Asset freezing rules.

One of two "standard" methods for freezing the value of a business is the buy-sell agreement.  The purchase of a business at an option price granted in the founder's will should, theoretically, establish its value. But when the buyers are, say, the founder's children, the value for estate tax purposes may be questioned.

For many years the process operated under regulations which, in effect, taxed the business at its fair market value, regardless of the price set in a buy-sell agreement. Those regulations were validated by an addition to the Code in 1990. That addition deals with the entire gamut of freezing values for estate tax purposes, not just businesses. In general, it employs the technique of setting a value of zero on any rights in property retained by the transferor of an interest. A gift of stock, for example, with the transferor retaining a life estate in the securities calls for a gift tax based on the full value of the stock. The value of the retained interest is zero.

The significant portion of these "antifreeze" sections for buy-sell purposes is one providing that property is valued without regard to any option, agreement to acquire at less than its fair market value, or any restriction on the right to use the property.  In short, on the death of a holder of stock, the stock is valued at its fair market value. Options, restrictions, contracts to buy at a stated price all are ignored if they lead to a value for the stock other than its fair market value without taking those things into account.

An exception is provided to this foundation rule, but it is an exception that leads back to the same result.  This exception provides that the above rule does not apply to any option, agreement, right, or restriction that meets three requirements:

1. It is a bona fide business arrangement.

2. It is not a device to transfer the stock to family members for less than its full monetary value.

3. Its terms are "comparable to similar arrangements entered into by persons in an arms' length transaction."  Each of these three requirements must be met.

For unrelated parties, a 50 percent rule is in effect.  If more than 50 percent (by value) of stock is owned by nonfamily members, rights and restrictions on the stock will not be disregarded. For this purpose, members of a transferor's family include any individual who is a "natural object of the transferor's bounty."

Before the Code was amended to include the provisions discussed above, regulations on the subject required four things before the value in a buy-sell agreement became binding for estate tax purposes:

1. The shares must be subject to an obligation or option to purchase that is binding on the estate. The buyer is not obligated to purchase the shares, but the estate must be bound to sell them.  (The usual buy-sell agreement, though, is binding on both sides since the estate normally needs the funds from the transaction.)

2. The value, or valuation method, must fix the purchase price with certainty.

3. The shares cannot have been subject to lifetime transfers that would defeat the right to purchase. At a minimum, a right of first refusal must be part of the agreement. It is the position of the IRS that the first refusal price cannot exceed the option price on death in order for the option price to be valid.

4. The agreement to purchase must be a bona fide business agreement, not a device to transfer shares at a low value to the objects of the decedent's bounty.

Though these regulations were adopted before the new Code provisions, their import is likely to be significant in future adjudications of buy-sell valuations