Page 266 - TaxAdviser_2022

CASE STUDY

If A’s preferred stock interest were time (i.e., the owner’s death or retire- value of F’s retained preferred stock,
entitled to noncumulative dividend ment), some or all of the owner’s voting therefore lowering the amount of the
distributions, the value of A’s retained stock could be transferred to active gift of the common stock to his son.
interest would be zero. Therefore, the children and the nonvoting shares to
value of the gift of common stock to B inactive children. As a result, the active Liquidation participation rights
would be the entire value of the corpora- children receive control of the corpora- The right of a shareholder to par-
tion (estimated to be $1.5 million). tion, and the inactive children receive ticipate in a liquidating distribution
No matter how skillfully a taxpayer nonvoting stock that has equal value. will enhance the value of the retained
manipulates the valuation rules when Then, the active children can continue preferred stock. However, the right to
planning a transfer of common stock to operate the business without any in- compel liquidation is an extraordinary
to a family member while retaining terference from the inactive children. payment right and will add no value
a preferred stock interest, Congress to retained preferred stock (in family
intends for at least a minimum value to Extraordinary payment rights transfer situations).
be assigned to the transferred interest. In family transfer situations, extraordi-
This is accomplished by requiring the nary payment rights are valued at zero Nonlapsing conversion rights
value of all the common stock of the (i.e., will not increase the value of the The permanent right to convert the
corporation (after the transfer) to equal preferred stock). Therefore, rights such preferred stock into a fixed number of
at least 10% of the sum of (1) the value as put options, call options, and rights shares or a fixed percentage of shares
of all stock in the corporation, plus (2) to compel liquidation do not add value of common stock will add value to the
the total corporate indebtedness owed to the retained preferred stock for gift retained preferred stock. This type of
to the transferor or an applicable family tax valuation purposes. However, these permanent conversion right should be
member (Sec. 2701(a)(4)). Indebted- rights should be given proper non- given serious consideration in almost
ness for this purpose does not include tax consideration. all corporate restructurings involv-
short-term indebtedness incurred in ing a transfer of stock from an older
the ordinary course of business (such as Mandatory payment rights individual to a younger person. It al-
amounts payable for current services), Mandatory payment rights add value lows the older-generation shareholder
nor does it include a corporate obliga- to the retained preferred stock only if an opportunity to later change his or
tion to make future lease payments, so payment is to be made at a fixed price her mind and again participate in the
long as they are made when due and and at a fixed time. These rights are growth of the company. For example,
represent full and adequate consid- to be considered for shareholders who if the growth of the company greatly
eration for use of the leased property desire to retain control over the busi- exceeded initial expectations, the older
(Regs. Sec. 25.2701-3(c)(3)). ness through voting preferred stock but generation could recapture a share of
Note: In a recapitalization in who also know when they wish to retire the growth by exercising the conver-
which the owner receives preferred completely from the business. sion rights. However, the planner
stock in exchange for common stock, should also note that the exercise of
the preferred stock may be considered Example 2. Using mandatory these rights would ultimately decrease
Sec. 306 stock. A subsequent sale or payment rights to increase the value the value of the stock that initially was
disposition of this stock may produce of retained stock: F owns all of the transferred to the children (because
ordinary income instead of capital gain. cumulative voting preferred stock they would no longer own all of the
Ordinary income from the disposition and nonvoting common stock of J common stock) and correspondingly
of Sec. 306 stock is a dividend that is Inc. His son, B, has done well in the increase the value of the interest held
taxed at the maximum rate of 20%. business, and F transfers all of the by the older generation.
This treatment can be disadvantageous common stock to B. The corporate
because the shareholder’s basis in the charter is amended so that in three Coupling a recapitalization
stock cannot offset the dividend income. years, F must offer the stock to the with gifts of stock
company, and the company must Although a recapitalization involv-
Recapitalizing with two redeem it for its stated par value of ing voting and nonvoting common
classes of common stock $2 million. stock does not freeze the value of the
Alternatively, the recapitalization could owner’s stock, it can be coupled with
create two classes of common stock: vot- The redemption right is a mandato- an annual gifting program to remove
ing and nonvoting. At the appropriate ry payment right that will increase the future appreciation on the gifted

48 May 2022 The Tax Adviser