Applying the Estate Freeze Special Valuation Rules to S Corporations

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 18th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ((800) 323-8724; www.ppcthomsom.com).

While S corporations are often viewed as being taxed similarly to partnerships, the Code applies C corporation tax concepts to S corporations. Subchapter C provisions (governing corporate formations, reorganizations, redemptions and liquidations, among other areas) specifically apply to S corporations and their shareholders, except to the extent inconsistent with other provisions in subchapter S; see Sec. 1371(a). This means that an S corporation can participate as a corporate entity in a reorganization; see the Committee Reports to the Small Business Job Protection Act of 1996, Section 1310. Thus, S corporations have a substantive advantage over partnerships: S corporations and their shareholders can accomplish stock exchanges, corporate divisions, mergers and the many other forms of transactions known as “tax-free reorganizations,” while partnerships cannot.

Rules on Valuing Retained Interests

In addition to ensuring that a reorganization qualifies for tax-deferred treatment and does not unintentionally terminate an S election, a corporate reorganization may also have to comply with the Sec. 2701 special valuation rules, under which, on the transfer of stock to a “member of the transferor’s family,” most rights retained by the transferor will be valued at zero for estate and gift tax purposes. For this purpose, the word “transfer” can, under certain circumstances, include a recapitalization or other change in the corporation’s capital structure; see Sec. 2701(e)(5) and Regs. Sec. 25.2701-1(b)(2).

Example 1: Sam is the sole shareholder of an S corporation with one class of voting common stock that has a $100,000 fair market value (FMV). The corporation is recapitalized to create a class of voting preferred stock and a class of nonvoting common stock (thus terminating S status). Sam transfers the common stock to his daughter Mattie; for gift tax purposes, he assigns a $65,000 value to the retained preferred stock and a $35,000 value to the transferred common stock.

If Sec. 2701 applies to the retained preferred stock, it is valued at zero. The gift of common stock is valued at $100,000, instead of $35,000.

Exceptions to the Special Valuation Rules

Two exceptions to these special valuation rules can apply to reorganizations or recapitalizations involving S corporations. The first involves the issuance or exchange of only common stock; the second involves no shift in ownership among the family group.

Common Stock

According to Sec. 2701(a)(2), Sec. 2701 does not apply if the retained interest is of the same class as the transferred interest, or if the retained interest is proportionately the same as the transferred interest, except for nonlapsing differences in voting power. Thus, the special valuation rules do not apply to a transfer of common stock when the transferor retains common stock. In addition, the rules do not apply to a transfer of nonvoting common stock if the transferor retains voting common stock (and vice versa).

Because an S corporation can have only one class of stock, if the shareholders intend to retain S status (which means that only voting and nonvoting common stock will be issued and/or exchanged), Sec. 2701 should not be an issue; see, e.g., Letter Rulings 200026011 and 200026012. But if S status is terminated (because preferred stock is involved or the issued and/or exchanged stock’s distribution or liquidation rights differ), this exception will not apply.

Example 2: Helen is the sole shareholder of an S corporation that has one class of voting common stock with a $100,000 FMV. The corporation is recapitalized to create a new class of nonvoting common stock with the same distribution and liquidation rights as the outstanding voting stock. Helen exchanges part of her voting stock for the nonvoting stock and gives the nonvoting stock to her son, Ben.

Sec. 2701 does not apply, because of the “same-class-of-stock” exception. If Helen assigns a value of $60,000 to the retained voting stock, the value of the transferred nonvoting stock for gift tax purposes is $40,000.

Family Ownership Safe Harbor

A safe harbor exists under Sec. 2701(e)(5) for a transfer in which the transferor and certain designated family members own substantially identical interests before and after the transfer.

Observation: The Conference Committee’s Statement of the Managers for the Revenue Reconciliation Act of 1990, p. 156, states that Sec. 2701 “would not apply, for example, to a recapitalization not involving a contribution to capital if all shareholders held substantially identical interests both before and after the recapitalization.”

The scope of this safe harbor exception hinges on the definition of the phrase “substantially identical.” While Regs. Sec. 25.2701-1(b)(3)(i) adds, “common stock with nonlapsing voting rights and nonvoting common stock are interests that are substantially the same,” this is simply a restatement of the exception for common stock discussed previously. Because preferred stock and common stock evidently are not deemed to be substantially the same, it appears that this safe harbor exception does not provide an S shareholder with any benefit not already provided by the “same-class-of-stock” exception.