bears a post-2005 estate tax liability of $3,915,000.³ This liability is allocated one-third ($1,305,000) to each child, leaving nothing net of estate tax to pass under H's Will. The $3.9 million of actual cash/assets in the estate is consumed by the $3,915,000 estate tax liability. Dave and Eve each want more. Carol is satisfied with her share. The children are left to battle over the tax allocation provisions and Dave and Eve want to sue someone - or everyone.

Is this case an example of tough love or tough law?⁴ Most likely the latter, and the results are very real. Unless the formula price in the restrictive agreement is accepted for estate or other transfer tax purposes, the potential for injustice, angry beneficiaries (read litigation within the family and against the advisors), and a dysfunctional estate becomes an almost certainty. Coordination between the client's transaction and contract attorneys and the clients estate planning and accounting advisors is vital to harmonizing the business and tax planning perspectives and enabling the business succession to advance successfully.

This article will first review the state of the law governing business valuations, including: the general rules that apply to valuation formulas; the special considerations raised by §§2703 and 2704 for family businesses and the IRS' expanding application of these rules; unexpected problems that can arise if the price determined under the buy-sell agreement is not recognized for transfer tax purposes; and valuation formulas that are practical and workable.

TRADITIONAL FAIR MARKET VALUE RULES

The traditional approach to determining fair market value follows a two-step analysis: (1) valuation of the business as a whole; and (2) valuation of the particular interest being transferred, e.g., the fractional or majority interest in the corporation, partnership, or other entity.

The grandfather of the valuation rules that apply to closely held stock is Rev. Rul. 59-60.⁵ The concept of "fair market value" (FMV) is essentially an exercise of a factual analysis, unless arms'-length sales of comparable assets occurred in reasonably close time to the valuation date.⁶ The regulations apply the concept of the "willing buyer and willing seller" and create the fictional purchase and sale. In this setting, a wide variety of factors and judgment calls may be considered and the relationship between the science and art of appraisal becomes clouded.

In analyzing the first step, the practitioner will seek to establish through an expert appraiser the best approach as among, liquidation value, capitalization of earnings, comparative sales, and other valuation methods. The appraiser will need to select the most appropriate method. The choice of valuation method can have a significant impact on the appraiser's final determination of value. In addition, the appraisal can have a significant effect on the business, as well as tax, results. While a conservative valuation may provide a favorable estate tax result, it may also cause some family members (such as Dave and Eve in the above example) to be shortchanged when the estate is "equally" divided.⁷ After the entity is valued, discounts or control premiums are considered. These valuation adjustments are measured by the decedent's interest, the nature of the business, and other factors. As revealed in a very extensive line of cases, these discount issues receive considerable focus in estate tax audits and court decisions.

The method of valuation of the business as a whole is important not only for the determination of estate tax, but for possible application with any restrictive agreement. Section 2703 imposes a "comparability test,"⁸ which makes certainty of planning with fixed price or formula valuation methods more illusive and places even greater importance on the expert appraiser, who supports both the price and the methodology/formula used in the agreement.

HISTORIC RECOGNITION OF BUY-SELL AGREEMENTS

Regulatory Requirements: Obligation to Sell and Binding During Life

"Restrictive agreements have been effective for estate tax purposes where the agreement restricts transfers during life as well as transfers upon death," observed the Tax Court in Littick Est. v. Comr.,⁹ citing a long line of cases. These decisions are in line with Regs. §20.2031-2(h), which provides:

Another person may hold an option or contract to purchase securities owned by the decedent at the time of his death. Little weight will be accorded a price contained in an option or contract under which the decedent is free to dispose of the underlying securities at any price he chooses during his lifetime.

This statement indirectly establishes the requirement that there exist a binding obligation to sell. An effective buy-sell agreement can establish value even if it would be less than would otherwise apply under the law. As stated in Seltzer Est. v. Comr.,¹⁰ "[a]n exception to the general valuation rules may exist where the security or stock is subject to an option or contract to purchase (buy-sell agreement). The effect of the option or contract upon value may be to reduce the fair market value or, in appropriate circumstances, fix the value for Federal estate tax purposes, in spite of an otherwise established value."

Rev. Rul. 59-60 amplifies the regulation on the issues of lifetime restrictions and obligation to sell as follows:

Where the option, or buy and sell agreement, is the result of voluntary action by the stockholders and is binding during the life as well as at the death of the stockholders, such agreement may or may not, depending upon the circumstances of each case, fix the value for estate tax purposes. However, such agreement is a factor to be considered, with other relevant factors, in determining fair market value. Where the stockholder is free to dispose of his shares during life and the option is to become effective only upon his death, the fair market value is not limited to the option price. It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent, and other material facts, to determine whether the agreement represents a bonafide business arrangement or is a device to pass the decedent's shares to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth.¹¹

Littick upheld a buy-sell agreement with reciprocal obligations that were binding during life and at death under traditional valuation principles, despite the fact that the death of one shareholder was foreseeable. The buy-sell agreement among the decedent and his brothers was signed one year prior to the decedent's death, while he was ill with the disease that eventually killed him. The agreement fixed a value of $200,000 for the decedent's holdings. The decedent's Will directed his executors to comply with the agreement and that any conflict between the agreement and the Will was to be resolved in favor of the agreement. The IRS and the estate stipulated a value of $257,910.97 for the corporation without taking the agreement into account. The Service argued: (1) the agreement was not made at arm's length in view of the decedent's "impending demise"; (2) the agreement was a transfer in contemplation of death; and (3) the agreement was a tax avoidance scheme. The Tax Court rejected these arguments with the following reasoning: (1) the agreement was not a "transfer" (in contemplation of death or for the purpose of taking effect in possession, or enjoyment at or after the death of the decedent, nor a retention of income or benefit for life); (2) the agreement was reciprocal, binding on all parties; and (3) most important:

Where for the purpose of keeping control of a business its present management, the owners set up in an arm's-length agreement, which we consider this to be, the price at which the interest of a part owner is to be disposed of by his estate to the other owners, that price controls for estate tax purposes, regardless of the market value of the interest to be disposed of. (Emphasis added.)

The court "recognized" that the decedent was likely to die before his brothers, but that such order of demise "was not a foregone conclusion."

Hall Est. v. Comr.,¹² represents a significant financial and strategic loss for the Service. Prior to that decision, the Service had taken the position that an adjusted book value price in the agreement would not be recognized if a different price could be used for third parties even if the shares purchased would remain subject to the buy-sell agreement.¹³ The decedent's shares in Hall, valued under the restrictive agreement, were "worth" substantially less than their unrestricted value, which applied to other family members. The Tax Court rejected the Service's argument that the shares should be valued without respect to the buy-sell agreement because unrestricted sales to other family members reflected an insufficient lifetime restriction. The court took into consideration both the extensive sales using adjusted book value and the economic reality that under the agreement the contract price was all that would be received.

Littick is part of an extensive bbdy of case law which amplifies and reinforces the requirement that an obligation to sell exist.¹⁴ The obligation to sell may arise either under a mandatory buy-sell contract under which both parties are obligated to close or under an option to purchase with an obligation to sell.¹⁵ A right of first refusal has also been approved as a valid lifetime restriction in establishing value.¹⁶ In May v. McGowan, above, the shareholders of a family business agreed to a fixed price for lifetime sales with the option for the survivor to purchase the shares for the same price. The appellate court approved the value under the agreement for estate tax purposes. However, in Bommer v. Comr.,¹⁷ the court considered the pre-set price a testamentary substitute and not a transaction that would be made by unrelated parties.

In PLR 9133001, the Service incorrectly concluded that the estate tax value of a partnership interest was not established when an option to purchase existed because there was no obligation to purchase - there was only an obligation to sell. The Service incorrectly relied on Seltzer, above (a decision that the Service lost where the agreement and its price were followed with three stock redemptions), and Regs. §20.2031-2(h).

From a business standpoint, a right of first refusal may make it very difficult to sell stock or other assets subject to that right. After all, a prospective buyer would know that the better the job done in negotiating a lower price, and the more thorough the due-diligence review, the less likely it would be for that buyer to close (because the holder of the right of first refusal is more likely to exercise it). Moreover, the legal, accounting, and time-value expense of negotiating a business buy-out can be large, and the right of first refusal poses a deterrent to even starting that process. Even if the right of first refusal does not establish the price as a matter of law, it can influence the value of the shares.¹⁸

From an estate planning perspective, the option to buy with the obligation to sell is far more flexible and less risky than the obligation to both buy and sell. A binding contract value, if recognized, can fix the value and preclude the use of discounts under the traditional valuation principles discussed above. Second, even if the buyer defaults on the purchase, the contract may establish the price.

Three-Part Test

Above and beyond the regulatory requirement to have an obligation to sell, the courts historically applied a three-part analysis to determine whether the agreement established the estate tax value: (1) the price must be fixed or determinable; (2) the agreement must have a bona fide purpose under the facts upon execution of the buy-sell agreement; and (3) the agreement must not be a tax-avoidance device.¹⁹ The Tax Court recognizes that restrictive agreements can be part of the decedent's estate planning, yet also may uphold the agreement as fixing value because of bona fide business purposes integral to the plan.²⁰

Fixed or Determinable (and Reasonable) Price

The price must be either fixed or determinable according to a formula. Accordingly, a stated price or one that is subject to an established method of valuation, appraisal, or the like satisfies this requirement as long as the price can be determined with reference to the agreement.²¹ However, if the establishment of the price is subject to further negotiation or approval without fallback to an objective method, the agreement would likely not be recognized as establishing the estate tax value. For example, in Bommer, above, a contract price requiring approval of at least 75% of the outstanding stock was not fixed or determinable because the decedent owned 86% of the stock. The decedent's estate, therefore, controlled the price.

Many buy-sell agreements provide for a fixed price and for the parties to agree from time to time upon updated values. If the revisions are subject to a fixed price, the agreement should meet this test.²² However, if the shareholders can revise the price, the Service may find the agreement inadequate to establish the estate tax value.²³ In the PLR 9133001, ruling noted above, the Service reasoned that the parties (the decedent and his nephew) could revise the price to whatever they wanted. This ruling ignores the basic fact that any agreement can be modified with the consent of the parties, no matter how empirical the formula; and, the subject agreement could not be unilaterally amended.

When a fixed price or formula is used, it should be reasonable and support the concept of fair and adequate consideration. The highly visible decision in Lauder Est. v. Comr., above, reflects indicia of taxpayer conduct that will likely not support the adequacy of an agreement: (1) there was no negotiation of the formula price, which was unilaterally established by one child, who was the company president at that time; (2) there was no professional advice in establishing the formula price; (3) the price was established without a formal appraisal or reference to comparables; and (4) good will was disregarded, yet it is an important factor in the cosmetics business. (After all, isn't considerable profit with cosmetics linked to name and image.)

If the method of valuation is reasonable, however, the court may accept substantial differences between the fair market value price without restriction and the price set by the agreement.²⁴

The valuation regulations and Rev. Rul. 59-60 impose the subjective requirement that the agreement carry out a bona fide business purpose. It is easy to establish business purpose among unrelated parties - such as the desire to. promote continuity and avoid unwanted shareholders or partners.²⁵ This test receives greater scrutiny in the family setting. Basically, the buy-sell agreement cannot be a device to pass the decedent's interest to the natural objects of his or her bounty for less than adequate and full consideration in money or money's worth.

Applied in the family context, this "bona fide" business requirement is largely a "smell test." The most significant taxpayer victory was Hall, above, in which "permitted transferees" could acquire shares at lower value than would apply to other transferees. The Tax Court found no reason to ignore the restrictions and determined that the buy-sell restrictions incidentally coincided with the policy of keeping the company involved (Hallmark) privately held.

On the other hand, the court will conclude that restrictions on transfer are "testamentary substitutes," and not in furtherance of a legitimate business purpose when the disposition is to reject the contractual restrictions.²⁶

While the business purpose test is one that can be readily met, practitioners should take care to document the nontax benefits and purposes of the agreement.

Agreement Not a Tax-Avoidance Device

The buy-sell agreement cannot be a device to transfer the business to natural objects of the transferor's bounty for less than full and adequate consideration.²⁷ Because the device test is one of intent, it is important to establish a good record, and, if possible, execute the agreement well before the principal shareholder is nearing death.²⁸

Although this test is most frequently applied in the family context, it is not limited to that arena.²⁹

St. Louis County Bank, above, in which the Eighth Circuit reversed the lower court's acceptance of the contract price, reflects a stricter application of the device test. The appellate court found that the agreement was a device because the decedent, who had had two heart attacks, was in weakened health when the agreement was made; the agreement had not been updated despite substantial changes in the operation of the agreement; and, the agreement had been ignored when another family member died.³⁰ Although not discussed in the case, ignoring or waiving purchase rights can also create a taxable gift.³¹ In Lauder, the court held that the maintenance of family control, standing alone, would not be sufficient reason to give effect to a buy-sell restrictive agreement.

In applying the criteria of "transfer tax-avoidance device," special consideration is given to particular factors, such as the health of the decedent, disparity of sale price from market value, and enforcement of the agreement between the parties. St. Louis County Bank departed from the traditional approach found in an extensive line of cases.³²

While these cases demonstrate that the courts will find a testamentary device to exist notwithstanding concurrent business purpose, the following are some actions that may be taken by the family and practitioner to give the agreement the greatest opportunity not to be classified as a testamentary device:

• Apply the agreement to all transfers, not just those made by the majority or elderly shareholder.

• If possible, have the agreement reviewed by independent counsel for a family member or outside shareholder.

• Make the agreement while people are in reasonably good health.

• Update the agreement in the event of significant changes in the company's affairs.

ENTER CODE §§2703 and 2704

The Omnibus Budget Reconciliation Act of 1990³³ (1990 Act), which enacted Chapter 14, included two provisions, §§2703 and 2704, which apply for purposes of all three transfer taxes to buy-sell agreements, in general, and restrictive covenants and lapses, in particular.

Section 2703(a) provides that in general (1) any options (or agreements or other rights) to acquire or use property for less than the property's fair market value and (2) any restrictions on the sale and use of property will be ignored in determining the value of such property. Section 2703(b) provides that this general rule does not apply to any options, agreements, rights or restrictions which meet all of the following three requirements: (1) it must be a bona fide business arrangement; (2) it must not be a device to transfer the subject property to members of the decedent's family for less than full and adequate consideration; and, (3) it must have terms comparable to similar arrangements entered into by persons in arms-length transactions.

The first two elements apply traditional criteria from the regulations.³⁴ The third requirement of §2703, "comparability," creates many uncertainties. In addition, §2703(b) makes it clear that the business purpose test and the device test are separate and distinct tests.³⁵ Thus, the mere showing that a right or restriction is a bona fide business arrangement is not sufficient to establish that the right or restriction is not a device to transfer property for less than full and adequate consideration. For example, legitimate purposes for a restriction and term can be to centralize management, promote consistency and planning, or avoid ownership from a competitor. However, if the circumstances of the transaction arise in a primarily estate-planning context (especially the ill health of the principal owner - notwithstanding the Littick case), the device test may not satisfied.

A very small safe harbor is created in Regs. §25.2703-l(b)(3), which provides:

A right or restriction is considered to meet each of the three requirements ... if more than 50 percent by value of the property subject to the right or restriction is owned directly or indirectly (within the meaning of §25.2701-(6) by individuals who are not members of the transferor's family. In order to meet this exception, the property owned by those individuals must be subject to the same right or restriction to the same extent as the property owned by the transferor. For purposes of this section, members of the decedent's family include persons described in §25.2701-2(b)(5) and other individual who is a natural object of the transferor's bounty. Any property held by a member of the transferors's family under the rules of §25.2701-6 (without regard to §25.2701-(a)(5) is treated as held only by a member of the transferor's family. (Emphasis added.)

Accordingly, the limitations of §2703 apply when one half or less of the business value is owned not only by nonfamily members, but by persons who are not objects of the transferor's bounty. It should be noted that the Tax Court has applied the traditional valuation tests among unrelated persons.³⁶

The new third element was first discussed in the Senate explanation to §2703:

...the bill adds a third requirement, not found in the present law, that the terms of the option, agreement, right or restrictions be comparable to similar arrangements entered into by persons in arm's length transactions. This requires that the taxpayer show that the agreement was one that could have been obtained in an arms' length bargain. Such determination would entail 'consideration of such factors as the expected term of the agreement, the present value of the property, its expected value at the time of exercise, and the consideration offered for the option. It is not simply by showing isolated comparables, but requires a demonstration of the general practice of unrelated parties. Expert testimony would be evidence of such practice. In unusual cases where comparables are difficult to find because the taxpayer owns a unique business, the taxpayer can use comparables from similar business.

The House-Senate conferees recognized that more than one valuation method could apply.

Regs. §25.2703-1(b)(4) states:

(4) Similar arrangement. (i) In general. A right or restriction is treated as comparable to similar arrangements entered into by persons in an arm's length transaction if the right or restriction is one that could have been obtained in a fair bargain among unrelated parties, in the same business dealing with each other at arm's length. A right or restriction is considered a fair bargain among unrelated parties in the same business if it conforms with the general practice of unrelated parties under negotiated agreements in the same business. This determination generally will entail consideration of such factors as the expected term of the agreement, the current fair market value of the property, anticipated changes in value during the term of the arrangement, and the adequacy of any consideration given in exchange for the rights granted.

(ii) Evidence of general business practice. Evidence of general business practice is not met by showing isolated comparables. If more than one valuation method is commonly used in a business, a right or restriction does not fail to evidence general business practice merely because it uses only one of the recognized methods. It is not necessary that the terms of a right or restriction parallel the terms of any particular agreement. If comparables are difficult to find because the business is unique, comparables from similar businesses may be used.

This comparability requirement imposes a tremendous burden on practitioners, business owners, and appraisers. Keeping in mind that the taxpayer has the burden to prove comparability, the appraisal or valuation formula will require a substantial data base. Reliance on bold assertions, percentages, or prior cases may be insufficient.³⁷ This burden may be very difficult to meet because most businesses are reluctant to share proprietary or confidential information - information which may be important in substantiating comparability. When selecting an appraiser, it is important to inquire about the appraiser's experience and data base in the relevant business.

TAM 9550002 applies the comparability test to an option granted in a QTIP trust to purchase the shares at an undetermined price over five years with interest as established by a bank. The National Office declared that the option was a restriction subject to §2703 and that unless it fell within an exception in §2703(b), the option would have no effect on value. The Service advised that the restriction created by the will, which affects only the shares subject to the will, does not pass the testamentary substitute test. Second, the mere fact that the shares could be purchased based on a promissory note at market rate created terms more favorable than those afforded other shareholders, and it was therefore, a "device." Finally, there was no price stated and the Service did not infer a "fair market price."

"GRANDFATHERED" AGREEMENTS AND THE EFFECTIVE DATE

Section 2703 applies to any right or restriction created or "substantially modified" after October 8, l990,³⁸ and the §2703 regulations are effective generally as of January 1, 1992.³⁹ With respect to transfers occurring before January 28, 1992, taxpayers may rely on any reasonable interpretation of statutory history, including the proposed and final regulations.

Taxpayers with grandfathered agreements should carefully consider the advisability of any amendment to prevent unintentionally invoking §2703. If a change might be otherwise significant, the Service may consider the overall effect of the amendment as making it more or less likely that a fair market price will be achieved as a central point in its evaluation of whether the change is "substantial."⁴⁰ The transfer of closely held stock to family members coupled, with a release of the shares from an existing shareholder's agreement, constituted a substantial modification, according to the IRS.⁴¹ The Service also noted that the recipients of the shares were of a generation lower than those individuals already subject to the agreement, and distinguished between family and non-family transfers.

The regulations state that the following actions do not constitute substantial modifications:

• A modification required by the terms of the agreement.

• A discretionary modification that confers a right or restriction but does not change the right or restrictions in the agreement.

• A modification of a capitalization rate used in respect of a right or restriction if that modification is because of a fixed relationship to a specific market rate.

• A modification that results in an option price more closely approximating fair market value.

While there have been numerous private letter rulings which provide guidance but not precedential authority, the practitioner should consider advising the client to seek a ruling if there is doubt in a particular case.

Section 2703 is not limited to buy-sell agreements. It applies to leases and all other forms of restrictions and agreements affecting use or rights, although the Service has ruled that §2703 does not apply to stock options (which are not equity).

The additional requirements of § 2703 and the aggressive manner in which the Service applies the comparability test - even to the point of asserting that reliance on an interest rate established by an independent bank is not a comparable provision - reveal the importance of drafting and respecting agreements that will have values recognized in order to achieve consistency between the economic deal and tax result. The engagement of a qualified appraiser, who can support value and who has a suitable reference library of similar businesses and industries, will be a cornerstone of this process.

SECTION 2704: FURTHER LIMITATIONS ON THE BUSINESS DEAL AND THE IMPORTANCE OF AN ESTATE-TAX SENSITIVE STATE LEGISLATURE

Section 2704 arises from the Service's defeat in Harrison Est. v. Comr.,⁴² where the value of the decedent's partnership interest (established with his children six months prior to his death) was discounted based upon the lapse of a power of dissolution, which lapse occurred upon the decedent's death. Because of the timing of the lapse, no transfer took place and significant value "disappeared."

Section 2704 treats the lapse of certain rights as a gift by, or includible in the gross estate of, the owner of the lapsed right at death and it disregards certain restrictions on the ability of the entity to liquidate when determining the transfer tax value (gift, estate or GST) of the interest to which the restriction applies. Section 2704 applies only to rights that are similar to voting or liquidating rights (whether in partnerships or corporations). Under the general rule of §2704(a), a lapse of a voting or liquidation right is treated as a taxable transfer if the individual holding such right immediately before the lapse and members of such individual's family hold, both before and after the lapse, control of the entity. The value of the transfer under §2704(a) is the excess (if any) of (1) the value of all interests in the entity held by the individual immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing) over (2) the value of such interests immediately after the lapse. In addition, Treasury is authorized is issue regulations to apply this rule to rights similar to voting and liquidation rights.

Section 2704(b) applies to "applicable restrictions," which are defined as follows:

(1) In general - if -

(A) there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor's family, and

(B) the transferor and members of the transferor's family hold, immediately before the transfer, control of the entity, any applicable restriction shall be disregarded in determining the value of the transferred interest.

(2) Applicable restriction.

For purposes of this subsection, the term "applicable restriction" means any restriction -

(A) which effectively limits the ability of the corporation or partnership to liquidate, and

(B) with respect to which either of the following applies:

(i) The restriction lapses, in whole or in part, after the transfer referred to in paragraph (1).

(ii) The transferor or any member of the transferor's family, either alone or collectively, has the right after such transfer to remove, in whole or in part, the restriction.

An applicable restriction is disregarded in determining the value of the transferred interest. Section 2704(b) goes on to provide important exceptions to this rule:

(3) The term "applicable restriction" shall not include-

(A) any commercially reasonable restriction which arises as part of any financing by the corporation or partnership with a person who is not related to the transferor or transferee, or a member of the family of either, or

(B) any restriction imposed, or required to be imposed, by any Federal or State law.

Accordingly, a reasonable, commercially imposed restriction is outside of this rule as is a restriction imposed by state law. The following is an example from the regulations of this second exception:

D owns a 76% interest and each of D's children, A and B, owns a 12% interest in General Partnership X. The partnership agreement requires the consent of all the partners to liquidate the partnership. Under the State law that would apply in the absence of the restriction in the partnership agreement, the consent of partners owning 70% of the total partnership interests would be required to liquidate X. On D's death, D's partnership interest passes to D's child, C. The requirement that all the partners consent to liquidation is an applicable restriction. Because A, B and C (all members of D's family), acting together after the transfer, can remove the restriction on liquidation, D's interest is valued without regard to the restriction; i.e., as though D's interest is sufficient to liquidate the partnership.⁴³

However, in the event that state law imposes restrictions on transfer or liquidation that are more onerous than those the agreement provides, the lesser contractual restrictions are not applicable restrictions.⁴⁴

The sanction for violating §2704 is harsh. In fact, it is potentially worse than in the event no offending contractual restriction existed and state law was simply followed. Consider the following example from the regulations:

D owns 60% of the stock of Corporation X. The corporate by-laws provide that the corporation cannot be liquidated for 10 years after which time liquidation requires approval of 60% of the voting interests, in the absence of the provisions in the by-laws, state law could require approval by 80% of the voting interests to liquidate X. D transfers stock to a trust for the benefit of D's child, A, during the 10-year period. The 10-year restriction is an applicable restriction and is disregarded. Therefore, the value of the stock is determined as if the transferred stock could currently liquidate X."⁴⁵

Therefore, state or applicable federal law needs to be considered and followed. The California state legislature, in an effort to make limited liability companies (LLCs) more attractive (and receive the franchise tax paid by these entities but not by limited partnerships) amended Cal. Corp. Code § 17,530 to avoid automatic dissolution on the death of a member.⁴⁶ California's Revised Limited Partnership Act,⁴⁷ for example, was also amended to make the implied rule of law more favorable to enhancing discounts by making dissolution more readily avoidable and limiting the transfer of partnership rights.⁴⁸

By incorporating state law provisions into the partnership agreement, the exception in §2704(b) can be applied to enhance discounts. While there may be reason to include restrictions that go beyond those of state law, the starting point should be state law, and, in this regard the practitioner may want to recommend creating the organization under the law of a state that has favorable default provisions.

TAM 9804001 analyzes a limited partnership agreement and illustrates the types of comparisons the IRS makes in determining whether or not restrictions carry weight in valuing the interest for transfer tax purposes or are disregarded under § 2704 as lapses in voting and liquidation rights. The partnership consisted mainly of cash and notes. The partnership agreement provided: (1) the general partners manage the partnership; (2) no limited partner has a right to withdraw; (3) the partnership is to be dissolved upon an event of withdrawal or the date of disposition of all partnership assets; (4) a general partner can withdraw; (5) the death, incapacity, withdrawal or termination of a limited partner does not dissolve the partnership; and (6) on the withdrawal of the general partner, the interest is converted to a limited partnership interest if the general partner continues as a partner, or if the general partner's interest is assigned, the assignee becomes a limited partner. Under applicable state law, in the event a withdrawal occurs and a winding up of the partnership does not occur, the partnership interest of the withdrawing partner is automatically redeemed. A fair market value price is to be used under that state's law, unless the withdrawal is prior to the expiration of the partnership term. The appraiser discounted the limited partnership interest based on the limited partner's inability to participate in partnership management, have access to the capital balance, and trade the asset in the market. Because the decedent was both a general and limited partner, and the general partnership interest held a right of withdrawal or dissolution, the National Office advised that the limited partnership interest had a greater value than if the decedent held only a limited partnership interest. In addition, the decedent could have withdrawn his general partnership interest at any time; and, under state law, the partnership interest would have to be redeemed or the partnership wound up within a specified time. The agreement restricted voting rights on death. The ruling concluded that the decedent's gross estate included an amount equal to the excess of (1) the decedent's limited and general partnership interests when compared to pre-death and post-death value as though the liquidation and voting right lapses did not exist over (2) the value of these interests immediately after death.

This TAM illustrates the importance of following state law because state-law imposed restrictions and lapses are recognized under § 2704 in obtaining a discounted value. Hopefully, other states will adopt statutes as estate-planning friendly as the California Uniform Revised Limited Partnership Act.

The commercially reasonable restriction arises when the condition is imposed by an independent lender. The capital may be provided as debt or equity.⁴⁹ For example, a prohibition imposed by a lender against liquidation without the consent of the independent lender is reasonable and within the exception.

Members of the transferor's family for purposes of §2704 include the transferor's spouse, any ancestor or lineal descendant of the transferor or his/her spouse, any brother or sister of the transferor; and any spouse of any of the people just described. In addition, the attribution rule of §2701(e)(3) applies for purposes of determining the interests held by any individual.

SERVICE 'SEEKS TO EXPAND §§2703 and 2704 IN EFFORT TO ELIMINATE VALUATION DISCOUNTS

Beginning in 1997, the Service issued several TAMs challenging family limited partnerships.⁵⁰ The decedent in most of these cases was very close to death - the decedents died between two days and two months after the agreement was signed although the period was not mentioned in one ruling. The Service's attacks are three-pronged:

• the entity should be disregarded because the formation of the entity and subsequent transfer of entity interests was done shortly before death solely to avoid estate tax;

• the entity should be disregarded under §2703(a)(2) because it imposes restrictions on the right to sell or use property and is not a bona fide business arrangement; and

• the restrictions on the decedent's ability to liquidate the entity are more restrictive than state law would permit and should be ignored under §2704(b).⁵¹

The Service's first challenge was based on substance over form, relying most particularly on Murphy Est. v. Comr.⁵² The government's theory is that a "single integrated testamentary transaction exists" based on the proximity to death.⁵³ However, the Service's position ignores Frank Est. v. Comr.,⁵⁴ which upheld death-bed discount planning.

Second, the Service argued - and a point to which taxpayers may take great issue - that the formation of the partnership (or other entity) was done solely for the purpose of obtaining valuation discounts. The Service's larger issue was that any restriction on the right to sell or transfer property is subject to §2703 and should be ignored. The Service's analysis follows a two-step approach to the transfer: (1) the transfer of the property to the partnership and (2) the transfer of the partnership interest. This approach, collapsing the transfer to treat the formation and gift or sale of thepartnership interest as one transaction, stems from a desire to preclude any gift tax discount as well. Yet, how can that be the case in view of Mooneyham Est. v. Comr.,⁵⁵ where undivided interests in real property were discounted by 15% and immediately transferred to a partnership between the donor and donee? The Tax Court approved that transaction.

Recognizing that the collapsing of the transaction theory may not work to defeat the discount, the Service went on to argue that those elements of the partnership agreement that reduce value should be ignored, including the absence of limited partner liquidation or withdrawal rights, inability to bring a partition action and loss of the power to terminate the partnership. The Service in its initial 1997 TAM⁵⁶ concluded, "Any reduction in value of the underlying assets caused by the partnership agreement is disregarded under §2703(a)(3) [sic] in determining the value of the transfers." The Service applied a Murphy-Cidulka collapse-the-transaction approach to eliminate discounts.

With death-bed transfers, the Service gives little weight to taxpayer assertions that the entity has meaningful nontax benefits, including asset control, maintenance of the ownership within the family, improved management, or the like. '(The Service's overall effort to eliminate entity-created discounts reflects that the Service disregards the nontax benefits of entity-planning, regardless of timing.)

TAM 9723009 is of additional interest to estate planners and the well educated, because of the extensive discussion regarding the fact that the taxpayer was an estate planning attorney and lecturer. Practitioners facing audits with family discount entities, particularly those formed close to death, may receive Requests for Information that inquire about (1) the purposes of forming the partnership; (2) any discussion of alternatives to a partnership considered; (3) the identity of the parties recommending the partnership (presumably taxpayers are better off hearing the idea from someone other than their CPA or tax attorney); and (4) activities of family advisors or members in estate planning lectures.

This issue is obviously one that bears watching. Litigation will most likely be extensive in this arena. Unfortunately for the practitioner facing death-bed transfer planning, if such planning is not undertaken - or at least considered - the likelihood of disgruntled surviving family members increases.

The Service's position that entity formation is a device under §2703 flies in the face of significant judicial, legislative and public ruling precedent. The Conference Report for §2704 states:

The conference agreement modifies the provision in the Senate amendment regarding the effect of certain restrictions and lapsing rights upon the value of an interest in a partnership or corporation. These rules are intended to prevent results similar to that of Estate of Harrison v. Commissioner, .... These rules do not affect minority discounts or other discounts available under present law. The conferees intend that no inference be drawn regarding the transfer tax effect of restrictions and lapsing rights under present law. (Emphasis added.)

Moreover, the Service announced in Rev. Rul. 93-12,⁵⁷ that it acquiesced in the Tax Court's decision in Lee Est. v. Comr.,⁵⁸ and will no longer assume that all voting power held by family members must be aggregated for purposes of determining whether the transferred interests should be valued as part of a controlling interest. Also, a minority discount will not be disallowed simply because a transferred interest, when aggregated with the interests held by other family members, would be part of a controlling interest.

SECTION 2701 CHALLENGES: BEWARE OF DISTRIBUTION PREFERENCES AND GUARANTEED PAYMENTS

Section 2701 imposes a substantial gift tax when the "senior" or preferred return is retained by the transferor. To avoid the imposition of that gift tax liability, there should be no preferences or guaranteed payments in favor of the "donor." While preferences are not permitted if S Corporation status is elected, they can exist with other corporations, LLCs and partnerships

In PLR 9808010, the taxpayers planned to contribute a building to an existing limited partnership in which the children already held 93% of the limited partnership interests, and receive a fixed guaranteed payment for a specified number of years. Because of this preference, the Service ruled that the value of the gift would be measured without regard to the restrictions in the partnership agreement, except that an offset would be allowed for the value of the guaranteed payments. Accordingly, the value of the gift would be the value of the real estate to be contributed less the value of the guaranteed payments.

1. All section references are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder unless otherwise indicated.

2. See Trenchard v. Comr., T.C. Memo 1995-121. There is no blockage discount because the shares are not publicly traded.

3. The applicable exclusion amount under §20 10 will be $1 million for estates of decedents dying after 2005.

4. The misfortune of the hypothetical is exacerbated by the allocation of estate tax to H s residuary estate. This type of allocation is not unusual and would likely be consistent with an equitable apportionment statute. See, e.g., California Probate Code §20,100 el seq. While the tax allocation accentuates the inequity, even a fair allocation may not carry out what the client really intended, In any event, there would likely be considerable litigation over the decedent's overall intent and the allocation of estate taxes.

5. 1959-1 C.B. 237.

6. Regs. §§20.2031-1 and 20.2031-2(f) (estate tax) and Regs. §25.2512-1 (gift tax).

7. Clients should avoid the concept of "equality" in estate planning. Assets, particularly business and investment property or any asset subject to a judgment of its value or discounts which cannot truly be "equal." The concept of "fairness" is more appropriate and enables clients to achieve a successful and satisfying result. In an estate where discounts benefit mainly one child, the parents could provide a specific allocation to the other child based on an assumed capital gain rate. After all, the lower estate tax value also decreases basis and increases later capital gain. While this approach does not produce "perfection" it helps to avoid children being on opposing sides of the valuation and discount issue by having a make-up to the child or share that does not receive discounted value.

8. The comparability test generally requires that the valuation method applied (generally, the terms of the restrictive agreement) be similar to that used with like-kind businesses. This test is reviewed in depth in this article.

9. 101 T.C. 181 (1958), citing May v. McGowan, 194 F.2d 396 (2d Cir. 1952); Broderick v. Gore, 224 F.2d. 892 (10th Cir. 1955).

10. T.C. Memo 1985-519.

11. See also Rev. Rul. 65-194, 1965-2 C.B. 370; Rev. Rul. 77-287, 1997-2 C.B. 318; and Rev. Rul. 83-120, 1983-2 C.B. 170.

12. 92 T.C. 312 (1989).

13. PLR 86032004.

14. See, e.g., Wilson v. Bowers, 47 F.2d 682 (2d Cir. 1932); May v. McGowan, above; Anderson Esi. v. Comr., 36 T.C.M. 972 (1977), aff'd, 619 F.2d 587 (6th Cir. 1980).

15. Wilson v. Bowers, above; Lomb v. Sugden 82 F.2d 166 (2d Cir. 1936), rev'g 11 F. Supp. 472 (W.D.N.Y. 1935).

16. Slocum v. U.S., 256 F. Supp. 753 (S.D.N.Y. 1966).

17. T.C. Memo 1997-380.

18. Lauder Est. v. Comr., T.C. Memo 1992-736 and T.C. Memo 1994-527 (1994); See Rev. Rul. 59-60.

19. Hall, above.

20. Id.

21. See Dickinson Est. v. Comr., 63 T.C. 771 (1975), acq., 1977-2 C.B. 1.

22. See, Littick, above.

23. PLR 8710004.

24. May v. McGowan, above; Hall, above; Wilson v. Bowers, above.

25. Bishoff Est. v. Comr., 69 T.C. 32 (1997).

26. Gloeckner Est. v. Comr., T.C. Memo 1996-148, rev'd on other grounds, No. 94-4007 (2d Cir. 8/18/98). St. Louis Co. Bank v. U.S., 674 F.2d 1207 (8th Cir. 1982); PLR 8710004 (a confused ruling mixing valuation formulas with life insurance); Dorn v. U.S., 28 F.2d 177 (3d Cir. 1987) (where the court found no legitimate business purpose in granting of options to children and grandchildren.) In Gloeckner, the option price for the preferred shares was the shares' par value plus an amount equal to any accumulated but unpaid dividends, and the option price for the common shares was $100 a share. The 1960 redemption agreement provided for yearly revaluations of the option price for common shares.

27. Regs. §20.2031-2(h). See Lauder, above.

28. See Slocum v. U.S., above (agreement with individual in failing health not upheld) and Littick, above (agreement upheld).

29. See Carpenter Est. v. Comr., T.C. Memo 1992-653.

30. Accord Lauder.

31. PLR 9117035.

32. See, e.g., Weil v. Comr., 22 T.C. 1267 (1954), acq., 1955-2 C.B. 10; Slocum v. U.S., above, which held that the agreement was not a device for tax avoidance if a business purpose was found and the restrictions were also binding during life.

33. P.L. 101-508.

34. Regs. §20.2031-2(h) includes the first two exceptions of §2703(b).

35. Regs. §25.2703-1(b)(2).

36. Gloeckner Est. v. Comr., T.C. Memo 1996-148. Although the Second Circuit reversed the decision because there was no evidence to support a finding that a nonfamily member was an object of the decedent's bounty, the court did not dispute the premise that a nonfamily member could be such an object. No. 97-4007 (2d Cir. 8/18/98).

37. Fittl Est. v. Comr., 804 F.2d 1332 (7th Cir. 1986); Rebane, "Living with Chapter 14: An Appraiser's View," 17 Tax. Mgmt. Est., Gifts, and Tr. J. 178 (Nov.-Dec. 1992).

38. P.L. 101-508, §11602(a).

39. Regs. §25.2703-2.

40. See PLRs 9432017 and 9652010.

41. PLR 9620017.

42. T.C. Memo 1987-134.

43. Regs. §25.2704-2(d), Ex. 1.

44. PLR 9710021.

45. Regs. §25.2704-3(d); see PLR 9735003.

46. Cal. Corp. Code §17,530 provides, "A limited liability company shall be dissolved and its affairs wound up upon the 'happening of the first to occur of the following: (d) Except as otherwise provided in the articles of organization or a Written operating agreement, upon death of any member unless the business of the limited liability company is continued by a vote of a majority in interest of the remaining members within 90 days of the happening of the event."

47. Cal. Corp. Code § 15,501 et. seq.

48. See Cal. Corp. Code §15,672 (a limited partnership interest can be assigned but the assignee has the right to become a substitute limited partner if all members (except the assignor) consent, unless the partnership certificate gives the assignor that right); §15,663 (limited partner can withdraw only if allowed in partnership agreement); §15,681 (death of general partner dissolves the partnership, unless the business is continued by the remaining general partners under a right so stated in the partnership certificate or with the consent of all members); and § 15,675 (on the death of a limited partner, the rights of the limited partner pass to the estate).

49. Regs. §25.2704-2(b).

50. TAMs 9719006, 9723009, 9725002, 9730004, 9735003, 9736004, and 9751003.

51. To implement this attack in field audits, some of the Service's Estate Tax Offices commenced using an expanded Request for Information addressing a wide range of matters in the formation of the entity.

52. T.C. Memo 1990-472.

53. Cidulka v. Comr., T.C. Memo 1996-149.

54. T.C. Memo 1995-132.

55. T.C. Memo 1991-178.

56. TAM 9719006.

57. 1993-1 C B. 202

58. 69 T.C. 860 (1978).