Revenue Ruling 63-19 for Buy-Sell Agreement Valuation

Valuing stock in a closely held corporation presents unique challenges, particularly for estate and gift tax purposes. Unlike publicly traded securities, shares in a private, often family-owned, business require a more complex valuation process. Owners frequently use buy-sell agreements to establish a predetermined price and method for transferring shares when a triggering event, such as an owner’s death, occurs.

The Internal Revenue Service (IRS), however, maintains specific standards to ensure these agreements are not simply tools to artificially lower the value of a business interest and reduce tax liabilities. The price set within a buy-sell agreement is not automatically accepted for federal tax purposes, as the government has established a framework to test the legitimacy of these valuation clauses.

Core Requirements for Agreement Acceptance

For a buy-sell agreement’s valuation to be respected by the IRS, it must satisfy tests laid out in Internal Revenue Code Section 2703. The law establishes a general rule that the value of property is determined without regard to any agreement to acquire it at a price less than its fair market value. An agreement can overcome this general rule only if it meets three specific requirements.

The first test is that the agreement must be a bona fide business arrangement. This means the agreement must serve a legitimate, non-tax business purpose. Common examples of valid purposes include maintaining family ownership and control, preventing shares from passing to unknown third parties, and providing liquidity for an estate to pay taxes.

A second requirement is that the agreement must not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration. The IRS will examine the circumstances surrounding the agreement’s creation, including the health of the parties and the nature of the negotiations, to determine if the primary intent was to pass wealth to heirs at a discounted value.

The final requirement is that the terms of the agreement must be comparable to similar arrangements entered into by persons in an arm’s-length transaction. This means the agreement must reflect terms that unrelated parties, each acting in their own best interest, would have negotiated. Factors considered in this analysis include the valuation method used, the payment terms, and any restrictions placed on the shares.

Information Required for Valuation Analysis

To analyze whether a buy-sell agreement will withstand IRS scrutiny, a comprehensive collection of documents and data is necessary. This information allows for a thorough review of the agreement against the standards set in the tax code.

The primary document is the buy-sell agreement itself, along with any amendments or related contracts. Accompanying this should be the company’s articles of incorporation and bylaws, which outline the fundamental rules of corporate governance and shareholder rights. These documents provide the legal framework within which the buy-sell agreement operates.

Next, detailed information about the shareholders is needed to assess the relationships and ownership structure. This includes a complete capitalization table listing all shareholders, the number and class of shares each person owns, and a description of their relationships to one another. This is important for evaluating intra-family agreements.

A robust collection of financial documentation is also required to evaluate the company’s economic health and the reasonableness of the valuation formula. This involves gathering at least three to five years of complete financial statements, including balance sheets, income statements, and statements of cash flows. If the statements are audited or reviewed by an independent CPA firm, they carry more weight.

Finally, any data specifically related to the valuation of the business interest must be compiled. This includes any prior business appraisals or valuation reports. Details of the formula used to set the price in the buy-sell agreement must be documented, along with the underlying calculations and supporting data for any industry comparisons.

Tax Consequences of Non-Compliance

When the IRS determines that a buy-sell agreement fails to meet established legal standards, the consequences can be financially significant. The primary result of non-compliance is that the IRS will disregard the valuation price set forth in the agreement for federal estate or gift tax purposes.

Once the agreement’s price is set aside, the IRS will proceed to determine the fair market value (FMV) of the stock on its own terms, which can result in a much higher valuation. A factor in this valuation is the treatment of corporate-owned life insurance. In the 2024 case Connelly v. United States, the Supreme Court ruled that life insurance proceeds intended to fund a stock redemption must be included when valuing the corporation.

The Court also held that the company’s obligation to redeem the shares does not offset this increase in value. This decision can significantly raise the taxable value of an owner’s interest, creating a larger potential gap between the buy-sell agreement price and the FMV determined for tax purposes.

The financial impact of this revaluation can be substantial. The difference between the agreement’s price and the IRS-determined FMV is added to the decedent’s taxable estate or the value of the gift. For example, if an agreement fixed a price at $2 million but the IRS valued it at $4.5 million, the additional $2.5 million would be subject to federal estate tax, which could result in an additional tax liability of $1 million.

This unexpected tax burden can create a severe liquidity crisis for the estate. The estate is contractually obligated to sell the shares at the lower price dictated by the buy-sell agreement. However, it must pay estate taxes on the much higher $4.5 million valuation, forcing it to find funds from other assets to cover the significant tax shortfall.