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Business succession planning: a new ball game.

Business Succession Planning A New Ball Game

Once upon a time, and such a very nice time it was, family business succession planning was simple and comprehensible: Family members were merely expected to act as though they were unrelated. The Revenue Act of 1987, however, changed all of that by the enactment of the now infamous Section 2036(c). The Omnibus Budget Reconciliation Act of 1990 repealed Section 2036(c) retroactively to its effective date of December 17, 1987. In turn, the tax and estate planning communicaties have breathed a collective sigh of relief. While the 1990 act includes a substatitute provision to Section 2036(c) - the new provision is now contained in Chapter 14 of the Internal Revenue Code of 1986 - Congress has established new rules much more favorable to succession and estate planning in throwing out the old rules. Under the new rules, certain transfer are valued at the time of the transfer and are not considered part of a person's gross estate after the person dies. Further, the new rules apply to fewer types of transactions and, thus, are narrower in scope than those included in Section 2036(c). Unlike Section 2036(c), leases, debt (generally), private annuities, irrevocable life insurance trusts, employment contracts and stock in publicly traded companies, for example, are not affected by the new rules.

Even though the dreaded Section 2036(c) is dead, the new rules do not remove the elements of planning from the estate freeze process. To the contrary, the new rules impose many unfavorable assumptions on transactions which are not carefully examined in full. Despite their restrictions and some uncertainty regarding these new rules, businesses are certainly in a much better position today to prepare and implement business succession plans. For optimum succession planning, accountants should blend the new rules with the old when developing plans.

Chapter 14 Additions

The new rules affect transactions completed after October 8, 1990. Transactions completed before October 9, 1990, are exempt, unless changes to a pre-October 9, 1990, arrangement are made.

The crux of the new rules contains four sections. Section 2701 applies special valuation rules to certain transfers of interests in corporations and partnerships. Section 2702 deals with special valuation rules for certain transfers of interests in trusts. Section 2703 disregards certain options, restrictions and agreements for valuing specific interests in businesses and other company. Finally, Section 2704 treats the lapse of certain voting and liquidation rights as transfers and disregards certain restrictions on liquidation.

It should be noted that while the new rules apply to transfers between parents and children, they also apply to transfers between other family members as well, including spouses.

Examining a hypothetical situation may prove helpful in understanding the new rules. Assume that and individual makes a transfer of an interest in a business. First, certain questions must be answered to determine the applicability of the new rules. * Was there a transfer of a junior

equity interest to a member of

the family (including spouses)?

If not, Section 2701 does not

apply. If so, * Was a senior interest in the entity

retained by the transferor or

applicable family member? If

not, Section 2701 does not apply.

If so, * Do any of the following exceptions

apply: 1) Are market quotations

readily available? 2) Is

the retained interest of the same

class as the transferred interest?

3) Is the retained interest proportionally

the same as the transferred

interest? If the answer to

any of these three questions is

yes, then Section 2701 does not

apply. If, however, none of the

exceptions are applicable, * Does the retained interest include

a right of liquidation, put,

call or conversion? Does the

retained interest include a distribution

(preferred dividend)

right? If not, then Section 2701

does not apply. If, for example,

it does include a distribution

right, * Did the transferor and the applicable

family members have control

of the entity immediately

before the transfer? If not, Section

2701 does not apply. If so, * Does the distribution right provide

for qualified or cumulative

payments? If so, then Section

2701 does not apply unless the

transferor elects out of the qualified

payment provision. If not,

Section 2701 does apply unless

the transferor elects into a qualified

payment provision.

A similar walk-through can be completed with the other Sections of Chapter 14 as well. Similar hypothetical situations make it easier to understand the new rules and apply them. In general, the new rules are not nearly as complicated as those under Section 2036(c) and are not nearly as complicated as they might first appear.

Preferred Stock


Section 2701 reinstates the usage of a traditional preferred stock recapitalization to freeze the value of the parent's interest. To avoid problems, however, certain rules must be followed. For instance, Section 2701 imposes fixed valuation rules meant to approximate arm's-length rules. They require that the preferred stock pay a dividend on a periodic basis at a fixed or ascertainable rate and on a cumulative basis.

Optimally, the value of the common stock transferred to the children is determined by taking the entire equity value of the business, subtracting the value of the equity interest retained by the parent and determining the pro rata value of the common stock transferred to the children. Preferred stock that pays a dividend on a periodic basis (at a fixed rate with a dividend accumulating if it is not paid) can be valued under regular valuation techniques. Accordingly, the value of the common stock transferred by the parent to the children can be calculated for gift and estate tax purposes.

It is likely, however, that unless the specific rules are followed carefully, the preferred stock retained by the parent will have a value of zero (as valued under Section 2701) and the common stock transferred will have a value equal to its pro rata portion of the value of the entire equity of the business - potentially 100%. The new valuation rules combined with the continuing estate and gift tax risks that predated Section 2036(c) (allowing that the owner may value the business or the preferred stock improperly) require that the planner now must be wary of both potential pitfalls. If the economic realities of the proposed recapitalization are that the dividends are likely not to be paid, the new rules govern and will have to be dealth with to successfully complete the freeze.

One factor that is causing uncertainty and may frustrate the use of business freeze arrangements is the interest rate or yield that applies to the frozen interest retained by the parent (such as preferred stock). The higher the yield on the frozen interest, the higher the value will be of the frozen interest and, accordingly, the lower the value will be of the appreciating interest given to the children. To date, no guidelines have been issued to determine the relationship between the yield on the frozen interest and its value.

A Return to Buy-Sell


Buy-sell agreements historically have been the tools used in business succession planning and were affected adversely by Section 2036(c). Now, the new rules have brought them back into favor. Typically, the buy-sell agreement imposes certain restrictions on transferring ownership of the business during an owner's lifetime. Most often it provides that when the owner dies, the owner's interest in the business will be purchased, either by the business itself or by other surviving co-owners. Now new rules have been established under Section 2703 to determine whether a buy-sell agreement will be respected for gift and estate tax purposes. In general, a buy-sell agreement will be given absolutely no weight or consideration for gift or estate tax purposes unless three conditions are met: 1. The buy-sell agreement must be

abonafide business arrangement; 2. It must not be used to transfer

the business interest to members

of the decedent's family at a bargain

price (however, members of

the decedents' family may be

broadened under legislation currently

being reviewed by Congress);

and 3. The terms of the agreement are

comparable to similar arrangements

entered into by persons in

an arm's length transaction.

If these conditions are met, the buy-sell agreement then will be considered in determining the value, for gift and estate tax purposes, of a business interest given away or owned by a person when that person dies.

In enacting the new rules, Congress attempted to codify rules affecting buy-sell agreements that had been established by the courts. However, the court-established rules and the rules of the new law are not exactly alike. Specifically, the statute has added the arm's length requirement mentioned earlier. In determining whether an agreement meets the arms' length rule, accountants must consider the present value of the property, its expected value at the time the option of purchase is exercised, the expected term of the agreement and the consideration offered for the agreement. The recently distributed Senate report on the new rules indicates that this arm's length requirement will not be met merely by demonstrating isolated comparables, but will require a demonstration of the general practice of unrelated parties. Expert testimony might be sufficient, but since this testimony is often difficult to obtain, it is conceivable that the buy-sell agreement may not set the value as originally intended. Carefully drafting the agreement will be necessary to accomplish that end.

Complicating matters, the Internal Revenue Service issued proposed regulations concerning some of the rules. A trap potentially exists in dealing with pre-October 9, 1990, buy-sell agreements entered into among family members. Such agreements are "grandfathered" and not subject to the new rules unless they are substantially modified after October 9, 1990. For those buy-sell agreements affected, all of the new rules must be adhered to, including the arm's-length requirement, for the buy-sell agreement to establish a value for tax purposes.

Many buy-sell agreements require that the purchase price of the business be updated on a periodic basis. Under the proposed regulations, failing to update the purchase price is a substantial modification to the terms of the buy-sell agreement and jeopardizes the grandfather status of the agreement. An exception is permitted - with grandfather status being retained - if failing to update the purchase price would not have resulted in a substantial modification to the buy-sell agreement, presumably because the price has not changed or the formula that applies approximates the fair market value. Many buy-sell agreements use book value as a back-up formula, and it might be difficult to successfully argue that book value approximates fair market value in most situations.

Changes in Trusts

Section 2702 of Chapter 14 deals with transfers of interests in trusts and replace the rules on Grantor Retained Interest Trusts (GRITs). Long a popular planning technique, GRITs involve the establishment of a trust under an irrevocable agreement. Under this arrangement, a trust lasts for a specified period of time while the grantor places assets into the trust and retains the right to receive income from the trust for that period. After the time expires, the assets in the trust are distributed to children or other beneficiaries.

In valuing the gift to children, large discounts generally were available, based on IRS table. For instance, if the grantor retained the right to receive income from the trust for 10 years, the gift to children was approximately one-third of the fair market value of the assets placed into the trust. This technique provided an opportunity to transfer interests in businesses to children at a reduced value for gift tax purposes.

Now, Section 2702 requires that the value of an interest in a trust transferred to a member of the transferor's family be determined by taking the value of the property transferred to the trust and subtracting the value of any interest in the trust retained by the transferor or by an applicable family member. The value of the retained interest that is not a "qualified interest" is zero, the result of which is that the transferred interest will be valued at 100% of the value of the property. Generally, a qualified interest is one which involves the payment of a fixed amount each year to the parent (an annuity) or the right to receive annual payments that are a fixed percentage of the fair market value of the trust property (so-called "unitrust" payments).

Further, the fundamental estate tax rule still applies when the parent retains the right to receive income from the frozen interest. If the grantor dies before the end of the trust term, a portion of the assets in the trust are included in the grantor's estate for federal estate tax purposes.

The special valuation rules under Section 2702 do not apply to transfers of interests in trusts if the transfer would not be treated as a gift and whether or not consideration was received for the transfer. Additionally, they do not apply to a transfer of an interest if all the property in the trust consists of a residence that is to be used as a personal residence by persons holding term insterests in the trust. It is not clear, however, if the personal residence also must be the principal residence of the interest holder. It is unlikely this will be required, although many experts do not believe rental property will qualify. Accordingly, it appears this may be a viable option for the acquisition or succession of a residence or vacation home.

Voting and Liquidation


Another important aspect of Chapter 14, Section 2704, deals with a lapse of any voting or liquidation right. It affects voting or liquidation rights transferred by gift or included in the gross estate of an individual if the individual intially holding the right and members of that individual's family control the corporation or partnership both before and after the lapse of the right. Impacted is the excess of the value of the interests in the corporation or partnership held by the individual immediately before the lapse, valued as if the voting and/or liquidation rights were non-lapsing, over the value of the interests held by the individual after the lapse.

Interestingly, the new statute gives no guidance on the recipient of the transfer and whether or not the transfer will qualify for the marital (or charitable) deductions or as to the applicability of the stepped-up basis rules. Of all of the new rules, Section 2704 creates the most ambiguity and either regulations or technical amendments will be needed to assist the planner in properly interpreting this provision.

Other Issues

One new area of the law, Section 6501(c), holds the potential of impending doom for any succession plan unless special attention is paid to it. Section 6501(c) creates an unlimited statute of limitations for unreported gifts of an interest in a corporation, trust or partnership. It affects those unreported gifts which should have been subject to the special valuation rules under Sections 2701 or 2702 if the transfer is not shown or otherwise disclosed on the gift tax return for the applicable period. Included are gifts which were not otherwise required to be reported because they were within the annual exclusion amounts.

The statute of limitations will not run on a transfer not treated as a gift because consideration was paid, based upon conventional valuation rules, if the transfer would have been a gift under the special valuation rules. Accordingly, if it is determined that no gift was made under Section 2701 or 2702, a statement describing the transaction must be filed with the gift tax return, indicating that no gift resulted from the transaction. Failure to fully disclose the transaction will give the IRS an ulimited opportunity to audit the transaction.

Similarly, certain elections are permitted (and may be advisable) under the new rules. Additionally, care must be taken to make and disclose any such election on the gift tax return. Failure to adequately elect and/or disclose them may prohibit future elections.

It is important to note that one of the old rules that has not changed under the act is a fundamental estate tax rule dealing with the retention of rights. If a person gives away property, but retains the lifetime right to receive income from or retains the lifetime right to use the gifted property, then the gifted property will be considered part of the person's estate for federal estate tax purposes upon the person's death. The asset will be valued in the person's estate at its value on the date of the person's death (or the alternate valuation date under certain limited circumstances).

A Final Consideration

The overdue demise of Section 2036(c) has been well received and long awaited. The new rules, while infinitely more workable and comprehensible, still present a danger to the unwary planner. Careful analysis of the new rules is critical, and estate, business and successional planning is as important as ever. Some of the new provisions are a dramatic and drastic change from historic laws and precedent, and, accordingly, accountants need to be careful that the old and the new are properly blended in planning activities. Regulations and technical amendments will be eagerly awaited for further clarification. Until, then, it appears that planners have a workable set of guidelines and may proceed after the hiatus created by Section 2036(c).
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No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:new accounting rules for estate and succession planning
Author:Fiala, David M.
Publication:The National Public Accountant
Date:Aug 1, 1991
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