Small business tax solutions.

This series is based on questions from AICPA certificate of educational achievement (CEA) courses.

Q: Internal Revenue Code section 2701 can adversely affect the classic estate freeze scenario involving recapitalization of a C corporation with Smith Sr. retaining preferred stock and giving common stock to Smith Jr. Does section 2701 have the same impact on estate freezes involving limited liability companies?

A: No. Because LLCs are taxed as partnerships, they have unique features that prevent section 2701 from having a negative effect.

OVERVIEW OF SECTION 2701

In broad terms, section 2701's purpose is to provide rules for determining the value of a transferred interest in a corporation or partnership. Valuation of the common interest transferred to Smith Jr. is accomplished by subtracting the value of Smith Sr.'s retained preferred interest from the total business value. For the latter's interest to be valued on the basis of its "preferred dividend" rate, the dividend must be cumulative.

Impact on C corporations. From a theoretical and policy perspective, section 2701 is a substantial improvement over the old antifreeze device of IRC section 2036(a). Section 2701 attacks a gift tax valuation issue with a gift tax valuation solution, instead of with an estate tax solution.

From a practical perspective, however, section 2701 essentially prohibits a corporate freeze for three reasons:

1. The corporation may not have sufficient cash to pay the required dividend.

2. Payment of the required dividend is subject to double taxation.

3. There are no safe harbor capitalization rates to assure a satisfactory valuation.

AVOIDING THE IMPACT OF SECTION 2701 WITH LLCs

With an LLC, several factors help prevent the negative effect of section 2701.

Tax-free recapitalization. As with a corporate recapitalization, the transfer of an LLC interest in exchange for a preferred class of membership interest with a fixed return to be retained by Smith Sr., along with a common class of membership interest to be transferred to Smith Jr., can be accomplished as a tax-free exchange under IRC section 721.

Low valuation of transferred interest. The transfer of the common class of membership interest to Smith Jr. is a gift subject to the section 2701 valuation rules. Through careful selection of the preferred dividend rate, the transferred interest can receive a low valuation, providing Smith Sr. an ideal vehicle for using his annual gift tax exclusion and unified estate tax credit and at the same time creating an excellent device for shifting value and income to Smith Jr. Unfortunately, as in the case of a gift of corporate stock, no safe harbor capitalization rate is provided to assure a satisfactory valuation. However, increasing the qualified payment to Smith Sr. to assure the desired valuation of the retained interest is not as detrimental as it would be if he held stock because cash distributions are not subject to double taxation and may be entirely avoidable.

No double taxation. While LLCs provide the legal benefit of limited liability, they also offer the tax benefit of flow-through of income because they are taxed as partnerships. This allows LLCs to pay a preferred dividend to Smith Sr. without subjecting it to double taxation. This is the key advantage of estate freezes using LLCs and provides the basis for the other benefits discussed below.

No cash flow requirement. Because LLCs are taxed as partnerships, LLC income is allocated to members and treated as received by them whether or not cash is distributed. Therefore, if Smith Sr. has other resources with which to pay the tax, it is not necessary that he receive any cash. Such income can be allocated to his capital account and distributed tax free at a later date. Unlike a C corporation, an LLC can even redeem or partially liquidate Smith Sr.'s preferred interest without risking an additional dividend under IRC section 302. If he dies before the cash is distributed, although his estate would include the additional capital account represented by the unpaid dividend, the amount would be a frozen share of the LLC as if the cash had been distributed and an additional preferred interest purchased.

Inside basis step-up of partnership assets. When Smith Sr. dies and the basis of the preferred class of LLC membership interest steps up to fair market value, under section 754 the LLC may elect to adjust the tax basis of its underlying assets to the value of his preferred membership interest. This means any subsequent sale of property by the LLC would produce gain only to the extent the sales price exceeded the adjusted tax basis.

STEVEN J. CROWELL, CPA, PhD, JD, is a tax attorney with Blanco Tackabery, Combs & Matamoros in Winston-Salem, North Carolina.