Applying the estate freeze special valuation rules to S corporations.While S corporations are often viewed as being taxed similarly to partnerships, the Code applies C corporation tax concepts to S corporations. Subchapter C provisions (governing corporate formations, reorganizations, redemptions and liquidations, among other areas) specifically apply to S corporations and their shareholders, except to the extent inconsistent with other provisions in subchapter S Subchapter S IRS regulation that gives a corporation with 35 or fewer shareholders the option of being taxed as a partnership to escape corporate income taxes. ; see Sec. 1371(a).This means that an S corporation can participate as a corporate entity in a reorganization; see the Committee Reports to the Small Business Job Protection Act of 1996, Section 1310. Thus, S corporations have a substantive advantage over partnerships: S corporations and their shareholders can accomplish stock exchanges, corporate divisions, mergers and the many other forms of transactions known as "tax-flee reorganizations" while partnerships cannot. Rules on Valuing Retained Interests In addition to ensuring that a reorganization qualifies for tax-deferred treatment and does not unintentionally terminate an S election, a corporate reorganization may also have to comply with the Sec. 2701 special valuation rules, under which, on the transfer of stock to a "member of the transferor's family," most rights retained by the transferor will be valued at zero for estate and gift tax purposes. For this purpose, the word "transfer" can, under certain circumstances, include a recapitalization Recapitalization Restructuring a company's debt and equity mixture often with the aim of making a company's capital structure more stable. Notes: Companies often want to diversify their debt-to-equity ratio to improve liquidity. or other change in the corporation's capital structure; see Sec. 2701(e)(5) and Regs. Sec. 25.2701-1(b)(2). Example 1: Sam is the sole shareholder of an S corporation with one class of voting common stock that has a $100,000 fair market value (FMV FMV - full-motion video ). The corporation is recapitalized to create a class of voting preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. and a class of nonvoting common stock (thus terminating S status). Sam transfers the common stock to his daughter Mattie; for gift tax purposes, he assigns a $65,000 value to the retained preferred stock and a $35,000 value to the transferred common stock. If Sec. 2701 applies to the retained preferred stock, it is valued at zero. The gift of common stock is valued at $100,000, instead of $35,000. Exceptions to the Special Valuation Rules Two exceptions to these special valuation rules can apply to reorganizations or recapitalizations involving S corporations. The first involves the issuance or exchange of only common stock; the second involves no shift in ownership among the family group. Common Stock According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. Sec. 2701(a)(2), Sec. 2701 does not apply if the retained interest is of the same class as the transferred interest, or if the retained interest is proportionately the same as the transferred interest, except for nonlapsing differences in voting power. Thus, the special valuation rules do not apply to a transfer of common stock when the transferor retains common stock. In addition, the rules do not apply to a transfer of nonvoting common stock if the transferor retains voting common stock (and vice versa VICE VERSA. On the contrary; on opposite sides. ). Because an S corporation cats have only one class of stock, if the shareholders intend to retain S status (which means that only voting and nonvoting common stock will be issued and/or exchanged), Sec. 2701 should not be an issue; see, e.g., Letter Rulings 200026011 and 200026012. But if S status is terminated (because preferred stock is involved or the issued and/or exchanged stock's distribution or liquidation rights Liquidation rights The rights of a firm's securityholders in the event the firm liquidates. differ), this exception will not apply. Example 2: Helen is the sole shareholder of an S corporation that has one class of voting common stock with a $100,000 FMV. The corporation is recapitalized to create a new class of nonvoting common stock with the same distribution and liquidation rights as the outstanding voting stock Voting stock The shares in a corporation that entitle the shareholder to vote. voting stock Stock for which the holder has the right to vote in the election of directors, in the appointment of auditors, or in other matters brought up at the . Helen exchanges part of her voting stock for the nonvoting stock Nonvoting stock A security that does not entitle the holder to vote on the corporation's resolutions or elections. nonvoting stock and gives the nonvoting stock to her son, Ben. Sec. 2701 does not apply, because of the "same-class-of-stock" exception. If Helen assigns a value of $60,000 to the retained voting stock, the value of the transferred nonvoting stock for gift tax purposes is $40,000. Family Ownership Safe Harbor Safe Harbor 1. A legal provision to reduce or eliminate liability as long as good faith is demonstrated. 2. A form of shark repellent implemented by a target company acquiring a business that is so poorly regulated that the target itself is less attractive. A safe harbor exists under Sec. 2701(e)(5) for a transfer in which the transferor and certain designated family members own substantially identical interests before and after the transfer. Observation: The Conference Committee's Statement of the Managers for the Revenue Reconciliation Act of 1990, p. 156, states that Sec. 2701 "would not apply, for example, to a recapitalization not involving a contribution to capital if all shareholders held substantially identical interests both before and after the recapitalization." The scope of this safe harbor exception hinges on the definition of the phrase "substantially identical." While Regs. Sec. 25.2701-1(b) (3)(i) adds, "common stock with nonlapsing voting rights Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. and nonvoting common stock are interests that are substantially the same," this is simply a restatement Restatement A revision in a company's earlier financial statements. Notes: The need for restating financial figures can result from fraud, misrepresentation, or a simple clerical error. of the exception for common stock discussed previously. Because preferred stock and common stock evidently are not deemed to be substantially the same, it appears that this safe harbor exception does not provide an S shareholder with any benefit not already provided by the "same-class-of-stock" exception. Editor's note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat. Trained by D. : This case study has been adapted from PPC's Tax Planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. Guide-S Corporations, 18th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ((800) 323-8724; www.ppcthomsom.com). |
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