A tax-efficient way to transfer your business

By Jeffrey A. Markowitz, Christopher A. Davis

Estate tax “freeze” techniques offer great flexibility for the senior generation to protect and oversee business operations as the younger generation eases into operational control. The owner of a successful family business can use these techniques to transfer appreciating assets to the next generation or to key employees.

The goal is to maintain the value of the business while avoiding a double level of corporate taxation and minimizing gift and estate taxes. There are a variety of ways to structure an estate freeze, such as recapitalizing the business, setting up a grantor-retained annuity trust or making an installment sale to a trust or family member. Although the adoption of any transfer technique must depend on the specific circumstance of the transferring business, one variation of a recapitalization, often called a “drop and freeze” transaction, is designed for owners of closely held businesses, especially those organized as C corporations.

The C corporation conundrum

Many small and family-owned businesses are organized as C corporations, but there are more tax and non-tax advantages to being a limited liability company (LLC) or partnership. Consequently, according to Internal Revenue Service data, the number of businesses filing tax returns as C corporations has declined almost 16% over the past three decades, while the number of businesses organized as partnerships or LLCs has increased more than 55% over the same period.

As the owners of older family-owned C corporations begin to contemplate various exit strategies, such as a sale or transition to the next generation of owners, the corporate form poses several problems:

• A sale of the corporation’s assets will create a double level of tax on capital gains—once at the corporate level and again when the assets are distributed to the shareholders in a liquidation of the corporation or as a dividend.

• Gifts of valuable corporate stock are subject to federal gift tax at rates as high as 35%.

• The owners of a rapidly appreciating asset, such as a successful small business in any form of entity, face an ever-increasing estate tax liability as the value of their estate increases.

The drop and freeze solution

Many small businesses use the drop and freeze transaction to solve these problems. In this transaction, an existing C corporation contributes its operating assets to an LLC or partnership in return for a “frozen” partnership interest. As part of the transaction, two classes of equity are created in the partnership: (1) a preferred interest that is “frozen” in value and pays a fixed and certain rate of return, with little participation in equity growth; and (2) a common interest that enjoys all of the income, growth and appreciation above and beyond the preferred return.

For estate tax purposes, this technique can effectively “freeze” the current value of the preferred business interest within the owners’ estate. The common interest transfers the desired portion of the appreciation in the business to family members and employees at a reduced tax cost. The common interest is generally structured without voting rights and with restrictions on its transferability. As a result, the common interests have valuation discounts for lack of control and marketability, allowing them to be sold or transferred at a lower value.

B>Step-by-step

While the procedures in any specific case must be tailored to the facts of the business and the needs of the transferor, here are the steps in implementing the technique:

1. Transfer assets to the LLC. The existing C corporation contributes all of its operating assets to a wholly owned LLC in exchange for 100% of the membership interests in the LLC. Initially there are no tax consequences, because the LLC is wholly owned by the corporation. The LLC now owns all of the assets necessary to conduct the corporation’s business. Owners may consider a Subchapter S election for the corporation as part of this restructuring.

2. Assess the asset value. After the corporation’s assets are transferred to the LLC, the value of the assets is assessed to determine the potential gift tax consequences of a gift or sale of the LLC interests to family members. The LLC will be treated as a partnership for tax purposes when the interests are later transferred to family members and employees.

3. Structure the preferred and common interests. After the assets are valued, the two LLC equity classes—the preferred, or “frozen,” interest and the common interest—are set up. The preferred interest must generally carry a preferred return that entitles the holder to a priority payment of the LLC’s cash flow. The preferred return would have priority over other distributions and would be paid to the corporation first. One disadvantage of the drop and freeze is that this preferred return is subject to the corporate double level of tax. As a result, many LLCs make the preferred return as low as possible without its being commercially unreasonable.

4. Begin buying down the corporation. The owners begin a gradual buy-down of the corporation’s equity through allocations of the LLC’s cash flow. This process attempts to “freeze” the taxable value of a business within a taxpayer’s estate so that future appreciation is transferred to family members and employees free of tax. Using the asset value established when the corporation’s assets were transferred to the LLC, this “invested capital” amount would be paid down over time as the stockholders of the corporation are gradually bought out.

5. Complete the asset transfer. During the buy-down, the corporation continues to receive a preferred return as described above. However, as payments in excess of the preferred return are made to the corporation over time, its invested capital is bought down until reaching zero (or some other minimal level desired by the owners), and the corporation is bought out of the LLC at a nominal amount. The result is an effective and tax-efficient transfer of wealth to younger generations or key employees.

Gift tax issues

Any succession planning strategy, including the drop and freeze, must comply with Chapter 14 of the Internal Revenue Code, which provides that the transaction must meet certain tests in order to be considered a bona fide business transaction and not a taxable gift. That is especially so when family members receive interests in the LLC, regardless of whether the LLC common interests are purchased for fair market value or given for no consideration.

In general, the value of the common interests must be at least 10% of the total value of “frozen” or preferred interest. Thus, if the value of the preferred interests in the LLC is $10 million, then the common interests must be valued (for gift tax purposes) at a minimum of $1 million. Chapter 14 also requires that the common interest transfer:

• Is a bona fide business arrangement.

• Does not transfer the assets for less than full and adequate consideration.

• Compares with similar arrangements that would not involve family members.

All three of these tests are presumed to be met if the agreement is only between unrelated individuals, such as non-family key employees. If common interests are issued or sold to key employees at the same time as they are issued to family members, and if each interest transfer is commensurate with the recipient’s role in the LLC, there is less likely to be gift tax liability. However, if family members receive preferential treatment, it is more likely that at least a portion of the equity grants would be considered a gift.

Looking toward the future

The partnership drop and freeze must be carefully structured to comply with the relevant laws and regulations in order to avoid adverse gift tax consequences. It should be done in consultation with a competent legal adviser. However, if done correctly, the estate freeze transfer can be accomplished while minimizing gift tax on the asset appreciation. The drop and freeze can thus be an effective strategy to preserve hard-earned financial assets and ensure that the family business is well positioned for the future.

Jeffrey A. Markowitz (left) is a principal and Christopher A. Davis is an associate in the Tax and Wealth Management group at Miles & Stockbridge P.C. They are based in the law firm’s Baltimore office (www.milesstockbridge.com).

Copyright 2012 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permssion from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.

 

 

Article categories: 
Print / Download
Issue: 
March/April 2012

OTHER RELATED ARTICLES

  • Low Interest Rates — Recession or Distortion?

    Financial markets have been volatile for the better part of the last two years. In the meantime, the current U.S. economic expansion has progressed to now become ...

  • September/October 2019 Family Matters

    [[{"fid":"11287","view_mode":"default","fields":{"format":"default","field_file_image_alt_text[und][0][value]":false,"field_file_image_title_text[und][0][value]":false},"type":"media","field_deltas...

  • July/August 2019 Family Matters

    Kyle Fernley has been named the fifth president of Fernley & Fernley, a 133-year-old association man­agement company based in Philadelphia.

    Fernley has also been named p...

  • Building a community

    When Family Business Magazine debuted in 1989, business leaders who had grown their companies after returning from World War II service were passing the baton to their baby boomer children...