Corporate

							 Corporate Life Insurance Proceeds as Part of Stock Value When There Is a Redemption Agreement
                                             by Burgess J.W. Raby and William L. Raby

Burgess J.W. Raby, Esq., and William L. Raby, CPA, both associated with the Raby Law Office, Tempe, Ariz., discuss the
Estate of Blount case.

Date: Nov. 9, 2005




In Estate of George C. Blount et al. v. Commissioner, T.C. Memo. 2004-116, Doc 2004-10258 [PDF], 2004 TNT 93-13 , Tax
Court Judge Joseph H. Gale had to decide the value of the stock of a closely held Georgia corporation, Blount Construction Co.
(BCC), whose controlling shareholder, George C. Blount, died in September 1997 owning 83 percent of the BCC stock. Under a
stock redemption agreement, the estate sold the shares back to the corporation for $4 million. BCC owned a $3 million life
insurance policy on Blount that was intended to fund that stock redemption.

The estate appealed Judge Gale's conclusions that, among other things, the stock purchase agreement had to be disregarded
and that the life insurance proceeds had to be treated as a corporate asset in valuing BCC. In Estate of George C. Blount v.
Commissioner, No. 04-15013, Doc 2005-22052 [PDF], 2005 TNT 210-21 (11th Cir. 2005), the appeals court agreed with Judge
Gale that the estate had to include the shares at their fair market value, not at the price set by the stock purchase agreement, but
reversed his holding that that fair market value should include the $3 million insurance proceeds.

                                                  The Stock Purchase Agreement

At the time of his death, Blount had such control of the corporation that he could have modified or changed the stock purchase
agreement at will. Since it was not binding during his lifetime, it would not be effective in setting the value of the stock for estate
tax purposes under the long-standing rule of Treas. reg. section 20.2031-2(h). Also, the stock purchase agreement, while
originally entered into in 1981, had been substantially modified in 1996. Thus, it fell under the section 2703 provision enacted into
law in 1990 that disregards a stock purchase agreement unless it meets the three tests of section 2703(b):

(1) a bona fide business arrangement;

(2) not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in
money or money's worth; and

(3) terms that are comparable to similar arrangements entered into by persons in arm's-length transactions.

The first two requirements had been stipulated as being met. The third test was a different matter. To meet it, said Judge Gale, the
taxpayer had to "demonstrate that the terms of an agreement providing for the acquisition or sale of property for less than fair
market value are similar to those found in similar agreements entered into by unrelated parties at arm's length in similar
businesses." This is not information that is generally available. As a practical matter, obtaining that information in a form usable at
trial would probably require that the estate retain someone who could qualify as an independent witness, could make an
investigation, and could put together a report on which he or she could testify that would show the agreement met the section
2703(b)(3) requirements.

                                                       Proving Comparability

In fact, that is what the estate attempted to do. Its witness, a certified public accountant who had represented clients in mergers
and acquisitions, testified that the terms of the BCC stock purchase agreement were comparable to similar arrangements
negotiated at arm's length. He had examined three transactions of companies he considered comparable and found that the ratio
of selling price to adjusted cash flow was 4 to 1. However, he focused solely on one factor -- price. He asserted that "[p]
rofessionals familiar with the industry most often value a construction company by applying a multiple of four (4) to the cash-flow
adjusted for non-operating and non-recurring items." He then adjusted BCC's cash flow and compared the purchase price for
decedent's BCC stock in the 1996 agreement to the adjusted cash flow. His conclusion? The price for Blount's BCC shares
represented a 4.25 multiple of the BCC adjusted cash flow. Because that multiple was consistent with the multiple he claimed
professionals familiar with the construction industry would use and with his three examples, he concluded that the price set forth in
the modified 1981 agreement was a fair market price and that the terms of the modified 1981 agreement were therefore
comparable to similar arrangements entered into at arm's length.

Judge Gale noted, however, that the expert did not actually conclude that the sales prices for his sample firms were determined as
a multiple of cash flow. Rather, the expert had backed into the number by dividing the selling price by his calculated cash flow.
More importantly, he did not present evidence of other stock purchase or similar arrangements actually entered into at arm's
length. Nor did he attempt to establish in any fashion that the method Blount had used to arrive at his $4 million price was similar
to the method employed by unrelated parties acting at arm's length.

Practitioners should note that the expert did testify that the $4 million was the fair market value of the stock as of both the date of
the agreement and the date of Blount's death. If the expert had been correct regarding the fair market value of decedent's BCC
shares, then section 2703(a) would not even have been applicable, because it only applies to agreements that set a price below
fair market value. No evidence of similar arrangements would then be required. The problem on the planning end, when the stock
purchase agreement is being put together, is how to assure that any fixed or formula-determined price would subsequently be
determined by a court to be fair market value. The solution most adopted in the years since section 2703 came into the law seems
to us to be the use of fair market value, determined by appraisal, as the price at which the stock would be redeemed.

In the Blount case, Judge Gale was not persuaded that the $4 million price in the agreement was the fair market value of the stock
at either the date of agreement or of death. It was too much less than the valuations produced by the experts who testified as to
valuation. Judge Gale concluded that because the expert failed to provide any evidence of similar arrangements actually entered
into by parties at arm's length, as required by section 2703(b)(3), and his opinion was based solely on his belief that the purchase
price for the BCC shares was set at fair market value, his conclusion that the agreement was comparable to similar agreements
entered into by unrelated parties at arm's length was unsupportable. Thus, even if the agreement was viewed as binding during
Blount's lifetime, it still would not have been given effect for estate tax valuation purposes under section 2703. The appeals court
found no error in Judge Gale's conclusion to disregard the stock purchase agreement for valuation purposes.

                                                      Life Insurance Proceeds

In addition to its expert on comparability, the estate produced a valuation expert, as did the IRS. While their analyses were not
identical, Judge Gale reasoned that they were similar enough in their thinking so that he could conclude that both experts had
arrived at a value of $6.75 million for BCC as of the date of death. The appeals court accepted that number. Judge Gale then
added the $3 million to which BCC became entitled immediately upon Blount's death and put the value of 100 percent of BCC at
$9.75 million and of the decedent's stock in BCC at $8,233,583.

Judge Gale viewed the life insurance proceeds as a nonoperating asset. He also determined that the life insurance proceeds of
$3 million were not offset by BCC's $4 million obligation to redeem Blount's stock. He reasoned that the obligation was part of a
stock purchase agreement, which he had decided was to be disregarded for valuation purposes. Also, it seemed illogical to him to
treat the obligation as a liability when the redemption of the stock would increase the per share value of the remaining shares.
Section 20.2031-2(f) of the estate tax regs provides that "consideration shall also be given to nonoperating assets, including
proceeds of life insurance policies." If, for example, the value of the corporation was determined solely on the basis of
capitalization of earnings, it might or might not be reasonable to add the life insurance proceeds if the company otherwise had
adequate operating assets.

In Estate of Huntsman v. Commissioner, 66 T.C. 861, 874-5 (1976), the Tax Court set out a general approach for including
corporate life insurance in the valuation of an entity in language that is still relevant today:


       In determining the price a willing buyer would pay, it is obvious that life insurance proceeds must be given "consideration,"
       but it is equally obvious that the price paid by a willing buyer would not necessarily be increased by the amount of the life
       insurance proceeds. A buyer would take into consideration such proceeds in the same manner as he would consider other
       liquid assets of the corporation. If the corporation is operating a going business, the willing buyer will be influenced by the
       prospective earning power and dividend-earning capacity of the business, as well as its net worth, including any life
       insurance proceeds. See Hamm v. Commissioner, 325 F.2d 934, 941 (8th Cir. 1963), aff'g a Memorandum Opinion of this
       Court, cert. denied, 377 U.S. 993 (1964); Central Trust Co. v. United States, 305 F.2d 393, 408 (Ct. Cl. 1962); see also
       Rev. Rul. 59-60, 1959-1 C.B. 237. Even if the value of the stock is based on the net worth of the corporation, such value
       may not be increased concomitantly by the amount of life insurance proceeds payable to the corporation.


BCC had significant nonoperating assets as of the date of death -- far in excess of its operating needs and far more, as a
percentage of revenues, than other companies in its standard industrial classification group. Thus, Judge Gale concluded that the
fair market value would be best calculated by adding the life insurance proceeds to the value otherwise determined.

                                                 The Appeals Court to the Rescue

Treas. reg. section 20.2031-2(f)(2) actually provides that "consideration shall also be given to nonoperating assets, including
proceeds of life insurance policies payable to or for the benefit of the company, to the extent that such nonoperating assets have
not been taken into account in the determination of net worth." The appeals court emphasized that limiting phrase, "to the extent
that such nonoperating assets have not been taken into account." It pointed out that in Cartwright v. Commissioner, 183 F.3d
1034, Doc 1999-24331, 1999 TNT 138-18 (9th Cir. 1999), "the Ninth Circuit approved deducting the insurance proceeds from
the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout." 183
F.3d at 1038.
The Blount appeals court reasoned that excluding the life insurance proceeds from the corporate assets to the extent committed
to the stock redemption was "consistent with common business sense." That the agreement itself might not be determinative in
fixing the estate tax value of the stock did not mean, emphasized Circuit Judge Stanley F. Birch Jr., who wrote the opinion, that it
was a nullity for other purposes.1 BCC was obligated to redeem the stock from the estate. Judge Birch concluded:


      The Tax Court erred when it ignored the amended agreement's creation of a contractual liability for BCC, which the
      insurance proceeds were committed to satisfy. We reject the Tax Court's inclusion of the insurance proceeds paid upon the
      death of the insured shareholder as properly included in the computation of the company's fair market value.

                                                   The Issue Never Discussed

Neither the Tax Court nor the appeals court dealt with the equitable argument raised by the estate in its brief on appeal (Doc
2005-3690 [PDF] or 2005 TNT 43-51 ):2


      This challenging case raises important policy issues concerning the just administration of federal estate taxes. In this
      appeal, the Court must determine whether the Tax Court properly determined the value of stock of a closely held company
      owned by Blount when it (a) disregarded a valid, legally binding obligation of BCC to purchase Blount shares, and (b) for
      purposes of determining the value of BCC, added to the determined fair market value of BCC stock the full amount of life
      insurance proceeds received by BCC, which were earmarked solely for such purchase.

      This determination has had the effect of depriving Blount's heirs of the vast majority of the proceeds received from the sale
      of Blount's BCC shares back to the Company, as the $4,000,000 received from the sale of Blount's BCC shares is virtually
      eliminated by the estate taxes and interest deemed payable with respect thereto. The Estate should never have paid more
      than 55 percent of what the Executor received for Blount's interest in BCC in taxes. Yet, as a result of the Tax Court's
      decision, the Estate has paid federal and state taxes attributable to the BCC stock owned by Blount at his death, at an
      effective rate of more than 70 percent. After adding interest payments attributable thereto and the costs incurred in
      contesting the valuation, the entire $4 million in proceeds is eradicated.

      This confiscatory level of taxation results from a misapplication of federal estate tax law to the valuation of the stock by the
      I.R.S. and the Tax Court.


Courts cannot, however, deal directly with the equitable consequences of tax laws. The appeals court had little leeway as to the
acceptability of the stock purchase agreement in setting a $4 million value for the Blount stock in BCC. Given the language of
Treas. reg. section 2031-2(h) and the requirements of section 2703(b), neither the facts nor the law were with the estate. The
court, however, did have discretion in how it viewed the life insurance proceeds -- and the court exercised that discretion in a way
that mitigated the tax damage done to the heirs. Not mentioned by the appeals court was that none of the stockholders who would
be benefited by the Blount stock being redeemed for $4 million was a member of the Blount family. An employee stock ownership
plan apparently was the sole other shareholder. Thus, the $4 million price in the stock purchase agreement did not constitute a
disguised gift to the natural objects of the decedent's concern.

                                                            Conclusion

Tax practitioners reviewing documents and disposition plans are the taxpayer's first line of defense against results that should
never occur and that the tax law does not really intend. Because the law is complex, however, and because the variety of
individual and corporate transactions and arrangements seems almost infinite, there is no way that every possible unfair result can
be avoided. Hence the need for tax practitioners who will ask the questions -- difficult to project and sometimes even more difficult
to answer -- as to the consequences if these plans or agreements are carried out under this, that, and those circumstances.

Sometimes the business and estate planning objectives can be best met by keeping the life insurance out of the business. A
direct corporate redemption of stock provides no tax benefit to either the corporation or the continuing stockholders, although it
may provide an economic windfall to the continuing stockholders who now become owners of 100 percent of the stock, such as
the employees who were the beneficiaries of the BCC ESOP. Depending on the gross receipts of the corporation,3 the life
insurance proceeds in a C corporation will create alternative minimum tax income via the adjustment for current earnings. Thus,
for C corporations subject to AMT, the life insurance proceeds may not really be tax-exempt. Cross- ownership of life insurance by
the stockholders, on the other hand, can keep insurance proceeds out of the AMT trap, as well as prevent those proceeds from
entering into the valuation of the business. Cross-ownership also provides the surviving stockholder(s) with a purchase price tax
basis for the stock that is being "redeemed" and leaves with the decedent's estate a life insurance policy on the life of each of the
surviving shareholders. What cross-ownership lacks are the "windfall" aspects that can accompany corporate redemption and the
relative simplicity of having the corporation handle the buyout of the decedent.

It is not uncommon in succession planning situations to have a controlling (or sole) shareholder who is considerably older than the
one or more minority (or potential) shareholders who will be succeeding him. If the corporation were to purchase the life insurance
and redeem the control stock, the costs would be before-tax and could be viewed as being borne, to the extent of his percentage
ownership, by the controlling shareholder. In a sense, he is paying for a life insurance policy to redeem his stock from his estate.
He could purchase the life insurance in an irrevocable life insurance trust without reference to the corporation and obtain for his
heirs both the benefit of the life insurance proceeds and the fair market value of the corporate stock. With cross-ownership, the
insurance is owned and paid for by minority shareholders active in management and avoids the perception that the controlling
shareholder is buying the very insurance that will be used to fund redemption of his or her stock. It also avoids another possible
problem -- that stock redemption by the corporation is as much a windfall to minority shareholders not active in management as it
is to those who are active.

Tax considerations should not be the prime drivers of the use of stock redemption or similar agreements, of course. The 1996
revision of the 1981 BCC agreement was driven by a desire to perpetuate the business to which Blount had devoted his life. In
that sense, it was successful, albeit at the expense of his own family. Restrictive agreements are vital to the continuation of
businesses -- and, as in S corporations, may be essential to prevent ownership interests from winding up in hands that may
invalidate tax elections or be inimical to the welfare of the business itself. We have seen successful small businesses forced to
liquidate with little realized for the owners when those owners were unable to agree on either what to do or how to arrange an
orderly exit for one of the owners. So while it may be difficult to plan around the tax traps in stock purchase agreements, it may be
utterly disastrous for the tax practitioner's clients to not use such agreements.

                                                               FOOTNOTES

1 The appeals court also cited True v. Commissioner, 390 F.3d 1210, Doc 2004-23046 [PDF], 2004 TNT 234-11              (10th Cir.
2004), which dealt with the question of whether a restrictive agreement that was being ignored for purposes of fixing the estate tax
value should nevertheless be taken into account as an obligation of the entity being valued. After reviewing the many cases
holding that the agreement's provisions other than price would still be taken into account by the hypothetical buyer in determining
fair market value, as well as the fewer cases holding with the IRS that the entire redemption agreement should be ignored, the
True appeals panel had decided that in the True case the Tax Court had not ignored the price provisions after all. Rather, the
panel concluded, the restrictions were reflected in the marketability discount that the Tax Court allowed in arriving at its valuation.

2 The government's brief is at Doc 2005-7459 [PDF] or 2005 TNT 72-40         .

3 Corporations with average gross receipts under $7.5 million are generally exempt from AMT.

                                                            END OF FOOTNOTES


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Tax Analysts Information

Code Section: Section 2703 -- Valuation, Disregarded Rights; Section 2103 -- Definition of Gross Estate
Geographic Identifier: United States
Subject Area: Closely held business
Estate, gift and inheritance taxes
Author: Raby, Burgess J.W.; Raby, William L.
Institutional Author: Tax Analysts
Tax Analysts Document Number: Doc 2005-22743 [PDF]
Tax Analysts Electronic Citation: 2005 TNT 216-39

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