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Recapitalization: Estate Freeze Techniques

August 18, 2011

Recapitalization: Estate Freeze Techniques


In a classic corporate recapitalization, the owner of a closely held corporation recapitalizes the corporation by creating two classes of stock: common stock and preferred stock. Preferred stock usually contains a stated or par value, includes voting rights, and provides for a dividend preference (i.e., dividends on outstanding shares of preferred stock generally must be paid before any dividends may be paid on outstanding shares of common stock). The dividend can be cumulative or noncumulative. Upon liquidation of the corporation, the holders of the preferred stock must receive its par value and, if the dividends are cumulative, any accumulated and unpaid dividends, before any distribution is made to the common stockholders. This preferential treatment for payment of dividends and for return of capital upon liquidation is the reason why it is called preferred stock.

In a classic recapitalization for estate planning purposes, the older generation business owner retained the preferred stock and gifted the common stock to members of a younger generation. For gift tax purposes, a low value was assigned to the common stock because most of the value of the company was contained in the owner’s preferred stock due to its dividend preference and voting and liquidation rights. However, all future appreciation in the company was assigned to the common stock, thus removing it from the owner’s estate. The owner’s voting and liquidation rights lapsed at his or her death, reducing the value of the preferred stock for estate tax purposes. The owner was thus able to pass the business on to his or her heirs with minimal gift and estate tax consequences.

Congress saw the inequity in the traditional corporate reorganization and enacted Internal Revenue Code Sections 2701 and 2704. Sections 2701 and 2704 deal with the valuation of the owner’s preferred shares at the time of the initial transfer to the younger generation and at the owner’s death. Essentially, the enactment of Sections 2701 and 2704 has made the use of recapitalizations much less attractive as an estate freezing strategy.

Although less attractive than in previous years, a recapitalization can still be advantageous for certain business owners. Estate planning attorneys can structure the recapitalization so that the owner’s preferred stock retains some value which is recognized for purposes of Section 2701, thus reducing the value of the common stock passed to the younger generation. Attorneys may also be able to draft the transaction so that Section 2704 does not apply at all.

  • Section 2701 applies when the owner retains senior equity interest in the company and transfers junior interest to the younger generation who are members of the transferor’s family
  • The owner’s retained interest in the preferred stock (senior equity interest) is valued at zero in most cases where the owner transfers common stock (junior equity interest) to members of his or her family
  • The right of the older generation to receive distributions from the corporation will be valued at zero unless the right is a qualified payment right
  • The owner’s retained interest in the business is valued under IRC Section 2704 for estate tax purposes
  • Reverse freeze may be used to avoid Section 2701

Key Strengths

  • Corporate recapitalization can be structured to allow you to transfer growth of a corporation to the younger generation
  • Recapitalization may allow the owner to retain control of the corporation while transferring future appreciation to the younger generation

Key Tradeoffs

  • Recapitalization may have substantial gift tax consequences upon transfer of the common stock to the younger generation
  • Recapitalization can result in substantial estate tax liability
  • Preferred stock issued in a recapitalization may be classified as Section 306 stock, which may cause adverse income tax consequences
  • Preferred stock issued in recapitalization may qualify for Section 305 treatment, which may result in adverse income tax consequences to holder
  • Generally, a corporation is not eligible for Subchapter S treatment if it has more than one class of stock
  • The ordinary loss deduction on preferred stock is not available after a recapitalization
  • Large, cumulative dividends on preferred stock may drain the corporation of needed cash
  • A recapitalization may be extremely expensive and difficult to implement
  • Recapitalization may cause other income, gift and estate tax problems

Variations from State to State

  • In community property states, consent of nonstockholding spouse may be required before a recapitalization can be effective because it could change his or her rights in community property

How Is It Implemented?

  • Hire competent, experienced legal counsel
  • Separate tax advisor may be needed to provide tax advice
  • Appraiser will be needed to value stock and other assets of company

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by,,,,, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

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