Photo of Saul B. AbramsRobert WorthingtonBy Saul B. Abrams and Robert WorthingtonDecember 29 2016
Tax & Estate Planning

Family Values - the Tax Version

Estate planning clients often seek to transfer ownership of a family business incrementally during their lifetimes. These incremental transfers can motivate younger family members to take a more active interest in the business (or their senior relatives) and facilitate an orderly business succession. On the tax side, incremental transfer of ownership is often achieved through a “freeze”, which generally fixes (“freezes”) the value of the interests held by senior family members and shifts future appreciation in value to “common” shares held by younger family members.

Canadian clients frequently use a tax free recapitalization to accomplish a freeze. Shares in a family business are converted into senior preferred shares and junior growth shares. The preferred shares have a fixed value corresponding to the value of the business at the time of the freeze. All future growth in value accrues to the growth shares. Since all of the current value is retained by the preferred shares, the growth shares have little or nominal value immediately after the recapitalization and can be acquired by family members, or a family trust, without significant tax on the deemed fair market value disposition. A similar approach can be taken with businesses held in a partnership structure.

This strategy does not work for Canadians subject to US gift and estate taxes. US estate tax law applies multiple valuation rules that lower the value of the freeze shares and increase the value of the growth shares. These valuation rules assign value to the junior growth shares even immediately after a “freeze” transaction. A transfer of these shares for other than full consideration is therefore treated as a gift of value.

These valuation rules generally operate by ignoring different rights or restrictions that apply to interests retained by the transferor and interests transferred to the transferee.

The various valuation rules applicable to intra-family transfers are lengthy and complicated. However, a recent development in those rules provides an opportunity to (a) learn a bit about cross border estate planning and (b) take advantage of a current planning opportunity. Suppose that Frank holds a 40% interest in a partnership. The other interests are held by his children Sam (20%), Diane (20%), and Simon (20%). Frank’s partnership interest is the only interest entitled to participate in the management of the partnership. Frank decides to transfer a 30% interest in the partnership to his children (10% each). However, the interests he transfers to his children are also restricted from participating in the management of the partnership. Section 2704 disregards this restriction in determining the transferred value. The restriction is an “applicable restriction” which must be ignored when valuing transferred interests.

The IRS has proposed regulations which (a) expand the restrictions considered to be “applicable restrictions”; (b) add an additional category of “disregarded restrictions” that will also be ignored in determining the value of transferred interests; and (c) divide all entities into either corporations or partnerships, generally depending on their default classification for income tax purposes, regardless of whether they have “checked the box” to be treated as a corporation.

The application of these new rules is complex and highly fact specific. However, a number of general principles emerge from these rules that should inform cross border estate planning.

The first is that the IRS has distinguished between the income tax rules and the estate tax rules regarding the “check the box” election. The proposed regulations clearly provide that even an entity that has elected to be treated as a corporation for income tax purposes may be viewed as a “pass-thru” entity for (at least some) estate tax purposes. This is an important consideration when analyzing how non-US residents should hold US based assets.

The second is that the proposed regulations place great emphasis on “local law”. This increases the likelihood that in analyzing any particular entity and its treatment for estate tax purposes the IRS will look to the governing provincial or other law, even if a general income tax rule may suggest an alternate treatment. 

Third, the proposed regulations also indicate that the IRS is more willing to address specific perceived issues in the estate planning context by promulgating regulations. Fourth, and finally, the IRS has issued entity specific rules that go beyond the classic corporation/partnership distinction.

All of these principles need to be considered in crafting a cross border estate plan. Fortunately, this is great time to give these issues some thought. These proposed regulations are not yet finalized, giving planners additional opportunity to use the current rules for the benefit of their clients.

Invitation for Discussion:

If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Tax & Estate Planninggroup at Nerland Lindsey LLP.


Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

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