Family Attribution Rules

The redemption (unless under 303) will usually terminate the estate's or heir's interest in the corporation. The problem is that the estate or heir may be treated under the attribution rules as constructively owning stock actually owned by others: spouse, children, grandchildren, or parents (and also certain entities such as trusts, estates and businesses). However, assuming all direct interests in the corporation have ceased, including any interest as an officer, director or employee (being a creditor is permitted), the family attribution rules may be waived by filing an agreement with the IRS not to reacquire an interest in the corporation in the next 10 years. This will then allow a redemption to be a "complete termination of interest" despite continuing ownership by close family members.

Note that the entity attribution rules may not be waived.

The Deceased Owner's Estate

If specific requirements are met, a properly drafted buy-sell agreement can establish the value of a deceased owner's business interest for estate tax purposes. However, the value derived from the agreement must approximate the fair market value of the business interest when the agreement is made. Under IRC Sec. 2703, an agreement entered into after October 8, 1990, can establish the value of a closely held business if (1) it is a bona fide arrangement, (2) it is not a device to transfer the business to family members for less than full and adequate consideration, and (3) it has terms comparable to those of arm's-length agreements.

The accumulated case law has created certain additional rules, which apply even if a particular agreement is not subject to IRC Sec. 2703 (e.g., because it was executed before October 8, 1990): (4) the estate must be obligated to sell at an owner's death, either under a mandatory agreement, or under an option held by the business or the surviving owners; (5) the sale price must be fixed by the agreement, either as a dollar amount or by some formula for determining the price; (6) the agreement must prohibit an individual owner from selling his or her interest during life without first offering it to the business or to the other owners at a specified price; and (7) the price set in the agreement must have been fair and adequate at the time the agreement was made.

If the methodology for determining the price is reasonable, it may discourage the IRS from challenging the valuation of the business interest. One thing is certain, however—with no agreement in place, it might take years before an equitable disposition of a business interest occurs. This may mean that the deceased owner's estate cannot be closed and may be subject to erosion through costly delays and possible litigation.

Beyond the Buy-Sell Agreement

In a business setting, it is easy to look at the role of life insurance in terms of how it helps satisfy a contractual requirement.

However, life insurance does more than provide essential funds for the business at a time when the business itself must recover from the loss of a key contributor. It can prevent unnecessary financial strain for the business and the surviving owners. And it can help assure that a deceased owner's heirs are treated fairly.