Tax Matters

Buy-Sell Agreements
There are numerous legitimate business reasons to establish a buy-sell agreement for a closely-held family business. Many of these agreements set the value for estate tax purposes when one of the shareholders dies. If the IRS rejects the price set to represent the value of the stock, a significant estate tax liability may result. Recently, the Tenth Circuit Court of Appeals examined the validity of a buy-sell agreement and rejected its price as the stock’s value, siding with the Tax Court and the IRS.

H.A. True Jr. created numerous oil and gas and related companies, all of them family-owned. Each company had a mandatory buy-sell agreement that obligated shareholders to sell the stock back to the other shareholders when they left the corporation’s employment or wanted to dispose of the shares. The price was set at the book value of the shares. When True died on June 4, 1994, his stock was sold to the other shareholders (family members) at the stated book value. The IRS revalued the stock for estate tax purposes. The estate objected and filed with the Tax Court. The court sided with the IRS, and the estate appealed.

Result. For the IRS. In reaching its decision the Tenth Circuit reviewed the four requirements for a valid buy-sell agreement:

The price must be determined by the agreement.
The terms of the agreement must be binding throughout life and death.
The agreement must be legally binding and enforceable.
The agreement must be entered into for bona fide business reasons—not as a testamentary substitute designed to pass assets to beneficiaries at less than full and adequate consideration.

The agreement met the first three requirements. The question was whether it met the fourth.

In evaluating the fourth requirement, it is important to note that it contains two separate tests. First, the buy-sell agreement has to have been entered into for a legitimate business purpose. Second, the agreement cannot be a testamentary device. The estate convinced the Tax Court there was a legitimate business purpose for the agreement, but it did not overcome the presumption of a testamentary device.

Prior cases evaluating testamentary devices have considered the following factors: the health or age of decedent on entering into the agreement; the lack of regular enforcement of the agreement; the exclusion of significant assets from the agreement; the arbitrary manner in which the price was set; the lack of negotiations among the parties; whether the agreement allowed adjustments or revaluation; whether all parties were bound by the agreement; and other evidence of a testamentary plan. Using these factors the court found too many indications of a testamentary device.

The court found the price was set arbitrarily and was not based on an appraisal or in consultation with professionals. There was no revaluation or adjustment to the price in the buy-sell agreement. No negotiations took place. True had arbitrarily set the price and the terms. The use of book value left out significant assets—in this case, the oil reserves. Finally, there was evidence of a testamentary plan as a result of the deletion of the daughter from his will when she sold her stock.

Losing on the testamentary device issue does not automatically mean the value set was incorrect. It means only that the agreement will not be automatically honored. The taxpayer still can prove the agreement provided for full and adequate consideration if the agreed price equals the stock’s fair market value. The estate argued that under Broderick v. Gore (224 F2d 892 (CA-10)), and in several other cases, a buy-sell agreement that was mandatory for all parties was, by definition, fair market value. However, the appellate court said the cases cited by the estate were based on old law before the issuance of new regulations. Consequently, the cases were no longer an enforceable precedent. Examining the buy-sell agreement based on the evidence of actual value, the court concluded the price was not the value of the stock.

This case provides an excellent review of the qualification to use a buy-sell agreement to set values for gift and estate tax purposes. It would be relevant to other businesses that have developed intangibles through R&D since these would not be recorded on the books. The court, by rejecting precedent, made it more important that these agreements meet all the requirements and not just the one involving enforceability.

Estate of H.A. True, Jr. v. Commissioner, 2004 US LEXIS 24844 (CA-10).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Does Bankruptcy Terminate S Corp Status?
A business that elects to be an S corporation continues to be taxed as such until the election is terminated. It can be terminated in any of three ways: (1) The shareholders revoke the election, (2) the corporation no longer satisfies the eligibility requirements or (3) the corporation has too much passive income during the three previous tax years.

Alphonse Mourad was the sole shareholder of V&M Management, an S corporation that owned and operated a 275-unit apartment complex. In 1996 V&M petitioned for reorganization under chapter 11 of the Bankruptcy Code. To administer the reorganization, the bankruptcy court appointed an independent trustee who, in 1997, sold the apartment complex. The sale resulted in a gain of $2.1 million, which was reported on V&M’s 1997 form 1120S and Mourad’s 1997 schedule K-1. Mourad did not file a tax return for 1997, the IRS issued him a notice of deficiency for that year and he, in turn, petitioned the Tax Court for relief.

Mourad argued the gain should have been reported by V&M, not by him, since V&M’s filing for bankruptcy had terminated its status as an S corporation. The Tax Court disagreed (see Mourad v. Commissioner, 121 TC no. 1). The Tax Court held that a bankruptcy proceeding conducted under chapter 11 did not end S corporation status. Its finding was similar to that in an earlier case, In re Stadler Associates, Inc, 186 Bankr. 762, in which a bankruptcy court decided a petition under chapter 7 of the bankruptcy laws had not terminated S corporation status. In Stadler the court said that, if it permitted a bankruptcy to end S corporation status, it would be adding a fourth way of S corporation termination not specified in the tax code.

Mourad also argued it was unfair to tax him on the income of the property during the bankruptcy proceeding since he had received no benefit from it during that time. The court disagreed with this as well, saying Mourad had single taxation before the bankruptcy and also had benefited later, since the proceeds from the sale of the property reduced the liabilities of V&M for which he was personally responsible. Mourad appealed the decision to the First Circuit Court of Appeals.

Result. For the IRS. The taxpayer reiterated that V&M’s S corporation status ended when it entered bankruptcy proceedings but now used the argument that V&M no longer met the eligibility requirements under the Internal Revenue Code. He said when the trustee took control of V&M the corporate creditors were, in essence, the new owners. Since these new owners were not individuals, V&M no longer was an eligible corporation and its S corporation status was terminated. He also argued that another class of stock had been created because the “new owners” had rights and preferences different from his; therefore V&M was no longer an eligible corporation.

The appellate court rejected these arguments, saying the trustee was more like the management of V&M and that neither the trustee nor the creditors took the place of the taxpayer as the sole shareholder. It said the law states any income in a bankruptcy case should be “taxed only as though such case had not been commenced.” The court agreed with the Tax Court that none of the three ways the tax code laid out for terminating an S corporation applied in this case. The court also could find no shareholders with different rights from the taxpayer’s. This case emphasizes that a bankruptcy proceeding under Chapter 11 does not affect the S corporation status of an entity.

Alphonse Mourad v. Commissioner, 387 F3d 27.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.