There are many advantages to buy-sell agreements. These agreements can be used to restrict the transfer of a business to outside parties, protect “S” corporation status by preventing transfers to disqualifying shareholders, or ensure the liquidation of the business interest on the death of an owner. However, if the buy-sell agreement is between family members, the owner may encounter unintended transfer tax consequences upon his or her sale of the business interest.For the purpose of determining the taxable value of a business interest in the estate of a deceased owner, or for establishing the taxable value of the interest as a gift, the fair market value of such interest must be established at the time of the transfer. The tax code states that fair market value is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” The establishment of a purchase price under a buy-sell agreement would seem to fall neatly within this definition of fair market value, but not if the parties are family members and not if the purchase price for the business interest is below its independently determined fair market value. Under those conditions, the value of the business interest, as used for transfer tax purposes (i.e. - gift, estate and generation-skipping taxes), may be determined without regard to the price established in the buy-sell agreement (or in any other option, agreement, right or restriction on the acquisition or use of property). Essentially, the IRS is allowed to ignore the value established by the buy-sell agreement and set the transfer tax value at the business interest’s then current fair market value. This can create significant transfer tax problems for the seller, because he or she is still under a legal obligation to sell for the lower purchase price established in the buy-sell agreement, but would get taxed for transfer tax purposes on the greater value determined by the IRS. Imagine this set of facts: Dad and Child each own 50% interests in a business with a total fair market value of $10,000,000. Dad and Child decide to enter into a cross-purchase buy-sell agreement that provides that at the death of either stockholder, the survivor will be required to purchase the deceased stockholder’s shares. Dad and Child set a buy-out price of $2,000,000 for each stockholder’s 50% interest, and each acquires a $2,000,000 life insurance policy on the other’s life to fund the purchase at death. Dad dies and his estate takes the position for estate tax purposes that the value of Dad’s business interest is $2,000,000 due to the legal obligation of Dad’s estate under the buy-sell agreement to sell the interest to Child for that amount. The IRS would likely challenge this value and (successfully) assert that the value for estate tax purposes is the fair market value of $5,000,000. In this situation, Dad’s estate is taxed for estate tax purposes on $5,000,000, but it only has assets of $2,000,000 (equal to the cash received on the sale), much of which may be needed to pay the estate tax liability on the higher value. Greater problems may be encountered if Dad’s estate is to pass to his surviving spouse, as the $3,000,000 worth of “phantom” assets could give rise to a taxable estate, where there otherwise might not be one at all. Not every buy-sell agreement between family members will be disregarded for transfer tax purposes. A buy-sell agreement will be considered valid for such purposes if it meets the following three criteria: (1) It is a bona fide business arrangement; (2) It is not a device to transfer property to members of the seller’s family for less than full and adequate consideration in money or money’s worth; and (3) Its terms are comparable to similar arrangements entered into by individuals engaged in an arm’s length transaction. Further, a buy-sell agreement will be deemed to have met the above three criteria if more than fifty percent of the value of the property subject to the agreement is owned directly or indirectly by individuals who are not members of the seller’s family. Any business owner who has entered into a buy-sell agreement, or other option, right or restriction to buy or sell property, with one or more family members should make sure the agreement complies with appropriate safe harbors in the tax code. Otherwise, the seller under the buy-sell agreement may incur transfer tax liability that was not accounted for under his or her estate plan.