Shareholder Agreements: How You Can Benefit from Lessons Learned the Hard Way
 
April 19, 2006
 
R. Douglas "Doug" Wright- Atlanta

The use of shareholder agreements by closely-held corporations is a valuable tool. Properly constructed agreements can ensure management continuity or business succession, eliminate the risk of losing a corporation’s S election and establish a market for closely-held stock at the death of a shareholder while setting the fair market value for federal estate tax purposes.

There are times, however, when even the most carefully-laid plans can be thwarted by unanticipated shareholder actions. One of these situations is illustrated by the Estate of Blount,¹ in which a business owner’s realization of impending mortality, and subsequent unadvised actions, created a mess to be cleaned up after his death.

This case involved Blount Construction Company, Inc. (BCC), a closely-held corporation engaged primarily in the paving business. In 1981, the company was owned 50-50 by George Blount and his brother-in-law, Jennings. No other members of their families were active in BCC at any time. Blount and Jennings entered into a stock redemption agreement (the 1981 Agreement), which provided that: (1) no lifetime transfers of stock could be made without the prior consent of the remaining shareholders; (2) the stock owned by a deceased shareholder would be redeemed by the corporation, either for cash or over a period of time; (3) the purchase price would be determined annually by consent of the shareholders or, in the absence of an agreement, by a formula tied to the book value of BCC; and (4) future shareholders, if any, would automatically become subject to the terms and conditions of the 1981 Agreement.

After signing the agreement, Blount and Jennings took two additional steps. First, they purchased life insurance policies on their lives to ensure that funds would be available to redeem their stock without impairing the liquidity of the corporation. Second, they established an employee stock ownership plan (ESOP) and sold approximately 8 percent of their stock to the ESOP. Although the ESOP was an additional BCC shareholder, the trustee of the ESOP never signed an addendum or amendment to the 1981 Agreement.

Jennings passed away in January 1996. The shareholders had never made the annual evaluation of interests contemplated by the 1981 Agreement, so his interest was valued for redemption purposes at book value – approximately $3 million. Life insurance proceeds of approximately $3 million were received by BCC. Presumably because of corporate liquidity concerns, only $2 million in proceeds were paid immediately, with the remaining purchase price to be paid over time.

After Jennings’ death, a series of events transpired which would ultimately lead to litigation. Blount, who owned approximately 83 percent of BCC due to the redemption of Jennings’ shares, was diagnosed with terminal cancer. He immediately became concerned that if his stock were to be redeemed at the formula set forth in the 1981 Agreement, the impact on the corporation would be significantly more adverse than the impact of Jennings’ redemption. He held a series of meetings with BCC management regarding the operations of the corporation following his impending death. Subsequent to those meetings, and without the benefit of professional advice, he amended the 1981 Agreement to reflect what he thought was a fair price for his shares. He prepared a one-page document entitled “Shareholders Agreement,” which mirrored the section of the 1981 Agreement that dealt with the determination of the redemption price and, without further explanation, changed the price to $4 million. He also eliminated the ability of BCC to pay the purchase price over time. The ESOP trustee did not sign the amendment (the 1996 Agreement).

Blount died in September 1997. BCC collected approximately $3.1 million in life insurance, which it used to repurchase Blount’s shares. In accordance with the 1996 Agreement, the total purchase price of the stock, and the value as reported on Blount’s federal estate tax return, was $4 million. The IRS audited his return and, in total disregard of the 1981 and 1996 Agreements, determined that the BCC stock should have been valued at approximately $7.9 million.

The Tax Court Decision

The executor of Blount’s estate asked the Tax Court to resolve its dispute with the IRS. At trial, it was argued that the value set forth in the 1996 Agreement should be respected because: (1) the 1996 Agreement did not create any new obligations, but rather was an amendment to the 1981 Agreement; (2) the 1996 Agreement was not a “substantial modification” within the meaning of the Treasury Regulations as issued under Section 2703 of the Internal Revenue Code (the Code) and, therefore, under pre-1990 tax law, the amended 1981 Agreement was legally sufficient to establish the value of Blount’s BCC stock; and (3) the modified 1981 Agreement satisfied the requirements of Section 20.2031-2 of the Treasury Regulations and thus required the IRS to respect the $4 million valuation. The estate also argued that even if the 1981 Agreement was deemed to be “substantially modified,” all pre-1990 requirements were satisfied and the three tests in Code Section 2703(b) were also satisfied, thereby requiring the IRS to respect the $4 million valuation.

The Tax Court agreed with the estate that the 1996 Agreement was merely a modification of the 1981 Agreement; however, it also found that the changes in the 1996 Agreement (i.e., a “flat” purchase price with a mandated lump-sum pay-out) were “substantial,” thereby making the Agreement subject to additional scrutiny under Code Section 2703(b), as well as under the Treasury Regulations applicable to all such agreements. Those Regulations provide that the IRS may disregard restrictions in a shareholders’ agreement for valuation purposes unless:

(1) the agreement represents a bona fide business arrangement

(2) the agreement fixes a determinable value for the interest which is reasonable at the time

(3) the shareholder is prohibited during his lifetime from transferring his interest without first offering the interest to remaining shareholders or gaining their prior consent to transfer and

(4) the agreement is not merely a device to pass the decedent’s interest to the natural objects of his bounty for less than adequate or full consideration

The Tax Court fixated on the third requirement. It determined that the ESOP was a shareholder whose consent was required to lifetime transfers of stock under the terms of the 1981 Agreement. Oddly, however, the Tax Court held that the 1981 Agreement could be unilaterally changed by Blount and, therefore, was not a sufficient lifetime restriction on the transfer of his interest in BCC. In addition, the Tax Court examined the tests under Code Section 2703(b), which provide that an agreement must:

(1) have a bona fide business purpose

(2) not constitute a transfer of wealth to the natural objects of the decedent’s bounty and

(3) be comparable to similar arrangements negotiated at arm’s length

At trial, the estate presented expert testimony on the issue of comparability, focusing solely on the comparability of the price term and the methodology typically utilized by purchasers of comparable businesses to arrive at a purchase price. The evidence suggested that a prospective buyer of a paving company would arrive at a purchase price by using a multiple of three or four applied to an adjusted cash flow for the company. The estate’s expert testified that the $4 million purchase price for Blount’s stock would have been in this range if a similar methodology had been utilized to evaluate BCC. The IRS offered no evidence on the issue of comparability under Code Section 2703(b). Nevertheless, the Tax Court rejected the testimony of the estate’s expert, and focused instead on the fact that under the formula in the 1981 Agreement, the price for Blount’s stock would have been much higher. The Court also determined that since other experts had valued BCC in excess of $4 million using “blended” valuation approaches, the estate’s valuation of approximately $4 million was not “comparable.”

The Tax Court was then left with the task of determining a fair market value for Blount’s BCC stock, assuming the absence of a binding shareholders agreement. After listening to the experts, the Tax Court arrived at a blended fair market value for BCC of $6.75 million, which would have valued Blount’s interest at approximately $5.6 million. However, the Tax Court then added the approximately $3.1 million in life insurance proceeds received by BCC upon Blount’s death to the value established pursuant to expert testimony, giving a total value for BCC of approximately $9.85 million, and a corresponding value for Blount’s interest of just over $8 million.

The Eleventh Circuit Decision

The Court of Appeals agreed with the IRS that it was not required to respect the $4 million valuation because Blount could unilaterally change the 1981 Agreement. Although not required to do so, the Court then addressed the “comparability” issue, agreeing with the Tax Court that the estate’s expert had not considered “non-economic factors that would lead to truly comparable transactions.”

The Court reversed, however, on the important issue of how to treat BCC’s receipt of $3.1 million in life insurance proceeds. The Court noted that in valuing corporate stock, “consideration shall also be given to nonoperating assets, including the proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth.” (Treasury Regs. Sec. 20.2031) The Court ruled that notwithstanding its holding that the Agreement was to be disregarded for tax purposes, it was still a binding obligation for state law purposes, and, therefore, had to be taken into consideration in determining what a prospective buyer might be willing to pay to a current owner in the sale of corporate stock. Accordingly, the Court sent the case back to the Tax Court with instructions to disregard the value of the life insurance in its determination of the value of Blount’s stock.

Lessons Learned

1. A stock redemption agreement between a majority- (or wholly-) owned corporation and its owner is likely never to be taken into consideration in fixing the estate tax value of the owner’s interest, unless there is another shareholder whose consent is required to amend the agreement (or, perhaps, an independent director who must consent to any amendments to the agreement).

2. The “comparability” prong under Code Section 2703(b) may be impossible to satisfy in disputes with the IRS over the value of an interest in a closely-held company. In the Blount case, the Eleventh Circuit disregarded the testimony given by the estate’s expert even though the testimony addressed the nature of companies involved in similar transactions, along with employment and regulatory issues that similar companies encounter. Therefore, this case adds little, if any, guidance for practitioners in future disputes with the IRS which may require proof of “comparability.”

3. The exclusion of life insurance proceeds from the valuation by the Eleventh Circuit has led to some critical commentary. However, it seems clear, under the facts, that the proceeds should have been excluded. The IRS arguments for including the life insurance proceeds in the value of the company ignore the very standard by which a valuation is to be made, that is, what a willing buyer would pay a willing seller for the interest being valued. No willing buyer seeking to acquire an 83 percent interest in a corporation would take into account $3.1 million in cash as a corporate asset knowing that there was an offsetting obligation to pay that cash to the estate of a deceased shareholder. Moreover, in the real world, if Blount were actually selling stock to a third party, how many “competent” business buyers would actually believe that the insurance policies insuring the selling shareholder’s life would actually be part of the corporation’s assets after the sale closed? The Eleventh Circuit appears to have gotten it right when it concluded that “[t]o suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.”

For more information, e-mail R. Douglas Wright at douglas.wright@hklaw.com or call toll free, 1-888-688-8500.

¹ Estate of George C. Blount v. C.I.R., 428 F.3d 1338 (11th Cir. 2005), aff’g in part, rev’g in part, 2004-116 T.C. Memo.