Apr 1, 2005 12:00 PM, By Louis A. Mezullo, partner, McGuire Woods LLP, Richmond, Va.

By: By Louis A. Mezullo, partner, McGuire Woods LLP, Richmond, Va.

Owners of closely held businesses have traditionally used buy-sell agreements to restrict the transfer of interests in their businesses to unwanted third parties, and to establish the price and terms for purchases of interests in their businesses upon the occurrence of certain events, such as the death, disability or retirement of an owner. In addition, when a business is family-owned, a buy-sell agreement's price terms can establish the value of the interest for estate-tax purposes, if the agreement satisfies requirements spelled out in the regulations and case law.

Congress suspected such agreements were being abused by owners who were setting purchase prices artificially low so that interests would be more lightly taxed upon transfer. In 1990, the lawmakers enacted Internal Revenue Code Section 2703, which applies to buy-sell agreements, as well as other arrangements affecting the value of an interest in a business entered into, or substantially modified after Oct. 8, 1990. IRC Section 2703, generally applicable to family-controlled entities, codified several of the requirements that then existed under regulatory and case law. According to the new rules, for a buy-sell agreement to effectively establish the value of an interest in a business, it must be a bona fide business arrangement, and not a device to transfer the interest to the natural objects of the transferor's bounty for less than full and adequate consideration in money or money's worth. IRC Section 2703 also added what some perceived as a new requirement: that the terms of the agreement must be comparable to terms in similar arrangements entered into by unrelated parties dealing at arm's length. The U.S. Court of Appeals for the Tenth Circuit, upholding the Tax Court's decision in the True case¹ and applying the law in existence before Oct. 8, 1990, has created a guide to what constitutes a testamentary device, that is to say a device that passes a business to heirs at less than fair market value.

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