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Estate pays the price for a bad buy-sell agreement - Part II

The Eleventh Circuit Court of Appeals recently upheld the Tax Court’s ruling that a buy-sell agreement could be disregarded in determining the estate tax value of the closely-held business stock subject to it. However, the Court of Appeals found that the Tax Court incorrectly added the value of life insurance proceeds to the value of the company’s assets in calculating the stock’s estate tax value.

In Estate of Blount, a Tax Court case which we first reported in Issue 5, 2004 of theLaw Letter, George Blount and his brother-in-law, James Jennings, were equal owners of a Georgia road construction and paving company, known as Blount Construction Co. (BCC). In 1981, Blount, Jennings and BCC entered into a buy-sell agreement whereby they all agreed that no stockholder could transfer his shares of BCC without the consent of the other stockholders. The agreement established the share price at book value and BCC purchased a $3 million life insurance policy on the life of each stockholder to fund a stock repurchase upon a stockholder’s death. In 1992, BCC formed an Employee Stock Ownership Plan (ESOP) and funded it with annual contributions of stock from both stockholders.

Jennings died in 1996 and his stock was redeemed by BCC at book value pursuant to the 1981 buy-sell agreement. Later in 1996, after Blount was diagnosed with terminal cancer, Blount, as the sole individual shareholder (and without the ESOP’s consent), entered into a new buy-sell agreement establishing the value of his BCC stock at $4 million. It was a one-page do-it-yourself buy-sell agreement. Blount died in 1997 and his estate valued his BCC stock at $4 million pursuant to the 1996 buy-sell agreement. The book value of Blount’s shares was $7.6 million at the time of his death. The IRS objected to the estate’s valuation and concluded that the fair market value of Blount’s BCC stock was really $7.9 million.

The Eleventh Circuit, affirming the Tax Court, held that the 1996 buy-sell agreement should be disregarded for two reasons. First, the buy-sell agreement was not binding during Blount’s lifetime because Blount was BCC’s controlling shareholder. As such, during Blount’s lifetime, he could change the buy-sell agreement at will. Thus, both courts found that if the agreement was not binding during Blount’s lifetime, it was not binding after his death.

Second, a 1990 tax law grandfathering pre-1990 buy-sell agreements did not save the estate either. The 1990 law provided that any grandfathered buy-sell agreement that was “substantially modified” after 1990, or any new buy-sell agreement entered into after the date of the new law, must contain terms that are comparable to similar arrangements entered into by persons in an arm’s-length transaction. Both courts found that the 1996 buy-sell agreement substantially modified the 1981 agreement. Also, both courts held that Blount’s estate did not present evidence of similar below market arrangements entered into by parties at arm’s length to support the estate’s valuation.

To add insult to injury, the Tax Court had found that the value of BCC should include the $3 million of life insurance that BCC received due to Blount’s death, but had disallowed as an offset BCC’s $4 million obligation to repurchase Blount’s stock under the buy-sell agreement. Since the Tax Court found that the buy-sell agreement should be disregarded, the Tax Court reasoned that the repurchase obligation could not be used as an offset in the stock valuation process. Due to the inclusion of the life insurance proceeds, the Tax Court settled on a value of $8.2 million for Blount’s stock in his estate.

On appeal, the Eleventh Circuit found that the Tax Court erred in including the life insurance proceeds in determining the estate tax value of Blount’s stock.  Although the regulations under the Internal Revenue Code provide that consideration may be given to non-operating assets, such as life insurance proceeds payable to a company, in valuing a company’s stock, the Eleventh Circuit held that the insurance could not be included in this case since BCC acquired it solely to fund its obligation to purchase Blount’s shares in accordance with the buy-sell agreement.

The Eleventh Circuit stressed that even though the buy-sell agreement will be ignored for determining the value of Blount’s stock for estate tax purposes, the buy-sell agreement remained an enforceable liability against BCC.  Thus, the Eleventh Circuit determined that the insurance proceeds should not be considered as ordinary non-operating assets to be included in valuing Blount’s stock.

  • Partner

    John is Chair of the firm's Estate Planning Department. He also leads the firm's Senior Partner Committee, and is a member of the firm's Finance Committee. John, a former Certified Public Accountant, began his career in the tax ...

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