Extracting value from closely held corporations.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) has provided an opportunity to revisit and revise planning for small business owners with significant locked-in corporate asset value, especially when an active trade or business has wound down and the tax costs of liquidation are prohibitive. New options are available.

Background

A particularly thorny facet of financial planning for owners of closely held corporations is extracting asset value, to facilitate and implement retirement and estate plans without expensive tax consequences. Such individuals may be faced with one of the following situations and, thus, need to distribute value from the corporation:

1. Retirement needs.

2. Pre-death estate planning to gift assets to the next generation, some or all of whom may not desire continued ownership.

3. Postmortem planning to distribute the value among beneficiaries. Even though the stock ownership receives a basis step-up at death (See. 1014), the corporation retains its original basis in its assets. Thus, death is not a solution to the taxation of appreciated assets reside the corporation.

Typically, these situations arise in one of the following ways:

Situation 1: A C corporation with an active trade or business sells or winds down the business. The corporation could not be (or was not) liquidated without double taxation. In some cases (usually family situations), liquidation may not have been pursued because the founder and/or principal owners desired continued control of the assets. The corporation continues, but its activities are now passive (i.e., investments in securities, real estate rentals, etc.). After some time, the corporation still has earnings and profits (E&P) from its original business and from its investment activities and has substantial unrealized appreciation in its remaining assets. Because of the substantial C E&P an S election has not been appropriate.

Situation 2: A corporation whose business activities have always been investments, or one as described in the previous paragraph, has accumulated E&P and substantial unrealized appreciation in its investment assets. The corporation may be a personal holding company (PHC) if it meets the complex ownership and income tests of Sees. 542 and 543. Because its activities have always generated "passive investment income" (see Sec. 1362) and because of the C E&R the shareholders have never made an S election.

Situation 3: A corporation with an active trade or business accumulated substantial C E&P. It makes an S election and continues to operate an active trade or business, but for various planning purposes, its owners want to distribute the E&P. In many cases, corporations may also have a second class of stock, usually preferred as to dividends, which prevents an S election (see Sec. 1361). The issuance of preferred stock frequently happens during the financial or succession planning process, when the owners realize that a particular shareholder (or class of shareholders) are not involved in management, but desire some cash return on their ownership. In addition, preferred stock is often used as an estate planning tool to cap the corporation's value in the estates of the older generation and pass future appreciation to subsequent generations.

Liquidate or Not?

The JGTRRA generally lowered the capital gain tax rates for individuals to a maximum of 15% (5% for individuals in the 10% or 15% tax brackets (0% for those individuals in 2008)). The JGTRRA did not change the corporate capital gain rates.

Liquidation: Sec. 3.36 requires a corporation to recognize gain or loss on assets disposed of, whether or not as part of a plan of complete liquidation. Similarly, gain or loss is recognized if property is distributed, measured as if it were sold for fair market value. Thus, the first step in calculating the cost of liquidation is determining the corporate level tax.

Example 1: In 2004, X Corp. has assets with a $200,000 basis that it sells for $ 1.2 million; its tax on the gain is $340,000. X's shareholders pay a maximum tax of $129,000, leaving them $731,000 (approximately 61% of the original asset value), calculated as follows:

Sale price of assets    S1,200,000   a
X's basis                  200,000
X's gain                $1,000,000
X's tax                   $340,000   b

Proceeds distributed to
  shareholders            $860,000   c(a - b)
Maximum shareholder
  tax(15% x $860,000)      129,000   d
After-tax proceeds
  distributed to
  shareholders            $731,000   e(c - d)
% of original asset
  value                        61%   e/a

Of course, the shareholders' X stock basis also needs to be considered (and state tax, if any).

A corporation with both appreciated and depreciated assets needs to plan liquidation carefully when assets are to be distributed rather than sold. Sec. 336(d) limits loss recognition at the corporate level when property is distributed to Sec. 267 related persons or non-pro rata, or the property is disqualified because it was acquired in certain Sec. 351 transactions.

No liquidation: A corporation and its shareholders may not want to liquidate after assessing the tax costs and the results for shareholders. Generally, the corporation will continue on as before, with one important change. The JGTRRA provided that dividends are subject to the same rates as capital gains; thus, the after-tax value the shareholders receive may be substantially increased.

Example 2: Y Corp. has $100,000 of taxable income in 2004; its tax is $22,250. If Y distributes the remaining $77,750, its shareholders will pay a maximum tax of $11,663, leaving them $66,087, approximately 66% of Y's taxable income.

While this may appear to be a better deal than liquidating, it may not fit well with future needs, because:

1. It does not consider ownership needs; some shareholders may want to exit with their asset value, and some may want to continue as shareholders. This can occur when succeeding generations are the owners and those not otherwise connected to the corporation simply want to extract their value.

2. Some or all shareholders may seek to continue their ownership, but at reduced levels.

3. The JGTRRA dividend rate will revert back to ordinary income rates after 2008.

In these situations, it may be beneficial to redeem all shareholders partly and some shareholders entirely at current reduced rates. Depending on the corporation's and shareholders' needs, it may also make sense for all or part of the transaction to take place between shareholders, rather than as a redemption. In a redemption, shareholders do not receive a basis adjustment, even though the redeemed shareholder may be incurring capital gain tax. If" one shareholder buys stock from another, the purchaser's basis is cost.

PHCs

Special considerations apply to corporations that are PHCs. Many of them unwittingly received that status because they did not liquidate when they ceased operating as an active trade or business, or were organized as investment companies at a time when achieving limited liability was not possible (i.e., by using a flowthrough entity such as an S corporation or a limited liability company).

Operating a PHC requires ongoing vigilance. Annually, the corporation must determine if it meets the ownership and complex income requirements for PHC status. If it does, it is required to pay out all of its undistributed PHC company income before year-end or pay a 15% penalty tax, in addition to regular corporate tax. Although some relief is possible through the use of consent or post-year-end dividends, these rules are detailed and complex. In many cases, the owners may not want to maintain PHC status.

Frequently, these entities have both large accumulated earnings and substantial appreciated assets. To minimize taxes, they invest in dividend-paying stocks to qualify for the Sec. 243 deduction. This often means that investments are subject to undesirable volatility, making sound asset allocation difficult (or impossible) to achieve. Shareholder frustrations compound the tax issues (especially for shareholders not in control of company ownership or management); they fear their wealth is not accessible and not under their control.

S Election?

When a complete liquidation is prohibitively expensive in tax terms, or is not practical for other reasons, the shareholders might consider conversion to S status. While it may not immediately solve the problem, it does (1) eliminate the double tax on future earnings and (2) ensure that eventually, the corporation's value can be realized without incurring a corporate-level tax on appreciated assets.

Converting to S status: A corporation must meet Sees. 1361 and 1362 qualification and election requirements to convert to S status. Among those is a requirement in Sec. 1361 that the corporation have only one class of stock. An S corporation that has a second class of stock must either convert it or redeem it. Before the JGTRRA, a redemption frequently triggered the imposition of the ordinary income tax rate, because the stock was deemed Sec. 306 stock. Now the proceeds are subject to a maximum 15% rate.

In addition, eliminating preferred stock does not mean sharing control with the preferred stock owner. Sec. 1361 allows nonvoting common stock to be issued without running afoul of the one-class-of-stock rule.

E&P Bailout

A C corporation that converts to and maintains S status is limited in the amount of passive income it generates each year, if it has accumulated C E&P. In the three situations described earlier, this will almost always be the case. The corporation can convert to S status, but is subject to corporate-level tax under Sec. 1375 if passive income exceeds 25% of gross receipts for the tax year. In addition, if the 25% limit is exceeded for three consecutive tax years, the S election terminates in year 4 and the corporation reverts to C status.

To avoid or minimize the Sec. 1375 tax and possible termination of the S election, a corporation should distribute all of its accumulated E&P while still a C corporation. Alternatively, the corporation can make an S election and "bail out" E&P over the following three years, depending on the individual shareholders' planning needs. If the tax rates remain constant (as contemplated by the JGTRRA), it may be advisable to wait until year 3, for maximum tax deferral. Each situation will differ, of course; when there is substantial current passive income, the tax adviser will have to make alternative calculations to determine the best course of action. For comparability purposes, the annual tax cost must consider the Sec. 1375 corporate-level tax on net passive income, as well as the shareholder-level tax on the net passthrough.

Determining how to accomplish the E&P distribution can also be complicated. If the corporation has sufficient cash to distribute the E&P, the process is Fairly simple. However, in many cases, the corporation will have little cash, with the bulk of its value invested in substantially appreciated assets. Either distributing these assets or converting them to cash can cause corporate-level tax, thus increasing the bailout's tax cost. If possible, the corporation should borrow from an unrelated party and distribute the E&P to the shareholders. The corporation can continue with unrelated-party debt or have the shareholders contribute the cash back to the corporation, net of taxes.

The shareholders could also loan the funds back to the corporation, planning the transactions to fall within the Sec. 1361 safe-harbor debt restrictions, to avoid classification as a second class of stock. These transactions can facilitate the complete redemption of a shareholder desiring to terminate ownership, thereby accomplishing some of the financial planning distribution/separation goals. Regardless of the specific process, the corporation will, of course, be required to have sufficient cashflow to service any necessary debt.

Appreciated Assets/BIG Tax

When a corporation has substantially appreciated assets, an E&P bailout to allow a continuing S election with significant passive income is only the first planning step. At this point, the assets are still not easily distributable to the shareholders without a corporate-level tax. Sec. 1374 provides that gain on the sale or distribution of appreciated assets, attributable to any asset appreciation present on the day of conversion to S status, is subject to a corporate-level tax (the built-in gains (BIG) tax) for the 10-year period following the conversion. Careful, ongoing planning is required to ensure this tax is minimized.

Essentially, when Sec. 1374 applies, it adds 10 years to the distribution/liquidation process. Notwithstanding this additional period, it is often better to adopt such a plan, rather than continue to operate as a C corporation. The tax issues will worsen, not improve, if no action is taken.

In addition, even if the BIG tax is avoided, the sale/distribution of appreciated assets will ultimately still result in tax to the shareholders.

Timing

The planning process should begin immediately; implementation should begin as soon as taxes can be minimized. Especially critical is the fact that the reduced tax rates on dividends will expire after 2008.

Conclusion

The JGTRRA provides new opportunities to extract asset value from closely held corporations; reduced capital gain rates may make liquidation attractive and reduced dividend tax rates may facilitate conversion to S status and double-tax avoidance.