It is not unusual for a parent to have successfully started and grown a business, only to find that his children either have no interest in continuing the business or are incapable of doing so.  Prior to that moment of realization, however, Parent may have transferred equity in the business to his children, either as an incentive to keep them engaged in the business, or as part of his estate planning.  There are several benefits to having Parent maintain a reduced equity position.

Favorable Estate Tax Valuation

If Parent were to pass away holding a reduced equity position in the business, his ownership interest would, of course, be included in his gross estate for purposes of the estate tax.  In assigning a value to that interest, an appraiser would consider the fact that the business was closely-held, that there was no ready market for its equity, and that Parent’s interest represented something less than a controlling interest.  Thus, the value of Parent’s equity would be determined by applying discounts for lack of marketability and lack of control (though the latter may be tempered by some swing vote premium).  In other words, it would likely be valued at less than what his equity interest would receive in the way of proceeds on a liquidation of the business.

Stepped-Up Basis

In addition to a favorable estate tax valuation at the Parent’s death, his equity in the business would pass to his estate or other beneficiaries with a stepped-up basis; i.e. increased from what was essentially a zero basis to the fair market value of the equity at the date of his death.  This would, of course, benefit the holder with respect to the tax liability generated by any later sale or liquidation of the equity.

Conflicting Plans

However, what happens when Parent’s children begin to push for a sale of the business?  They want cash and they don’t want the business; from their perspective, a sale makes sense, and the sooner the better.  The equity may be sold to a third party, or the assets may be sold and the business liquidated.  Each owner, including Parent, will end up with cash from the equity sale, or asset sale/liquidation, and will pay income tax on the gain realized.  Since Parent’s basis is very low, the full amount received by him is subject to income tax (albeit as capital gain).  In addition, because cash is not subject to valuation discounting, the full amount thereof held by Parent at his death would be subject to estate tax.  If Parent is older, he may prefer to hold on to his equity, both for estate tax valuation purposes and for the basis step-up.

Is there some way to accommodate both Parent’s desire to hold his equity in the business until his death, while also generating the liquidity desired by his children?

The IRS OK’s a Compromise

The IRS once considered the following scenario: Taxpayer owned 14% of Target Corp’s common stock, with the balance being widely held; Taxpayer was of an advanced age and had very low basis in his Target stock; and Buyer Corp sought to purchase all of Target Corp’s stock for cash and to operate Target Corp as a subsidiary.  While the other Target Corp shareholders were willing to accept cash for their stock, Taxpayer was not because a sale would result in recognition of substantial taxable gain.  In order to accommodate Taxpayer’s wish to avoid gain recognition, Buyer Corp and Taxpayer agreed to organize a new corporation, Sub, for the purpose of acquiring and holding all of the Target Corp stock.  Buyer Corp transferred cash and other property to Sub in exchange for all of Sub’s common stock, and Taxpayer transferred his shares of Target Corp stock in exchange for all of Sub’s preferred stock.  The transaction was intended to be a tax free exchange under IRC Sec. 351.  Sub then used the cash to acquire all the stock of Target Corp (other than that contributed by taxpayer to Sub).  Both Sub and Target Corp remained in existence as a holding company and an operating company, respectively.

Although it hesitated at first, the IRS eventually concluded that the transaction would qualify as tax-free exchange under IRC Sec. 351.  Thus, taxpayer did not recognize a gain on his exchange of Target Corp stock for preferred stock in Sub.

Partnership

Under other rulings issued by the IRS, it may be possible to arrive at a similar result in connection with the acquisition of a partnership’s business, when an older partner does not want to “liquidate” his interest and recognize gain.  For example, Partner Taxpayer may contribute his membership interest in Target LLC to Buyer LLC in exchange for a membership interest therein.  In general, this exchange would be tax-free.  Buyer LLC may acquire the other Target LLC membership interests in exchange for cash, thereby making Target LLC a wholly-owned division.

It may also be possible to combine a Sec. 351 exchange with another form of tax-free corporate exchange in order to effect the same result.  For example, Parent and the other members of Target LLC may contribute the LLC’s assets to a newly-formed corporation, Newco, in exchange for Newco common stock, which it then distributes to its members.  At the same time, Buyer Corp merges into Newco, on a tax-free basis, with the Buyer Corp shareholders receiving Newco common stock in cancellation of their Buyer Corp stock.  The two asset transfer transactions, as a whole, constitute a tax-free Section 351 exchange.  Moreover, this treatment should not be affected if Newco subsequently uses cash received in the merger with Buyer Corp to redeem the Newco shares held by the former members of Target LLC, other than parent.

 

Conclusion

In light of the foregoing, when presented with a situation where the younger generation wants to cash out of a business, while the older generation would prefer to defer gain recognition and possibly achieve a more favorable estate valuation and a basis step-up, consideration should be given to some variation, or combination, of the partially tax-free, partially taxable exchange transactions described above.  Although there are a number of other issues that need to be considered (based upon the unique facts and circumstances of the particular parties), achieving the appropriate structure to accommodate the older generation of a target company may be a pre-requisite to getting a deal done.