Buy-sell agreement with a twist.

• Author: Robbins, Valerie C.

There is little doubt that good business planning includes planning for the death of the business's owners. A well-structured buysell agreement is often important to the planning process. But how the buy-sell is structured can have a major impact on the seller's estate tax.

There are two basic types of buy-sell agreements. The more typical arrangement is a redemption, in which the corporation buys the stock from the shareholder's estate at a price determined by the buy-sell documents. In nonfamily situations, to be honored by the IRS, the price must reflect the stock's fair market value {FMV) at the time of the agreement and must be binding on the parties during lifetime and at death. At the same time, a significant amount of flexibility exists.

Such arrangements are generally funded by insurance, with the corporation named as the insured and paying all the premiums. While a redemption has the advantage of simplicity, it is not without problems.

[] Any build-up of cash value in the policy is subject to the claims of corporate creditors.

[] The life insurance proceeds may cause the corporation to be subject to the alternative minimum tax.

[] The value of the stock may be increased by its proportionate share of insurance proceeds.

To avoid these pitfalls, many corporations are switching to the second type of buy-sell agreement-the cross-purchase agreement. In this arrangement, the corporation is not a party to the agreement at all. Instead, each shareholder agrees to buy a proportionate share of each other's stock in the event of a shareholder's death.

Cross-purchase agreements are not simple. For example, a corporation with five shareholders would need 20 separate insurance policies to accomplish their goals. leach shareholder needs four policies.) But this method does eliminate the problems identified with redemptions.

One of the most difficult aspects of the buy-sell agreement is determining a way to value the stock that reflects its true worth. Remember, when the buy-sell agreement is drafted, the parties do not know who among them will be the buyers and who will be the sellers. Assuming an arm'slength relationship {special rules under Chapter 14 may apply to related parties) and a methodology that clearly reflects FMV, a formula stated in a buy-sell agreement should suffice to fix the stock's FMV for estate tax purposes.

One company went a step beyond just fixing the value in the buy-sell agreement. In Mitchell, 37 BTA 1 {1938), the...