Hendrix v. Commissioner, TC Memo, 2011-133 (June 15, 2011) dealt the IRS another blow as they continue to fight against defined formula clauses used in private company stock transactions. This is one more nail in the coffin for the Service which has long contended that such clauses are contrary to public policy. And actually, this is the fourth defeat of the Service’s approach to an outright dismissal of any buy-sell formulas.
So what do we learn from these developments? While the recent cases knock down the IRS’s outright attacks, the formulas that prevailed were not simple.
- Formula-based pricing is not in and of itself bad. IF fairly constructed, worded and negotiated, a defined value can indeed be viewed as the agreement-dictated succession price.
- Formulas need structure in a manner that is not blatantly inaccurate.
- Book value is not an answer. Some adjustments to stated book value, GAAP equity or capital account balances, etc., at a minimum, are typically needed. With no adjustments, “book value” will miss the “value” of an entity.
- Valuation involves the analysis of asset based approaches and some form of income stream approaches. As time marches on, formulas need to adjust with time.
While a “simple” formula may not be appropriate, a “straight-forward” formula can be very effective and functional. Each situation is very, very different. What works for a physician practice will not work for a construction company, and the formula for a home builder is not the same as that for a highway contractor. In addition, we have to be very careful with situations involving family members, as these agreements will be looked upon with a greater degree of skepticism. The formula can lay out the approach to pricing, with variables being clearly defined, however, the variables will change with time, and thus the “formula” should incorporate prevailing market conditions.
During the planning process, if we listen to clients, understand their personal and business needs first, and then apply legal processes and tax efficiencies, if we work in this order, the result will be the type of document which holds up to third-party scrutiny.
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Anthony Duffy is the managing director of ValuQuest based out of our Albany, NY office.