“Defined Value Purchase Agreements,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. Learn how to draft sale agreements to try to avoid IRS challenges to the purchase price of closely held business interests. To tell us more about this topic, you’ll be hearing today from ACTEC Fellow, Steve Gorin, of St. Louis, Missouri. Welcome, Steve.

Thank you, Travis. Delighted to be here. So, when a business owner is transferring an interest in a business to a trust or otherwise for estate planning purposes, it’s very difficult to really know what the business’s value is. Appraisal of business interests includes valuation adjustments for lack of control, lack of marketability, and perhaps for other factors as well. No matter how good your appraiser is, there’s a good chance that on audit, the IRS will come up with a different value.

Now, as a business owner, the client really just cares about doing the right thing – not necessarily trying to game the system, but simply recognizes that because there can be a difference between the client’s appraiser and the IRS’s appraiser, there could be exposure. Perhaps some gift tax exposure. So, if you sell a value for X, and the IRS determines that the sale price is Y, then there could be gift tax on the difference between that, or at least use of the exemption.

So, how does one deal with this uncertainty? So, sometimes people will try to use a formula to express how much of their business interest they’re selling or giving or whatever it is they’re doing with it.

My preference, though, is to use a formula to determine the sale price of a business interest. So, if I’m selling ten percent of my company, then I want to sell it for whatever the fair market value of that ten percent is. Or maybe, if I’m giving away some and selling some, I may want to say that I’m going to sell it for fair market value minus whatever my gift element is. So, if I think the fair market value is $10 million and the gift element that I want to give is $6 million, then I could simply say, I’m selling it for the fair market value minus $6 million.

Now, how does one couch that I’m selling for fair market value? Well, what you need to do is to say that I am selling it for the fair market value as finally determined for federal gift tax purposes. And all of your documentation needs to be couched in those terms. You need to say in the sale agreement that it’s for the fair market value finally determined for gift tax purposes. And then in the promissory note, I put a blank in the dollar amount of the promissory note – at the very top. And then, where it says what the principal is, I say the principal is the sale price, as determined in the sale agreement. And then, I put a provision in that says that as soon as the parties know what the finally determined amount is for gift tax purposes, then they will fill in the blank. And until then, they can also have some documentation to say what they estimate the purchase price to be.

So, the key here is that the appraisal does not determine the fair market value. Rather, the appraisal estimates the fair market value. And then, you report this on the gift tax return and attach all of your sale documents and your appraisal. And you tell the IRS, we’re doing it for whatever the fair market value is. Here’s our best guess so far. But whatever you determine it is, IRS, that’s the number we’re using.

So, then if the IRS doesn’t audit within – typically, it’s three years after you do your sale, not after you do the sale but after you report it on a timely filed gift tax return. If the IRS doesn’t audit it, then the number you used as your estimate winds up being the finally determined value. And if the IRS does audit it, well, whatever the end result is – whatever you work out with the IRS or whatever you might litigate – that will be your finally determined value.

So, again, the goal here is to do your best to do the purchase price. Recognize that the IRS might adjust that. Make sure that all of your sale documents and any collateral documents show that this is just an estimate. When you get the appraisal, which is often after the sale closes, then you attach what’s called an allonge – A-L-L-O-N-G-E – to the note, giving the estimated purchase price. And then, you use that until you find out about the gift tax audit results or when you find out the statute of limitations has passed.

So that, simply, is how you do a formula sale that uses the purchase price as the formula. If you do this right, then hopefully you can avoid an audit result that will result in any gift taxes being due related to the sale. Hope you find this helpful. And good luck with helping your business clients transfer their business interests.

Thank you, Steve, for educating us on the use of defined value purchase agreements.

This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel.

If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org.

© 2018 – 2024 The American College of Trust and Estate Counsel. All rights reserved.

Latest ACTEC Trust and Estate Talk Podcasts