Considerations When Preparing Buy-Sell Agreements

Buy-sell agreements (BSA) can be useful tools for restaurant owners if they are prepared and utilized correctly. It is not uncommon to see BSAs being used to limit or discourage the sale of a company’s stock by current ownership trying to maintain control of their company. These agreements have also been used to accomplish other goals, such as providing an agreed upon purchase mechanism for a deceased or disabled shareholder for a stipulated price.

Internal Revenue Code (IRC) Section 2703, which applies to BSAs made or substantially modified after Oct. 8, 1990, was instituted to set guidelines for these agreements. Section 2703 requires that the fair market value of the stock in a closely held company be calculated without regard to the terms of any restrictive agreement, unless the following conditions are met:
  • The agreement is a bona-fide business arrangement.
  • The agreement is not a device to transfer stock to a family member for less than fair market value.
  • The terms of the agreement are comparable to those entered into in an arm’s-length transaction.
It should be noted that a BSA between family members is more likely to be flagged and challenged by the IRS than a BSA between unrelated parties. Interestingly, the IRS has consistently taken the position that the application of IRC Section 2703 extends beyond BSAs to include partnership agreements that restrict limited partners from controlling investments, forcing distributions, or compelling a liquidation of their interest.

Courts have listed the following requirements for making a BSA’s price binding:
  • The price must be fixed or determinable.
  • The agreement must be binding on the parties both before and after death.
  • The agreement must have been entered into for a bona-fide business reason.
  • It must not be a substitute for testamentary disposition.
Further, courts have looked at several factors to determine if an agreement is a testamentary device (i.e., a will), including:
  • The health and age of the decedent when entering into the agreement
  • The lack of regular enforcement of the agreement
  • The exclusion of significant assets from the agreement
  • The manner (arbitrary or otherwise) in which the price was selected, including the failure to obtain appraisals or seek professional advice
  • The lack of negotiations between the parties in reaching the agreed terms
  • Whether the agreement allowed for adjustment or revaluations of price or terms
  • Whether all the parties to the agreement were equally bound to its terms
  • Evidence highlighting that the agreement supported the decedent’s testamentary plan
  • Whether the beneficiary of the agreement is the object of the decedent’s bounty
  • The relationship between the parties
When drawing up a BSA, we recommend engaging a qualified business valuation consultant to assist in determining the fair market value of the company at the time of the agreement. The consultant should be engaged to periodically review the valuation to ensure that the sales price continues to reflect fair market value and that the document does not grow stagnant. Quite often, with restaurants that are enjoying sustained periods of growth, we see the BSA language stating that an appraisal should be done every year to ensure that potential transactions, regardless of the reason, are occurring at fair market value.