Estate freeze transfers of a family business or farm.

The 1990 Revenue Reconciliation Act, passed by Congress in October 1990, repealed section 2036(c) and added chapter 14 to the Internal Revenue Code. Chapter 14 represents continued efforts to control "abusive" lifetime transfers of common stock or junior partner equity interests in family-owned business and farm corporations and partnerships. The legislation further undermines families' efforts to retain ownership of their businesses despite federal gift and estate tax (unified transfer tax) rates up to 60%.

GIFT VS. ESTATE TAX RATES

Why do owners of family businesses undertake estate freeze transactions? Such transfers are motivated in part by disparate rates applicable to lifetime transfers (gifts) and transfers at death. As explained below, the rate disparity discourages straightforward gifts.

The gift tax on a lifetime transfer of family company stock is payable immediately on the stock's full market value, with no provision for installment payments. The special use value for farm property and other real estate and safe-harbor stock redemptions to fund gift tax payments are not available. Further, no deduction is allowed for interest payable on gift tax deficiencies and no step up in the stock's income tax basis applies, except for a portion of the gift tax the donor pays.

In contrast, the estate tax on a closely held business constituting more than 35% of a decedent's adjusted gross estate can be paid in installments over a 14-year period, at 4% interest on the tax applicable to the first $1 million of value. The value of farm or other real estate is computed on the property's earning power or special use value (subject to a $750,000 limit on the reduction from market value).

Interest paid on deferred estate taxes is deductible in computing the taxable estate. Money can be withdrawn from the corporation, exempt from taxable dividend treatment, to fund estate tax payments. An alternate value (usually determined six months after death) can be used and is frequently elected when the business value declines after a principal's death. Reasonable-cause extensions of time to pay estate taxes also are available.

ESTATE FREEZE TRANSACTIONS

A classic estate freeze before the Revenue Act of 1987 typically involved recapitalization of a corporation with the business owner recasting most of his or her investment into preferred stock. The owner (often a parent) gave or sold the common stock to his children. Only a moderate amount of gift or income tax was assessed because of the relatively small value assignable to the common stock. The value of the parent's investment was "frozen" at the par value of the preferred stock retained; any future increase in value, if the corporation prospered, and any earnings on the common stock, were shifted out of the parent's taxable estate.

The Internal Revenue Service issued a number of technical advice memorandums from 1984 to 1987 asserting adverse gift and estate tax consequences in such estate freeze transactions. Subsequently, the IRS position was rejected by the Tax Court in two cases decided early in 1987. Congress's Joint Committee on Taxation and the House Ways and Means Committee therefore proposed "revenue enhancement" legislation in June 1987 to prevent marketability and minority discounts in valuing closely held business interests as well as to prevent estate freeze transactions. In the meantime, the IRS reported increasing difficulty in preventing unreasonable valuations asserted for gift and estate tax purposes.

INCOMPLETE TRANSFER RULES

A House-Senate conference committee adopted an incomplete transfer rule shortly before passage of the 1987 Revenue Act by adding IRC section 2036(c). Under these rules, any transfer after December 17, 1987, of common stock expected to appreciate more rapidly than the preferred stock retained by the transferor was taxes in the transferor's estate, if the transferor still held the preferred stock or other retained interest at the time of his or her death. The provision was broadly worded so retention of other rights such as an employment agreement, loan, lease or use of corporate property could be considered a retained interest resulting in inclusion of the common stock's value in the transferor's estate.

There was no provision for information returns to report freeze transactions to the IRS. In addition, it appears the transferor could have avoided having the common stock included in his estate by subsequently transferring the retained preferred stock or eliminating other rights prior to death. It was unclear whether section 2036(c) would apply to a family residence, insurance policies and collections. The scope of retained rights was uncertain. Many feared retention of a company car or club membership could bring the common stock back into the transferor's taxable estate.

SAFE HARBORS AND DEEMED GIFTS

Congress amended section 2036(c) in the 1988 Technical and Miscellaneous Revenue Act (TAMRA) generally effective June 21, 1988, to

* Provide safe harbors for retained interests, thereby avoiding capture of the common stock value at the transferor's death.

* Impose deemed gift rules to prevent avoidance of the estate tax capture by pre-death transfers of retained interests.

These safe harbors immunized an employment agreement up to 3 years for the transferor; loans by the transferor up to 15 years (30 years for a real estate loan); certain working capital loans and loans to a start-up business or farm; and common stock transferred into a grantor retained income trust (GRIT) that satisfied the qualified trust income interest rules.

The IRS issued notice 89-99, to interpret both the 1987 act estate tax capture rules and the 1988 act safe-harbor and deemed gift rules. The notice exempted freeze transactions involving life insurance policies, family dwellings, decorative art collections, etc. The notice suggested in some cases the freeze transaction rules that otherwise would apply to a family owning 10% of the business might be confined to transfers where the family owned 50%.

1990 TREASURY PROPOSAL

Early in 1990, Treasury Department personnel recommended the incomplete transfer rules of IRC section 2036(c) be replaced by legislation preventing abusive under-valuation of common stock given or sold by a transferor in an estate freeze transaction. Chapter 14 was proposed as an addition to the IRC that would provide a special value for the retained preferred stock solely for the purpose of valuing common stock sold or given in a freeze transaction.

AICPA PROPOSALS

As chapter 14 was developing, the American Institute of CPAs tax division made policy recommendations including these:

* Repeal the 1987 act estate tax capture provision and 1988 act deemed gift rules.

* Require information returns for estate freeze transactions and enforce this with additional statute of limitation provisions.

* Require submission with the gift or income tax return of a certified appraiser report (similar to that for charitable gifts) upon transfer of the common stock.

* Establish a study group to consider tax policies for transfer of interests in the family business or farm including elective IRS advance valuation rulings or expert valuation panels.

* Study legislation to target abusive freeze transactions such as manipulation of investment instruments, lapsing rights, unrealistic buy-sell agreements and valuation of preferred stock upon a subsequent gift of the preferred stock, or death of the preferred stockholder, inconsistent with the valuation of the preferred stock at the time of the freeze.

* Do not mandate a statutory formula to value either preferred or common stock of a family corporation.

When it appeared these policy proposals would not be accepted, the AICPA tax division made a series of technical proposals, many of which were included in the final legislation:

* Limit chapter 14 to corporation stock and partnership interests (and exclude loans and leases).

* Affirm the marketability and minority discounts for the fair market value of family corporation stock as well as partnership interests.

* Recast the automatic gift for unpaid preferred dividends as a preferred stock value increase, subject to the overall increase in value of the corporation.

Other technical proposals were made (and not adopted) to

* Provide safe-harbor discount rates to compute the special value of retained preferred stock, including industry-specific returns on capital, generic safe-harbor rates or the actual internal return on investment for the family corporation or partnership.

* Permit the transferor to rebut the special value if a defined higher burden of proof was met.

* Permit an S corporation to issue preferred stock and undertake a freeze transaction under chapter 14.

* Require information returns for freeze transactions.

* Provide rules for transfers of partnership interests related to investment pay-outs and for carried interests in the extractive industries.

CHAPTER 14

Chapter 14, as enacted effective October 9, 1990, follows the Treasury proposals in IRC section 2701 for outright transfers and section 2702 for transfers in trust (with the modifications listed above), substitutes a grantor retained annuity trust (GRAT) and/or grantor retained unitrust (GRUT) for GRITs and provides a personal residence trust exception.

IRC section 2703 provides a buy-sell agreement will be recognized only if

* It is a bona fide business arrangement.

* It is not a device to transfer property for less than full consideration.

* Its terms are comparable to similar arrangements formed by persons in arm's-length transactions.

The third provision above relates to generally accepted stock valuation formulas, particularly when industry-specific rule-of-thumb values are used. The intent is to assist taxpayers by permitting use of stock or partnership interest valuation formulas contained in buy-sell agreements between unrelated stockholders. IRC section 2704 treats a lapse of voting or liquidation rights as a taxable gift or bequest.

NEW LAW PLANNING

In most cases, an outright freeze transaction should not be undertaken until guidance (if any) is provided as to the discount rate used (1) to compute the special value of preferred stock retained in a freeze transaction and (2) to compound unpaid dividends or distributions on the retained interest. A capital contribution, stock redemption, recapitalization or other change in the structure of a family corporation or partnership should be avoided when preferred stock or senior partner equity is retained, until exemptive regulations are issued under the indirect transfer rules of section 2701(e)(5).

Modifications to grandfathered buy-sell agreements formed before October 9, 1990, should be avoided except when changes in the business make the revision advisable to satisfy the bona fides of the agreement. In addition, the stock price formula in the agreement should be defined when possible by reference to an industry-specific rule of thumb or agreement in a similar company when unrelated parties are involved.

An outright gift of common stock or partner capital may be desirable. The transfer tax value is frozen as of the gift date for the adjusted taxable gift computation in the transferor's estate tax returns. Future earnings on an increases in value of the gift property are removed from the transferor's estate. In addition, the gift tax funds are not taxed in the estate unless the donor dies within three years.

PERSONAL RESIDENCE TRUSTS

Elaborate provisions are contained in the proposed regulation released by the IRS on April 14, 1991, for a qualified personal residence trust. (For more on the proposed chapter 14 regulations, see the sidebar on page 88.) The trust can be established for both a personal residence and a second residence, but not for other holdings. The dwellings can be mortgaged. The trust can maintain a bank account covering expected expenditures for the next three months. House sale and fire insurance proceeds can be retained in the trust for two years. If not used to purchase a replacement property, the trust terminates and the assets are distributed to the trust "term holder" or can be converted to a 1990 act gift trust, such as a GRAT.

Apparently, the trust also terminates if the grantor moves out of the house, that is, no longer uses the property as a personal residence. This could become a difficult area in view of uncertainties in income tax cases regarding conversion of a personal residence to rental property. Home furnishings cannot be placed in the trust, but the immediate land can.

OTHER TRUST GIFTS

If a client wishes to undertake an estate freeze transaction before guidance is obtained on discount factors for preferred stock, practitioners should consider recommending use of a GRAT or GRUT to hold the common stock. The discount factor used to value the remainder interest in the GRAT or GRUT will be based on the interest rates that are prescribed in IRC section 7520, providing certainty as to the amount of the gift.

A contingent reversion provision can be inserted in the GRAT or GRUT, which will return the gift property to the transferor's estate if he dies during the trust term. If this value exceeds 5%, the GRAT or GRUT will qualify as a permitted S corporation shareholder. However, the value of the contingent reversion can no longer be used to reduce the value of the gift to the GRAT or GRUT.

In lieu of a contingent reversion, the transferor also can reserve a general power of appointment over the trust property, if he dies within the trust term, to qualify the GRAT or GRUT as a permitted S corporation shareholder. Distributions from an S corporation usually are more likely than distributions from a C corporation. These will provide funds to the GRAT or GRUT to service the annuity or annuity trust amount payable each year.

MULTIPLE VALUATION DATES

Practitioners should remember that applying the preferred or senior partner equity value "cap" for unpaid preferred stock dividends or partnership distributions and compounding thereof will require valuation of the common stock in the family corporation at the

* Time of the freeze transaction.

* Date of the subsequent gift of the retained preferred stock.

* Death of the transferor holding retained preferred stock or senior partner capital.

In particular, a practitioner planning an estate freeze transaction should note the special value for the preferred stock or senior partner capital is used only to value the common stock transferred in the freeze transaction. A "reverse" freeze transaction, that is, a transfer of the preferred stock and retention of the common stock by the transferor, will require a valuation of the preferred stock to include all of its value attributes such as conversion, mandatory redemption or liquidation rights.

A DRAMA IN THREE ACTS

Many have referred to attempts to limit estate freezes as a drama in three acts: the 1987 adoption of section 2036(c), the 1988 safe-harbor amendments and the repeal in 1990 of 2036(c) and its replacement by chapter 14. Two acts in the drama have been concluded. The interpretation and application of the third act and its chapter 14 rules still are in progress. Congress has not yet addressed the disparity in gift and estate tax rules that discourages straightforward gifts of family corporation stock and partnership interests, even though these gifts may well be desirable for business, economic and social reasons.

WILLIAM T. DISS, CPA, is a consultant in the national tax department of Ernst & Young in Washington, D.C. He is a member of the American Institute of CPAs tax executive committee and was chairman of the estate and gift tax committee from 1988 to 1990.