Estate Freeze Transfers of a Family Business or Farm
The 1990 Revenue Reconciliation Act, passed by Congress in October 1990, repealed section 2036(c) and added chapter 14 to the Internal Revenue Code. Chapter 14 represents continued efforts to control "abusive" lifetime transfers of common stock or junior partner equity interests in family-owned business and farm corporations and partnerships. The legislation further undermines families' efforts to retain ownership of their businesses despite federal gift and estate tax (unified transfer tax) rates up to 60%. GIFT VS. ESTATE TAX RATES Why do owners of family businesses undertake estate freeze transactions? Such transfers are motivated in part by disparate rates applicable to lifetime transfers (gifts) and transfers at death. As explained below, the rate disparity discourages straightforward gifts. The gift tax on a lifetime transfer of family company stock is payable immediately on the stock's full market value, with no provision for installment payments. The special use value for farm property and other real estate and safe-harbor stock redemptions to fund gift tax payments are not available. Further, no deduction is allowed for interest payable on gift tax deficiencies and no step up in the stock's income tax basis applies, except for a portion of the gift tax the donor pays. In contrast, the estate tax on a closely held business constituting more than 35% of a decedent's adjusted gross estate can be paid in installments over a 14-year period, at 4% interest on the tax applicable to the first $1 million of value. The value of farm or other real estate is computed on the property's earning power or special use value (subject to a $750,000 limit on the reduction from market value). Interest paid on deferred estate taxes is deductible in computing the taxable estate. Money can be withdrawn from the corporation, exempt from taxable dividend treatment, to fund estate tax payments. An alternate value (usually determined six months after death) can be used and is frequently elected when the business value declines after a principal's death. Reasonable-cause extensions of time to pay estate taxes also are available. ESTATE FREEZE TRANSACTIONS A classic estate freeze before the Revenue Act of 1987 typically involved recapitalization of a corporation with the business owner recasting most of his or her investment into preferred stock. The owner (often a parent) gave or sold the common stock to his children. Only a moderate amount of gift or income tax was assessed because of the relatively small value assignable to the common stock. The value of the parent's investment was "frozen" at the par value of the preferred stock retained; any future increase in value, if the corporation prospered, and any earnings on the common stock, were shifted out of the parent's taxable estate. The Internal Revenue Service issued a number of technical advice memorandums from 1984 to 1987 asserting adverse gift and estate tax consequences in such estate freeze transactions. Subsequently, the IRS position was rejected by the Tax Court in two cases decided early in 1987. Congress's Joint Committee on Taxation and the House Ways and Means Committee therefore proposed "revenue enhancement" legislation in June 1987 to prevent marketability and minority discounts in valuing closely held business interests as well as to prevent estate freeze transactions. In the meantime, the IRS reported increasing difficulty in preventing unreasonable valuations asserted for gift and estate tax purposes. INCOMPLETE TRANSFER RULES A House-Senate conference committee adopted an incomplete transfer rule shortly before passage of the 1987 Revenue Act by adding IRC section 2036(c). Under these rules, any transfer after December 17, 1987, of common stock expected to appreciate more rapidly than the preferred stock retained by the transferor was taxes in the transferor's estate, if the transferor still held the preferred stock or other retained interest at the time of his or her death. …