The gist of an estate “freeze” technique is to lock-in for estate tax purposes a low valuation of any assets—such as an ownership interest in a small or medium sized business—that is likely to appreciate in value in the foreseeable future. Such techniques are well-regarded even in the best of economic environments, let alone times such as these when many owners of small and medium sized businesses have seen valuations on those businesses drop, albeit hopefully only temporarily.
A simplified example is illustrative. Say Ms. Howard is the 75-percent shareholder of a medium-sized business. As of August, 2009, the value of Ms. Howard’s shares is $3,000,000. Let’s presume that Ms. Howard implements a freeze technique on the value of those shares, which are still valued at $3,000,000. Let’s also assume that Ms. Howard goes on to live an additional 15 years, eventually passing in 2024. Upon Ms. Howard’s passing, her ownership interest in the business is valued at $5,000,000. If Ms. Howard’s freeze technique is successful, then her ownership interest in the business will still be valued at $3,000,000 rather than $5,000,000 for estate tax purposes.
Please keep in mind, however, that as with most tax related issues, there are multiple conditions associated with freeze techniques to which business owners and their advisors should pay close attention. Moreover, there are a number of different mechanisms available to implement a freeze, including gifts, loans, and trust agreements. This blog post outlines the conditions for one particular freeze technique, with more discussion about alternative methods and other attributes coming in future posts.
One technique for freezing the value of business ownership interests is to execute a buy-sell or option agreement with a business associate or partner who does not also happen to be a family member. If three conditions are satisfied, the buy-sell or option agreement should effectively freeze the value of those ownership interests. First, the buy-sell or option agreement must be a “bona fide business arrangement.” Second, the buy-sell or option agreement must not be a devise to transfer the property to family members “for less than full and adequate consideration in money or money’s worth.” Finally, the terms of the buy-sell or option agreement must be “comparable to similar arrangements entered into by persons in an arm’s length transaction.”
A common hurdle for owners of closely held businesses attempting to satisfy those three conditions is establishing that the buy-sell or option agreement is "comparable to similar arrangements entered into by persons in an arm’s length transaction." Many closely held businesses do not, for example, make those types of agreements public. Nonetheless, determining whether a buy-sell or option agreement is comparable to similar agreements entered into by persons in an arm’s length transaction will entail a consideration of such factors as:
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The expected term of the agreement;
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The current fair market value of the property subject to the agreement;
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Anticipated changes in value of that property during the term of the agreement; and
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The adequacy of any consideration given in exchange for the rights granted.
One method that can be effective in addressing the above “comparability” condition is to commission a professional appraisal of the business interests, and then to use that appraisal in negotiating a price for the buy-sell or option agreement.
Of course, each business and business owner is different, so please evaluate the viability of any freeze technique with your business and tax advisors. Future posts will discuss some alternatives to the above freeze technique.
