How IRS Revenue Ruling 79-53 Affects Buy-Sell Values
IRS Revenue Ruling 79-53 provides key guidance on whether a buy-sell agreement's valuation will be respected for estate and gift tax purposes.
For a buy-sell agreement’s valuation to be accepted for federal estate tax purposes, it must satisfy specific requirements under the Internal Revenue Code. For agreements created or substantially modified after October 8, 1990, Section 2703 is the primary authority. This law provides a framework to ensure the price set in an agreement reflects a fair, business-oriented arrangement rather than a disguised transfer of wealth to heirs. To be binding for estate tax purposes, the agreement must pass three distinct tests.
The Bona Fide Business Arrangement Test
A buy-sell agreement must first satisfy the bona fide business arrangement test. This test requires the agreement to be founded on a legitimate and significant non-tax business reason. The IRS examines the underlying purpose for the agreement’s creation, looking for objectives that serve the company’s operational stability and continuity.
A primary example of a valid business purpose is the desire to maintain continuity of ownership within a specific group. For a closely held business, this prevents shares from being sold to unknown or potentially disruptive third parties, ensuring the original vision and management structure remain intact.
Another valid purpose is to facilitate a smooth and orderly transition of management and ownership upon a shareholder’s death, disability, or retirement. This provides certainty for the remaining owners and the deceased’s estate.
The Device Test
An agreement that passes the business purpose test must also clear the device test. This second requirement scrutinizes whether the buy-sell agreement is a “device” to transfer property to the natural objects of a decedent’s bounty for less than full and adequate consideration. The focus shifts from the general business purpose to the specific intent behind the valuation and its effect on the decedent’s heirs.
Agreements between family members are subject to higher scrutiny than those between unrelated business partners. The health and age of the parties when the agreement is signed are also relevant. If a shareholder is in poor health, an agreement with a low valuation could be seen as an attempt to fix the estate tax value in anticipation of imminent death.
The Comparability Test
Finally, the agreement must pass the comparability test. This test requires that the terms of the agreement, not just the price, must be comparable to similar arrangements entered into by persons in an arm’s-length transaction. The method used to determine the purchase price is closely examined here.
A fixed price that is not periodically reviewed or updated is a significant red flag. In contrast, a valuation based on a clear and reasonable formula, such as a multiple of earnings or a book value calculation that is reviewed regularly, is more likely to be accepted. The fairness of the price is assessed based on the circumstances that existed at the time the agreement was made, not at the time of the triggering event.