General Practice, Solo & Small Firm DivisionMagazine
The Availability of the Marital Deduction for Interests in a Closely-Held Business Subject to a Buy-Sell Agreement
By Edward N. Polisher
Small business in our country represents a significant portion of the total business community. The reports of the U.S. Small Business Administration, Office of Advocacy, 1994-1995 editions, reveal that small business represents 99 percent of all employers, employs 53 percent of the private work force, contributes 47 percent of all sales in the country, and creates 50 percent of the private gross domestic product. Industries dominated by small businesses produced an estimated 75 percent of the 2.5 million new jobs created during 1995. The number of small business starts had broken records in the last three years.
These small businesses, which are usually begun by one or more individual entrepreneurs, may be conducted as sole proprietorships, general partnerships, limited partnerships, limited liability companies, and in closely-held corporations. Their success results from the dedication and combined efforts of the principals. Should death or other events occur that causes one or more of the entrepreneurs to separate from the business, the introduction of third parties unfamiliar with the enterprise could disrupt the harmony of the participants and threaten the venture’s viability. Thus, it is usual for the principals to enter into buy-sell agreements to ensure the continuity of the enterprise.
These buy-sell agreements usually cover the disposition of the withdrawing or deceased principal’s ownership interest by setting the conditions, the price and the terms of payment should such events occur. If the principals are married, it is important that the buy-sell agreement be drafted so that the disposition of the principal’s interest, whether by gift to spouse during life or payment received for it after death, qualifies for the marital deduction. By so qualifying, the principal can pass on to the surviving spouse, the full value of the interest in the business enterprise without payment of any gift or estate taxes, whether federal or local. Two recent pronouncements shed light on what provisions in a buy-sell agreement will and will not qualify for the marital deduction.
The first pronouncement, PLR 9606008, involved an inter vivos gift. The donor wife proposed to transfer to her husband the shares in a closely-held corporation, subject to a buy-sell agreement. The agreement placed restrictions on the husband’s ability to transfer the shares of stock he received from his wife. If the husband wished to sell the shares, the corporation and the wife had the right of first refusal to purchase the shares at the price offered by the third party purchaser. If the wife and husband divorced or if the husband predeceased the wife without passing his shares to her, the corporation, and then the wife had the option to purchase the shares at their fair market value, as determined by an independent appraiser.
The IRS concluded that, because the husband or his estate would receive full value for any stock sold, his interest in the property would not be deemed to be a terminable interest; it would not terminate or fail. As a result, the proposed gift qualified for the gift tax marital deduction under section 2523(a).
In the second situation, Rinaldi v. United States, 38 Fed. Cl. 341 (July 11, 1997), conditions on the spouse’s sale of the interest prevented the transfer from qualifying for the marital deduction. At the time of his death, decedent, who was survived by his wife, Nellie, and his son William, as well as several grandchildren, was the director of Rinaldi Printing Co., a corporation, and his son was chief executive officer. Decedent owned 52.06 percent of the capital stock, with a total book value of $1,290,178 and a fair market value of $1,520,067.
Rinaldi’s will provided that if his wife survived him, the stock would go to the "Nellie M. Rinaldi Trust," the net income of which was to be payable to the wife, at least annually. At her death, the trust would terminate and the stock would be distributed outright to his son, unless the son failed to survive Nellie, in which case, the stock would be distributed at her death to the grandchildren.
The will further provided that if the son gave up his day-to-day management, or if Nellie were no longer living, then the fiduciary of the trust was to offer to sell the trust’s stock to the son at book value. If the son did not purchase the stock, the fiduciary was to select other potential buyers and offer reasonable terms for its sale. The will authorized the personal representative to elect that the stock, which constituted the trust principal, be treated as qualified terminable interest property ("QTIP") for the purpose of qualifying for the marital deduction under the federal estate tax.
After decedent’s death and before the estate elected QTIP treatment, the corporation elected "S" status. Because it would have lost its S Corporation status, thereby subjecting it to a heavier tax burden, if the trust became a permanent stockholder of the company, the interested parties arranged for the redemption of the stock at a price reflecting a fair market value. Thus, at the time of the QTIP election, the corpus of the trust consisted of money, not stock.
The court decided that the decedent’s will did not give his spouse "the qualifying income interest for life," because it provided that in the event Rinaldi’s sons ceased day-to-day management of the company, the son, as trustee, was obligated to sell the stock to himself at "book value," a price substantially below the fair market value of the stock at that time. Such a transaction would effectively diminish the value of the trust corpus, violating the QTIP requirement that "no person has the power to appoint any part of the principal to any person other than the surviving spouse." I.R.C. § 2056(b)(7)(B)(ii)(11). The court held that the trust established by the terms of Rinaldi’s will was clearly ineligible for QTIP treatment because it subjected the trust’s value to diminution through the potential sale of its assets at a bargain price to someone other than the surviving spouse.
The court also concluded that the post-mortem redemption of the trust stock and its conversion into cash did not bring the trust into compliance with the statutory requirements for QTIP eligibility. According to the court, the status of the stock at the time of decedent’s death controlled and the decedent clearly intended to establish a trust with the condition that would render it ineligible for QTIP treatment. He did not want his wife’s trust to be made up of a printing company, if his son no longer managed the company. He directed that the stock be sold to his son at a bargain price. According to the court, this arrangement violated both the letter and the spirit of section 2056(b)(7).
Conclusion. From these authorities, the conclusion is clear that to be eligible for the marital deduction, sales under a buy-sell agreement must provide that the donee-spouse receive full fair market value upon the disposition of any interest received from the principal. Failure to do so will affect the eligibility for the marital deduction under the gift tax, as well as eligibility for the QTIP provisions under the estate tax.
Edward N. Polisher is of counsel at Cozen and O’Connor in Philadelphia.
- This article is an abridged and edited version of one that originally appeared on page 7 in Section of Taxation Newsletter, Winter 1998 (17:2).