CH. 18 Family Business
Possible options for arrangements to:
Sell an interest in
a closely held enterprise
to non-family members at retirement or death, i.e., no
continuing family involvement. Ch. 19.
within a closely-held family
enterprise from older generation members to younger family members
Estate Planning “Freeze” in the Family
Tax planning objectives:
1) freeze the enterprise value held by the older family
members (with only limited gift tax effect, if possible), and
shift the future
appreciation potential to the younger generation family members (i.e.,
children, grandchildren & trusts).
Note the applicability of valuation rules in the gift tax context
– Code §§2701-2704.
Possible Family Enterprise Structures
including an S (flow-through) corporation
2) Partnership, including a family limited
partnership (or “FLP”), or a limited liability company (LLC) treated as a
partnership for federal tax purposes
ownership (e.g., TIC)
4) Investment trust arrangements, e.g.,
the family business.
emotional linkage of family members in the future.
Note: Many family businesses fail in the second/third
generation (unless going to professional management/public ownership).
Corporate Restructuring –
Income Tax Elements p.3
Corporate tax elements:
Federal tax status
of a corporate reorganization/restructuring?
distribution upon a corporate ownership reshuffling?
3) Deferred dividend treatment for shareholders
upgrading their positions? E.g., Code §306 stock, with possible
elimination of the §306 taint at death (e.g., §1014 applicability).
Corporate Tax-free “Recapitalization”
Shifting of the ownership interests into a multiple tier
value) stock for the older generation members, and
(appreciation potential) for the younger generation members.
A corporate “recapitalization” is a tax-free reorganization for
federal income tax purposes. §368(a)(1)(E).
Family members can “recapitalize” the corporation with older
generation members receiving senior equity interests (and younger members
retaining or receiving junior stock, e.g., common stock).
Not available if “S” corporation status.
Current Dividend Distribution
Code §305 provides for no ordinary dividend effect for a
distribution of stock on stock, except:
§305(b)(1) – distribution payable in stock or cash, at
election of shareholder.
§305(b)(2) – distribution produces an increase in the
proportionate interest of some shareholders.
§305(b)(3) – transaction results in common stock to some and preferred stock
I.e., ownership disproportionality results.
Special exception from this dividend treatment for an “isolated
transaction,” i.e., an “estate planning recapitalization.”
See Reg. §1.305-3(e), Example 12, for the “isolated transaction”
exception (authority to implement this regulation sourced from a Senate floor
Preferred Stock Bailout
Code §306 provides for ordinary income treatment of the proceeds
received upon the disposition of §306 stock.
recognition when the distribution of this stock occurs (i.e., an attempted “preferred
stock bailout”), but at the later disposition event (& ordinary
Definition of §306 stock: “other than common stock” (i.e.,
ordinarily preferred stock)
Gift Tax Risks in Recapitalizations
Rev. Rul. 86-39, p.9: A recapitalization can result in
the shifting of values between shareholders (& a gift for federal gift tax
purposes). Here, a transfer from one trust to another & no P/A in
recipient trust for surviving spouse (but having an income interest in the
See Code §2701(e)(5) (p. 12) providing that a recapitalization can
be treated as producing a transfer of an interest for gift tax purposes.
Section 2701 & Gift Tax Risks in
P. 12. Code §2701 provides special (gift tax) valuation
rules for transfers of interests in corporations or partnerships.
All interests have been transferred unless demonstrating precise value of the
retained interest. Exception for:
1) “Qualified payment” - §2701(c)(3) specified
a dividend payable on periodical basis on cumulative preferred
2) Marketable retained interests - §2701(a)(2).
§2701 & Gift Tax Risks in
Restructurings – cont.
P. 12 Required minimum value of the junior equity is imposed
- Code §2701(a)(4). A ten percent minimum value is required.
What happens if actual failure to pay dividends on the preferred
stock occurs for an extended period? P. 12.
Other Shareholder Benefit
Possible gift transfer treatment for:
payment to juniors.
Rent-free use of
property to juniors.
Low interest loans
to a relative. §7872.
Waiver of right to
dividends. P.14 & Rev. Proc. 67-14.
5) Failure to convert preferred stock.
Family Limited Partnership ( FLP)
What is a “limited partnership”?
What is a “family partnership” (FP)?
See Code §704(e). What is a “family limited
In a family partnership capital must be a “material income
Further, to enable income deflection the donor partner must
respect the rights of the donee partners (minors?) after gifts of FLP
Flow-through income/loss treatment to the partners occurs for
federal income tax purposes.
FLP Is Organized P.17
Revocable trust for the parents as the GP (3%).
Children as the 1% limited partners in FLP.
1) LP interest transfers to 3 children (96% of
FLP interests) were gifts. Partnership receives real estate
(subject to a guaranteed payment).
2) Value of gifts determined under the Code
§2701 subtraction method. What is the “subtraction method”?
3) §704(e)(2) allocation of income by FLP. P.21
4) §2703 buy-sell impact not determined here.
Code §2701 Rules
§2701(a)(3) specifies that the value of a retained right shall be
zero (i.e., all is a gift transfer), unless it is a retained right to receive a
§2701(c)(3) describes a “qualified payment” as an amount payable
on a periodic basis at a fixed rate.
§2701(a)(4) mandates a minimum 10% interest for the junior equity
Recent Gift Tax Cases
Valuation Issue p.22
Example: Holman case (8th Cir., 2010), re
Dell stock transfer into FLP.
Issue: Gift of an FLP interest or a gift of the asset
transferred to FLP? Held: FLP interest.
Noting also Pierre case, p. 22 in U.S. Tax Court (earlier
in materials)., re (1) transfer of assets or (2) transfer of LP interest;
including applicability of “step transaction” doctrine. Subsequent application
of step-transaction rules.
Gross Estate Inclusion
Estate of Strangi case, re §2036, p.23
Corporate GP of an FLP, using the “Fortress” FLP documents.
Decedent had assigned 98% of his own (mostly liquid) wealth
to an FLP (done by agent through a durable P/A). FLP assets then used to
fund donor’s living expenses.
Matter was remanded by 5th Cir. to U.S. Tax Court to
consider the §2036 applicability.
On remand (after Strangi II): Inclusion in the gross estate
under both §2036(a)(1) & (2).
FLP Litigation Risks and
See IRS Settlement Guidelines, p.41.
for transfers of FLP interests? What percentage?
Indirect gift of
the underlying assets? Substance v. form.
4) Penalty exposure? §6662(g) – 20% for
substantial valuation understatement.
Code §2031 inclusion.
Discount available for minority interests?
Discount available for illiquidity (i.e., lack of marketable
What discount for cash (& equivalents) when inside a
partnership & only a partnership minority interest held (even if other
family member partners)?
How Limit Potential §2036 Exposure?
Estate tax planning:
Do not transfer all client’s assets into the FLP.
Do not pay personal expenses from the FLP.
Keep the capital accounts of the various partners balanced.
Continually keep good records & annual maintenance for the FLP.
Run the FLP like a business.
FLPs & Tax
Apply future limits to FLPs?
Limit where an infusion of liquid properties into FLPs occurs?
Does it constitute professional malpractice if not
suggesting an FLP? P.56.
Even if only for exclusively liquid assets?
Impending IRS regulations (2017?).