Preferred Stock Freeze
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Family Corp
Common Stock Cumulative Preferred
Parent
No hope with S corp - One Class of Stock Requirement Double tax hit on preferred dividend Real Killer - preferred value under 2701 based sole on market value of cumulative yield. All other value in common under 2701 Hence, strategy only works with extreme annual growth rate
Gift Common Stock Children
Law T510 - Estate and Gift Tax-Instructor: Dwight Drake
2701 – The Anti-Freeze Statute.
When 2701 doesn’t apply:
1. Non-family transfers.2. Market quotations readily available to value applicable
retained interests (“ARI”).3. ARI same class as interest transferred.4. ARI is proportional to interests transferred.
When does 2701 apply:
1. Transfer to family member.2. Transferor retains ARIs.3. Conditions 1 to 4 above don’t apply.
Consequence of 2701: All ARIs except “qualified payment”valued at zero and junior security transferred, at minimum, must satisfy 10% rule.
Law T510 - Estate and Gift Tax-Instructor: Dwight Drake
2701 – The Anti-Freeze Statute.
What is “applicable retained interest’?
• “Distribution right” – right to receive distribution on stock where, after transfer, T and family own 50% of stock.
• Liquidation, put, call or conversion right (but not proportionalconversions).
What is “qualified payment”?
• Cumulative dividend or partnership equivalent.• Any payment within legal document that is elected to be
treated as “qualified payment.”
Downside of “qualified payment” – If not paid, 2701(d) kicks in to subject failures to pay, plus interest, to added estate and gifttaxes.
Unrelated Party Common Stock Sale
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
6-21
Family Corp
$ 3 Mill Common$ 2 Mill Non-cum Preferred
Parent
Parent Income Tax = $ 3 mill less common stock basis
Common StockUnrelated Party
$ 3 Mill Cash, Notes
Preferred Stock 2701 Trap
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
6-21
Family Corp
$ 3 Mill Common$ 2 Mill Non-cum Preferred
Parent
Parent Income Tax = $ 3 mill less common stock basis PlusTaxable Gift of $2 million. Plus - Parent still owns preferred
Common StockRelated Party
$ 3 Mill Cash, Notes
Grantor Retained Annuity Trust
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Trust
AnnuityTerm of Years
Parent &Estate
Fixed Annuity Amount
Fixed Annuity Term
Annuity Paid Annually
No Debt, Etc.
No additions or others
Mortality Risk of Deal
Yield Risk of Deal
A “Darling”
Children
PropertyRemainder
GRAT Something For Nothing Example
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Trust
Annuity $ 336,291 yr.Term - 5 Yr
Parent &Estate
7529 Rate 5.4%
Zero Remainder Value
Annuity Funded Heavily From Principal
5 Yr Mortality Risk
Any Remainder Pass Transfer Tax FreeChildren
Property$ 1.44 Mill
Remainder
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
The GRAT & Family Stock
Factors • Will work with S or C stock - just make grantor trust• Best to Use Nonvoting Stock• Negative impacts of corp earnings distributions• Yield risk at odds with other value strategies? • Opportunity cost of gift tax exclusions & credits • Gift tax payments with mortality risks - hard sellZero Out Play• Fund annuity with stock transfers back?• Valuation boomerangs & costs• Impacts on health of business• Big costs and risks v. how much real benefit• Screwy message to inside kids
3 YEAR GRIT
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Trust
All trust incomeTerm - 3 Yr
Parent
Term value zero
Remainder Value 100%
Parent pays gift taxes
Gift taxes in parent estate if death within 3 yr
Parent death within 3 yr term triggers basis step-up
Trade-off is appreciation included in estate
Nullity if parent survives 3 yr term
Children
PropertyRemainder
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Parent
FamilyCorporation
GrantorTrust
Intentional Defective Grantor Trust Installment Sale “IDGT”
Stock
Installment Note
Stock ownership
Other asset Gift
Children
Beneficiaries
Dream Scenario
No gain on sale
No gift tax impacts
Stock outside parent’s
estate
Trust income taxed to
parent
No mortality risk
Asset substitution pre-
death for basis step-up
Works with C and S stock
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
IDGT Issues
What we think we know:• Dual status possible• No gain on sale to grantor trust• No gift tax on income tax payments by parent• No estate inclusion under 2036 if parent outlive note
What we are not sure of:• Gift tax impact going in if interest rate is applicable federal rate• Estate inclusion under 2036 if death before note paid• Debt v. retained equity on note – need for other assets equal to
10%
What we don’t know• Tax treatment on note payments post death – IRD?
• Gain recognition on note on grantor trust status termination
• Basis impacts on death with grantor trust termination
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
IDGT & Family Stock
Key questions:
• Is cross purchase strategy best option?
• Parent’s capacity to gift other assets?
• Has stock basis been stepped-up at first death?
• Impact on business?
• Client’s stomach for tax uncertainty?
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
Parents
Assets
Limited Partnership
Children
Distributions
Family LP Disappearing Act
Assets DistributionsLPUnits
Distributions
S Corp
Gift of Assets
GP Units
Assets
Stock
Bottom Line Goal: Valuation Discounts in Parent’s Estate
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