By Raymond Nash
Business Planning
IRC Section 2703(b) and Case Law Requirements
During the month of July, we are focusing on business planning in the wake of the Supreme Court ruling in Connelly v. U.S. On June 6, 2024, the U.S. Supreme Court affirmed the 8th U.S. Circuit Court of Appeals’ decision in Connelly v. United States. This ruling determines that the value of the business at a shareholder’s death will be increased by any life insurance proceeds that are received without an offsetting reduction for the amount of the stock redemption liability.
The Connelly Supreme Court decision might or might not be a narrow ruling; time will tell. It is possible that if IRC Sec. 2703(b) and existing case law requirements had been met, the United States Court of Appeals for the Eighth Circuit might have ruled in favor of Connelly and the Supreme Court would never have been involved. According to the US Court of Appeals holding, the “courts thus recognize that an agreement must contain a fixed or determinable price if it is to be considered for valuation purposes.” The Connelly brothers ignored the valuation provisions during their lifetime and the agreement failed to establish a fixed or determinable price. Thus, multiple courts made the decision to rule against them when determining the value of the company and the application of life insurance proceeds. With the current environment of extra scrutiny from the IRS, it’s important to understand the nuances of the code and law requirements when determining which arrangement to use for a company’s Buy/Sell Agreement.
IRC Sec. 2703(b) reads as follows:
(1) — It is a bona fide business arrangement.
(2) — It is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth.
(3) — Its terms are comparable to similar arrangements entered into by persons in an arms' length transaction.
Per Treas. Reg. 25.2703-1(b)(3), a company automatically meets the criteria for the exclusion if more than 50% of the property is owned directly or indirectly by individuals who are not members of the same family. The presence of non-family members will ensure that fair market value terms are being used in any agreements. The overarching purpose of IRC Sec. 2703(b) is to stop any perceived valuation discounts in familial transfers. The intent of these transactions is judged at the time the agreement is entered into, rather than with hindsight. A parent cannot discount the value of the company (via restrictions or buy/sell options) for the purpose of gifting it to their child and expect the company to be taxed according to their debatable discounted value, even if there is a reasonable basis for discounting the assessed value.
Navigating the 3-pronged safe harbor as outlined in IRC Sec. 2703(b) can be tricky, given the broad language used for each safe harbor requirement. Generally, a restriction contained in an agreement can satisfy the bona fide business arrangement requirement if the arrangement furthers a business purpose. For example, maintaining a familial control of a business, implementing a business succession plan, or planning for future liquidity needs that will occur after the death of a family member have been used to meet the requirement for IRC Sec. 2703(b)(1).
The language for IRC Sec. 2703(b)(2) is clearer, but there are several factors that might be considered when assessing if the company meets this requirement. In the Estate of True v. Commissioner, the court outlined the factors that they reviewed: (1) the decedent’s ill health when entering into the agreement, (2) lack of negotiations between the parties before executing the agreement, (3) lack of (or inconsistent) enforcement of buy-sell agreements, (4) failure to obtain comparables or appraisals to determine the buy-sell agreement’s formula price, (5) failure to seek professional advice in selecting the formula price, (6) lack of provision in buy-sell requiring periodic review of a stated fixed price, (7) exclusion of significant assets from the formula price, and (8) acceptance of below-market payment terms for purchase of decedent’s interest. Applying this subjective test of intent can help to determine if an option or restriction at issue is a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth.
IRC Sec. 2703(b)(3) is the last safe harbor requirement to consider, and it can be the most difficult to navigate. There are no databases that house arrangements for other companies that are in arm’s length. It can be difficult to ascertain what is comparable for each company. If challenged, the courts generally rely on expert testimony and appraisals to determine if this safe harbor requirement has been met. Considerations for the appraisal of a company to determine fair market value include the company’s net worth, prospective earning power, dividend paying capacity, the good will of the company, the economic outlook in the industry, and the company’s position in the industry. Detailed documentation and regular updates to the appraisals are key to establishing that terms are comparable to similar arrangements entered into by persons in an arms' length transaction.
It is also wise to consider the case law requirements when determining the preferred arrangement for a Buy/Sell Agreement. Case law states that an estate must be obligated to sell at death. The price must be established by the agreement or contain a method or a formula for valuing the business. If selling during an owner’s lifetime, the interest must first be offered to other owners at the agreement price. And the price must be fair and adequate when made.
Connelly v. U.S. demonstrates the importance of including all members of an advisory team when implementing a Buy/Sell plan for a company. Careful planning and ongoing monitoring can help prevent these situations. It’s important to work with subject matter experts to help ensure that every aspect of the plan is fulfilled. Buy/Sell Agreements need to be technically sound when they are established and then regularly reviewed for accuracy and compliance. Using stock redemption arrangements, in light of the heightened IRS scrutiny and the negative repercussions if one of the three IRC Sec. 2703(b) exception requirements are not met, might not be worth the risk. In any case, valuations need to be updated regularly and additional life insurance needs to be implemented as the business value increases.
Contact us with any questions or opportunities to help you or your clients achieve identified goals. This is what we enjoy doing for only a select number of families, businesses, and charitable institutions each year, and we look forward to hearing from you.