Using a buy/sell agreement to establish the value of a business interest.

AuthorOwen, Sheila A.

A buy/sell agreement can be used to establish the value of a member's limited liability company (LLC) interest when the member dies or retires and can have other important advantages, including:

* Providing for continuity of business operations at the death or disability of an owner;

* Establishing a market for an asset that might otherwise be difficult to sell;

* Preventing ownership from being transferred to unwanted owners;

* Providing for the liquidity to buy out a member's interest;

* Ensuring the LLC interest passes to those family members who are active in the business, while providing financially for other family members who are not active; and

* Avoiding potential legal conflicts between members of the LLC.

A buy/sell agreement is a contract between the members of an LLC that provides for the sale (or offer to sell) of a member's interest in the business to the other members or to the LLC when a specified event or events occur. Common events triggering a buy/sell agreement include death, disability, retirement, and divorce. The sales price is determined under a valuation method specified in the agreement. Common valuation methods include a fixed price, an independent appraisal, a formula approach such as a multiple of earnings, or book value.

Establishing the value of an LLC interest prior to a client's death helps to identify and quantify the liquidity needs of the client's estate. A properly structured buy/sell agreement can help establish this value. However, if the valuation provisions in a buy/sell agreement are not recognized for estate tax purposes, the estate may face costly valuation disputes with the IRS, as well as potential liquidity problems.

Transferability restrictions

A fundamental purpose of a buy/sell agreement for a family LLC is to restrict the owners' ability to freely transfer their interests, to avoid unwanted owners. This is usually accomplished by limiting the situations in which an owner can dispose of his or her interest to the identifiable events specified in the agreement. Accordingly, the buy/sell agreement facilitates the creation of a market for the ownership interests at times when an owner may need liquid assets.

When a triggering event occurs, the buy/sell agreement will provide the entity or the other owners with certain requirements or options (e.g., a mandatory obligation to purchase the selling owner's interest or a right of first refusal), depending on the client's objectives. In a sense, it establishes an exit strategy for the owners at the inception of the entity, which reduces the potential for conflict later, when a triggering event occurs.

Buy/sell agreements and restrictions on transferability are useful in determining how a member's interest will be valued for transfer-tax purposes, and the owners will be bound by the terms of the agreement. Possible methods for determining the value of an ownership interest (i.e., purchase/sale price) under a buy/sell agreement include (1) a fixed price per unit; (2) requiring an independent appraisal; or (3) using a formula approach. The authors recommend that the chosen method establish the fair market value (FMV) of the interest at the date of sale, net of any applicable discounts. A fixed price as of the date the agreement is drafted is not appropriate for transfer-tax purposes (Bommer Revocable Trust, T.C. Memo. 1997-380).

Warning: If the IRS determines that the buy/sell agreement is a device to transfer property to family members for less than full and adequate consideration, it can redetermine the value of the transferred interest for gift, estate, and generation-skipping transfer (GST) tax purposes. The IRS may also challenge the value established in a buy/sell agreement when it appears the decedent was...

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