Property transfers to family members can have tax consequences. Business owners should have estate plans, but many owners are unaware of the tax implications associated with recapitalizing their business entities to help family members.Business owners probably already know that sales of stock, for example, have tax consequences. Selling stock for an amount for more than was paid for it (“in excess of basis”), results in a taxable gain. However, they may not realize that there are other transfers of property that also result in taxable transactions.
According to the Internal Revenue Service...
In Internal Revenue Service (IRS) Chief Counsel advice memorandum, CCA 201442053, the Chief Counsel held there was a gift when a family business was recapitalized (For more information, check out this PDF from the IRS)
The family business was a limited liability company (LLC). A parent transferred a percentage of the LCC to her children in exchange for an agreement to manage the LLC. The LLC’s operating agreement was amended to provide that profits and losses would be allocated between her two children. After the re-distribution, the sole equity interest of the donor in the LLC was a right to distributions based upon the donor’s capital account balance immediately prior to the recapitalization.
The benefits of recapitalizing your business
Clients who own closely-held businesses want control and the flexibility to change their plans. A technique that enables clients to have flexibility in transferring closely held businesses to the next generation, but still retain control, is to recapitalize the business.
For corporations, including S corporations, this involves issuing nonvoting stock. For an LLC, nonvoting membership units are often issued. A recapitalization will involve amending the articles of incorporation or the membership agreement for an LLC and then issuing nonvoting stock or nonvoting units.
However, from the above facts, there was not just a transfer of control, but also a shift in value. After the recapitalization, the donor’s sole equity right was frozen at her capital account balance immediately prior to the recapitalization. The owner’s future distributions were shifted to her children. The Chief Counsel’s advice memorandum discussed this shift and the application of the gift tax rules.
Under the terms of the operating agreement, each member's capital account was credited with the amount of that member's capital contribution, with profits and losses allocated based on that member's pro rata interest. After the recapitalization, the children’s equity interests were based solely on their capital account balances as they existed immediately before the transaction. This resulted in future income and appreciation in the LLC going solely to the children rather than being based on pro rata shares based on percentages of ownership.
Special Valuation Rules
The IRS Counsel stated that Sec. 2701’s special valuation rules apply to determine the amount of a gift when an individual transfers an equity interest in a family-controlled corporation or partnership to another family member. This section applies to a recapitalization of a corporation or partnership if the transferor holds an "applicable retained interest." A "applicable retained interest" includes any equity interest in a controlled entity for which there is a distribution right. The IRS found the LLC was family controlled and that the donor held an applicable retained interest before and after the recapitalization. The IRS stated that the donor's interest, which was based on her existing capital account balance, was senior to the transferred interests, which carried only a right to distributions based on future profit and gain. In addition, the donor received property in the form of the agreement by the sons to manage the company. Therefore, the transaction fell under Sec. 2701.
Using trusts to your benefit
The use of trusts can control the next generation’s access to income and principal associated with the value of the transfer of the nonvoting stock or LLC membership units. Trusts used for these strategies include qualified subchapter S trusts, small business trusts, a transfer to a grantor retained annuity trust, or a sale to an intentional defective grantor trust. For S corporations, these types of trusts maintain an S corporation election status if nonvoting stock is involved in the planning.
Another option involving recapitalization is the issuing voting preferred stock to one generation and gifting common stock to younger generations. The benefits of the growth of the corporation is passed to the holders of the common stock.
When we advise our business owner Clients (keeping control, flexibility, liabilities and value in mind), we explore all available strategies for transferring ownership including transfers using trusts or family limited partnerships. Strategies depend on Client objectives. Our clients are diverse and so are their goals. We urge you to consult us if you are considering developing a business success plan.
If you have a legal issue you need help with, the attorneys at Whitcomb, Selinsky Law PC would love to share their expertise with you. Please call (303) 543-1958.