Freezing stock value with a corporate recapitalization

One business succession strategy to consider is a corporate recapitalization. A recapitalization is a form of reorganization that involves changes in the class of stock a shareholder possesses. It occurs when a shareholder exchanges some or all of his or her stock for another class of stock in the corporation (i.e., a recapitalization results in the shareholder's acquiring a new class of stock in return for giving up all or some of his or her original stock). Generally, recapitalizations are not taxable events for the shareholders (however, they may create gift tax considerations between the shareholders) or corporation as long as the exchange has a business purpose and the value of the stock given up equals the value of the stock received.

A corporate recapitalization can freeze the value of the owner's stock, potentially reducing the owner's estate tax liability by removing future appreciation in the value of stock from the owner's estate. However, with the increased exclusion amount, planners must weigh the benefits of freezing the stock's value versus holding the stock until death and receiving a step-up in basis for income tax purposes.

Shifting control using a recapitalization is especially useful when:

• A stock sale would result in substantial tax;
• A redemption does not qualify for capital gain (exchange) treatment because it is not substantially disproportionate or the redeemed shareholder does not or cannot terminate his or her interest completely;
• The value of existing stock is too high to allow purchases by other family members, shareholders, or employees; or
• A shareholder wishes to protect the interests of children actively involved in a corporation while providing some benefit for those with no active involvement.

In a typical recapitalization, one class of voting common stock is exchanged for two classes of stock (usually voting preferred with a cumulative dividend feature and nonvoting common). The owner retains the voting preferred stock and, therefore, control of the business operations. Because the preferred stock does not participate in the growth of the corporation's value, the owner's stock value is frozen.

The common stock created in the recapitalization is transferred to the owner's children. Because the total value of the corporation's stock does not change as a result of the recapitalization (i.e., new preferred + new common = old common), the value of the new common stock transferred to the children is reduced by the value attributed to the preferred stock retained by the owner. The recapitalization allows the owner to transfer ownership and future appreciation in the corporation at a reduced gift tax cost without giving up control of the business operations.

Under current rules, the retained preferred stock would be assigned a value of zero, unless certain requirements are met (Sec. 2701(a)(3)(A)). The gifted interest (usually common stock) would be assigned the entire value of the corporation. This could create a gift tax liability for the donor.

The valuation provisions of Sec. 2701 apply when there is a transfer of a junior equity interest in a business to a family member and, immediately after the transfer, the transferor holds an applicable retained interest (Regs. Sec. 25.2701-1(a)(1)). In general, the provisions tend to shift a major portion of the value of the corporation to the interest that has been gifted, making the typical estate freeze transaction much less attractive. The following definitions help to understand these provisions.

• Junior equity interest: Common stock in which the rights to income or capital (e.g., dividend or liquidation rights) are subordinate to the rights of all other classes of stock (Sec. 2701(a)(4)(B)(i)).
• Family member: The transferor's spouse, any descendant of the transferor or transferor's spouse, and the spouse of any descendant (Regs. Sec. 25.2701-1(d)(1)).
• Applicable retained interest: Includes an equity interest in a controlled entity for which there is a distribution right.

If the interest retained by the donor or applicable family members is assigned certain distribution rights, the retained interest may have some value based on these rights (Sec. 2701(a)(3)(B)). However, these distribution rights, such as extraordinary payment rights, mandatory payment rights, liquidation payment rights, and nonlapsing conversion rights, must meet certain requirements. In general, they must call for a periodic dividend payment on cumulative preferred stock payable at least annually at a fixed rate (Sec. 2701(c)(3)(A); Regs. Sec. 25.2701-2(b)(6)).

Planning in this area involves avoiding the Sec. 2701 rules entirely or structuring the transaction so that the retained interests are assigned qualified payment rights with a substantial value.

Example 1. Recapitalizing a corporation with preferred stock: A owns 100% of the common stock of X Corp. A is 50 years old and would like to turn control of X over to his son, B. However, B does not have funds to purchase the stock, and X does not have funds to redeem the stock. X's common stock has a par value of $200,000 and a fair market value (FMV) of $1.5 million, but A believes the value will be greater than $12 million in the next five years.

A would like to remain active in the business. While X represents a major portion of his planned retirement income stream, A wants to keep as much of the future increase in value of X's stock out of his estate as possible.

A chooses to recapitalize X by receiving one share of voting preferred stock for each share of common stock he owns. (This is a tax-free stock dividend under Sec. 305(a).) The preferred stock will have a face value of $100,000 and be entitled to an annual dividend of 25% of its face value. Then, A will gift all of his common stock toB.

This transaction is subject to Sec. 2701 for the following reasons. The stock transferred to B is a junior equity interest because the preferred stock has dividend and liquidation rights senior to the common stock and B is a family member. Also, X is a controlled entity because A, directly or indirectly, owns over 50% of the stock. Because A's preferred stock is entitled to distributions from X, A has an applicable retained interest (Regs. Sec. 25.2701-2(b)(1)).

Using cumulative preferred stock with annual dividend rights at a fixed rate increases the value of A's retained preferred stock interest and decreases the amount of the gift to B. For instance, A's preferred stock calls for annual cumulative dividend payments of 25% of its face value, yielding an annual payment of $25,000 ($100,000 × 25%). Therefore, A's retained preferred stock interest is valued based on the present value of this stream of payments over his remaining life expectancy. If this valuation equals $500,000, the value of the common stock gifted to B would be reduced to $1 million ($1.5 million total FMV less $500,000 allocated to preferred stock). There may be other discounts, such as for lack of marketability, that would reduce the value of the gift even further.

A's gift of all of his common stock shifts the future appreciation in the value of X to B. The dividend payments, along with some reasonable salary, will provide A with a stream of income to build funds for his retirement.

If A's preferred stock interest were entitled to noncumulative dividend distributions, the value of A's retained interest would be zero. Therefore, the value of the gift of common stock to B would be the entire value of the corporation (estimated to be $1.5 million).

No matter how skillfully a taxpayer manipulates the valuation rules when planning a transfer of common stock to a family member while retaining a preferred stock interest, Congress intends for at least a minimum value to be assigned to the transferred interest. This is accomplished by requiring the value of all the common stock of the corporation (after the transfer) to equal at least 10% of the sum of (1) the value of all stock in the corporation, plus (2) the total corporate indebtedness owed to the transferor or an applicable family member (Sec. 2701(a)(4)). Indebtedness for this purpose does not include short-term indebtedness incurred in the ordinary course of business (such as amounts payable for current services), nor does it include a corporate obligation to make future lease payments, so long as they are made when due and represent full and adequate consideration for use of the leased property (Regs. Sec. 25.2701-3(c)(3)).

Note: In a recapitalization in which the owner receives preferred stock in exchange for common stock, the preferred stock may be considered Sec. 306 stock. A subsequent sale or disposition of this stock may produce ordinary income instead of capital gain. Ordinary income from the disposition of Sec. 306 stock is a dividend that is taxed at the maximum rate of 20%. This treatment can be disadvantageous because the shareholder's basis in the stock cannot offset the dividend income.

Alternatively, the recapitalization could create two classes of common stock: voting and nonvoting. At the appropriate time (i.e., the owner's death or retirement), some or all of the owner's voting stock could be transferred to active children and the nonvoting shares to inactive children. As a result, the active children receive control of the corporation, and the inactive children receive nonvoting stock that has equal value. Then, the active children can continue to operate the business without any interference from the inactive children.

Extraordinary payment rights

In family transfer situations, extraordinary payment rights are valued at zero (i.e., will not increase the value of the preferred stock). Therefore, rights such as put options, call options, and rights to compel liquidation do not add value to the retained preferred stock for gift tax valuation purposes. However, these rights should be given proper nontax consideration.

Mandatory payment rights

Mandatory payment rights add value to the retained preferred stock only if payment is to be made at a fixed price and at a fixed time. These rights are to be considered for shareholders who desire to retain control over the business through voting preferred stock but who also know when they wish to retire completely from the business.

Example 2. Using mandatory payment rights to increase the value of retained stock: F owns all of the cumulative voting preferred stock and nonvoting common stock of J Inc. His son, B, has done well in the business, and F transfers all of the common stock to B. The corporate charter is amended so that in three years, F must offer the stock to the company, and the company must redeem it for its stated par value of $2 million.

The redemption right is a mandatory payment right that will increase the value of F's retained preferred stock, therefore lowering the amount of the gift of the common stock to his son.

Liquidation participation rights

The right of a shareholder to participate in a liquidating distribution will enhance the value of the retained preferred stock. However, the right to compel liquidation is an extraordinary payment right and will add no value to retained preferred stock (in family transfer situations).

Nonlapsing conversion rights

The permanent right to convert the preferred stock into a fixed number of shares or a fixed percentage of shares of common stock will add value to the retained preferred stock. This type of permanent conversion right should be given serious consideration in almost all corporate restructurings involving a transfer of stock from an older individual to a younger person. It allows the older-generation shareholder an opportunity to later change his or her mind and again participate in the growth of the company. For example, if the growth of the company greatly exceeded initial expectations, the older generation could recapture a share of the growth by exercising the conversion rights. However, the planner should also note that the exercise of these rights would ultimately decrease the value of the stock that initially was transferred to the children (because they would no longer own all of the common stock) and correspondingly increase the value of the interest held by the older generation.

Although a recapitalization involving voting and nonvoting common stock does not freeze the value of the owner's stock, it can be coupled with an annual gifting program to remove future appreciation on the gifted shares from his or her estate. If the owner begins a current gifting program for the stock, the owner's estate will be reduced by any future appreciation on the transferred shares. If the owner has no present intention to retire, the owner could gift up to 49% of the voting common stock without relinquishing control of the corporation.

Example 3. Recapitalizing a corporation and gifting stock to the owner's children: J is age 58 and is the sole shareholder of W Inc. J is married and has two children. His spouse, M, is a homemaker. His daughter, Y, (age 30) has worked for W for seven years and would eventually like to take over the business from her father. His son, D, an attorney with a successful practice, has no desire to be involved in the business.

J is in good health and is unwilling to commit to a retirement date. However, he ultimately wants to transfer the business to Y. His estate planning goals are to provide for his spouse and divide his wealth equally between his son and daughter.

There are several alternatives forJto consider. J can recapitalize the corporation with voting preferred stock and nonvoting common stock. J keeps the voting preferred stock to retain control of the corporation, and Y receives the nonvoting common stock, which accumulates all of the future appreciation in the company. Alternatively, J can recapitalize with voting and nonvoting common stock. Then J can make gifts of voting stock to Y and nonvoting stock toD.

The first step may be for J to adopt a lifetime gifting program to reduce future appreciation in his estate. J could make gifts to each child (and to his grandchildren) up to the annual gift tax exclusion amount ($16,000 for 2022). He and M could also elect gift-splitting to double this amount per year per donee. J could effectively transfer a significant amount of value out of his estate without incurring any gift taxes.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide's Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).