MPI - Business Valuation Reports

Articles:
Intrafamily Tax Planning Under Chapter 14
Beneficial Prevailing Rates
The Subtraction Method of Valuation
Section 2710 Checklist

Intrafamily Tax Planning Under Chapter 14

The Omnibus Budget Reconciliation Act of 1990 provides an opportunity for the creation of preferred interests in family controlled corporations and partnerships that are considerably more flexible than those allowed under the October 1987 rules. The new rules of the Internal Revenue Code Chapter 14 (which were amplified by the final regulations issued in 1992) are attractive to both those families interested in additional planning involving existing estate freezes and those that want to create new preferred interests. Management Planning has extensive experience in Chapter 14 valuations and can help you to assess the applicability of Chapter 14 to your client’s particular situation.

Beneficial Prevailing Rates

In order for a senior equity interest to have significant value under the rules of section 2701, it is necessary for the interest to have a distribution right which entitles the holder to receive qualified payments. In the case of a preferred stock, this means cumulative, fixed-rate dividends payable at least annually. The value of a qualified payment right will depend on the relationship between the stated dividend amount and the prevailing level of market yields on similar securities of comparable investment quality.

At the present time (January 1993), market yields on publicly traded preferred stocks are at their lowest levels in many years. This is extremely helpful when structuring new senior equities for estate freezing purposes. At all investment quality levels, paying a full market yield on the preferred interest will mean a substantially lower financial cost to the business than was the case only a few years ago. Investment grade yields are now in the upper single digit range while the yields on many speculative grade preferreds are in a low double digit range.

Since partnership distributions are not subject to income tax at the partnership level, a partnership may be more attractive than a corporation as a freeze vehicle. The avoidance of double taxation further enhances the ability of the enterprise to meet qualified payment obligations.

To maximize the benefit from current low market yields, we recommend that estate freezing capital structures avoid excessive amounts of senior equity interests. While section 2701 permits these interests to constitute as much as 90% of the total equity value, such high proportions will generally cause the senior equity to be of such poor quality that high yields are still required. In most situations, better results will be achieved if the senior equity interests do not exceed about 50% of the total equity total.

The Subtraction Method of Valuation

At the heart of section 2701 is the Subtraction Method for determining the value of the interests to be transferred. Let’s consider the application of this method using the example of a company now worth $10,000,000 which was capitalized with 10,000 shares of voting Common stock and 50,000 shares of non-cumulative voting Preferred stock. Assume that all of the Common is owned by the transferor (son of the company founder) and that 49,000 of the Preferred shares are owned by the founder. The remaining 1,000 Preferred shares are owned by the transferor’s son (the founder’s grandchild).

This example is typical of those situations where the transferor desires to make current gifts of Common stock in a company which was capitalized under pre-1987 rules for estate freezing equity structures.

Sec 2701 Procedure	Company Valuation	Explanation
Step 1: Determine the fair market value of all family-held equity interests in the entity as if the interests were held by one individual	$10,000,000.00	Step 1: Fair market value of all Company Preferred and Common stock held by "family" of transferor (son of founder) after the gift, assuming all shares held by one individual.
Step 2: Reduce the amount from step 1 above by the fair market value of all family-held senior equity interests not held by the transferor and applicable family members and by the fair market value of all family-held junior equity interests not held by the transferor, members of his family and applicable family members.	$100,000.00 00.00 256,000.00 $9,644,000.00	Step 2: Subtract from Step 1 value: a. Fair market value (per appraisal) of all Company Preferred stock held by "family" other than founder and son (=1,000 shares of Preferred held by grandson founder) b. Fair market value of all Company Common stock held by "family" other than founder, son and grandson c. Value of all Company Preferred stock held by founder and son determined by appraisal under Section 2701 and IRS regulations (=value of voting control rights of 49,000 shares Preferred)
Step 3: Allocate the value remaining among the transferred interests and family-held subordinate equity interests.	$964.40	Step 3: Allocate Step 2 value among transferred Common stock and other "family" Common stock (assuming transfer of one share)
Step 4: Adjust the amount allocated to the transferred interests for minority or similar discounts, retained interest and consideration received.	500.00 200.00 300.00 $664.40	Step 4: Determine gift tax value of transferred Common stock (assuming transfer of one share) a. Fair market value (per appraisal) of Company Common stock held by "family," assuming all voting rights by one Common stockholder ($10,000,000 - $5,000,000 divided by 10,000 shares) b. Fair market value (per appraisal) of Company Common stock on a minority interest basis after discount for lack of marketability (.6667($8,000,000 - $5,000,000)/ 10,000 shares) c. Excess of (a) over (b) d. Gift tax value of Company Common stock transferred (Step 3 value minus Step 4(c) amount).

Note: The application of the section 2701 valuation rules increased the gift tax value of a Common share from $200.00 to $664.40.

The transferred asset must be an asset in a corporation or an interest in a partnership (see IRC §2701(a)(1)) ("Corporate Asset Test).

The transferred asset must be an asset for which market quotations are not readily available on an established securities market (see IRC §2701(a)(1)) ("Transferee Non-marketable Asset Test").

The asset must be transferred or deemed to be transferred (see IRC §§2701(a)(1), 2701(e)(3)(A), and 2701(e)(1)) ("Transfer Test").

The asset must be transferred to or for the benefit of a member of the transferor’s family (see IRC §§2701(a)(1), 2701(e)(1)) ("Family Member Transferee Test").

After the transfer of the interest in the corporation of partnership, the transferor or an applicable family member must retain an interest in the corporation or partnership (see IRC §§2701(1)(1)) ("Retention Test").

After the transfer of the stock of partnership interest, the transferor and/or applicable family members are in control of the corporation or partnership (see IRC §§2701(a)(1), 2701(b)(1)(A), 2701(b)(2), and 2701(e)(3)) ("Control Test").

The transferor’s retained asset in the corporation or partnership, in which the transferor has made a transfer of an interest, must be an asset in which market quotations are not readily available as of the date of the transfer (see IRC §2701(a)(2)(A)) ("Transferor Non-marketable Asset Test").

At least part of the transferor’s retained interest in the corporation or partnership must be an interest which is not the same class as the transferred interest (see IRC §2701(a)(2)(B)) ("Same Class Test").

At least part of the transferor’s retained interest in the corporation or partnership must be an interest which is not proportionately the same as the transferred interest without regard to non-lapsing differences in voting power (see IRC §2701(a)(2)(C)) ("Proportional Test").

There exists at least some rights in the transferor’s retained interest in the corporation which are either distribution rights or liquidation, put, call, or conversion rights (see IRC §2701(b)(1)(A), (B)) ("Potential Valuation Abuse Rights Test").

If a retained distribution right exists, at least part of the transferor’s retained distribution rights must constitute a right to distributions from corporate stock or a partnership interest (see IRC §2701(c)(1)(A)) ("Equity Distribution Rights Test").

If a retained distribution right exists, at least part of the transferor’s retained distribution rights must constitute a right to distributions from a senior equity interest (i.e. the transferor must have retained preferred stock or, in the case of a partnership, a partnership interest under which the rights as to income and capital are senior to the rights of all other classes of equity interest) (see IRC §§2701(c)(1)(B)(i) and 2701(a)(4)(B)) ("Preferred Distribution Rights Test").

If a retained distribution right exists, at least part of the transferor’s retained distribution rights must constitute distribution rights which are not guaranteed payments under IRC §707(c) of a fixed amount (see IRC §2701(c)(1)(B)(iii)) ("Guaranteed Partnership Distribution Rights Test").

If retained liquidation, put, call, or conversion rights exist, the exercise or non-exercise of at least some of the transferor’s retained liquidation, put, call, or conversion rights must affect the value of the transferred interest (see IRC §2701(c)(2)(A)) ("Valuation Manipulative Liquidation Right Test").

If retained liquidation, put, call, or conversion rights exist, at least part of the transferor’s retained liquidation, put, call, or conversion rights in his retained asset must not be exercised at a specific time and at a specific amount (see IRC §2701(c)(2)(B)(i)) ("Fixed Liquidation Right Test").

If a retained conversion right exists, at least part of the transferor’s retained conversion rights are not rights to convert into a fixed number (or fixed percentage) of shares of the same class of stock as the transferred stock (there exist similar rules for partnerships (see IRC §2701(c)(2)(C)) ("Fixed Convertibility Right Test").

Management Planning has practical expertise with Chapter 14 and is available to assist you in evaluating your clients’ particular situations, in structuring freeze transactions for those clients who would benefit from them and in valuing transferred interests under the rules of Chapter 14.

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