Small Business Tax Solutions

Article excerpt

This series is based on questions from AICPA certificate of educational achievement (CEA) courses.

Q: Internal Revenue Code section 2701 can adversely affect the classic estate freeze scenario involving recapitalization of a C corporation with Smith Sr. retaining preferred stock and giving common stock to Smith Jr. Does section 2701 have the same impact on estate freezes involving limited liability companies?

A: No. Because LLCs are taxed as partnerships, they have unique features that prevent section 2701 from having a negative effect.

OVERVIEW OF SECTION 2701

In broad terms, section 2701's purpose is to provide rules for determining the value of a transferred interest in a corporation or partnership. Valuation of the common interest transferred to Smith Jr. is accomplished by subtracting the value of Smith Sr.'s retained preferred interest from the total business value. For the latter's interest to be valued on the basis of its "preferred dividend" rate, the dividend must be cumulative.

Impact on C corporations. From a theoretical and policy perspective, section 2701 is a substantial improvement over the old antifreeze device of IRC section 2036(a). Section 2701 attacks a gift tax valuation issue with a gift tax valuation solution, instead of with an estate tax solution.

From a practical perspective, however, section 2701 essentially prohibits a corporate freeze for three reasons:

1. The corporation may not have sufficient cash to pay the required dividend.

2. Payment of the required dividend is subject to double taxation.

3. There are no safe harbor capitalization rates to assure a satisfactory valuation.

AVOIDING THE IMPACT OF SECTION 2701 WITH LLCs

With an LLC, several factors help prevent the negative effect of section 2701.

Tax-free recapitalization. As with a corporate recapitalization, the transfer of an LLC interest in exchange for a preferred class of membership interest with a fixed return to be retained by Smith Sr., along with a common class of membership interest to be transferred to Smith Jr., can be accomplished as a tax-free exchange under IRC section 721.

Low valuation of transferred interest. The transfer of the common class of membership interest to Smith Jr. is a gift subject to the section 2701 valuation rules. Through careful selection of the preferred dividend rate, the transferred interest can receive a low valuation, providing Smith Sr. …