In an earlier post, we noted that a parent who owns a business faces some difficult issues regarding the disposition of that business among his or her children. Among the options to be considered is a sale of the business, which would allow the parent to treat the children equally, inasmuch as each may share in the proceeds of the sale. However, a sale may not represent the best long-term economic choice where the business is profitable and growing, and where at least one of the children is capable of operating the business. In that case, the parent must consider how to transition ownership of the business to his or her family.

The tax laws have historically hampered the ability of business owners to transfer their interests in the business to their children, with the main obstacles being the gift tax and the estate tax, though the income tax has also been an important consideration.

In the last few years, Congress has made some significant changes in the gift, estate, and income tax planning landscapes.  The likelihood of more changes is far from remote. Thus far, these changes have not directly targeted any specific intra-family transfer vehicles, though there are several proposals outstanding which aim to do just that; for example, short-term and zeroed-out GRATs, GST-exempt dynasty trusts, and transactions with grantor trusts have all been highlighted as potential targets.  Until Congress acts, however, these transfer techniques remain viable and, when combined with the recent tax changes– in particular, the increased gift tax exclusion and GST exemptions amounts –they provide a parent with the tax-efficient means for reducing his or her taxable estate while benefiting the family.

The following summarizes the tax goals of a gifting program as they relate to interests in a family business. It also describes the various transfer methods by which these goals may be attained.

Goals of Gifting

Generally speaking, one goal of gifting property to a family member is not only to remove the value of such property from the parent’s estate, but also to “remove” any subsequent appreciation in the value of that property from the estate.  A taxpayer’s sale of appreciating property to a child in exchange for a promissory note will freeze the value of the property in the parent’s hands at the amount of the note, while shifting the property and any appreciation to the child.

 Had the parent not transferred the property during his or her life, the full value of that property as of his or her date of death would be included in his estate and be subject to transfer tax.

Another goal of gifting is to position the remaining business interests held by the parent in a more favorable valuation posture for estate tax valuation purposes (for example, by putting the parent in a minority interest position).

What is a Gift?

Before exploring the various transfer vehicles by which a parent may transition business interests to a child (which will be covered in the next post), it would be helpful to lay some conceptual groundwork.

When a parent gives property to a child, no gift has occurred if the parent receives adequate and full consideration in exchange for the property transferred.

A gift occurs, in most cases, if the consideration received is less than the fair market value (“FMV”) of the property transferred. In that case, the amount of the gift is equal to the excess of the FMV of the property transferred over the amount of the consideration received; to the extent that adequate consideration has been received, there has been a taxable sale of property by the transferor.  A part-sale/part-gift may occur where the business interest transferred “by gift” is “subject” to a liability and the child “assumes” that liability, a not infrequent event in the case of interests in a partnership or LLC (see IRC Section 752).

It should be noted that a transfer made “in the ordinary course of business” is not treated as a gift even though the parent-transferor does not, strictly speaking, receive full consideration. A genuine business-related transfer qualifies for this exception if it is bona fide, at arm’s-length, and free from donative intent (for example, a transfer ostensibly in exchange for services).  However, the taxpayer must be prepared to overcome the IRS’s predisposition to find a gift in a family setting.

Valuation

If a transfer of a business interest is a completed gift (and we will assume for our purposes that all of the transfers described herein are), the amount of the gift (i.e., the amount on which the gift tax is imposed) is the FMV of the interest on the transfer date.

The valuation of property for gift and estate tax purposes is based upon the “hypothetical willing buyer and willing seller” standard. In other words, it does not consider the actual transferor and transferee, and their relationship to each other (e.g., family) does not matter. These hypothetical individuals are under no compulsion to buy or sell, and they are each deemed to have reasonable knowledge of all the relevant facts (including, in most cases, the fact that the other owners of the business may be related to one another).

In the case of stock in a closely-held corporation or partnership, the FMV of an interest depends on the relevant facts and circumstances of each case. The IRS has set forth many of the factors to be considered (e.g., economic outlook, earning capacity, goodwill, the size of the interest to be transferred, etc.). The courts have accepted appropriate discounts in valuing these interests where they represent minority positions for which there is no ready market.  Among these are the discounts for lack of control (LOC) and for lack of marketability (LOM). The application of these discounts does not yield a predictable discount for any given valuation scenario, since each presents a unique set of facts.

Thus, if the interest being transferred by way of a gift is a minority interest in a closely-held entity for which there is no ready market, a hypothetical willing buyer will realize that he cannot easily realize the pro rata value of the entity to which the minority interest “entitles” him. He or she cannot force a dividend distribution, a sale or a liquidation; it will be difficult to convince another hypothetical party to purchase his or her interest. Under these circumstances, the courts and the IRS have recognized that various discounts may be applied to the so-called “normative” value of an equity interest in order to determine its fair market value.

Conversely, if the parent transfers a majority interest in the entity, which interest enables the holder (the child-transferee) to control the operation of the business, to cause it to make distributions to its owners, to sell the business or to liquidate it, etc., then the value of such interest is determined without regard to the discount for lack of control, though marketability discounts should still apply (depending, in part, upon the assets of the business).

Position for Estate Tax Valuation

This valuation reality supports the wisdom (from a tax perspective) of making gifts of minority interests in the family business to family members.  It also presents another benefit for lifetime transfers to family. Not only may such transfers remove the appreciation of the interests from the parent-donor’s estate, they may also cause the interests retained by the parent to fall below 50% of the total outstanding equity of the business. In other words, it may cause the parent to become a minority owner, which, at his or her death, will cause the parent’s remaining equity interest to be valued with the benefit of discounts for LOC and LOM.

Income Tax Considerations

Before describing some of the vehicles that are typically utilized in transferring business interests to family members, we should consider whether the parent’s transfer would make sense from various perspectives in addition to the estate tax.

First, and foremost, does the transfer make business sense? We will assume for our purposes that it does; otherwise, the discussion should end at this point.

Second, can the parent “afford” to make the transfer; i.e., does the parent need the income stream generated by the business interest, and is the parent “comfortable” with giving up ownership of the interest?

Third, what are the gift and estate tax benefits of the transfer? A gift will remove the business interest and its future appreciation from the parent’s estate. It may reduce the value of the parent’s remaining interests in the business (much the same way that inter-spousal transfers do, a la Bonner and Menninger).

However, with the increased gift tax exclusion – and its unification with the estate tax – to $5.34 million in 2014 ($10.68 million per married couple), the indexing of the exclusion amount for inflation, and the ability of a surviving spouse to utilize the unused exclusion amount of a pre-deceasing spouse (the so-called “portability” election), the estate tax-based justification for gifting business interests may be much diminished for many parent-business owners.

Indeed, from the perspective of many business owners, depending upon the anticipated value of their taxable estate, the better tax plan may be to hold on to the business until their date of death. In this way, they can secure a step-up in the adjusted tax basis of the business interests. This will enable the beneficiaries of their estates to secure certain income tax benefits, including the reduction of gain on a subsequent sale of either the interests or of the assets of the business (depending upon some other factors), or the reduction of ordinary income as a result of increased depreciation or amortization deductions (for example, as the result of an IRC Sec. 754 election). This will be the subject of a later post.

 

We have previously looked at the recognition period for built-in gains of S corporations, and the effect of the expiration of the temporary reduction of this period, under the American Taxpayer Relief Act of 2012, to five years.  Earlier this week, however, the House Ways and Means Committee approved six “tax extender” bills to extend certain tax provisions that expired at the end of 2013.  Among these bills was H.R. 4453, which would make the five-year recognition period permanent.  As we have discussed, electing S corporation status is still a smart option for C corporations in several scenarios to consider, and, if this bill is ultimately passed, it will make such an election even more attractive.  Stay tuned for updates as this bill and the companion Senate bill, S. 1855, wind their way through the legislative process.

“There was a man who had two sons; and the younger of them said to his father, ‘Father, give me the share of property that belongs to me,’ and he divided his land between them.  Not many days later, the younger son gathered all he had. . .and squandered his property in loose living.”  With apologies to St. Luke, the spendthrift son returned, tail between his legs, to his father’s home, and the old man prepared a feast for him.  But the older brother “was angry. . .and answered his father, ‘Lo, these many years I have served you, and I never disobeyed your command; yet you never gave me’ ” a dinner (to paraphrase the late Red Buttons).

I have never accepted the parable of the prodigal son.  I have always sided with the older brother, and I am certain that I am not alone.

However, query how a parent with a business will treat his children when one is actively engaged in its operation (the “participating child”) while the other is not.  The question presented is especially difficult where the business constitutes the greatest part of the value of what will be the parent’s estate.  The parent’s natural inclination may be to treat the children equally, sometimes “fairly” (not necessarily the same thing).  In any event, the parent typically wants to provide each of them a measure of security and the opportunity to succeed. But how?

 

Scenario 1

One option would be to give each child an equal share in every asset, including the business.  If it is likely that the children will not be able to work together  – and who better than the parent can foresee this not uncommon result? – and the business is comprised of different lines of business, or operates in different locations, it may be advisable to divide the business into two separate (though not necessarily equal) parts (via a split-up or split-off, preferably on an income tax-free basis).  This would give each child an opportunity to make his or her own way and to benefit from his or her own efforts.  But is this division the best option for the business and, consequently, for the family’s long-term financial well-being?

Scenario 2

In a case where the parent has other, non-business assets of significant value, he or she may pass the business along to the participating child, with the balance of the estate passing to the non-participating child.  Even then, however, friction may develop between the children.  For instance, in a situation in which only one child is involved in the business and the parent owns real estate, perhaps through a pass-through entity (like an LLC), that generates rental income, what if the business operates on the real property?  In that case, other factors must be considered.  Does the business pay fair market rental to the real estate entity?  Is there a written lease?  How are expenses and capital expenditures allocated between the tenant business and the property owner?  Who should control the real property entity; the child who is not in the business?  Will this effectively give the non-participating child undue influence over the business operated by the other child?

Scenario 3

Where the parent has few options in the way of other, non-business assets with which he or she may “equalize” the treatment of the children, the parent may want to look into obtaining life insurance on the parent’s life “for the benefit” of the non-participating child.  This policy may be acquired in a life insurance trust, so as to keep it out of the parent’s gross estate and, thus, undiminished by estate taxes.  Upon the parent’s death, the policy proceeds may be distributed to (or held for the benefit of) the non-participating child, or they may be used for another purpose, as described below.

Planning for Scenario 1

Where it may be too expensive to acquire sufficient life insurance coverage so as to “equalize”  the children, and there are no other available assets, the parent will have to plan for the transfer of equity interests in the business to each of the children, both participating and non-participating.

In order to prepare for this eventuality, the parent should consider the adoption of a shareholders agreement and the recapitalization of the business’s equity into voting and non-voting interests.  (Note that such a capital structure is available in both S corporations and limited liability companies.  In general, the recapitalization may be effected on an income and gift tax-free basis.) The terms of the shareholders’ agreement will depend, in part, upon whether the non-participating child will continue as an equity owner or not.  If not, then the agreement may give the participating child the right to purchase the other child’s equity interest at fair market value (as determined by an appraisal, and being mindful of the estate tax valuation in the parent’s estate, perhaps with an adjustment if the business is sold at a greater price within two years).  The terms of such a purchase should be spelled out as well; for example, $X at closing, a Y-year promissory note (accruing Z% interest) for the balance.  If there is some life insurance available on the parent’s life, the proceeds therefrom may help to fund the purchase.

If the non-participating child will remain a shareholder – for example, where an immediate buyout may be too expensive – then the parent should consider giving the voting equity to the participating child and the non-voting to the non-participating child.  In this way, the non-participating child will not be able to interfere with the operation of the business (though he or she will still have certain rights and remedies as a matter of state law; the participating child does not have carte blanche).  In addition, the shareholders’ agreement may provide for the buyout of each sibling’s equity in the business upon either sibling’s death (which may necessitate the acquisition of life insurance on their lives).  The shareholders’ agreement may also provide the participating child with drag-along rights so that, in the event of a proposed sale of the equity, that child can force the non-participating child to also sell his or her equity.  At the same time, the agreement should provide that the non-participating child should not be able to freely transfer or pledge his or her equity.  In some cases, in order to further remove the non-participating child from the business, and to further limit his or her ability to intervene in, or to interfere with, the business, that child’s shares may be transferred into a  trust for his or her benefit.  A trust may also be advisable where the non-participating child has creditor or marital issues, or when the parent seeks to provide for that child’s own children.

On the other hand, the parent must recognize the fact that the child in the business will be able to draw down a salary, while the non-participating child may not even be employed by the business.  The participating child will also be in a position to declare, or not to declare, dividends.  There may be valid business reasons for reinvesting net earnings (as opposed to paying a dividend) — for example, to pay down debt, to update equipment, or to expand – but that may not assuage the nonparticipating child.

The shareholders’ agreement should address distributions; for example, will there be mandatory distribution for taxes (in the case of a pass-through entity, like an S corporation, partnership or LLC), or will they remain discretionary with the participating child?  This can be a tricky issue because that child also controls compensation decisions.  Although it is proper that the participating child be reasonably compensated for his or her efforts, including bonuses after a particularly good year, the fact remains that a non-participating child will likely become very resentful; after all, he or she owns an interest in a valuable business from which no present economic benefit is being derived.  Indeed, under such circumstances, the non-participating child’s only prospect of enjoying the wealth passed to him or her from the parent would be on the ultimate sale of the business, the likelihood of which may be remote.

Speaking of the non-participating child, it may make sense to include a tag-along right in the shareholders’ agreement, so as to enable that child to participate in any sale of equity being contemplated by the participating child.  It may also make some sense to give that child the right to put a limited number of equity interests to the business entity (a redemption or partial liquidation of that child’s equity) or to the participating child, at designated times, and under certain conditions, in order to generate some liquidity, but without impairing the business.

Clearly there is much for the parent to consider.  Many of these issues will be difficult, and possibly expensive, to resolve.  The forgoing has considered only some of the most commonly encountered issues. (Others, like the payment and apportionment of the parent’s estate tax liability among the children, merit a separate article.  For more on splitting up the family corporations or partnership, see here and here.) At the end of the day, and after considering the options, the parent may conclude that the most reasonable thing to do is to sell the business, rather than leave it to one or more of the children.  A sale for cash will certainly allow the parent to treat the children equally, inasmuch as each will share equally in the proceeds of the sale.  Even that, however, may create resentment where the participating child’s livelihood (and perhaps that of some of his or her children) is thereby jeopardized.

There is no easy answer, but the planning exercise described above is a worthwhile one.  Where the obvious choice is to leave one child in charge of the business, the parent may want to start transferring some managerial authority over, as well as some equity in, the business to that child as early as possible, so as to set the stage for the ultimate operation and disposition of the business.  That is the subject for another blog post.

It has become relatively rare for an accountant or attorney to recommend the use of an S corporation for a newly-formed, closely held business.  Instead, the LLC, taxable as a partnership, has become the entity of choice for most start-ups, and for good reason: it is a flow-through entity for income tax purposes, and it is not burdened by restrictions on its ownership.  In addition, it affords great flexibility in the allocation of profits and distributions.

The fact remains, however, that there are many S corporations in existence, so an advisor cannot afford to be ignorant of the rules governing them.  Moreover, there are still a great number of closely-held C corporations, many of which may be better served to elect S corporation status.

Converting into an LLC?  Have You Thought It Through?

       In most cases, a corporation may be “converted” into an LLC, but not without triggering corporate-level and shareholder-level income tax.  These tax liabilities may be significant, because the conversion, in whatever manner it is accomplished, will be treated as a liquidating distribution (i.e., a taxable sale of its assets) by the corporation.  As a result of the deemed liquidating distribution, the corporation’s shareholders will be treated as having received the distributed assets in exchange for their shares of stock in the corporation.  Consequently, each shareholder will recognize gain equal to the excess of the fair market value of those assets over the shareholder’s adjusted basis in his shares.

Consider Electing Sub S

In contrast to the result of an LLC conversion, a qualifying C corporation may  achieve pass-through treatment without triggering an immediate income tax hit by electing to be treated as an S corporation.

In general, in order to qualify for the S election, the corporation must satisfy the following requirements:

–          It must not have more than 100 shareholders;

–          Its shareholders may only be individuals (other than nonresident aliens), estates and certain trusts; and

–          It may have only one class of stock.

Once a qualifying corporation’s “S” election becomes effective, each of its shareholders will be required to report on the shareholder’s income tax return his pro rata share of the corporation’s items of income, gain, loss, deduction or credit.  Thus, the shareholder will be taxed upon this share of the S corporation’s taxable income.  The corporation itself shall not be taxable, subject to certain exceptions.

Phooey on S Corps?

Notwithstanding the favorable pass-through treatment, S corporations still have many detractors.  These folks point to the single class of stock requirement and to the limitation on who may be an S corporation shareholder.  They also point out that there is pressure on S corporations to pay reasonable compensation to those of its shareholders that work in the corporation, thereby triggering employment taxes.  More recently, these detractors have indicated that, without mandatory distributions, passive shareholders face the prospect of phantom income, which subjects them not only to income tax but also to the new surtax on net investment income.

The shareholders of a C corporation, they continue, are not subject to any income tax or surtax until the corporation distributes a dividend.  Meanwhile, the compensation paid by the C corporation to the active shareholders effectively results in only one level of income tax, at least as to the compensation amount (provided it is reasonable for the services rendered); the profit remaining in the corporation is subject to corporate level tax, but at a maximum rate that is currently less than the maximum rate applicable to individual taxpayers.

The Asset Sale: An S Corp Trump Card

These are all valid points, but they overlook one critical item:  the tax consequences on the sale of the corporation’s business.  While it is true that some taxpayers have successfully bypassed the corporate-level tax on an asset sale by allocating a portion of the purchase price to a consulting agreement for each of the key shareholder-employees, or by maintaining that the goodwill associated with the business resides not in the corporation, but in the key shareholder, these “techniques” are either of limited benefit (especially where only some of the shareholders are active in the business) or may be difficult to support (as in the case of so-called “personal goodwill”).

The fact remains that, for an established, closely-held corporation, the S election offers the best means for avoiding corporate level tax, provided the sale occurs beyond the corporation’s recognition period.

Built-in Gain Tax: Losing Its Bite?

Unlike C corporations, S corporations generally pay no corporate-level tax.  Instead, items of income and loss of an S corporation pass through to its shareholders.  Each shareholder takes into account its share of these items on its individual income tax return.  Thus, any gain recognized by an S corporation on the sale of assets is passed through and taxed to its shareholders.

There is an exception to this rule for asset sales by S corporations that were previously taxed as C corporations.  Specifically, a corporate level tax, at the highest marginal rate applicable to corporations (currently 35%), is imposed on that portion of an S corporation’s gain that arose prior to the conversion of the C corporation to an S corporation (the “built-in gain” inherent in its assets at that time; “BIG”) and that is recognized by the S corporation during a specified period of time following the conversion (the “recognition period”).

The amount of corporate BIG tax imposed upon the S corporation is treated as a loss taken into account by the corporation’s shareholders in computing their individual income tax.  The character of the loss is based upon the character of the BIG giving rise to the tax; thus, the sale of an asset that produces a capital gain would generate a capital loss, thereby reducing the net amount of capital gain reported by the shareholder.

Given the economic impact of the BIG tax, shareholders have historically been reluctant to cause their S corporation to sell its assets during its recognition period.  After a number of reductions to the length of the recognition period in the past few years, the period recently was restored to ten years.  However, a discussion draft proposal being considered by Congress would “permanently” enact a five-year recognition period for S corporations, effective for taxable years beginning after December 31, 2013. Under this proposal, if an existing C corporation elected to be an S corporation effective January 1, 2014, its recognition period would expire at the end of 2018, after which it may sell its assets without incurring any corporate-level income tax.

 Consider Electing Now

Though nothing is certain in Washington, there is a fair likelihood that some version of this proposal will be enacted into law, effective retroactively to the beginning of 2014. In light of that possibility, it may behoove a qualifying C corporation to consider electing S corporation status as soon as possible so as to start the running of the BIG recognition period. This is especially so for corporations in which the key shareholder-employees are approaching retirement and have no one to succeed them. In that situation, where the only option will be a sale of the business, making the S election may substantially reduce the corporation’s income tax liability and increase their net proceeds from the sale.

One of the thorniest issues faced by the executor of an estate holding an interest in a closely- held business is the valuation of that interest. As if the preparation of the estate tax return was not daunting enough, the executor also has to determine the fair market value of the business interest. Although the executor is expected to retain a professional appraiser to assist in the valuation, and is entitled to rely upon the appraiser’s conclusions, the executor cannot simply abdicate responsibility for the valuation reflected on the return. Indeed, under certain circumstances, the estate may be subject to significant penalties where the estate tax is underpaid because of a substantial understatement of the value of the estate, including the business interest. In order to assist the executor in assessing the reasonableness of an appraisal, the estate’s tax advisers need to be familiar with basic valuation principles and with their application to specific kinds of assets. A recent decision by the U.S. Tax Court highlights how important such guidance can be.

 Estate of Richmond

Estate of Richmond v. Comr, T.C. Memo 2014-26, involved the valuation of a 23.44% interest in a family-owned investment holding company that was taxed as a C corporation and personal holding company. The company was formed in 1928 and, from its inception, it sought to preserve and grow its capital, and to maximize dividend income for the family shareholders (of whom there were twenty-five). The ultimate objective of the company was to provide a steady stream of income to the descendants of the company’s founder. Consistent with that investment philosophy, the turnover of the company’s securities was especially slow (a complete turnover would take seventy years). As a result, a substantial part of the value of its portfolio consisted of untaxed appreciation. In fact, at the time of the decedent’s death, over 87% of the value consisted of untaxed appreciation, and almost 43% of its portfolio was invested in the stock of four corporations. Because of the large tax liability inherent in its portfolio, the company chose not to sell its securities and, thereby, diversify its assets.

At the time of her death, the decedent owned 23.44% of the issued and outstanding shares of the company’s stock. She could not unilaterally change the management or investment philosophy, unilaterally gain access to the corporation’s books, increase distributions from the company, cause the company to redeem her shares, cause the company to make any tax elections or to diversify its holdings.

The executors of the decedent’s estate reported her interest in the company at approximately $3.15 MM. In valuing the interest, the appraiser retained by the estate used a capitalization-of-dividends method.

The IRS disagreed with the reported value, claiming that the interest should have been reported at approximately $7.3 MM. In preparing its valuation, the IRS appraiser used a net asset value method, and then applied discounts for lack of control and lack of marketability (a portion of which reflected a discount for the built-in capital gain tax liability inherent in the portfolio).

At trial, the estate’s expert adjusted the estate’s valuation of the decedent’s interest upward, to approximately $5 MM. The expert also presented an alternative valuation methodology as a check; specifically, he started with the net asset value of the portfolio, then reduced it by 100% of the built-in capital gain tax liability inherent in the portfolio before discounting the decedent’s interest. This yielded a value of approximately $4.7 MM.

The Tax Court Weighs In

The Tax Court began its analysis by laying out the basic principles for valuing a closely held company. In that case, it said, actual sales of stock in the normal course of business within a reasonable time before or after the valuation date are the best criteria of market value. If there are no such sales, then the value is determined by taking into account the company’s net worth, earning power and dividend-paying capacity, with the weight to be accorded to each factor depending upon the facts and circumstances of each case. In general, it said, an asset-based method of valuation applies in the case of corporations that are essentially holding companies, while an earnings-based method applies for companies that are going concerns.

The Tax Court rejected the estate’s capitalization-of-dividends approach. It conceded that the approach may be appropriate where a company’s assets are difficult to value, but not where the company holds a portfolio of publicly traded securities that are easily valued. Instead, it decided that the value of the company was better determined by a net asset value approach, pointing out that the dividends approach essentially overlooks the fact that the company’s assets have ascertainable market values.

The Court then addressed the difference in the discounts applied by the experts in respect of the built-in capital gain tax liability inherent in the portfolio. The Court conceded that two Courts of Appeals have held that, in a net asset valuation, the value should be reduced dollar-for-dollar by the amount of such tax liability. It pointed out, however, that other Courts of Appeals, as well as the Tax Court, have not followed this approach. The Court explained that a prospective tax liability (which may be deferred as the stock is sold off piecemeal) was not the same as a debt that really does immediately reduce the value of a company dollar-for-dollar (like a promissory note that must be satisfied). Thus, the Court said, a 100% discount was unreasonable in this case because it did not reflect the economic realities of the company’s situation.

It admitted that the a buyer would not be wholly indifferent to the tax implications of built-in gain that constituted almost one-half of the value of the company’s assets, and agreed that some discount therefor was warranted. The Court then held that the most reasonable discount is the present value of the cost of paying off that liability in the future. The Court decided that a 20-to-30-year turn over period was more reasonable than the company’s historic 70-year period (especially in light of the fact that with the passage of time the ownership of the company would become more diffuse among heirs and legatees with less identification with the company’s historic philosophy and goals, with less knowledge of and affinity for one another, which would make them more likely to seek to diversify the company’s holdings), which yielded a final value of approximately $6.5 MM for the decedent’s interest in the company.

Finally, the Court determined that the estate did not act in good faith and with reasonable cause in reporting the value of the company on the estate tax return. Because the valuation reported constituted a substantial estate tax valuation understatement, the Court sustained the imposition by the IRS of a 20% accuracy-related penalty.

Conclusion

The Court’s decision illustrates just how important it is for the executor of an estate that includes an interest in a closely held business to examine the appraisal of that interest, to vet it with the other professionals that comprise the estate’s team (e.g., the estate’s accountant and its attorney), and to question anything in the appraisal report that the executor does not understand. That is not to say that the executor is not entitled to rely upon a professional appraiser, or that the executor must become one. It does mean that the executor should not accept the report blindly. It also means that the estate’s accountant and attorney must be in a position to assist the executor in understanding the report, in appreciating its strengths, and in identifying and redressing its weaknesses. They can only do this by being familiar with general valuation principles, including the application of various discounts, such as that for the tax liability inherent in certain assets.

In an earlier post, we discussed the issue of splitting up the family-owned corporation, on a tax-free basis, so as to enable siblings to go their separate ways.

PLR 117674-13

A recent IRS ruling considered the following situation:  an S corporation (“Distributing”) had four equal shareholders, each of whom wanted to independently own and manage a separate business in accordance with each shareholder’s own goals and priorities.  In order to effect the separation enabling each shareholder to go his separate way (the “business purpose” for the transaction described herein), Distributing proposed to create four new corporations (each a “Newco”), each with a single class of stock.  Distributing would transfer substantially equal portions of all of its assets related to the conduct of its business to each Newco.  In exchange, each Newco would issue 100% of its common stock to Distributing and would also assume any liabilities associated with those assets.

Immediately after these contributions, Distributing would distribute all of the Newco 1 stock to shareholder 1, all of the Newco 2 stock to shareholder 2, and so on, in each case in exchange for the shareholder’s stock in Distributing.  Thereafter, each former shareholder of Distributing would own all of the stock of one of the Newcos.  At that point, Distributing would dissolve, and each Newco would elect to be treated as an S corporation for tax purposes.

In connection with the ruling, the taxpayers made a number of representations to the IRS.  For example, they represented that the fair market value of the Newco stock would approximately equal the fair market value of the S corporation stock surrendered, and that the fair market value of the assets of each Newco would exceed the amount of its liabilities.

They also represented that Distributing’s business had been actively conducted during the five-year period ending with the exchange, and that each Newco would continue, independently and with its separate employees, the active conduct of its share of all the integrated activities of the business conducted by Distributing prior to the consummation of the exchange.

They further represented that the transactions were not part of a plan or series of related transactions pursuant to which one or more persons would acquire stock representing a 50% or greater interest in any Newco.

The IRS ruled that the transactions would qualify as a tax-free reorganization.  Thus, no gain would be recognized by Distributing, by any of the Newcos, or by any of the shareholders.

 

Why This PLR Matters

There is nothing extraordinary about the holding in this ruling.  It represents a common form of “split-up” transaction in which the distributing corporation disappears entirely.  This is to be contrasted with a spin-off, in which the corporation distributes the shares of a subsidiary corporation pro rata to all of its shareholders, and with a split-off, in which the subsidiary is distributed to some shareholders in exchange for their shares in the distributing corporation. (I will refer to such transactions generically as “spin-offs”.)

It should be noted, however, that the ruling was issued shortly after the IRS announced that it would no longer issue similar rulings on whether a transaction, like the one described above, would qualify for non-recognition treatment (so-called “comfort rulings”).  Traditionally, taxpayers have been advised to seek a comfort ruling before undertaking a spin-off transaction.  The ruling served to assure a taxpayer that the proposed distribution would not be treated as a taxable event to either the corporation or its shareholders.  Considering the amount of the distribution that would typically be involved, and the size of the potential tax liability that would be incurred if the transaction failed to satisfy the requirements for tax-free treatment, this approach was justifiable.

Now, in an effort to conserve its limited resources, the IRS will only issue rulings that involve a significant “issue of law the resolution of which is not essentially free from doubt.”  Thus, this ruling may represent one of the last comfort rulings in the “spin-off” area that we are likely to see from the IRS.

The IRS’s recent announcement regarding spin-off rulings does not represent the first instance in which it has limited the scope of its rulings.  Years earlier, the IRS announced that it would not rule on the “business purpose” requirement for such transactions.  Notwithstanding this limitation, the fact that the IRS continued to issue rulings on spin-off transactions gave taxpayers comfort that the IRS must have approved of the stated business purpose — otherwise the IRS would never have issued the ruling.

The more restricted ruling policy now in effect means that taxpayers can no longer look to the IRS for its “approval” of a proposed spin-off transaction.

 

Don’t Be Scared Off

However, this does not mean that such transactions should no longer be considered.  They remain a viable option that, in the appropriate circumstances, may be utilized to resolve a number of business issues (including shareholder disputes) in a tax-efficient manner.  As is the case with so many transactional and reorganizational alternatives, the complexity thereof should not deter taxpayers, or serve as an excuse to disregard what may be a viable option for attaining a valid business goal.  Furthermore, the inability to get a comfort ruling from the IRS does not mean that a successful tax-free spin-off is now more difficult than it was in the past.  With the proper advice and guidance in exploring and, if appropriate, in structuring a spin-off transaction, the absence of a comfort ruling should not be an obstacle.

 

A partnership is not subject to Federal income tax. Instead, an item of income or loss of the partnership retains its character and flows through to the partners, who must include such item on their tax returns. Generally, some partners receive partnership interests in exchange for contributions of cash and/or property, while others receive partnership interests in exchange for services. Accordingly, if and to the extent a partnership recognizes long-term capital gain, the partners, including partners who provide services, will reflect their shares of such gain on their tax returns as long-term capital gain. If the partner is an individual, such gain is taxed at the reduced rates for long-term capital gains. Gain recognized on the sale of a partnership interest, whether it was received in exchange for property, cash, or services, is generally treated as capital gain. Under current law, income attributable to a profits interest of a general partner is generally subject to self-employment tax, except to the extent the partnership generates types of income that are excluded from self-employment taxes, e.g., capital gains.

The Administration’s 2015 Budget Proposal seeks to change the tax treatment of profits interests issued by certain investment partnerships. Shortly after the issuance of the Budget Proposal, a number of writers commented on the profits interest provision, pointing out that it bode well for real estate and other businesses by leaving them the ability to take advantage of profits interests to reward employees.  This implicit blessing of the use of profits interests by the Administration, plus the increased federal income tax rate applicable to compensation income (39.6%), makes the issuance of a profits interest all the more likely where the issuer’s goal is to attract and/or retain talented executives.

It also highlights the need to structure such an interest with care, and to revise certain LLCs’ operating agreements accordingly, so as to avoid the inadvertent creation of a capital interest.  The Tax Court’s recent decision in Crescent Holdings, LLC v. Comm’r provides an instructive discussion of the distinction between profits and capital interests.

 

Crescent Holdings

Crescent Holdings, LLC issued a 2% membership interest to a key executive.  The executive agreed to stay on for three years, failing which he would forfeit the membership interest.  In addition, the interest was nontransferable.  The executive was required to pay his employer an amount sufficient to cover all withholding and other taxes before the lapse of the forfeiture restriction.  The agreement also provided that the executive was entitled to the same distributions as other LLC members and that any distributions were not subject to forfeiture.  The agreement explicitly stated that the 2% interest was being granted subject to Section 83 of the Internal Revenue Code (the “Code”).

The executive did not make an election under Section 83(b) of the Code.

For each of 2006, 2007 and 2008, the executive received a Schedule K-1 from the LLC that allocated income to him.  He objected each time, claiming that because he was not vested in his LLC interest, he was not a member of the LLC for tax purposes.  In 2009, prior to the expiration of the three-year forfeiture period, the executive resigned from his position and forfeited his LLC interest.

The IRS audited the LLC and determined that the executive should be treated as a partner for the 2006 and 2007 tax years.  The executive argued that he was never vested in the 2% interest under Section 83 and, as a result, should not be allocated any LLC income.

The tax matters partner for the LLC argued that Section 83 did not apply, contending that the 2% interest was a profit interest under Rev. Proc. 93-27 and, so, the executive was liable for the tax on his allocable share of LLC profits.

 

The Court Finds a Capital Interest

The Court determined that the executive had been granted a capital interest, not a profits interest.  Starting with Rev. Proc. 93-27, the Court stated that a “capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in complete liquidation of the partnership.”  This determination is made at the time the interest is granted, even if, at that time, the interest is substantially non-vested.  Rev. Proc. 2001-43.  A profits interest, on the other hand, is “a partnership interest other than a capital interest.”  The recipient of a non-vested LLC interest can still be recognized as a member for tax purposes.

In examining the LLC’s operating agreement, the Court found that the executive would have shared in the proceeds of a hypothetical liquidation of the LLC.  Thus, consistent with the analysis called for by Rev. Proc. 93-27, the executive had been granted a capital interest, albeit one that was not yet vested.

Section 83

Having found that the executive’s interest was a capital interest, the Court next turned to the application of Section 83.  The Court re-affirmed that Section 83 applies to the grant of a capital interest in an LLC.  Since the interest was not substantially vested, and since the executive did not make an election under Section 83(b), the membership interest should not be treated as issued and outstanding.  Accordingly, the remaining members of the LLC should have been allocated the LLC income previously reflected on the K-1’s issued to the executive.

 

Takeaway

There are several lessons to be drawn from the decision in Crescent.  First, LLCs must take care in drafting the terms of profits interests, lest they inadvertently create a capital interest.  The former shares only in future earnings and appreciation attributable to the interest; the latter participates immediately in some portion of the LLC’s existing value.  Thus, if the Crescent agreement had provided for liquidating distributions in accordance with capital account balances (as opposed to membership percentage interests), the characterization of the 2% interest as a capital interest may have been avoided.  From the executive’s perspective, it was fortunate that the interest was not vested.  If it had been, the executive would have realized taxable compensation in an amount equal to the value of the interest.  An employer’s inadvertent issuance of a capital interest could, therefore, turn into an expensive proposition.  This brings us to the second lesson; specifically, because it may be difficult at times to distinguish between a profits interest and a capital interest, if may behoove the recipient of what purports to be an unvested profits interest to make an election under Section 83(b) of the Code and thereby cut off the compensation element that would be associated with the interest in the event it turned out to be a capital interest.  Although the election may result in the immediate recognition of some compensation in the event the interest is treated as a capital interest, the resulting liability is likely to be much less than it would have been had the compensation element been deferred until vesting.

Notwithstanding the risks associated with profits interests, they remain a valuable tool for rewarding and incentivizing key employees.  With the proper guidance and drafting, there is no reason why the issuance of a profits interest should not be considered a viable option.

A rapidly growing, closely-held business may find itself in need of additional capital.  When the owners of such a business do not have the liquidity or disposable assets from which to provide such capital, and with traditional lenders often unwilling to extend the necessary credit on acceptable terms, many close businesses have turned to private equity firms.  Such firms may be willing to make a loan to a close business that may or may not be convertible into equity, or they may purchase an equity (often preferred) interest in the business.

The Tax Court’s decision in Fish v. Comr (T.C. Memo 2013-270) involved one such scenario.  However, it also illustrated the importance of considering the potential tax consequences of such a transaction, especially where the owner of the closely-held business plans to withdraw some of the capital.

In order to fund its expansion into new markets, FishNet Consulting, Inc. (“FishNet”) agreed to issue preferred stock to Edgewater Funds (“Edgewater”) in exchange for a sum of money.  The preferred stock would represent 43% of the equity in FishNet.  Upon closing of the deal, a portion of the funds contributed by Edgewater would be distributed to Mr. Fish (the founder and sole shareholder of FishNet) in redemption of some of his shares.  In this way, Mr. Fish hoped to monetize some of his equity in the business.

In preparation for Edgewater’s investment, Mr. Fish incorporated Fish Holdings (“Holdings”) and elected to treat it as an S corporation.  He then contributed all of FishNet’s issued and outstanding shares to Holdings in exchange for Holdings common stock, and elected to treat FishNet as a Qualified Sub S Subsidiary (“Qsub”).  For income tax purposes, this election was treated as a tax-free liquidation of FishNet into Holdings, with all of the assets and liabilities of FishNet becoming the assets and liabilities of Holdings.

FishNet then amended its certificate of incorporation to create a class of preferred stock, with preferential rights to cumulative dividends.  Edgewater made a cash investment in FishNet in exchange for the issuance of shares of the preferred stock to Edgewater.  Upon issuance of the preferred shares, FishNet ceased to be a Qsub and, for income tax purposes, it was treated as a new C corporation, all of the assets and liabilities of which were deemed to have been contributed to it by Holdings in an otherwise tax-free contribution to capital in exchange for FishNet common stock.

FishNet immediately made a one-time cash distribution to Holdings, which reported the distribution as a dividend, taxable as long-term capital gain, which it allocated as flow-through income to its sole shareholder, Mr. Fish.

The IRS disagreed.  It claimed that the money distributed to Holdings constituted “boot” in the otherwise tax-free contribution of capital to FishNet.  The gain realized by Holdings in the exchange should, the IRS said, be taxed to the extent of the boot received.  Moreover, the IRS asserted, that gain should be taxed as ordinary income under Code Section 1239.  Under this provision, gain realized on the sale of property between certain “related” persons is treated as ordinary income if the property is depreciable or amortizable in the hands of the transferee.

The Tax Court agreed with the IRS that the distribution constituted taxable boot.  The Court explained that FishNet acquired an amortizable intangible from Holdings – the goodwill associated with the business – in exchange for FishNet common stock and cash.  When the cash was distributed to Holdings and gain was recognized, FishNet’s basis in the goodwill was increased and became amortizable.  (Indeed, FishNet claimed an amortization deduction following the transaction.)  Thus, if Holdings and FishNet were “related persons” under Section 1239, the gain would be taxed as ordinary income.

For purposes of Section 1239, “related persons” include a person and all entities which are “controlled entities” with respect to such person.  FishNet would be controlled by Holdings if the latter owned either more than 50% of the total voting power or of the total value of the FishNet stock.

The taxpayer argued that the shareholders’ agreement between Holdings and Edgewater included a number of restrictions on FishNet and its management.  For example, so long as Edgewater remained a shareholder, it prohibited a number of corporate actions without the prior written consent of a majority of the preferred stock.  Thus, notwithstanding Holdings’ record ownership of more than 50% of the FishNet voting stock, the taxpayer claimed that its actual voting power was less.

According to the Court, notwithstanding the various restrictions and negative covenants contained in the FishNet shareholders’ agreement (included at the behest of Edgewater), FishNet was a “controlled entity” as to Holdings.  The latter, in fact, owned more than 50% of the total combined voting power of all classes of FishNet voting stock, and more than 50% of the total value of shares of all classes of FishNet stock.  Moreover, Mr. Fish, as CEO and chairman of the FishNet board, continued to have primary control of the corporation’s business and affairs, effectively maintaining Holdings’ voting power.  The Court concluded that Mr. Fish was “essentially [FishNet], and it was his expertise and management of the company that was being purchased.”  This conclusion was supported by the fact that FishNet’s valuation was comprised almost entirely of goodwill, which was derived from Mr. Fish’s expertise, contacts and management.  The Court distinguished other cases in which restrictive covenants affected the rights of shareholders, pointing out that those cases involved large corporations, where the shareholders were “far removed from the management and operations” of the corporations.  In this case, the Court pointed out, Holdings had significant management control regardless of the negative covenants.

The Court in Fish confronted an interesting tax issue, and its analysis is instructive.  The important takeaway from its decision, however, is the Court’s emphasis on the closely-held nature of the business and the active involvement of its owner.  Fish presents only one of many scenarios in which the number of shareholders or shareholder-employees plays a significant role in determining the tax consequences of a transaction.  Other scenarios include the tax treatment of redemptions, the presence of a substantial risk of forfeiture as to compensation, and many others that are frequently encountered by closely-held businesses, where the “standard” analysis may not be appropriate. The bottom line: it behooves such a business to consider closely the tax ramifications of its capitalization, distribution, and other transactions involving its owners.

 

            We all know a story like Bill’s: Bill is a New Yorker that has built a successful business and has attained a level of  financial security.  His kids are grown, and have moved to the West Coast.

Bill decides that it is time to enjoy the fruits of his labor, preferably in a warmer climate.  He buys a condominium, and joins a club, in Florida.  He moves many of his favorite items to Florida, including some jewelry and photo albums, golf clubs and fishing gear.  He buys a new car in Florida. He spends most of his time in Florida.

Bill keeps his NYC apartment, his intention being to stay there when he visits New York during the warmer months.  He keeps his old car in NYC, he retains his membership at a NYC club, he keeps his art and coin collections in the NYC apartment, and he retains a safe deposit box in New York.

Bill formally declares Florida his domicile and claims the state’s homestead exemption.  He registers to vote in Florida, obtains a Florida driving license, executes a Florida will, and opens an account at a Florida bank.  He finds a Florida physician with a general practice, though he plans an annual visit to the New York specialist who has been treating him for years.  He retains his New York accounting firm.

Bill directs that all financial statements business correspondence be sent to his Florida address, and he enters the Florida address on his tax returns.

In order to avoid being treated as a New York statutory resident for income tax purposes, Bill starts to maintain a diary, and retains copies of credit card charges and other receipts, in order to keep track of his days in Florida and in New York,

Although he has significant investments in marketable securities, Bill’s business remains an important source of income on which he continues to rely to maintain his lifestyle.

 

New York Domicile?

Based on the foregoing, can Bill rest assured that he will be subject to New York income tax only as to his New York source income, and that all his other income will be beyond the reach of such tax?  Furthermore, at his passing, will his estate be free of New York’s estate tax, other than as to his New York real estate?  In other words, though he may succeed in avoiding statutory residence in New York, has he effectively abandoned his New York domicile and established Florida as his new domicile?

Based on the foregoing, it would appear to be a close call.

Domicile is defined as the place an individual intends to be his permanent home.  Intention is a decisive factor in the determination of whether a particular residence is one’s domicile.  Thus, this is a subjective inquiry—it goes to one’s state of mind.

Once a taxpayer’s domicile has been established, it continues until he abandons his old domicile and moves to a new one with the bona fide intention of making his permanent home there.

Whether or not one domicile has been replaced by another depends on an evaluation of the circumstances of the person in question.  Certain “primary” factors must be considered, but the evidence to support a change must be “clear and convincing.”  Thus, a taxpayer who has been historically domiciled in New York, and who is claiming to have changed his domicile, must be able to support his intention with unequivocal acts.

Each primary factor must be analyzed to determine if it points toward proving a New York or other domicile.  In conducting this analysis, the taxpayer’s New York ties must be explored in relationship to the taxpayer’s connection to the new domicile claimed.  Each factor is weighed individually, and then collectively.

The primary factors are as follows:

  • the individual’s use and maintenance of a New York residence,
  • his active business involvement, where he spends time during the year,
  • the location of items which he holds near and dear, and
  • the location of family connections.

In Bill’s case, his New York and Florida residences are comparable; he spends most of his time in Florida; his near and dear items are in both locations.  What about his business activity?

A taxpayer’s continued employment, or active participation, in a New York business, or his substantial investment in or management of such a business or entity, is a primary factor in determining domicile.  If a taxpayer continues active involvement or participation in New York business entities, without comparable or greater business activities outside New York, then the business factor will support continued New York domicile.

Is the taxpayer still actively involved in his New York business, despite moving out of state?

The extent of an individual’s control and supervision over a New York business can be such that his active involvement continues even when he is not physically present in New York.  Active participation in the day-to-day operation or management of a New York business points to continued New York domicile even if it is being run from an out-of-state location.

On the other hand, a taxpayer’s passive investment in a New York business is not indicative of domicile.

 

The Federal Return

In considering the nature and extent of the taxpayer’s involvement with a New York business, one must consider the taxpayer’s federal income tax returns, as well as those of the business entity.

Consider the taxpayer’s federal individual income tax return, on IRS Form 1040.  Has the taxpayer completed the lines relating to business income and income from partnerships and S corporations?  Has the taxpayer identified a New York business on Schedule C or on Schedule E?  Is the taxpayer’s participation in these businesses described on the returns and schedules as active or passive?  This same designation can be used to show that the taxpayer has significant New York business connections.

Although it remains to be seen how the newly effective 3.8% surtax on net investment income will be administered, it should be noted that any “former” New York taxpayer who claims an exemption therefrom with respect to his share of S corporation or partnership income, on the basis of having materially participated in the business, will have to reconcile the exemption with his claimed change of domicile.

Similarly, the completion of the line on Form 1040 relating to wages, and the issuance of a W-2 to the taxpayer by a New York employer, reflecting significant compensation, perhaps even an amount of compensation approximating what the taxpayer had earned prior to the purported change of domicile, may also point to continued active participation in the New York business.

In the case of an S corporation, the Form 1120-S should be reviewed for wages paid to officers.  In the case of a C corporation, Forms 1120 and 1125-E (Compensation of Officers) should be reviewed; the latter identifies officers of the corporation, their time devoted to the business and their stock ownership.  The same may be said as to “guaranteed payments” made to the taxpayer for services rendered by the taxpayer to a partnership or LLC, as reflected on the Form 1065, Schedule K-1 issued to the taxpayer.  Does the Schedule K-1 identify the taxpayer as a general partner or managing member?  Did the taxpayer complete Schedule SE, Self-Employment Tax, to Form 1040, with respect to any of the allocations made or any of the payments received from the New York business?  Did the taxpayer execute these business entity returns and, if so, in what capacity?

It is not uncommon for the “retired” taxpayer to retain a board seat and to continue to hold the position of president.  This is not necessarily fatal, provided the positions are ceremonial, or provided the taxpayer does not, in fact, materially participate in the business.

The issue to which these inquiries are directed is the following: is the level of involvement in a New York business, as reflected on the taxpayer’s federal income tax returns, consistent with the taxpayer’s assertion that the taxpayer has abandoned New York domicile?  Can the taxpayer reconcile his purported status as a Florida domiciliary with the federal returns reflecting his continued active participation in a New York business?

 

Decisions, Decisions

In too many situations, the answer is no, notwithstanding the taxpayer’s protestations to the contrary.  Indeed, it is often the case that the taxpayer has stepped away from his business, and has successfully transitioned the day-to-day operation and management to his children or to a key and trusted employee.  Why, then, would the taxpayer’s return contradict his actions?  A number of reasons may be given:  for example, the taxpayer needs a continued income stream from the business; or the taxpayer wants to reduce the corporation’s tax exposure (this could be federal and state taxes in the case of a C corporation; NYC taxes as to any corporation).

Unfortunately, as the song goes, “you can’t always get what you want.”  New York will use the taxpayer’s federal business tax filings against him, either in rejecting entirely his claim of non- New York domicile, or in extracting an expensive settlement from him.

Fortunately, “if you try sometimes, you might just find, you get what you need.”  In the case of our taxpayer, corporate dividends and/or partnership distributions may provide the cash flow required by the taxpayer to maintain his lifestyle.  In the end, the taxpayer needs to decide whether he can afford to present the strongest set of facts possible to support the abandonment of his NY domicile for both NY income and estate tax purposes.  With appropriate planning, the decision need not be an all-or-nothing proposition.

 

One of the issues most often encountered by the owner of a closely held business is succession planning.  This may be especially difficult where no member of the owner’s family is involved in the business.  In that case, the owner may have to consider the liquidation of his interest in the business, either by way of a sale to a third party or by a redemption of his interest by the business itself.  In either scenario, in order to maximize the net economic benefit of such a sale or redemption, it may be necessary to secure the ongoing employment of certain key employees of the business.

The Transaction

In a recent ruling, the IRS considered such a scenario.  A corporation had two equal shareholders.  They wished to retire and transfer the ownership and operation of the corporation to four key employees who were unrelated to the shareholders.

They proposed the following transaction:  the corporation would redeem all of their shares in exchange for promissory notes.  The redemption price was determined by a third-party appraisal; the notes required periodic payments of principal and interest (at a rate in excess of the AFR) over a period of no more than nine years; the payments were not contingent on future earnings or any other similar contingency; the notes were not subordinated to the claims of general creditors of the corporation; the corporation’s stock was not held as security for the notes. 

The Employee Shares

Immediately afterward, the corporation would issue shares of its stock to each of the four key employees.  The shares would be subject to transfer restrictions and service-related risks of forfeiture; in other words, the employees could not freely dispose of the shares and, if they failed to satisfy certain service-related requirements, they would have to return the shares to the corporation. 

Following these transactions, the only outstanding shares of corporation stock would be those owned by the key employees.  The departing shareholders, however, would remain employees of the corporation for a period of time, and they would continue to serve as chairman and vice-chairman of its board of directors.

In general, an employee’s receipt of shares in the employer-corporation would not be immediately taxable to the employee provided the shares were subject to a substantial risk of forfeiture; the taxable event would occur upon the lapse of the risk of forfeiture.  However, in the scenario considered by the ruling, as a condition to receiving the shares of stock, each key employee was required to elect, pursuant to Section 83(b) of the Code, to include the value of such stock in income (as compensation) in the year the stock was received.  (The ruling was silent as to whether the corporation was to “gross-up” the employees for the resulting tax liability.)

The Ruling

Based on the foregoing, the IRS ruled that the redemption of the shares held by the retiring shareholders would qualify as a complete termination of their interests in the corporation under Section 302(b) of the Code, the redemption would be treated as a sale, and the gain realized by the shareholders would be treated as capital gain, which they would report on the installment method as principal payments were made on the notes.  Interest payments received on the notes would be taxable as ordinary income and would be deductible by the corporation.  None of these holdings was surprising.  Nevertheless, the ruling is instructive.

“Security” Arrangement?

The ruling does not indicate the extent to which the term of the promissory notes overlapped with the period during which the risk of forfeiture as to the employees’ shares remained outstanding.  It is not unreasonable to assume, however, that they may have run coterminously.  The fact that the key employees were required to elect under Section 83(b) to include in their income the value of the shares issued to them appears to have been intended to incentivize the employees to remain with the corporation, by having caused them to incur an immediate tax liability (an economic cost) with respect to the shares.  It also gave them the prospect of capital gain (as opposed to ordinary income) treatment on a sale of their shares after the termination of the forfeiture period.  The transfer restrictions, plus the risks of forfeiture attached to the shares, which would cause the employees to forfeit the shares if they left the corporation before the expiration of a specified period of employment, or if they failed to satisfy certain performance targets (each a substantial risk of forfeiture), provided an additional incentive for the employees to remain with the corporation until the lapse of the risks of forfeiture.

 The continuing presence of the two former shareholders as employees of the corporation, and as members of its board of directors, not only ensured them an additional stream of income, but also afforded them the ability to oversee the performance of the four key employees. 

These “security” arrangements for the payment of the promissory notes issued by the corporation, which depended on the performance of the corporation, appears to have been a key element of the buyout.

Take-Away

The buyout arrangement described in the ruling appears to offer a viable and reasonable succession plan, at least for the subject business.  It provided liquidity for the departing shareholders, a measure of security for the payment of the purchase price for their shares, installment reporting (i.e., deferral) for their gain realized on the redemption, and an opportunity for the key employees to assume control and ownership of the business.

Of course, every closely held business is different, and every owner faces a somewhat unique set of circumstances, and has his or her own particular goals.  However, as the ruling demonstrates, there is a set of basic “tools” and principles which provide a common denominator from which an appropriate plan may be structured and implemented to suit the particular business and owner.  The ruling sets forth just one of many possible permutations.