Recapitalization occurring prior to the effective date of Chapter 14 treated as taxable gift.

Chapter 14 provides special valuation rules for transfers of interests in closely held corporations and partnerships occurring after Oct. 8, 1990. Under the special valuation rules, the lapse or termination of voting rights in a corporation (or the right of a general partner in a partnership to participate in its management) is treated as a current transfer subject to gift tax. If the lapse occurs at the holder's death, the value of the rights that terminate at death are includible in the holder's gross estate.

These rules prevent the transfer of closely held business interests at a discount created by voluntarily giving up voting rights prior to, or simultaneously with, the transfer. Although business interests with no voting rights can be valued at a discount for gift tax purposes, any action prior to the transfer that results in termination of voting rights without adequate consideration is treated as a taxable transfer at the time the rights are terminated. If voting rights terminate on the holder's death, the business interest is valued in the holder's estate as if the rights had not terminated.

Recently, the Tax Court ruled that a recapitalization prior to the effective date of Chapter 14, in which shareholders exchanged voting shares of common stock for the same number of nonvoting shares, resulted in taxable gifts at the time of the recapitalization (Bosca, TC Memo 1998-251).

Marlo Bosca was the owner of Hugo Bosca Co., Inc., an Ohio corporation engaged in the manufacture and sale of leather products; Mario and his brother Orsino had acquired the company from their father. After Orsino's death in 1986, Mario acquired his brother's interest under the terms of a buy-sell agreement. During 1987, Mario transferred 50% of his interest in the company to his wife Marie. Early in 1989, Marie transferred 55 of her then 402.5 shares of stock in the company to each of her two sons.

Mario Bosca had been diagnosed with lung cancer; in October 1989, he asked an attorney for advice about transferring control of Hugo Bosca Co., Inc. to his sons. The attorney recommended a plan of recapitalization under which Mario and Marie Bosca would exchange their shares of voting common stock for an equal number of nonvoting shares that carried the same dividend and liquidation rights as the shares surrendered. The plan was adopted and carried out in May of 1990. Mario died in September of the same year.

No amount was included on Mario's gift or estate tax returns for 1990 in connection with the recapitalization. The Service issued a deficiency notice to the estate, claiming that the recapitalization resulted in a taxable gift, the amount of which should be measured by the difference between the value of what Mario gave up (voting shares) and the value of what he received (nonvoting shares). The values of both voting and nonvoting shares were stipulated to by the parties.

The court agreed with the Service that Marlo had made a taxable gift as a result of the recapitalization.

Terminations of voting rights occurring prior to the effective date of Chapter 14 must be considered when determining lifetime taxable gifts. If an estate is claiming a valuation discount for lack of voting rights terminated on or before Oct. 8, 1990 without full and adequate consideration, the value of those voting rights must be treated as taxable transfers occurring at the time the rights were terminated.