When thinking about estate and gift planning, clients who own closely-held businesses often want control and flexibility. That is, they want some degree of control over their property and enough flexibility to change the plan. These points are especially important in what may be called, in our current tax environment, “the ever-changing tax law era.” The December 2010 tax law change provides taxpayers who want to gift business interest or gift in general on a tax-free basis an amount up to $5 million ($10 million for married donors).

A technique to enable clients to have flexibility in transferring closely held businesses to the next generation, but still retain control, is to recapitalize (recap) the business. For corporations, including S corporations, this involves issuing nonvoting stock. Or, for a limited liability company, nonvoting membership units are issued.

Basically, a recap will involve amending the articles of incorporation or the membership agreement for an LLC and then issuing nonvoting stock or nonvoting units. Each issued voting share or voting membership unit currently held is exchanged for some number of Class A voting shares or some number of Class B nonvoting shares (or likewise) for an LLC. This recap then allows any shareholder or member of an LLC to transfer a portion of or all of the nonvoting ownership interest to the next generation.

There are different options available to transfer the nonvoting stock or the LLC membership units to the next generation. These include such strategies as the use of trusts or a family limited partnership. The strategy used depends upon the ultimate objective.

The use of trusts can control the next generation’s access to income and principal associated with the value of the transfer of the nonvoting stock or LLC membership units. In addition, decisions regarding the trustees and how the income and principal will be paid also need to be considered. Trusts used for these strategies include qualified subchapter S trusts or an electing small business trust. A transfer to a grantor retained annuity trust or a sale to an intentional defective grantor trust is another planning tool. For S corporations, all of these types of trusts still maintain an S corporation election status if nonvoting stock is involved in the planning.

Another option involving a recap is the issuance of voting preferred stock to the older generation and gifting the common stock to the next generation. The result is that all future growth of the corporation is passed to the holders of the common stock. The preferred stock may require the payment of cash dividends. The Internal Revenue Service has specific revenue rulings regarding its views on this planning technique. S corporations cannot issue preferred stock and therefore this option cannot be used by these organizations.

Valuation is a major consideration. The valuation rules of the various IRS rulings and tax court cases must be considered. If a large transfer of nonvoting stock or units is being considered to take advantage of the December 2010 new tax limits of $5 million or $10 million for married individuals, a formal valuation report would be required. This will help support gift transfers, if challenged by the IRS, and assist in meeting the filing requirements for gift tax return purposes.

A “recap” can provide the control factor and the flexibility that companies desire. It can also provide some certainty and assurance regarding family gifting and tax planning in this era of ever-changing tax laws.

For more information, contact us at Email or 215.441.4600.