Estate Planning 101
A basic precept of effective estate planning is for a member of an older generation to transfer[i] property to a family member of a younger generation – for example, stock in a closely held corporation – that is reasonably anticipated to appreciate in value over time. In this way, not only will the property be removed from the older transferor’s gross estate for purposes of the federal estate tax, but any increase in the value of the property will also be excluded.[ii]
Thus, it is not uncommon[iii] for the owner (“Owner”) of a fairly new business venture to transfer to a trust for the benefit of their children some portion of their equity interest in the business entity through which the venture is to be conducted. At the time of the transfer – ideally, as close to the inception of the business as possible – the value of the equity may be relatively low, even speculative,[iv] thereby consuming only a small portion of the investor’s gift tax exclusion amount.[v] If the business ultimately fails, Owner will have “wasted” only that portion of their exclusion amount. However, if the business turns out to be a wild success, Owner will have effectively transferred a great deal of wealth to the next generation for a relatively small investment.[vi]
Beware of Deemed Gifts
This desirable result is the product of prudent gift and estate planning – not to mention some combination of foresight, effort and luck. There may be times, however, when too much of the proverbial “good thing” turns out to be a problem.[vii] For example, in their enthusiasm for shifting the hoped-for appreciation in the value of the business to their children, or to trusts for their benefit, Owner may get carried away.
Thus, Owner may contribute funds to the business without causing the business to issue additional equity to them in exchange for such funds, in the belief that by doing so they will direct more of the appreciation to the stock held by their children. In the case of a corporation, this contribution may be treated as a gift to the beneficiaries of the trust to which Owner has previously transferred shares of stock in the corporation.[viii]
Alternatively, and with the same goal in mind – to “freeze” Owner’s value while shifting appreciation to the younger generation – Owner may decide to treat their contributions of cash to the business as loans.[ix]
These loans may be recorded as such on the books of the business,[x] as well as on the balance sheet[xi] of the tax return filed by the business. They may be memorialized in a promissory note that sets forth the terms of the loan, including a maturity date,[xii] an interest rate,[xiii] and a payment schedule. The loan may even secured by the borrowing entity’s assets. Ideally, individuals who want to support the claim that their transfer of funds was a loan, rather than a gift, should require that interest be paid at least annually;[xiv] failing that, they should ensure that interest is accrued and imputed for tax purposes.[xv]
However, if this practice is not monitored closely, the combined effect of freezing Owner’s value while increasing that of Owner’s children, may leave Owner’s estate in a difficult position. Specifically, it may result in their estate failing to qualify for a special relief provision under the Code[xvi] which allows an estate that consists largely of equity in a closely held business to satisfy its federal estate tax liability attributable to such equity over a term of up to 14 years, during the first four of which only interest on the deferred tax is payable.[xvii]
In order to qualify for this relief, the fair market value of a decedent’s interest in a closely held business, which is included in their gross estate for purposes of determining the estate tax,[xviii] has to exceed 35-percent of their adjusted gross estate.[xix]
A decedent’s equity in a corporation[xx] will qualify as an “interest in a closely held business” if 20-percent or more in value of the voting stock of the corporation was included in the decedent’s gross estate,[xxi] or if the corporation had no more than 45 shareholders.[xxii]
If a decedent owned a qualifying interest in a closely held business, then the estate tax attributable to the value of such interest is eligible for installment payments.[xxiii] For purposes of determining that value, however, the value of the interest attributable to any passive assets held by the business is disregarded. Thus, the benefit of the estate tax deferral is limited to the tax attributable to assets that are used in carrying on a trade or business by the closely held business.[xxiv]
Advisers to the owners of a closely held business – for whom the ability to pay their estate tax in installments in accordance with the above rule – will often check on the status of an owner’s qualification.[xxv] In the event they discover that the owner’s estate may not be eligible for the installment rule, it may be possible to remedy the failure; for example, by adjusting the owner’s adjusted gross estate – perhaps by structuring certain otherwise testamentary dispositions as “liabilities” – or by increasing the owner’s relative equity in the business or the value of such interest relative to the owner’s other assets.
For example, the attribution rules mentioned above may be helpful.[xxvi] The owner may also purchase equity from other shareholders, exchanging value for value, and thereby avoiding a taxable gift, but probably triggering a taxable gain for those shareholders. In the case of a trust that is treated as a grantor trust on account of the owner’s retained power of substitution,[xxvii] the owner may exchange other property for the stock held by the grantor trust, which is treated as a nonevent for purposes of the income tax.[xxviii] If practicable, the corporation may redeem some of the shares of stock held by other shareholders; if treated as an exchange for tax purposes, there may be taxable gain;[xxix] if treated as a “dividend” distribution, then the entire amount will be taxable.[xxx]
Each of these options has its own economic costs which must be weighed against the benefit to the estate and its beneficiaries of being able to pay the estate tax in installments.
What about the Loans?
This brings us back to Owner, described above, who may have been overly eager about shifting value in the business away from themselves and to their children. In furtherance of that goal, Owner chose to treat their continued capital infusions into the nascent business as loans rather than as contributions to capital in exchange for more equity in the business.
Owner’s business is not at risk of failing to meet the definition of a “closely held business” under the installment payment rule – the corporation has fewer than 46 shareholders. The issue, rather, is that the value of Owner’s interest in the corporation may not exceed 35-percent of Owner’s adjusted gross estate.
In that case, Owner’s estate will not be able to defer payment of the estate tax attributable to either the stock in the closely held corporation or to the indebtedness owed by the corporation to Owner.
How, then, can the 35-percent test be satisfied?
Conversion of Debt to Equity?
Depending upon how much of the corporation’s debt is owed to Owner, the latter may decide to transfer some or all of such debt to the corporation as a contribution to capital. This transaction may result in Owner’s estate satisfying the 35-percent test by reducing the value of the debt in Owner’s estate; however, such a transfer may also result in a gift by Owner to the other shareholders of the corporation. If Owner’s transfer of the debt is paired with the corporation’s issuance of additional stock to Owner, the chance of success is increased, and the risk of a taxable gift is reduced.
In either case, however, it is imperative that Owner, the corporation, and the other shareholders consider the income tax consequences of Owner’s transfer.
Income Tax Consequences
In general, if a shareholder gratuitously forgives the debt owed to them by their corporation, the transaction represents a contribution to the capital of the corporation to the extent of the principal amount of the debt.[xxxi]
However, the Code provides more specific rules that describe the consequences of such a transaction for both the shareholder-creditor and the corporation-debtor.
From the shareholder-creditor’s perspective, the contribution of the debt to the corporation without the receipt of any additional shares of stock should be treated as a nonevent for income tax purposes.[xxxii]
If the corporation issues additional shares to the shareholder-creditor, the stock-for-debt exchange will be taxable to the shareholder if the debt is not evidenced by a security.[xxxiii] The amount of gain to be recognized will be equal to the fair market value of the stock received by the creditor over the creditor’s adjusted basis for the debt exchanged.[xxxiv]
Even if the debt is evidenced by a security, the exchange will be taxable to the shareholder unless they are in control of the corporation immediately after the exchange.[xxxv]
Alternatively, the exchange may qualify as an “E” reorganization – a recapitalization.[xxxvi] In that case, the creditor’s surrender of a debt security issued by the corporation in exchange for stock issued by the corporation would qualify for tax-deferred treatment.[xxxvii]
In either case, however, shares that are attributable to any accrued but unpaid interest will be taxable to the shareholder-creditor as ordinary interest income.[xxxviii]
Unfortunately, the Code does not define the term “security.” That being said, there is some authority for the proposition that a debt obligation with a term of fewer than five years will not be treated as a security.[xxxix] In other words, generally speaking, the obligation should represent a longer-term investment in the debtor-corporation in order to qualify as a security.[xl]
Of course, in the context of a shareholder-creditor and corporation-debtor relationship, it is not enough to consider only the consequences to the shareholder arising from the “conversion” of the indebtedness into equity. The tax cost to the debtor-corporation also has to be determined.
Where the shareholder-creditor cancels the corporation’s debt by contributing it to the corporation without receiving any stock in exchange, the corporation is treated as having satisfied the principal amount of the debt – generally, its issue price[xli] when the debt bears adequate stated interest – with an amount of money equal to the creditor’s adjusted basis[xlii] in the debt.[xliii] Thus, if such adjusted basis is less than the debt’s adjusted issue price,[xliv] the corporation will recognize cancellation of indebtedness income.[xlv] If the creditor’s adjusted basis in the debt is at least equal to debt’s adjusted issue price, then no cancellation of indebtedness income will be recognized.
Where the corporation-debtor issues additional shares of stock to the shareholder-creditor in exchange for, and in cancellation of, the corporation’s indebtedness, the corporation is treated as having satisfied the debt for an amount of money equal to the fair market value of the stock issued.[xlvi] Thus, if the value of the stock issued is less than the adjusted issue price for the debt, the corporation will recognize cancellation of indebtedness income. This is the case even where the debt obligation is evidenced by a security and the reorganization rules apply to the debt-for-stock exchange.[xlvii]
The foregoing illustrates just one instance of the interconnectedness of the estate and income taxes in the context of a closely held business. There are many more.
The adviser to such a business has to be attuned to this fact – they should not make any recommendations with respect to one of these taxes without considering its effects on the other – it will not always be possible to unwind an exchange or transaction without adverse tax consequences of one sort or another.
Moreover, in no case should they advise a course of action without first determining its impact on the business as such, including its relationship to third parties such as lenders and other investors.
It is difficult to ignore the circumstances in which we now find ourselves. It is natural to wish that things were different. In times of stress, I often find guidance in literature. The following is from The Lord of the Rings:
“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”
[i] Whether by a completed gift or a sale, whether outright or in trust. In the case of a trust, and depending upon the current value of the property, the expected cash flow and rate of appreciation, the transfer may take the form of a gift, a GRAT, a sale, or a sale to a grantor trust.
[ii] Assuming, of course, that the transferor has not retained an interest in the property such that, notwithstanding the transfer, they continue to enjoy the benefits of ownership themselves, or the ability to determine the enjoyment of the property by others, or they retain a reversionary interest in the property. In that case, the transferred property will be included in the transferor’s estate at its value as of their date of death. IRC Sections 2035, 2036, 2037 and 2038.
[iii] Which is to say that it is not common, though it does happen. Most owners of a closely held business are reluctant to give up any part of their equity, let alone control, until after the business has established itself – i.e., appreciated in value – and the owners have reaped the rewards of their efforts. At the point, an owner may begin to think on their eventual withdrawal, both from the business and from this world. (Of course, there are some who say, “if I die,” rather than “when.”)
[iv] As always, a well-reasoned valuation report by an experienced and well-regarded professional appraiser is necessary. The money is well spent.
[v] IRC Sec. 2010(c) and Sec. 2505. Of course, any part of the exclusion amount consumed during the life of the grantor will not be available to shield the grantor’s testamentary transfers.
[vi] Indeed, if the grantor had also allocated part of their GST exemption amount at the time they transferred the property to the trust, subsequent distributions from the trust to their grandchildren would not be subject to the GST tax. IRC Sec. 2601 and Sec. 2631. See the automatic allocation rules in IRC Sec. 2632 and the regulations thereunder.
[vii] Examples abound; for example, drugs, perhaps longevity. Mark Twain had his own exception to this rule of thumb: “Too much of anything is bad, but too much good whiskey is barely enough.”
[viii] See, e.g., Reg. Sec. 1.351-1(b), which treats the contributor as having received shares of stock, which they then transfer to the other shareholders.
In the case of a partnership, the owner’s adjusted basis for their partnership interest and their capital account will reflect the additional capital contribution. IRC Sec. 705 and Sec. 722; Reg. Sec. 1.704-1(b)(2)(iv).
But, in an arm’s length deal, who would put their capital at risk without requiring additional equity, or a preferred return on their investment, or a guaranteed payment for the use of their capital? There’s a donative transfer in there.
[ix] We assume for our purposes that the loans are respected as such.
[x] If the owner-lender prepares personal financial statements at the request of a third party, they should be careful to include the loans as such.
[xi] Schedule L of either IRS Form 1065 for a partnership or IRS Form 1120 for a corporation. “Loans from partners” or “loans from shareholders” as the case may be.
[xii] In the absence of a maturity date, the loan is deemed to be a demand loan, which may be called at any time by the lender.
In some cases, it may be necessary to determine whether the loan is a “security,” in which case the length of the term will likely be pretty important. See, e.g., IRC Sec. 354 and Sec. 368(a)(1)(E).
[xiii] Often at the applicable federal rate, or AFR, under IRC Sec. 1274.
If the debt bears interest at a rate less than the AFR (a “below market rate”), the “lender” may be treated as having made a gift of the foregone interest. IRC Sec. 7872.
[xiv] In related party settings, it is important to treat with one another as closely as possible as one would with an unrelated party.
[xv] IRC Sec. 7872.
[xvi] IRC Sec. 6166. Of course, the policy underlying this relief is based upon the concededly illiquid nature of the closely held business and the desire to avoid a forced sale of the business solely for the purpose of satisfying the deceased owner’s estate tax liability. In accordance with this policy, the tax deferral will cease, and the tax will come due immediately, upon certain sales of the decedent’s interest or upon certain withdrawals of money from the business – in other words, upon the happening of certain “acceleration” events that eliminate the estate’s liquidity problem. IRC Sec. 6166(g).
[xvii] IRC Sec. 6166(a) and (f). Beginning with the fifth year, the estate will start paying the deferred estate tax and the interest thereon.
[xviii] IRC Sec. 2031.
[xix] IRC Sec. 6166(b)(6). The adjusted gross estate is determined by subtracting from the decedent’s gross estate only the estate’s administration expenses and certain casualty losses.
[xx] We’re limiting this discussion to corporations.
[xxi] The fact that the decedent was treated, for income tax purposes, as the owner of stock held by a grantor trust through the date of their death is irrelevant for purpose of this estate tax rule if the stock is not included in the decedent’s gross estate.
[xxii] IRC Sec. 6166(b). Certain attribution rules apply for purposes of determining the “number of shareholders test, or may be elected for purposes of the “percentage of value” test. IRC Sec. 6166(b)(2) and (7), respectively. The election under Sec. 6166(b)(7) comes at a price, including the loss of the initial period of interest-only payments.
[xxiii] The liquidity for an installment payment will often come from the corporation itself, in the form of a redemption of stock. Redemptions described in Sec. 303 of the Code – which are treated as exchanges of stock (not as dividends) and may thereby take advantage of the basis step-up at death under IRC Sec. 1014 – are not treated as acceleration events. IRC Sec. 6166(g)(1)(B).
[xxiv] IRC Sec. 6166(b)(9).
[xxv] That is not to say that they know when the owner will die, but reasonable assumptions may be made to enable some helpful analysis.
[xxvi] See endnote xxii.
[xxvii] Under IRC Sec. 675(4).
[xxviii] See, e.g., Rev. Rul. 85-13.
[xxix] IRC Sec. 302(a). Beware the Sec. 318 attribution rules.
[xxx] IRC Sec. 302(d), Sec. 301. The federal income tax would be imposed at a rate of 20%, plus the 3.8% federal surtax on net investment income. IRC Sec. 1(h), Sec. 1411.
Of course, if we are dealing with an S corporation that does not have earnings and profits from C corporation tax years, a redemption treated as a dividend distribution would be described in IRC Sec. 1368, and would be treated as a return of the shareholder’s entire basis in their stock before gain would be recognized.
[xxxi] Reg. Sec. 1.61-12(a).
[xxxii] We’ve already seen how it may result in a gift to the other shareholders if they are the natural objects of the contributing shareholder’s bounty.
[xxxiii] IRC Sec. 351(d)(2). Such a debt is not treated as “property” within the meaning of IRC Sec. 351.
[xxxiv] IRC Sec. 1001.
[xxxv] IRC Sec. 351(a). “Control” is defined in IRC Sec. 368(c) as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.
[xxxvi] IRC Sec. 368(a)(1)(E); Reg. Sec. 1.368-2(e)(1) (exchange of bonds for preferred stock).
[xxxvii] IRC Sec. 354.
[xxxviii] IRC Sec. 351(d)(3).
[xxxix] See, e.g., Rev. Rul. 2004-78.
[xl] More than five years, though the other terms of the debt have to be considered.
[xli] IRC Sec. 1273.
[xlii] In the case of the original holder of the debt – i.e., the shareholder-lender – this will be the amount of the loan when the debt bears adequate stated interest.
A special rule applies for S corporation debt under which any reduction in the basis of the debt caused by the shareholder-creditor’s distributive share of corporate losses is disregarded. IRC Sec. 108(d)(7)(C).
[xliii] IRC Sec. 108(e)(6). This provision overrides IRC Sec. 118, under which contributions to the capital of a corporation are otherwise excluded from its income.
[xliv] This is initially the issue price for the debt. IRC Sec. 1272(a)(4); Reg. Sec. 1.1275-1(b). This is the amount of the loan where the debt bears adequate stated interest.
[xlv] IRC Sec. 61(a)(11). I am assuming for our purposes that none of the exclusions to recognition of such income under IRC Sec. 108 are applicable; for example, cancellation of debt when the debtor is insolvent.
[xlvi] IRC Sec. 108(e)(8). The issuance of the stock by itself is not otherwise taxable to the corporation. IRC Sec. 1032.
It appears that the IRS respects the form of the transaction, meaning that even in the case of a corporation with a single shareholder – in which case the issuance of additional shares may be treated as a “meaningless gesture” under Sec. 351’s jurisprudence – the issuance of stock in satisfaction of the corporation’s debt will trigger application of IRC Sec. 108(e)(8), rather than Sec. 108(e)(6). See, e.g., PLR 20101608.
[xlvii] Rev. Rul. 77-437.