IRS hits business owners; attacks estate freezing.

IRS Hits Business Owners; Attacks Estate Freezing

Most people who own a small business have dreams--two in particular.

The first is that their small business will become large and very profitable.

The second is that they have launched a corporate dynasty that, some day, will be taken over by their children and carried to further greatness.

Making that first dream come true has always been tough. And now our friends at the Internal Revenue Service have made the second a lot more difficult.

New Regulations

After three years, the IRS is finally getting ready to explain how it will interpret Section 2036(c), a poorly worded portion of the 1987 tax act which attacks "estate freezing." Estate freezing is a technique many business owners have used to pass companies intact to their children, thus avoiding taxes which would otherwise require many firms to be sold.

As it turns out, the prospect of having your business sold to strangers so that your heirs can pay taxes on the proceeds does not bother the IRS. If that prospect bothers you, there are alternatives.

First, some background.

The way it was...

Before 1988, it was possible for a business owner to freeze the value of his or her estate, transferring any future increase in its value tax-free to the heirs. This was done with "preferred stock recapitalization" which basically worked like this:

Presume you own all the common stock in a firm that's worth $1 million. You exchange the common stock for new "preferred" stock worth $990,000, plus new common stock worth $10,000.

Preferred stock, by definition, has a fixed redemption price. So, even if the firm's value increased, the preferred stock will never be worth more than $990,000. All the added value builds up in the common stock, which can be given (or sold) to your child with minimal tax liability now.

This meant that, if the value of the business increased to $5 million by the time you died, your child would owe no estate tax on the additional $4 million--because he or she would already own the common stock.

And the way it is...

Unfortunately, the IRS got wind of this and, in 1987, Congress passed legislation which attempted to stamp out the practice. The new law's language was garbled, however, and the IRS has been trying ever since to come up with adequate explanatory regulations.

It still hasn't done so. Last fall, however, the IRS did issue a notice which outlined the agency's opinion of how the regulations on Section 2036(c) will eventually read. For would-be dynasty builders, it was not good news.

Section 2036(c) is a direct attack on estate freezing. It says that, for tax purposes, the value of a business remains the property of the owner if:

* The owner transfers a "disproportionate" share of its appreciation potential...AND...

* Retains control of the firm or receives income from it.

Essentially, this makes preferred stock recapitalization a pointless exercise. Take the parent who gave his child $10,000 worth of common stock while keeping preferred stock worth $990,000.

Since all appreciation builds up in the common stock, the parent has transferred a "disproportionate" share of potential appreciation while retaining an interest in the income of the enterprise--the preferred stock.

The result would be that upon the death of the parent, his estate would be taxed at $5 million, rather than at the $990,000 face value of the preferred stock. Hello, tax man. Goodbye, family firm.

Well, maybe not. Bureaucracies being what they are, the IRS is seldom complete or efficient when it closes a loophole. Section 2036(c) is no exception, and there are other options to limit your estate's tax liability.

Qualified debt

You can still sell your company to your children in exchange for a note if the note constitutes "qualified debt." Like preferred stock, the note would not increase in value.

Qualified debt must meet these criteria:

1. It must be an unconditional promise to pay.

2. It must have a fixed maturity of no more than 15 years. (If it is secured by real estate, the maturity can be extended to 30 years.)

3. It must contain a fixed rate of interest, or be tied to a market rate with fixed dates for payment of interest.

4. It must not be subordinated to the claims of general creditors.

5. It must not have any voting rights unless there is a default.

6. It must not be convertible to stock.

An owner who can comply with these rules can sell the business to his children, freeze the value of his estate and maintain a source of cash. And there are other options.

Various agreements

You can also retain an interest in the company with an employment or consulting contract if:

1. The term is for three years or less.

2. The salary is "reasonable."

3. The salary is not tied to profits, gross profits or sales.

Since these restrictions are so tough to meet, the IRS has said it will allow other employment/consulting agreements if they don't constitute a disproportionate transfer.

For example, if the employment agreement is for more than three years but can be terminated by the employer for reasonable cause, Section 2036(c) will not apply. Agreements not to compete are treated the same as employment contracts.

The bottom line: Business owners may be able to structure a generation-to-generation buy-out by combining qualified debt, employment/consulting contracts and non-compete agreements.

The leasing option

Leasing property to a child is another way to get around 2036(c), as long as the lease is at fair market value. (Note: In establishing market value, consider both the property itself and the terms of the lease.)

Following this strategy, a business owner would sell his stock to his children while retaining owners of its real estate, which he leases back to the company. Under the law, the business will not be included in his estate.

True GRIT

Half a loaf is better than none, which brings us to the Grantor Retainer Income Trust (GRIT). GRITs have not been widely used because preferred stock recapitalization simply worked better. Now, they've come to the forefront.

In a GRIT, you transfer property to a trust, retain its income for 10 years and, at the end of the term, the property goes to your children. A gift tax is paid when the trust is established, but the tax is based upon a discounted present value of the property.

If, for example, a 10-year GRIT was established for property having a $100,000 value, the discounted preset value would be $38,000 and a gift tax of $17,000 would be due--presuming a 50 percent estate tax rate.

If, after 10 years, the property passes to the children and is worth $500,000, no additional tax would be paid. They would receive $500,000 worth of property at a gift tax cost of $17,000, rather than $250,000. Not bad.

To qualify for a GRIT, all income must be distributed to the parent and the term of the trust must be no more than 10 years.

A GRIT has drawbacks. For one thing, the parent must be alive when it expires. If he is not expected to live 10 years, a GRIT is probably not a good idea. Also, they are irrevocable. The parent must decide today that he won't need the property in 10 years.

Further wrinkles 

As originally enacted, Section 2036(c) was relatively easy to avoid. If you used a preferred stock recapitalization and gave away both the preferred stock and the common stock before you died, you avoided 2036(c). The IRS realized this and added a gift tax provision. Now, Section 2036(c) applies if business owners give preferred stock to a child or if the child sells the common stock to a third party.

Let's presume that you sell your common stock to your child for $750,000 and retain preferred stock worth $250,000. The company is worth $1 million.

Your brilliant child makes the company a big success and, five years later, sells it for $2.25 million. You get $250,000 for your preferred stock; he gets $2 million for his common stock.

Under the new rule, this means you will have given your child $1.25 million--the difference between what he got ($2 million) and what he paid ($750,000). At a 50 percent tax rate, you now owe the IRS $625,000 on a sale that netted you only $250,000.

Of course, you can recover the taxes from your child.

The bottom line: Consider the impact of 2036(c) when selling any company in which there is more than one class of stock.

Good news, and bad

The good news is that Section 2036(c) applies only, to a business. This means you can still rather easily shield your home and other "personal use" property from estate taxes. Life insurance is also exempt.

The bad news is that 2036(c) probably won't be going away. Several congressmen have introduced legislation to repeal it, but success is not likely. The Bush administration is dead-set against anything that reduces revenue and, let's face it, Section 2036(c) brings in plenty.

For its part, the IRS says it is willing to discuss reasonable suggestions for change.

Minimizing estate taxes is a battle that won't end until you do--and maybe not then. Opportunities still exist, however, and that's better than nothing. The longer you wait, however, the tougher the problem. Consult your tax adviser about you and your heirs as soon as you can.

Robert Sabin is a partner in the tax practice of Laventhol and Horwath, a national accounting and business consulting firm with offices in 51 U.S. cities. He is based in Chicago.