Transitioning the family business

Washington Law Review

Volumn 83, Issue 2, 2008, Pages 123-217

  Drake, Dwight ^a  

^a NONE

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EID: 49149127466     PISSN: 00430617     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (278)

1. See generally M. F. R. Kets de Vries, "The Dynamics of Family Controlled Firms: The Good News and the Bad News," ORGANIZATIONAL DYNAMICS, Winter 1993, at 59-71;
2. P.L. ROSENBLATT ET AL., THE FAMILY IN BUSINESS (1985);
3. W.G. DYER, CULTURAL CHANGE IN FAMILY FIRMS (1986) 59-71; Arthur Anderson/Mass Mutual, American Family Business Survey, 2002.
4. LAIRD NORTON TYEE, FAMILY TO FAMILY: LAIRD NORTON TYEE FAMILY BUSINESS SURVEY 5 (2007), http://familybusinesssurvey.com/ pdfs/LNT_FamilyBusinessSurvey_2007.pdf.
5. Id. The survey also indicated that (1) only 56 percent of the respondents have a written strategic plan; (2) nearly 64 percent do not require that family members entering the business have any qualifications or business experience; and (3) 25 percent do not believe that the next generation is competent to move into leadership roles. Id. at 5.
6. See J.I. WARD, KEEPING THE FAMILY BUSINESS HEALTHY XXIV, 12, 247-50 (1987). This book suggests the survival rate to generation three is less than 15 percent. Id.
7. See TYEE, supra note 2.
8. Many factors can and often should impact the analysis, including the family's emotional ties to the business, evolving external business risks, children who have committed their careers to the business, qualified heir challenges, the availability of viable sellout options, and key business indictors (i.e., strategic- vs. relationship-based, institutionalization potential, margin tolerances, asset composition, low-tech vs. high-tech, barriers to entry, and capital structure). For a discussion of the "Keep vs. Sell" decision, see DWIGHT DRAKE, BUSINESS PLANNING: CLOSELY HELD ENTERPRISES ch. 16 (2006).
9. The estate tax unified credit under I.R.C. § 2010 is presently $780,800, an amount sufficient to shelter $2 million of property (the applicable exclusion amount) from the federal estate tax. I.R.C. § 2010 (2006). The applicable exclusion amount increases to $3.5 million in 2009 and, absent further action by Congress, goes away in 2010, along with the one-year demise of the estate tax. After 2010, the applicable exclusion amount returns to its pre-2001 level of $1 million along with a full restoration of the estate tax. Most expect that the one-year disappearing act will never occur because Congress will be forced to take action before 2010. Depending on their state of residency, the Wilsons may also have a state inheritance tax burden.
10. The Wilson family's situation mirrors that of most successful family-owned businesses in America. According to the 2007 Laird Norton Tyee Family Business Survey, 60 percent of the responding family companies had a CEO over age 55, 71 percent had no succession plan, 97 percent had one or more additional family shareholders, 91 percent had at least one additional member employed by the company, and 74 percent had fewer than five shareholders. See TYEE, supra note 3, at 5-15.
11. For all gifts of property, the donee's tax basis in the transferred property equals the donor's carryover basis plus the amount of any gift taxes paid with respect to the gift, but in no event may the basis exceed the fair market value of the property at the time of the gift. I.R.C. § 1015(a), (d).
12. Id. § 1014(a), (b)(6). For non-community property, the basis step-up is applicable only to property acquired from the decedent. Id. § 1014(a).
13. Id. § 2056.
14. Id. § 101(a)(1).
15. Id. § 303(a), (b)(2)(A). The 35-percent threshold may be satisfied by aggregating stock owned by the decedent's estate in two or more corporations if at least 20 percent of the outstanding stock value of each corporation is included in the decedent's gross estate. Solely for purposes of satisfying the requisite 20 percent ownership for an included corporation, the interest of the decedent's surviving spouse in stock held as community property, joint tenants, tenants by the entirety, and tenants in common may be considered property included in the decedent's gross estate. Id. § 303(b)(2)(B).
16. The family and estate ownership attribution rules of section 318 usually make it impossible for the transaction to qualify as a redemption that is not essentially equivalent to a dividend under 302(b)(1), that is a substantially disproportionate redemption under 302(b)(2), or that is a complete redemption of the estate's stock under section 302(b)(3). Id. §§ 302(a), 302(b), 318(a)(1), (a)(3)(A). As a result, any redemption proceeds not protected by section 303 are taxed as dividends under section 301. Id. §§ 302(d), 301.
17. The interest rate is two percent on the "2 percent portion," a number adjusted annually, and 45 percent of the normal section underpayment rate for any amounts over the "2 percent portion." Id. § 6601(j). For 2008, the "2 percent portion" is $1,280,000. Rev. Proc., 2007-66, 2007-45 I.R.B. 970. The favorable rate comes with a cost; the interest under section 6601 is not deductible for estate or income tax purposes. I.R.C. §§ 163(k), 2053(c)(1)(D). In Estate of Roski v. Commissioner, 128 T.C. 113 (2007), the Tax Court held that the Internal Revenue Service ("I.R.S.") had abused its discretion by requiring that all estates who elect the installment option of section 6166 provide a bond or security in the form of an extended tax lien. Roski, 128 T.C. at 115. In Notice 2007-90, 2007-46 I.R.B. 1003, the Service announced that it had changed its policy and the requirement for security would be determined on a case-by-case basis.
18. Treas. Regs. §§ 20.2031-1(b), 25.2512-1 (2006).
19. In 1959, the Service issued Revenue Ruling 59-60, 1959-1 C.B. 237, which set forth guidelines to be used in valuing the stock of a closely held corporation. The ruling did not use a mathematical formula. It discussed factors that should be considered in arriving at a fair market value. It recognized that the size of the block of stock was a relevant valuation factor in a closely held corporation, specifically noting that a minority interest would be more difficult to sell. Years later in Revenue Ruling 68-609, 1968-2 C.B. 327, the Service stated that the valuation principles of 59-60 also would apply to partnership interests.
20. See, e.g., Estate of Kaufman v. Comm'r, 77 T.C.M. (CCH) 1779, 1784 (1999) (declining to accept petitioner's valuation of stock and conducting own two-step inquiry into value); Rabenhorst v. Comm'r, 71 T.C.M. (CCH) 2271, 2276 (1996) (holding that a party's valuation cannot be accepted on its face without a consideration of its potential shortcomings).
21. I.R.C. § 7491 (providing that in any court proceeding, the burden of proof with respect to any factual issue relevant to ascertaining the liability of the taxpayer shall shift to the Secretary [the IRS] if the taxpayer introduces credible evidence with respect to the issue). In 2007, the Second Circuit refused to hold for the taxpayer even though credible evidence had been submitted to shift the burden of proof under section 7491 and the IRS had failed to submit a competent appraisal. Thompson v. Comm'r, 499 F.3d 129, 133 (2d Cir. 2007), vacating T.C. Memo 2004-174. The Court stated, "[Section 7491] does not require the Tax Court to adopt the taxpayer's valuation, however erroneous, whenever the Court rejects the Commissioner's proposed value; the burden of disproving the taxpayer's valuation can be satisfied by evidence in the record that impeaches, undermines, or indicates error in the taxpayer's valuation." Id. at 133.
22. Buffalo Tool & Die Mfg. Co. v. Comm'r, 74 T.C. 441, 452 (1980), acq. 1982-2 C.B. 1. ("[E]ach of the parties should keep in mind that, in the final analysis, the Court may find the evidence of valuation by one of the parties sufficiently more convincing than that of the other party, so that the final result will produce a significant defeat for one or the other, rather than a middle-of-the-road compromise which we suspect each of the parties expects the Court to reach.").
23. See, e.g., Spruill Estate v. Comm'r, 88 T.C. 1197 (1987), Estate of Gallo v. Comm'r, 50 T.C. 470 (1985), Estate of Daily v. Comm'r, 82 T.C. Memo 710 (2001), Estate of Strangi v Comm'r, 115 T.C 478 (2000), Smith v. Comm'r, 78 T.C. 745 (1999), Estate of Furman v. Comm'r, 75 T.C.M. (CCH) 2206 (1998); Kohler v. Comm'r, T.C. Memo 2006-152.
24. Of course, in some cases the court weighs the competing appraisals and makes its own determination. See, e.g., Estate of Lauder v. Comm'r, 68 T.C.M. (CCH) 985, 1001 (1994) (court's value nearly average of values asserted by respective parties); Estate of Fleming v. Comm'r, 74 T.C.M. (CCH) 1049, 1051-55 (1997) (court valued company at $875,000, with Service arguing for value of $1.1 million and taxpayer asserting value of $604,000); and Estate of Wright v. Comm'r, 73 T.C.M. (CCH) 1863 (1997) (court valued stock at $45 a share, with Service's appraisal at $50 a share and taxpayer's appraisal at $38 a share). In select instances, the Tax Court has rejected the appraisals submitted by both the Service and the taxpayer on the grounds that the appraisals were defective or unreliable. See Rabenhorst, 71 T.C.M. (CCH) at 2276; Estate of Kaufman, 77 T.C.M. (CCH) at 1784. When both appraisals are rejected, the Service prevails because the burden of proof ultimately is on the taxpayer. All the cases confirm the importance of having a quality appraisal from a reputable firm.
25. I.R.C. § 6662(a), (g).
26. Id.. § 6662(h). Section 6664(c)(1) provides that a taxpayer may avoid the penalties by proving reasonable cause and good faith. Reliance on a professional appraisal alone will not do the job. Treas. Reg. § 1.6664-4(b)(1) (2006). The taxpayer must show that the appraiser was a competent professional who had sufficient expertise to justify reliance, that the taxpayer provided the appraiser with all necessary and accurate information, and that the taxpayer relied in good faith on the appraisal. Decleene v. Comm'r, 115 T.C. 457 (2000). See also Thompson v. Comm'r, 499 F.3d 129, 135-36 (2007), vacating T.C. Memo 2004-174 (holding that the penalty is mandatory absent proof from the taxpayer of good faith reliance).
27. The annual gift tax annual exclusion is presently $12,000. I.R.C. § 2503(b)(1). See infra Section IV.A.
28. The gift tax unified credit is presently $345,800, an amount sufficient to shelter $1 million of value (the applicable exclusion amount) from gift taxes. I.R.C. § 2505(a). See infra Section IV.A.
29. See generally Dailey v. Comm'r, 82 T.C.M. 710 (2001); Janda v. Comm'r, 81 T.C.M. 1100 (2001); Barnes v. Comm'r, 76 T.C.M. 881 (1998).
30. See Janda, 81 T.C.M. at 1104 ("Mr. Schneider [IRS's expert appraiser] then listed various studies made on marketability discounts which are cited by Shannon Pratt in his book Valuing a Business: The Analysis and Appraisal of Closely-Held Companies (2d ed. 1989). The studies, which deal with marketability discounts in the context of restricted, unregistered securities subsequently available in public equity markets, demonstrate mean discounts ranging from 23 percent to 45 percent. Mr. Schneider also cited several U.S. Tax Court cases that established marketability discounts ranging from 26 percent to 35 percent. Finally, Mr. Schneider stated in his report that he had consulted a study prepared by Melanie Earles and Edward Miliam which asserted that marketability discounts allowed by the Court over the past 36 years averaged 24 percent.").
31. See, e.g., Dailey, 82 T.C.M. at 711 (holding that the applicable discount rate was 40 percent); Janda, 81 T.C.M. at 1105 (applying a discount rate of 40 percent both for lack of control and marketability to prediscount fair market value); Barnes, 76 T.C.M. at 889 (applying discount rates of 40 percent and 45 percent).
32. Rev. Rul. 93-12, 1993-1 CB 202; Mooneyham v. Comm'r, 61 T.C.M. 2445, 2447 (1991); Ward v. Comm'r, 87 T.C. 78, 107-08 (1986).
33. See Estate of Bright v. United States, 658 F.2d 999, 1005 (5th Cir. 1981).
34. I.R.S. Tech. Adv. Mem. 94-49-001 (March 11, 1984).
35. Courts have consistently held that, where a donor makes gifts of multiple shares of the same security to different donees at the same time, each gift is to be valued separately. See Estate of Bosca v Comm'r, 76 T.C.M. (CCH) 62 (1998); Mooneyham v. Comm'r, 61 T.C.M. (CCH) 2445 (1991); Ward v. Comm'r, 87 T.C. 78 (1986); Carr v. Comm'r, 49 T.C.M. (CCH) 507 (1985);
36. see also Rev. Rul. 93-12, 1993-1 CB 202,
37. revoking Rev. Rul. 81-253, 1981 C.B. 187.
38. See I.R.S. Tech. Adv. Mem. 200212006 (March 22, 2002) ("It is well established that where the steps of a donative transaction have no independent significance, the courts will collapse the individual steps in determining the substance of the transaction."); see also Heyen v. United States, 945 F.2d 359, 363 (10th Cir. 1991); Griffin v. United States, 42 F. Supp.2d 700 (W.D. Tex. 1998); Estate of Bies v. Comm'r, T.C. Memo. 2000-338; Senda v. Comm'r, 433 F.3d 1044 (8th Cir. 2006).
39. See Rev. Rul. 59-60, 1959-1 C.B. 237, § 4.02(e);
40. Treas. Reg. 20.2031-2(f) (2006);
41. Rev. Rul. 89-3, 1989-1 C.B. 278; Estate of Salisbury v. Commissioner, 34 T.C.M. 1441 (1975).
42. Lewis G. Hutchens Non-Marital Trust v. Comm'r, 66 T.C.M. (CCH) 1993-600, 1599, 1612-14, 1620 (1993).
43. Arthur Anderson/Mass Mutual, American Family Business Survey, 2002.
44. For a discussion of the relative tax advantages and disadvantages of each entity form, see DRAKE, supra note 8, at 33-51. Although the "choice of entity" analysis is heavily tax-driven, there are many important non-tax factors that can impact the ultimate decision. Some factors, deemed vitally important in the past, no longer impact the final outcome, and there are new issues that now must be factored into the mix. In most situations, the analytical process requires the family to predict and handicap the future and to consider and project earnings, losses, capital expansion needs, debt levels, the possibility of adding new owners, potential exit strategies, the likelihood of a sale, the estate planning needs of the owners, and a variety of other factors. The complexity of the challenge often is enhanced by the need to use multiple entities to accomplish specific family objectives, to protect assets from liability exposure, to limit or control value growth, to scatter wealth among family members, to segregate asset-based yields from operational-based risks and yields, to shift or defer income, to enhance tax benefits from recognized losses, to facilitate exit strategy planning, to satisfy liquidity needs, or to promote a structured discipline that helps ensure that all financial bases are covered. It complicates the process, but the benefits usually far outweigh any burdens of the added complexity.
45. In defining S status eligibility, trusts have received serious Congressional attention over the years. There has been a constant expansion of the trust eligibility rules. Trusts that are now eligible to qualify as S corporation shareholders include: (1) voting trusts; (2) grantor trusts; (3) testamentary trusts that receive S corporation stock via a will (but only for a two-year period of following the transfer); (4) testamentary trusts that receive S corporation stock via a former grantor trust (but only for a two-year period following the transfer; (5) a "qualified subchapter S trust" (QSST), which generally is a trust with only one current income beneficiary who is a U.S. resident or citizen to whom is distributed all income annually and who that elects to be treated as the owner of the S corporation stock for tax purposes; and (6) an "electing small business trust" (ESBT), which is a trust whose beneficiaries are qualifying S corporation shareholders who acquired their interests in the trust by gift or inheritance, not purchase. I.R.C. § 1361(c)(2), (d) (2006). An ESBT must elect to be treated as an S corporation shareholder, in which case each current beneficiary of the trust is counted as one shareholder for purposes of the maximum 100 shareholder limitation and the S corporation income is taxed to the trust at the highest individual marginal rates under the provision of section 641. Id. § 1361(c)(2), (e)(1)(A).
46. Section 1402(a) of the Code specifically provides that a partner's distributive share of income from a partnership constitutes earnings from self-employment. There is a limited statutory exception for retired partners and a broader exception for limited partners. Id. § 1402(a)(10), (a)(13). Limited partners generally can escape self-employment taxes on partnership income that is not a guaranteed payment as remuneration for services rendered. Id. § 1402(a)(13). Thus, the key in a partnership structure is to fit within this limited partnership exception. As for a limited liability company taxed as a partnership that has no limited partners and no basis for relying on historical state law distinctions between limited and general partners, the Service's first attempt to provide some guidance on the issue came in 1994 when it published its first Proposed Regulations. They provided that a member of a limited liability company could fit within the limited partner exception if the member lacked authority to make management decisions necessary to conduct the business and the LLC could have been formed as a limited partnership in the same jurisdiction. After public comment, new Proposed Regulations were issued in 1997 that defined the scope of the limited partnership exception for all entities taxed as a partnership, without regard to state law characterizations. Prop. Treas. Reg. § 1.1402(a)-2, 62 Fed. Reg. 1702 (Jan. 13, 1997). Under the 1997 Proposed Regulations, an individual would be treated as a limited partner for purposes of the self-employment tax unless the individual was personally liable for the debts of the entity by being a partner, had authority to contract on behalf of the entity under applicable law, or worked in the business for more than 500 hours during the taxable year. Id. at 1704. The 1997 Proposed Regulations also drew criticism because LLC members who had authority to contract on behalf of the entity could never fit within the limited partner exception. The result was a statutory moratorium in 1997 on the issuance of any temporary or proposed regulations dealing with the limited partnership exception. Taxpayer Relief Act of 1997 § 935, Pub. L. No. 105-34, 111 Stat. 883 (need year). The legislative history confirms that Congress, not the IRS, ultimately must resolve the issue. The IRS has provided no additional guidance. For planning purposes, this history provides some guidance. Any general partner under state law is exposed to the tax. Any limited partner under applicable state law is probably safe. As for LLC members, any member who can fit within the 1997 Proposed Regulations' definition is justified in relying on the statutory limited partner exception. Beyond that definition, it becomes more difficult and uncertain in evaluating the facts and circumstances of each situation. The risk escalates in direct proportion to the individual's authority to act on behalf of the entity and the scope of any services rendered.
47. I.R.C. § 2036. For a discussion of each of these issues in the context of transition planning, see infra Section V.B.
48. Id. §§ 331, 336. If, for example, the corporation is subject to a 34 percent marginal tax rate and the shareholder pays a 15 percent capital gains rate, the combined tax burden on any distributed appreciation in the liquidation will be 43.9 percent [34 + (15 x (1-34))].
49. Id. § 1363(d). The LIFO recapture amount is the excess of what the inventory value would be under the first-in-first-out (FIFO) method over the LIFO valuation method used by the corporation. Id. § 1363(d)(3). The size of the recapture amount is a function of the historical increases in inventory costs and how fast the inventory turns.
50. Id. § 1368(c)(2). The taxable dividend exposure is limited by the amount of the corporation's earnings and profits from its C corporation existence and ends once the earnings and profits have been distributed. An S corporation, with the consent of all shareholders, may elect to accelerate such dividends by treating all distributions as earnings and profits distributions. Id. § 1368(e)(3). Such an acceleration may facilitate the use of the favorable 15 percent tax rate on dividends before its scheduled expiration in 2010.
51. See generally id. § 1374. The tax is imposed at the highest corporate tax rate (presently 35 percent) on the lesser of (1) the gain recognized on the sale or (2) the asset's built-in gain at the time of the S conversion. This corporate level tax is in addition to the tax that the shareholder bears as a result of the S corporation's gain being passed through and taxed to the shareholder. The only relief to this forced double tax is that the tax paid by the corporation is treated as a loss to the shareholders in the same year.
52. See generally id. §§ 1375, 1362(d)(3). For purposes of these provisions, the term "passive investment income" includes interest, dividends, royalties, and rents. Id. § 1362(d)(3)(C). If the 25 percent threshold is met, the highest corporate tax rate (presently 35 percent) applies to the excess of the net passive income over 25 percent of the total receipts. The actual calculation of the tax is complicated by factoring in any expenses directly connected to the passive income. Plus, an S corporation can lose its S status - a disaster - if it allows the condition to exist for three consecutive years. If the S election is lost, relief may be possible by timely showing that the circumstances resulting in the termination were inadvertent. Id. § 1362(f).
53. In a 2002 survey of successful family business owners (average annual sales of $36.5 million), nearly one-half (47.7%) of the responding owners listed life insurance as their primary source of funds to pay death taxes and listed life insurance trusts as the most frequently used estate planning technique. Arthur Anderson/Mass Mutual, American Family Business Survey, 2002.
54. A cross-purchase buy-sell agreement is an agreement among the shareholders of a corporation in which the shareholders contractually agree to purchase the stock of a co-shareholder under defined conditions and on specific terms that are set forth in the agreement.
55. See, e.g., Johnson v. Comm'r, 74 T.C. 1316, 1322-24(1980); Ashby v. Comm'r, 50 T.C. 409, 417 (1968); Hood v. Comm'r, 115 T.C. 172, 179-81 (2000); Rev. Rul. 69-608, 1969-2 C.B. 42.
56. See Treas. Reg. § 1.1361-1(1)(2)(i)(vi) ex. 6 (CCH 2007). If there is a binding agreement to use corporate funds to pay the premiums, the risk of a second class of stock finding is very high and the S status may be in jeopardy. See id. § 1.1361-1(1)(2)(vi) ex. 6. See also Minton v. Comm'r, 2007 T.C.M. (RIA) 2011, 2016 (2007) ("[T]he corporation ceases to qualify as an S corporation . . . upon the creation of a second class of stock.").
57. Jeff's only income tax cost on the sale would be the capital gains hit on the gain recognized on the 10 percent stock interest that he has historically owned.
58. The calculation assumes that the present 45 percent marginal federal estate rate is in effect. [$9 million x (1-.45) = $4.95 million].
59. Treas. Reg. § 20.2042-1 (c)(6).
60. Id.
61. See I.R.S. Priv. Ltr. Rul. 97-46-004 (Aug. 8, 1997) (ruling that the majority voting stock requirement was not met when the decedent and his spouse each owned a 36 percent community property interest in the corporation's stock).
62. Treas. Reg. § 20.2042-1(c)(2), (6).
63. The tax-free receipt of the life insurance proceeds by the S corporation does not increase the accumulated adjustment account of the S corporation. See I.R.C. §§ 101(a)(1), 1368(e)(1)(A) (West 2007); Treas. Reg. § 1.368-2. Any distributions by the S corporation in excess of its accumulated adjustment account (a likely result if life insurance proceeds are distributed) will trigger a taxable dividend to the shareholders to the extent the S corporation has any undistributed earnings and profits from its C corporation existence. See I.R.C. § 1368(c)(2).
64. The corporate alternative minimum tax is structured to ensure that a C corporation that claims various tax benefits under the "regular tax" will pay a minimum tax amount. The corporate AMT is 20 percent of the amount by which the corporation's alternative minimum taxable income exceeds the $40,000 exemption amount, reduced by the corporation's alternative minimum foreign tax credit for the year. See I.R.C. §§ 55(a), (b)(1)(B), (b)(2), (c), (d)(2), 56.
65. See id. § 55(g). Not all C corporations are subject to an alternative minimum tax. There are blanket exceptions for a C corporation's first year of operation, any C corporation with average annual gross receipts of less than $5 million during its first three years, and any C corporation with average annual gross receipts of less than $7.5 million during any three-year period thereafter. Id. § 55(e). The Pension Protection Act of 2006 added section 101(j), which subjects a portion of the proceeds paid on certain employer-owned life insurance polices to income taxation. If section 101(j) is applicable to a policy, the excess of the death benefit received over the total premiums and other amounts paid for the policy will be taxable income. The section applies to an "employer-owned life insurance contract," which is generally defined to include any policy owned by and for the benefit of a business that insures the life of a person who was an employee of the business at the time the policy was issued. There are substantial exceptions that, as a practical matter, will render the provision irrelevant in most business and executive planning situations. The exceptions preserve tax-free treatment if the insured was an employee during the 12-month period before the insured's death, if the insured was a director or highly compensated employee of the business, if the proceeds were payable to the insured's estate, members of the insured's family or a trust established for their benefit, or if the proceeds were used to acquire an equity interest in the business from the insured's estate or members of the insured's family. Id. §§ 101(j)(2), 414(q), 105(h)(5). The one potential trap is that an exception will apply only if the notice and consent requirements of the new provision are met before the policy is issued. These requirements mandate that, before the policy is issued, the company must provide a written notice to the insured of the company's intention to own; be the beneficiary of the policy; the insured must consent in writing to being the insured on a policy that may continue after the insured's termination of employment. Id. §§ 101(j)(2), 101(j)(4).
66. Id. § 2703. See related discussion in infra Section III.E. 1.
67. A leading case in dealing with the valuation issue in the context of key person insurance is Estate of Huntsman.v. Commissioner, 66 T.C. 861 (1976), acq., 1977-2 C.B. 1. In Huntsman, the IRS claimed that all the proceeds of the insurance policies received by the corporation on the death of the decedent would have to be added in determining the value of the stock in the decedent's estate. Id. at 869-70. In rejecting the IRS approach, the Tax Court held that the insurance proceeds should be given " consideration" in the valuation process. Id. at 874. Essentially, the court determined that, to the extent the valuation of the business was based upon the net assets of the business, the insurance proceeds should be included in the asset value calculation. Id. at 874-75. However, the court reasoned that, to the extent the stock valuation was based on a price/earnings multiple, the insurance proceeds may strengthen the cash position of the company, which in turn may impact the determination, but it would not be a dollar-for-dollar impact. Id. at 878. The most interesting aspect of the Huntsman case is the final result that surfaced after all the calculations were completed. In that case, the earnings multiple basis of valuation was weighted three times heavier than the net asset basis of valuation. Id. In addition, the court discounted the value of the decedent's stock to reflect the loss of the decedent's value to the corporation. Id. at 879. The bottom line was that, for the first corporation in the case, the ultimate value was increased approximately twenty-four cents for each dollar of insurance received. See id. For the second corporation in the case, the ultimate valuation was increased approximately thirty-three cents for each dollar of insurance received. See id.
68. Amounts received under a life insurance contract generally are not taxable as income under section 101(a)(1). An exception to this broad income exclusion, known as the transfer-for-value rule, is triggered whenever a life insurance contract is transferred for valuable consideration. When such a transfer occurs, the portion of the proceeds excluded from the income tax may not exceed the sum of such valuable consideration and any premiums paid by the transferee. I.R.C. § 101(a)(2).
69. Id. § 101(a)(2).
70. Life insurance proceeds will not be included in the insured's taxable estate if the insured owned no incidents of ownership in the policy at death and owned no such incidents during the three-year period preceding death. Id. §§ 2035(a)(2), 2042.
71. The challenge in many plans is to build provisions into the trust that will enable the gifts that are made to fund the premium burden to qualify for the annual gift tax exclusion. In almost all situations, this is done by including special Crummey withdrawal rights in the trust that convert a trust beneficiary's future interest in the gifts to a present interest, which in turn qualify the gifts for the annual gift tax exclusion. This Crummey withdrawal right, named after the case that made it famous, Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), is a special provision in the trust that gives each beneficiary, for a limited period of time, the right to withdraw a portion of any gift made to the trust. The existence of this right, even if it is not exercised and is allowed to "lapse," will convert a future trust interest to a present trust interest so that the contribution will qualify for the annual gift tax exclusion under section 2503(b)(1). See Crummey, 397 F.2d at 86, 88.
72. See, e.g., St. Louis Bank v. United States, 674 F.2d 1207 (8th Cir. 1982); Estate of Lauder v. Comm'r, 64 T.C.M. (CCH) 1643 (1992); Carpenter v. Comm'r, 64 T.C.M. (CCH) 1274 (1992); Seltzer v. Comm'r, 50 T.C.M. (CCH) 1250 (1985).
73. I.R.C. § 2703(b).
74. Three criteria established under applicable law before the adoption of section 2703 must be satisfied: (1) the price must be specified or readily ascertainable pursuant to terms of the agreement and the value must have been reasonable when entered into; (2) the decedent's estate must be obligated to sell at death at the specified price; and (3) the decedent must have been restricted from selling or transferring the interest during life. See Treas. Reg. § 20.2031-2(h) (2007). This third condition is not satisfied if the decedent had a right to transfer the interest by gift during life to a person who was not subject to the same restrictions. Id. As a minimum, this provision generally requires that the interest be subject to a right of first refusal at the fixed or determinable price under the agreement during the decedent's life. Id.
75. Id. § 25.2703-1(b)(4)(i); see also Estate of Amlie v. Comm'r, 2006 T.C.M. (RIA) 539, 539 (2006) (holding that evidence of price in other arm's-length transactions may be used to sustain the burden of proof).
76. Treas. Reg. § 25.2703-1(b)(4)(i). It is not necessary that the provisions parallel the terms of any particular agreement. Id. § 25.2703-1(b)(4)(ii).
77. Id. § 25.2703-1(b)(4)(ii).
78. Id.
79. Id. § 25.2703-1(b)(3). Family members include the transferor's spouse, any ancestor of the transferor or the transferor's spouse, any spouse of any such ancestor, and any lineal descendant of the parents of the transferor or the transferor's spouse (but not spouses of such descendants). Id. §§ 25.2701-2(b)(5), 25.2703-1(b)(3). Broad entity attribution rules are used to determine ownership, with an interest being deemed a family interest if it is attributed to both a family and non-family member. Id. §§ 25.2701-6(a)(2)-(4), 25.2703-1(b)(3).
80. Id. § 25.2703-1(b)(3).
81. For a summary of the three criteria established under applicable law before the adoption of section 2703, see supra note 68; see also Treas. Reg. § 20.2031-2(h).
82. I.R.C. § 1361(b)(1)(D) (2006).
83. Id. § 2701(a)(3)(A).
84. Id. § 2701(a)(3), (c)(3).
85. See id. § 318.
86. Id. § 2036(b)(2).
87. See, e.g., I.R.S. Tech. Adv. Mem. 1999 (June 7, 1999) (transferor general partner of partnership);
88. Rev. Rul. 80-346, 1980-2 C.B. 271 (oral agreement with transferor).
89. Use of nonvoting stock does not trigger the trap. See Rev. Rul. 81-15, 1981-1 C.B. 458;
90. Prop. Treas. Reg. § 20.2036-2(a), 49 Fed. Reg. 35143 (Aug. 3, 1983).
91. Although both a direct bequest to the surviving spouse and a bequest to a QTIP trust may qualify for the marital deduction and eliminate any estate tax liability on the death of the first spouse, the QTIP offers advantages that often make it the preferred option. With a QTIP, the first spouse to die can specify and limit the surviving spouse's access to the principal (not income) of the trust, can designate how the trust remainder will be distributed on the death of the surviving spouse, can help protect the trust estate against creditor claims of the trust beneficiaries, and can help preserve valuable discounts.
92. See I.R.C. § 2056(b)(7).
93. See Estate of DiSanto v. Comm'r, 78 T.C.M. (CCH) 1220, 1226-27 (1999); I.R.S. Priv. Ltr. Rul. 90-50-004 (Aug. 31, 1990);
94. I.R.S. Priv. Ltr. Rul. 91-47-065 (July 12, 1991).
95. See I.R.S. Tech. Adv. Mem. 91-16-003 (Dec. 27, 1990).
96. See I.R.C. § 2036(a); I.R.S. Tech. Adv. Mem. 91-16-003 (Dec. 27, 1990).
97. Such a disclaimer is effective for transfer tax purposes if (1) it is in writing and delivered within 9 months of the date the property interest is created, (2) the disclaiming party has not accepted the property interest or any related benefits, and (3) the property interest passes without any direction by the disclaiming party. I.R.C. § 2518.
98. See Estate of DiSanto v. Comm'r, 78 T.C.M. (CCH) 1220, 1226-27 (1999).
99. See Estate of Chenoweth v. Comm'r, 88 T.C. 1577, 1588-90 (1987).
100. See supra Section III.E.1.
101. See I.R.C. § 2056(b)(7)(B)(ii)(II); Estate of Rinaldi v. United States., 97-2 U.S.T.C. 60,281 (Fed. Cl. 1997); I.R.S. Tech. Adv. Mem. 91-47-065 (Aug. 30, 1991).
102. See Estate of Bright v. United States., 658 F.2d 999, 1002-03 (5th Cir. 1981); see also Rev. Rul. 93-12, 1993-1 C.B. 202; Mooneyham v. Comm'r, 61 T.C.M. (CCH) 2445, 2447 (1991); Ward v. Comm'r, 87 T.C. 78, 107-09 (1986).
103. Estate of Bonner v. United States., 84 F.3d 196, 197-98 (5th Cir. 1996); Estate of Mellinger v. Comm'r, 112 T.C. 26, 32-37 (1999), action on dec., 1999-006 (Aug. 30, 1999).
104. See I.R.C. § 2056(b)(7)(B)(ii)(I).
105. See Treas. Reg. § 20.2056(b)-5(f)(4) (as amended in 2003).
106. See I.R.S. Priv. Ltr. Rul. 91-47-065.(July 12, 1991).
107. Under section 83(a), recognition of taxable income is deferred so long as the stock is subject to a substantial risk of forfeiture unless the recipient makes an election under section 83(b) to accelerate the recognition of income. See I.R.C. § 83(a), (b).
108. See id. § 83(h). Note, however, that if the service provided is capital in nature, the corporation will have to capitalize the expenditure. See Treas. Reg. § 1.83-6(a)(4) (as amended in 2003).
109. This common outcome is a result of the comparative marginal tax rates applicable to C corporations and individuals. A C corporation will be subject to a marginal rate of at least 34 percent once its annual income exceeds $75,000. I.R.C. § 11(b)(1)(C) (2006). For an individual joint-income filer in 2008, the taxable income thresholds for the 28 percent rate, the 33 percent rate, and the maximum 35 percent rate are $131,450, $200,300, and $337,700, respectively.
110. The "gross up" is accomplished by the corporation agreeing to use the cash benefit from its deduction to pay the child a cash bonus to cover his or her tax hit on the stock and the cash bonus. With marginal corporate rates in the 34 to 35 percent range after the low-end brackets (brackets for the first $75,000 of earnings) and top individual marginal rates in the 33 percent to 35 percent range, such a gross-up cash bonus often can be made with no after-tax cash cost to the corporation. The formula for calculating the gross-up bonus is as follows: [Stock Value / (1 - Executive Marginal Tax Rate)] - Stock Value = Gross-Up Bonus Assuming the child is in a 33 percent marginal tax bracket, the formula would produce a gross-up bonus of $49,254 on a transfer of stock valued at $100,000 [[100,000 / (1 - .33)] - 100,000]. If the corporation is subject to a 34 percent marginal rate, the cash tax savings to the corporation would be $50,746 (34 percent of $149,254), which more than covers the cash bonus to child. As an alternative to such a gross-up bonus, the corporation could use its tax cash savings to loan the child the funds needed to cover his or her tax hit in the year of recognition, with the understanding that the loan amount plus accrued interest would be repaid at some point in the future. Obviously, the child would much prefer the bonus structure.
111. See I.R.C. § 1015(a).
112. See Treas. Reg. § 1.83-4(b) (1978); I.R.C. § 1012.
113. For a discussion of the planning opportunities and traps of such arrangements, see supra DRAKE, supra note 8, at ch. 12.
114. See I.R.C. § 83(a).
115. See id. § 162(a).
116. See id. § 409A.
117. See Treas. Reg. §§ 1.409A-2(a), (b), 1.409A-3 (2007); I.R.C. § 409A(b)(1), (2).
118. See, e.g., Rakow v. Comm'r, 77 T.C.M. (CCH) 2066, 2073 (1999); Estate of Dailey v. Comm'r, 82 T.C.M. (CCH) 710, 712 (2001); Janda v. Comm'r, 81 T.C.M. (CCH) 1100, 1101, 1104-05 (2001).
119. See I.R.C. § 2503(b).
120. See id. §§ 2001, 2503(b).
121. This assumes that the annual gift tax exclusion continues to escalate in $1,000 increments as it has done in the past and that the value of the business grows at a rate of 6 percent per annum.
122. The grandchild must be the sole beneficiary of the trust during life, and the trust assets must be included in grandchild's estate if the grandchild dies before the trust terminates. See I.R.C. § 2642(c)(2).
123. See id. §§ 2505, 2631.
124. Because the tentative estate tax calculated under I.R.C. § 2001(b) and (c) is based on the amount of the decedent's taxable estate and the amount of adjusted taxable gifts made by the decedent, any appreciation accruing on gifted property subsequent to the date of transfer is excluded from the calculation.
125. Any gift taxes paid within three years of death are taxed in the decedent's estate. See id. § 2035(b).
126. Treas. Reg. §§ 1.162-7, 1.162-8 (2006).
127. The 2008 payroll tax burden is 15.3 percent of the first $102,000 of compensation and 2.9 percent of the compensation paid in excess of $102,000. SSA Pub. No. 05-10003, Jan. 2008, ICN 451385.
128. See supra Section III.C
129. I.R.C. § 1014(a).
130. Id. § 1015(a).
131. Id. § 1014(a), (b)(6).
132. Treas. Reg. § 25.2702-3(d) (2006).
133. Id. § 25.2702-3(b)(1)(i).
134. Id. § 25.2702-3(b)(5).
135. I.R.C. § 7520.
136. Section 2036(a) is triggered because the parent will possess a retained income interest at death. Although technically section 2039 would also be triggered on death because the annuity payments likely will continue after the death of the parent, the Service recently issued Proposed Regulation § 20.2036-1(c) that mandates the application of section 2036(a), not section 2039, in such a situation. Prop. Treas. Reg. § 20.2036-1(c), 72 Fed. Reg. 31487 (July 9, 2007), available at http://www.irs.gov/irb/2007-28_IRB/ar13. html.
137. There are other differences that could favor a direct gift when the yield risk is a problem. A direct gift may qualify for the gift tax annual exclusion under section 2503(b); a future interest transfer to a trust has no hope of qualifying. Plus, any appreciation on property subject to a direct gift will be excluded from the donor's taxable estate; any trust property may be taxed in the donor's estate under section 2036(a) at its full date of death value. I.R.C. § 2036(a).
138. Arguments are sometimes advanced for the proposition that, in extreme situations, a GRAT may pay in the end even if it does not beat the yield risk. Examples include a situation where a large block of marketable stock subject to a blockage discount is transferred to a GRAT and then sold off in pieces or where large losses in a transferred portfolio are recognized before larger gains. See, e.g., Jonathan G. Blattmachr & Diana S.C. Zeydel, Comparing GRATs and Installment Sales, 41ST ANNUAL HECKERLING INSTITUTE ON ESTATE PLANNING, 2-1, 2-9 (Tina Portuondo ed., 2007). Such theories, although potentially applicable to marble shifters, are of no help with a transition plan for a closely held family corporation.
139. 115 T.C. 589 (2000). In Walton, the Tax Court struck down old Example 5 in regulation 25.2702-3(e) by holding that an annuity payable for a term of years to a grantor or the grantor's estate is a qualified annuity for a specified term of years and can be valued as such, regardless of whether the grantor survives the term. Id. at 603. The case opened the door to zero-out GRAT's because the fixed term can be used to value the Annuity Component. The result was a new Example 5 and 6, which are commonly referred to as the "Walton" Regulations. Treas. Reg. § 25.2702-3(e), exs. (5) & (6).
140. The minimum term of a GRAT is a concern of some, based on an earlier position of the IRS that it would not rule on any GRAT that had a term of less than five years. The GRAT in the famous Walton case, supra note 130, was two years; the Service did not challenge the 366 day term of a GRAT in Kerr v. United States, 113 T.C. 449 (1999), aff'd, 292 F.3d 490 (5th Cir. 2002), and the Service ruled favorably on a two-year GRAT in PLR 9239015.1.R.S. Priv. Ltr. Rul. 9239015 (Sept. 25, 1992).
141. Rev. Proc. 2008-3, 2008-1 I.R.B. IRB 28-1, § 4(51).
142. See also I.R.S. Tech. Adv. Mem 2003-72, 2003-44IRB 964.
143. I.R.C. § 1361(c)(2).
144. Id. § 677(a).
145. Computation: $10,000,000 x .24 x. 60 = $1,440,000.
146. Computation: $1,440,000 - [$120,000 x 4.282 (Table B five year factor)] = $926,160. This assumes the annuity is paid annually and the Table K value is 1.
147. Computation: $1,440,000 - [$120,000 x 7.5739 (Table B ten year factor)] = $531,132. This assumes the annuity is paid annually and the Table K value is 1.
148. Computation: $1,440,000 / 4.282 (Table B five year factor) = $336,291. This assumes the annuity is paid annually and the Table K value is 1.
149. Computation: $336,291 / .24 = $1,401,212.
150. The recapitalization can be accomplished as a tax-free reorganization. I.R.C. § 368(a)(1)(E) (2006). If common stock is exchanged for common and preferred stock, the shareholders will not recognize any gain under section 354, and the corporation will be entitled to nonrecognition treatment. Id. § 354. Each shareholder's basis in his or her old common shares will carryover and be allocated to the new common and preferred shares based on their respective fair market values. Id. § 358(a), (b); Treas. Reg. § 1.358-2(a)(2) (2007). The preferred stock received in the recapitalization will be considered "Section 306 stock" if the effect of the transaction was substantially the same as the receipt of a stock dividend. I.R.C. § 306(c)(1)(B). The regulations mandate a cash substitution test for the dividend "effect" determination - if cash had been received instead of preferred stock - would it have been treated as a dividend under section 356(a)(2)? See Treas. Reg. § 1.306-3(d) (2007). Thus, if each shareholder receives a proportionate amount or common and preferred stock, a likely scenario in a family corporation recapitalization, the preferred stock will be section 306 stock.
151. I.R.C. § 1361(b)(1)(D).
152. See id. § 2701.
153. Treas. Reg. § 25.2701-1(a)(2). The subtraction method requires application of a four-step procedure. See id. § 25.2701-3(a)-(d).
154. I.R.C. § 2701(a)(3)(A).
155. Family members include the transferor's spouse, lineal descendants of the transferor or the transferor's spouse, and spouses of such descendants. Id. § 2701(e)(1).
156. Id. § 2701(c)(3). A fixed rate includes any rate that bears a fixed relationship to a specified market interest rate. Id. § 2701(c)(3)(B); Treas. Reg. § 25.2701-2(b)(6)(ii). Election options are available to treat, in whole or in part, a qualified payment right as not qualified, in which event it will be valued at zero under section 2701, or to treat a nonqualified payment right as a qualified payment, in which event it will valued at its fair market value under section 2701. I.R.C. § 2701(c)(3)(C)(i),(ii); Treas. Reg. § 25.2701-2(c)(2)(i),(ii). The determination to elect in or out of qualified payment status depends on the certainty of the fixed payments actually being made. If the interests are valued as qualified payments and the fixed payments are not made, additional transfer taxes are imposed on a compounded amount that is calculated by assuming that the unpaid amounts were invested on the payment due date at a yield equal to the discount rate used to value the qualified payments. I.R.C. § 2701(d); Treas. Reg. § 25.2701-4. Because gift or estate taxes on unpaid qualified payments can be painful under this compounding rule, some may choose to forgo the qualified payment status and avoid the tax risks of nonpayment. Similarly, against the risk of this compounding rule kicking in for nonpayment, an election may be made to treat a nonqualified payment right (i.e. noncumulative preferred stock dividend right) as a qualified payment right and value it as such under section 2701 on the assumption that it always will be paid.
157. I.R.C. § 2701(a)(3)(C). See Treas. Reg. § 25.2701-1(e) ex. 1. If the preferred stock that contains the qualified payment also contains a liquidation, put, call, or conversion right, the value of the preferred stock must be the lowest value based on all such rights. I.R.C. § 2701(a)(3)(B); Treas. Reg. § 25.2701-2(a)(3).
158. I.R.C. § 2701(a)(4)(A).
159. Id.
160. For an illustration of this transfer tax savings, see supra Section IV.A.1. 151. I.R.C. § 2702(a),(b); Treas. Reg. §§ 25.2702-1-3, 25.2702-2(d) ex. 1.
161. Treas. Reg. §§ 25.2702-1(b).
162. I.R.C. § 1014.
163. The IRS ruling guidelines indicate that the Service will not issue a favorable ruling on a redemption if the note payment period exceeds 15 years or if the stock is held in escrow or as security for the corporation's obligation to make payments under the note. Rev. Proc. 2008-3, §§ 3.01(31), 4.01(20), 2008-1 I.R.B. 110. If the note term is too long, the risk is that the parents will be deemed to have retained an equity interest that (1) violates the "creditor only" requirement of section 302(c)(2)(A)(i), (2) precludes waiver of the family attribution rules of section 318(a)(1) and a complete termination of the parents' interest within the meaning of section 302(b)(3), and (3) results in the amounts distributed to the parents being taxed as dividends. I.R.C. §§ 302(b)(3), 302(c)(1)-(2), 302(d), 318(a)(1). The Tax Court has been more forgiving. In Lisle v. Commissioner, 35 T.C.M. (CCH) 627, 636-40 (1976), the court found that a valid section 302(b)(3) complete termination had occurred even though the payment term was 20 years, the shareholder retained voting rights through a security agreement, and the stock was held in escrow to secure the corporation's payment obligation. 155. In any such redemption, the applicable state corporate law must be carefully analyzed to ascertain any applicable restrictions and impacts on the parents. Often appraisals are necessary. The Model Business Corporation Act, adopted in whole or part as the corporation statute of 30 states, prohibits a "distribution" (broadly defined to include proceeds from a redemption, MCBA § 1.40(6)) if, "after giving it effect: (1) the corporation would not be able to pay its debts as they become due in the usual course of business; or (2) the corporation's total assets would be less than the sum of its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution." MBCA § 6.40(c). These two tests, referred to as the "equity insolvency test" and the "balance sheet test," have been widely incorporated into state corporate statutes. See, e.g., WASH. REV. CODE ANN. § 23B.06.400 (2008), which adopts both tests and provides that the balance sheet test may be based "either on financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances . . . ."
164. See I.R.C. § 1(h)(11), added by P.L. 108-27 and amended by P.L. 108-311.
165. I.R.C. § 302(b). The family ownership attribution rules of section 318 usually make it impossible for a family transaction to qualify as a redemption that is not essentially equivalent to a dividend under section 302(b)(1) or as a substantially disproportionate redemption under section 302(b)(2). The only hope is to qualify for a waiver of the family attribution rules and, thereby, qualify the redemption as a complete redemption of the parent's interest under section 302(b)(3). Id. §§ 302(a), 302(b), 318(a)(1)-(a)(3)(A).
166. These are the conditions imposed by section 302(c)(2) to secure a waiver of the family attribution rules and qualify the redemption as a complete termination under section 302(b)(3). Id. §§ 302(b)(3), 302(c)(2), 318(a).
167. Id. § 302(c)(2)(A)(i).
168. See, e.g., Lynch v. Comm'r, 801 F.2d 1176 (9th Cir. 1986) (holding taxpayers who provide post-redemption services, either as an employee or independent contractor, as holding prohibited interests in the corporation).
169. See I.R.C. § 691(a).
170. See id. § 1012.
171. See Treas. Reg. §§ 1.162-8, 1.301-1(j) (2007); see, e.g., Exacto Spring Corp. v. Comm'r, 196 F.3d 833, 838 (7th Cir. 1999); Elliotts, Inc. v. Comm'r, 716 F.2d 1241, 1243 (9th Cir. 1983); Charles McCandless Tile Serv. v. United States, 191 Ct. Cl. 108, 112-115 (1970).
172. Even with an S election, a taxable dividend exposure remains to the extent of the corporation's earnings and profits from its C corporation existence. I.R.C. § 1368(c)(2). The exposure ends once the earnings and profits have been distributed. An S corporation, with the consent of all affected shareholders, may elect to accelerate such dividends by treating all distributions as earnings and profits distributions. Id. § 1368(e)(3).
173. See generally id. §§ 531-537; Treas. Reg. § 1.537-2(c)(1) (2007) (loans to shareholder for shareholder's personal benefit may indicate that earnings are being unreasonably accumulated).
174. See Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954); Rev. Rul. 75-447, 1975-2 C.B. 113-114.
175. The private annuity, a cross-purchase strategy that has been popular in the past, is not discussed because recent regulations proposed by the Internal Revenue Service have effectively eliminated the tax deferral benefit of the annuity and, thereby, destroyed the private annuity as a viable transition option. See Prop. Treas. Reg. § 1.1001-1(j) (providing that any person who sells property in exchange for any annuity contract will be deemed to have received "property in an amount equal to the fair market value of the contract, whether or not the contract is the equivalent of cash").
176. I.R.C. §§ 671-679.
177. Id. § 2036.
178. See id. § 675(4)(C); Treas. Reg. § 1.675-1(b)(4) (2007).
179. Estate of Jordahl v. Comm'r, 65 T.C. 92, 100 (1975), acq. 1977-2 C.B. 1; I.R.S. Priv. Ltr. Rul. 9227013 (Mar. 30, 1992).
180. See I.R.C. § 1361(c)(2)(A)(i).
181. See I.R.C. § 675(4)(C); Treas. Reg. § 1.675-1(b)(4).
182. See I.R.S. Priv. Ltr. Rul. 92-27-013 (Mar. 30, 1992); Estate of Jordahl v. Comm'r, 65 T.C. 92 (1975).
183. Rev. Rul. 85-13, 1985-1 C.B. 184.
184. Because the parent will not be receiving any payments at death, there is no risk of estate tax inclusion under section 2036(a).
185. See Rev. Rul. 2004-64, 2004-2 C.B. 7.
186. See I.R.C. § 2036(a).
187. In Sharon Karmazin, Tax Court Docket 2127-03, the Service took the position that both 2701 and 2702 were applicable because the note was not real debt, but the case was settled. See I.R.S. Priv. Ltr. Rul. 9515039 (Jan. 17, 1995) (real debt only if trustee/obligor has other assets);
188. I.R.S. Tech. Adv. Mem. 9251004 (section 2036 applied where closely held stock was only source of note payment and plan was to have trust retain stock for family purposes);
189. I.R.S. Priv. Ltr. Rul. 9639012 (June 14, 1996) (no section 2036 inclusion where note would be paid off in three years from earnings on S corporation stock); Estate of Rosen v. Comm'r, 91 T.C. M. (CCH) 1220, 1237 (2006) (loans from partnership characterized as retained interests that trigger 2036 inclusion); Dallas v. Comm'r, 92 T.C.M. (CCH) 313 (2006) (notes not challenged; trust funded with other asset that exceeded 10 percent of stock purchase price).
190. See Robert S. Keebler & Peter J. Melcher, Structuring IDGT Sales to Avoid Sections 2701, 2702, and2036, Estate Planning, Oct. 2005, at 19.
191. See id. at 24.
192. Because the parent never treated the sale as a taxable event under the rationale of Rev. Rul. 85-13, 1985-1 C.B. 184, the post-death payments do not fit the technical definition of "income in respect of a decent (IRD)" under section 691.
193. I.R.C. §§ 1012, 1014, 1015.
194. See Laura H. Peebles, Death of an IDIT Noteholder, Trusts & Estates, Aug. 2005, at 28, 29;
195. Jonathan G. Blattmachr, Mitchell M. Gans, & Hugh H. Jacobson, Income Tax Effects of Termination of Grantor Trust Status by Reason of Grantor's Death, 97 J. TAX'N 149, 149 (2002).
196. See generally Blattmachr & Zeydel, Comparing GRATs and Installment Sales, Heckerling Institute on Estate Planning, ch. 2 (2007).
197. I.R.C. § 1014(b)(6).
198. See Rev. Rul. 2004-64, 2004-2 C.B. 7.
199. See Estate of Moss v. Comm'r, 74 T.C. 1239, 1247 (1980), acq. 1981-2 C.B. 1; Rev. Rul. 86-72, 1986-1 C.B. 253; Estate of Frane v. Comm'r, 98 T.C. 341 (1992), aff'd in part, rev'd in part sub nom. Frane v. Comm'r, 998 F.2d 567 (8th Cir. 1993).
200. Presumably, the Premium calculation could be based on Table H in the Alpha Volume of the IRS actuarial tables or Table 90CM of such tables.
201. See, e.g., Estate of Musgrove v. United States, 33 Fed. Cl. 657, 658 (1995).
202. Estate of Frane v. Comm'r, 98 T.C. 341 (1992), aff'd in part and rev'd in part, 998 F.2d 567 (8th Cir. 1993).
203. I.R.C §§ 453B(f), 691(a)(5)(A)(iii) (2006); Estate of Frane, 98 T.C. 341.
204. I.R.C. § 1368(c)(1). If the distributions exceed the S corporation's accumulated adjustment account, a taxable dividend exposure remains to the extent of the corporation's earnings and profits from its C corporation existence. Id. § 1368(c)(2). The exposure ends once the earnings and profits have been distributed.
205. Id. § 1014(a)(1).
206. Id. § 1366(e).
207. Id. § 1363(d).
208. Id. § 1368(c)(2).
209. See generally id. § 1374.
210. See generally id. §§ 1375, 1362(d)(3).
211. Estate of Rosen v. Comm'r, 91 T.C.M. (CCH) 1220 (2006); Estate of Rector v. Comm'r, T.C.M. (RIA) 1955 (2007); Estate of Erickson v. Comm'r, T.C.M. (RIA) 757 (2007); Estate of Bigelow v. Comm'r, 503 F.3d 955 (9th Cir. 2007); Strangi v. Comm'r, 417 F.3d 468 (5th Cir. 2005); Estate of Hillgren v. Comm'r, T.C.M. (CCH) 1008 (2004); Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004); Estate of Thompson v. Comm'r, 382 F.3d 367 (3d Cir. 2004); Estate of Bongard v. Comm'r, 124 T.C. 95 (2005).
212. 124 T.C. 95 (2005).
213. For grandchildren under age 21, simple 2503(c) trusts can be used to avoid future interest characterizations that would otherwise compromise the availability of the annual gift tax exclusion. I.R.C. § 2503(c). Plus, care should be taken to ensure that the each grandchild's trust is structured to avoid the generation skipping tax by having an inclusion ratio of zero. Id. § 2642(c)(2). Generally, this will require that the grandchild be the sole beneficiary during his or her life, and that the trust assets be included in the grandchild's estate if the grandchild dies before the trust terminates.
214. Rev. Rul. 59-60 1959-1 C.B. 237.
215. Rev. Rul. 68-609 1968-2 C.B. 327.
216. Treas. Reg. § 1.704-1(e)(1)(iii) (2006).
217. Id. § 1.704-1(e)(2).
218. Id. § 1.704-1(e)(2)(ii)(a).
219. Id. §§ 1.704-1(e)(2)(ii)(d), 1.704-1(e)(2)(ix).
220. Id. § 1.704-1(e)(2)(ix).
221. Id. § 1.704-1(e)(2)(ii)(c).
222. Id. § 1.704-1(e)(2)(vii).
223. I.R.C. § 704(e)(1) (2006); Treas. Reg. § 1.704-1(e)(1)(iv).
224. I.R.C. § 1361(b)(1)(B).
225. The section 704(e) provisions are not exclusive and do not provide a safe harbor against general assignment of income principles that may be applied to reallocate income among family members in extreme situations. Treas. Reg. § 1.704-1(e)(i)(b). See Woodbury v. Comm'r, 49 T.C. 180 (1967).
226. Section 704(e) applies to all gifts, including those made to non-family members. Plus, any partnership interest acquired by purchase from a family member is considered a gift for purposes of the section 704(e) provisions. I.R.C. § 704(e)(2) (2006). Family members include one's spouse, ancestors, and lineal descendents, and any trusts for the primary benefit of such persons.
227. Id. § 704(e)(1).
228. Treas. Reg. § 1.704-1(e)(1)(iv).
229. Id. § 1.704-1(e)(2)(ix).
230. I.R.C. § 704(e)(2).
231. Id. § 704(e)(2).
232. See WILLIAM S. MCKEE, WILLIAM F. NELSON & ROBERT L. WHITMORE, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS § 15.05[1][c] (4th ed. 2007) (discussing the issue and concluding that the section 704(e) limitations should trump any 704(b) allocation).
233. See Treas. Reg. § 1.704-1(b)(1)(iii).
234. See REVISED UNIFORM LIMITED PARTNERSHIP ACT § 7.03 (1976).
235. The creditors' rights are those of a transferee, which are limited to the partner's right to receive distributions from the partnership. See section 7.02 of the Revised Uniform Limited Partnership Act. For a description of the practical impacts of a charging order and how it often yields "little or nothing," see Author's Comments 8 & 9 of Section 504 or the Revised Uniform Partnership Act.
236. Rev. Rul. 1977-1 C.B. 178.
237. I.R.S. Tech. Adv. Mem. 97-36-004 (June 6, 1997);
238. I.R.S. Tech. Adv. Mem. 97-35-003 (May 8, 1997);
239. I.R.S. Tech. Adv. Mem. 97-30-004 (Apr. 3, 1997);
240. I.R.S. Tech. Adv. Mem. 97-25-002 (Mar. 3, 1997).
241. Estate of Dailey v. Comm'r, 2002 T.C.M. (RIA) 1816, 1818 (2002). See also Estate of Thompson v. Comm'r, 246 T.C.M. (CCH) 374 (2002); Knight v. Comm'r, 115 T.C. 506 (2000).
242. See Church v. United States, 85 A.F.T.R.2d 2000-804 (W.D. Texas 2000), aff'd, 268 F.3d 1063 (5th Cir. 2001); Estate of Strangi v. Comm'r, 115 T.C. 478, 448-89 (2000), aff'd, 293 F.3d 279 (5th Cir. 2002).
243. See Church, 85 A.F.T.R.2d 2000-804; Strangi, 115 T.C. at 490-93.
244. I.R.C. § 2704(a) (2006). Under this section, certain lapses in voting and liquidations rights are treated as transfers for gift and estate tax purposes by the persons holding the rights. The holder of the right and his or her family members must control the partnership both before and after the lapse in order for the section to apply. Id. § 2704(a)(1). Any interest that is held directly or indirectly may fall within the scope of section 2704. Treas. Reg. § 25.2704-1(a)(2) (2007).
245. Smith v. Comm'r, 94 A.F.T.R.2d 2004-5627 (W.D. Pa. 2004).
246. I.R.S. Tech. Adv. Mem. 2002-12-006 (Nov. 20, 2001); Shepherd v. Comm'r, 115 T.C. 376, 388-90 (2000), aff'd, 283 F.3d 1258 (11th Cir. 2002).
247. I.R.C. § 2503(b).
248. I.R.S. Priv. Ltr. Rul. 94-15-007 (Jan. 12, 1994);
249. I.R.S. Tech. Adv. Mem. 91-31-006 (Apr. 30, 1991).
250. I.R.S. Tech. Adv. Mem. 97-51-003 (Aug. 28, 1997).
251. 118 T.C. 279 (2002), aff'd, 335 F.3d 664 (7th Cir. 2003).
252. Id. at 293.
253. N. Choate, Leimberg, Estate Planning Newsletter (April 4, 2002). For a brief description of Crummey withdrawal rights, see supra note 65.
254. I.R.C. § 2036(a) (2006).
255. Estate of Rosen v. Comm'r, 91 T.C.M. (CCH) 1220 (2006); Rector Estate v. Comm'r, 2007 T.C.M. (RIA) ¶ 2007 367; Estate of Erickson v. Comm'r, 2007 T.C.M. (RIA) 2007, 107; Estate of Bigelow v. Comm'r, 503 F.3d 955 (9th Cir. 2007); Strangi v. Comm'r, 417 F.3d 468 (5th Cir. 2005); Estate of Hillgren v. Comm'r, 87 T.C.M. (CCH) 1008 (2004); Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004); Estate of Thompson v. Comm'r, 382 F.3d 367 (3d Cir. 2004); Estate of Bongard v. Comm'r, 124 T.C. 95 (2005).
256. See supra note 231.
257. Id.; see also Estate of Harper v. Comm'r, 2000 T.C.M. (RIA) ¶ 2000, 202.
258. Strangi, 417 F.3d 468; Kimbell., 371 F.3d 257.
259. Treas. Reg. § 20.2036-1(a) (2007); United States v. Byrum, 408 U.S. 125 (1972); Estate of Bigelow v. Comm'r, 503 F.3d 955 (9th Cir. 2007); Rosen, 91 T.C.M. (CCH) 1220; Strangi, 417 F.3d 468.
260. Strangi, 417 F.3d 468; Estate of Hillgren, 87 T.C.M. (CCH) 1008; Kimbell, 371 F.3d 257; Thompson, 382 F.3d 367 (3d Cir. 2004); Bongard, 124 T.C. 95; Bigelow, 503 F.3d 955; Rosen, 91 T.C.M. (CCH) 1220.
261. Strangi v. Comm'r, 85 T.C.M. (CCH) 1331 (2003), aff'd on other grounds, 417 F.3d 468 (5th Cir. 2005); Kimbell v. Comm'r, 244 F. Supp. 2d 700 (N.D. Tex. 2003), rev'don other grounds, 371 F.3d 257 (5th Cir. 2004).
262. See generally Mitchell M. Gans & Jonathan G. Blattmachr, Strangi: A Critical Analysis and Planning Suggestions, 100 TAX NOTES 1153 (Sept. 1, 2003);
263. Ronald H. Jensen, The Magic of Disappearing Wealth Revisited: Using Family Limited Partnerships to Reduce Estate and Gift Tax, 1 PITT. TAX REV. 155 (2004).
264. 408 U.S. 125 (1972).
265. I.R.C. § 2701(a)(3)(A), (c)(3) (2006).
266. Treas. Reg. §§ 25.2701-1(a)(2), 25.2701-3 (2007).
267. I.R.C. § 2701(a)(4)(A).
268. I.R.C. § 302(c)(2)(A)(i). See related discussion supra IV.B.
269. Any remaining payments on the note that are paid to the children will be taxed to the children as income in respect of a decedent under I.R.C. § 691(a).
270. I.R.C. §§ 55(e), 56(g).
271. The biblical King Solomon, when faced with two women each claiming to be the mother of a baby, proposed the ultimate solution - divide the baby in half. 1 Kings 3:16-28.
272. I.R.C. § 368(a)(1)(D). If done right, the assets of a C corporation (referred to as the "distributing corporation") can be transferred to multiple C corporations (referred to as "controlled corporations"), and the stock of the controlled corporations can be distributed to the shareholders of the distributing corporation, all tax free. I.R.C. §§ 355(a), 361(a), 1032(a). Six requirements must be satisfied: (1) A control requirement governed by I.R.C. §§ 355(a)(1)(A) and 368(c); (2) A complete distribution requirement governed by I.R.C. § 355(a)(1)(D); (3) A five-year active trade or business requirement governed by I.R.C. § 355(a)(1)(C) and Treas. Reg. § 1.355-3 (2007); (4) A 50 percent continuity of interest requirement governed by Treas. Reg. § 1.355-2(c)(2); (5) A business purpose requirement governed by Treas. Reg. § 1.355-2(b)(2); and (6) A no dividend "device" requirement governed by I.R.C. § 355(a)(1)(B) and Treas. Reg. § 1.355-2(d).
273. I.R.C. § 368(a)(1)(E). See related discussion supra note 140.
274. See generally I.R.C. § 2701. See related discussion supra section IV.A.4.
275. I.R.C. § 1361(b)(1)(D).
276. I.R.C §§ 331, 336.
277. If, for example, the corporation is subject to a 34 percent marginal tax rate and the shareholder pays a 15 percent capital gains rate, the combined tax burden on any distributed appreciation in the liquidation will be 43.9 percent [34 + (15 x (1-34))].
278. Treas. Reg. § 1.1361-1(1)(1).