Transferring Ownership of Stock in an S Corporation

 by Steven B. Gorin¹

Advising clients who own stock in S corporations is both rewarding and challenging. Because S corporations' income generally is taxable to its shareholders rather than the corporations themselves, transfers of S stock to family members often can be done while incurring little or no gift or estate tax. On the other hand, tax laws limit the classes and ownership of stock in S corporations, which can complicate matters. This article discusses transferring stock to the next generation, providing equity-type incentives to key employees, tax issues in buy-sell agreements, and tax planning when trusts are or will become shareholders.

I. Transferring S Stock To The Next Generation Without Losing Control

Many business owners wish to transfer equity in their business to the next generation while continuing to run the business until the next generation is ready to take over. This involves two steps: (1) changing the stock structure to have voting and non-voting stock, and (2) transferring the non-voting stock to the next generation.

II. Voting and Non-Voting Stock

Although S corporations cannot have more than one class of stock,² differences in voting rights do not by themselves create a second class of stock.³ Generally, if all outstanding shares of stock confer identical rights to distribution and liquidation proceeds, a corporation is treated as having only one class of stock.⁴ Thus, the corporation should issue voting and non-voting stock, each of which confers identical rights to distribution and liquidation proceeds. This capital structure also avoids gift and estate tax problems under the anti-freeze valuation rules of Chapter14.⁵

Typically, the S corporation starts with one type of voting stock. Then it issues a stock dividend of non-voting stock. The stock dividend does not constitute a taxable distribution.⁶ My tendency is to distribute 19 shares of non-voting stock for each share of voting stock. This allows the voting stock to retain a significant portion, yet allows the original owner to shift 95% of the distribution and liquidation rights when transferring the non-voting stock to the next generation. Retention of voting stock while transferring non-voting stock does not create estate tax inclusion issues.⁷

III. Transferring Non-voting Stock

For smaller companies, consider gifts either outright or in trust. A simple way to protect the principal from the donee's creditors (including the IRS through estate taxes) would be to use a qualified subchapter S trust (QSST).⁸ A QSST has only one beneficiary, and all of its income must be distributed to that individual. A QSST's income is taxed to its beneficiary,⁹ which means that the trust's fiduciary income tax returns simply report the trust's income on a statement, which the beneficiary then uses to prepare his or her own individual income tax returns. Later, this article will more fully discuss the merits of QSSTs compared to other alternatives.

For a company whose value is so high that its stock cannot be transferred merely by annual exclusion gifting, we often transfer Sstock to irrevocable grantor trusts - trusts with assets that are, or will be later, excluded from the grantor's estate, but whose income is currently taxable to the grantor. The two types of transfers most commonly used are:

Gift to Grantor Retained Annuity Trust (GRAT).¹⁰ The grantor gives property (non-voting stock) to the trust and receives an annuity for a fixed term of years in exchange for the gift. Usually, the annuity is expressed as a specific percentage of the initial value of the trust's assets.¹¹ This initial value is the value determined for federal tax purposes,¹² and adjustments to payments are required if the initial value is incorrectly determined.¹³ The amount of the gift is the excess of the gifted property's value over the present value of the retained annuity, determined using 26 U.S.C. §7520 interest rates.¹⁴ If the IRS increases the initial value, the annuity also increases, allowing the grantor to report a gift that is either zero or close to zero. GRATs have become more popular since a 2000 court decision on valuing retained annuities.¹⁵

Sale to Irrevocable Grantor Trust. The grantor establishes an irrevocable trust that is excluded from the grantor's estate for estate tax purposes but treated as owned by the grantor for income tax purposes. The grantor makes a gift equal to at least one-ninth of the value of the property the grantor is going to sell.¹⁶ The grantor sells property (non-voting stock) to the trust and receives a promissory note.¹⁷

The gift to a GRAT is safer than a sale to an irrevocable grantor trust, in that the grantor can ensure that the gift is close to zero, even if the IRS tries to adjust the property's value.¹⁸ It also does not require an up-front gift, which can be a problem when the grantor tries to move more than $18 million in stock.¹⁹

A sale to an irrevocable grantor trust has several advantages over GRATs, if one is willing to take gift tax audit risks. Payments back to the grantor are lower and more flexible than in a GRAT.²⁰ Also, if the grantor dies during the term, the assets in the trust should not be brought back into the grantor's estate.²¹ The grantor can apply GST exemption up front on a highly-leveraged basis (in other words, using a small amount of GST exemption relative to the property transferred to the trust), whereas to make a GRAT exempt the grantor would apply GST exemption at the end of its term, based on the trust's asset's values at that time.²²

In both cases, the grantor is taxed on all of the trust's income, and payments back to the grantor have no income tax consequences.²³ A GRAT can be disastrous to the grantor if the company is very successful and the grantor has to pay income tax in excess of the grantor's payments, so GRATs typically allow the grantor to be reimbursed for income taxes on part or all of the GRAT's income. This generally is not necessary for an irrevocable grantor trust, which is usually drafted so that the grantor trust taxation can be turned off. The trust agreement may authorize an independent trustee to reimburse the grantor's income tax so long as the decision to reimburse is made in the trustee's absolute discretion and cannot be legally compelled by the grantor.²⁴

S corporation stock can work very well for a GRAT or sale to an irrevocable grantor trust over a 5-10 year period. Frequently, Scorporation stock is valued at 4-5 times earnings, so it is easy to pay for the sale. For example, suppose an S corporation generates $200,000 of net cash flow per year and distributes $90,000 each year to the shareholders so that they can pay their taxes. The corporation is worth $1 million (five times earnings). In the first year, the promissory note payments from the trust to the grantor are $90,000, which the grantor uses to pay taxes as usual. The $90,000 payments are $60,000 interest (using a 6% AFR) and $30,000 principal. If the corporation distributes all of its earnings to take care of estate tax matters, then it distributes $200,000 in the first year, which the trust could use to pay $60,000 interest and $140,000 principal. In the second year, the trust could use the $200,000 distribution to pay $51,600 interest and $148,400 principal. The note could easily be paid off in 5-10 years, even if the corporation's earnings do not increase.

IV. Providing Equity-Type Incentives Without Violating The Second Class Of Stock Rules

As discussed earlier, S corporations cannot have more than one class of stock.²⁵ The single class of stock rules focus on rights to distribution and liquidation proceeds.²⁶ However, many techniques allow employees to be compensated in a manner similar to a shareholder without being considered to be a shareholder. Alternatively, employees could hold actual stock whose liquidation rights materially differ from the other stock but is not deemed a second class of stock because of special exceptions that apply only to shareholders who are employees.

Certainly, an employer can give an employee a bonus based on the company's profitability. How far can an employer go in providing compensation that functions as stock ownership without actually being stock?

• An employment agreement "is not a binding agreement relating to distribution and liquidation proceeds" (and therefore is not a second class of stock) "unless a principal purpose of the agreement is to circumvent the [single] class of stock" rules.²⁷ Even if the IRS finds that one shareholder's compensation is excessive, that finding will not violate the single class of stock rules unless a principal purpose of the agreement is to circumvent those rules.²⁸

• If a call option issued to an employee does not constitute excessive compensation, the option "is not treated as a second class of stock" if it "is nontransferable" and "does not have a readily ascertainable fair market value" when issued.²⁹ However, if the strike price is substantially below the stock's fair market value when the option becomes transferable, it may be treated as a second class of stock if the option is materially modified or transferred to an ineligible shareholder.³⁰ The safest course of action would be to (1)make the option always be non-transferable without a readily ascertainable fair market value as described above, or (2)start with an option that is transferable only to eligible shareholders and has a strike price that, at inception, is at least 90% of the stock's fair market value.³¹

Under certain circumstances, an employer may issue stock to an employee and repurchase it at a bargain price without violating the single class of stock rules:

Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation's shares of stock confer identical rights. In addition, if stock that is substantially nonvested (within the meaning of section 1.83-3(b)) is treated as outstanding under these regulations, the forfeiture provisions that cause the stock to be substantially nonvested are disregarded. ³²

The company can redeem an employee's stock "for an amount significantly below [its] fair market value on the termination of . . . employment or if [the company's] sales fall below certain levels," when the employee did not receive the stock in connection with his performing services and a principal purpose of the agreement is not to circumvent the single class of stock rules.³³ Could a sale price that is nominal be considered not to be bona fide or be considered to make the stock forfeitable, throwing it into the rules that apply to forfeitable stock? The author has not researched whether this is a legitimate issue, but would feel comfortable with a redemption price at book value.³⁴ Such a price would prevent the terminated employee from benefiting from valuation methods based on earnings or unrealized appreciation in the company's tangible or intangible assets.

V. Tax Issues In S Corp Buy-Sell Agreements

Shareholder agreements should consider a few important issues. First, each S corporation should have an agreement restricting ownership so that an ineligible shareholder does not acquire its stock and to make sure that the stock does not get into the hands of a person who is (or later becomes) someone with whom the other shareholders simply do not want to do business (or who doesn't want to do business with the other shareholders). Second, the buy-sell mechanism should be easy to enforce and maximize tax benefits. Finally, the agreement should facilitate fixing inadvertent terminations.

A. Avoiding Ineligible Shareholders

An S corporation cannot have:³⁵

(a) more than 100 shareholders,

(b) "as a shareholder a person (other than an estate," certain trusts, a 26 U.S.C. §401(a) qualified retirement plan, or a 26 U.S.C. §501(c)(3) charity) "who is not an individual," or

(c) "a nonresident alien as a shareholder."

We will discuss how to draft provisions and then focus on trusts as shareholders.

The American Jobs Creation Act of 2004 increased the shareholder limitation from 75 to 100. Also, 26 U.S.C. § 1361(c)(1)(A)(ii) authorizes an election to be made treating up to six generations as one shareholder for purposes of this rule. The election does not affect how these shareholders separately report their income.

To avoid transfers to ineligible shareholders, a shareholder agreement could simply provide that stock may not be transferred to any person if that transfer would cause the corporation not to be a "small business corporation" as defined in 26 U.S.C. §1361(b)(1). Such a provision would automatically update the buy-sell agreement for any changes in the tax laws, as Congress and the IRS have been passing laws and promulgating regulations at a fierce pace, a trend that has accelerated starting in 1996.

In drafting such a clause, "transfer" should be defined broadly. A transfer could be voluntary or involuntary, such as due to divorce, death or bankruptcy. If a grantor trust is no longer a grantor trust, whether by reason of the grantor's death or otherwise, a transfer may occur for tax purposes but not for state law purposes, and the definition of "transfer" should be geared toward governing transfers for tax purposes.

The following trusts may be shareholders:

(1) "A trust all of which is treated [under the grantor trust rules] as owned by an individual who is a citizen or resident of the United States."³⁶ The owner could be a grantor or beneficiary and is treated as the owner for purposes of the 100-shareholder limitation.³⁷ As we will discuss in more detail later, a beneficiary may be treated as the owner either by the way the trust is designed or if the beneficiary makes a QSST election³⁸ to have the grantor trust rules apply.

(2) "A trust [that was a grantor trust] immediately before the death of the deemed owner and which continues in existence after such death."³⁹ Generally, such a trust is an eligible shareholder only for the two-year period beginning on the day of the deemed owner's death. However, if the trust is subject to an election under 26 U.S.C. §645, then the trust is taxed as an estate and can hold the stock during the entire period during which the trust is taxable as an estate. In either case, the grantor's estate is treated as the owner for purposes of the 100-shareholder limitation.⁴⁰

Note that, if the grantor's gross estate (for federal estate tax purposes) might be subject to estate tax, it is common for the trustee to hold the Sstock for more than two years after the grantor's death. This is done to avoid the trustee incurring personal liability under the tax laws, because a final determination of estate tax might not be made until after the two-year period has expired. Therefore, the trustee should consider making a 26 U.S.C. §645 election by filing IRS Form 8855. The form is due by the time of the first income tax return filed for the grantor's estate (or grantor's revocable trust, if there is no probate estate).

(3) "A trust with respect to stock transferred to it pursuant to the terms of a will, but only for the 2-year period beginning on the day on which such stock is transferred to it."⁴¹ In such a case, the testator's estate is treated as an owner for purposes of the 100-shareholder limitation.⁴² Because a revocable trust that has made a 26 U.S.C. §645 election is treated as an estate, any transfer from that estate by reason of termination of the election or by bequest under that revocable trust is treated as transferred pursuant to the terms of a will.⁴³

(4) "A trust created primarily to exercise the voting power of stock transferred to it." ⁴⁴ In such a case, each beneficiary of the voting trust is treated as the owner for purposes of the 100-shareholder limitation.⁴⁵

(5) "An Electing Small Business Trust."⁴⁶ In such a case, each potential current beneficiary of the trust is treated as the owner for purposes of the 100-shareholder limitation.⁴⁷ In the next section of this article, we will discuss trust drafting techniques and a comparison between this type of trust and a QSST.

Again, the shareholder agreement does not need to specify these trusts, as the reference to causing the corporation not to be a "small business corporation" as defined in 26 U.S.C. §1361(b)(1) should be sufficient to limit which kinds of trusts may be owners without going into all the detail described above. However, when preparing shareholders' estate plans, make sure the beneficiaries of the estate plans qualify.

Retirement plans are trusts, so let's discuss those for a moment. First, IRAs are qualified under 26 U.S.C. §408, not §401(a). Therefore, IRAs are not eligible shareholders, as they are not trusts that qualify under these rules. Second, qualified retirement plans are taxed on "unrelated business taxable income,"⁴⁸ including income from Scorporations.⁴⁹ However, employee stock ownership plans (ESOPs) are not subject to this tax.⁵⁰

B. Tax Planning for Purchases

The two types of purchases are redemptions and purchases by other shareholders (cross-purchases). An advantage of a redemption is that only one purchaser is involved. An advantage of a cross-purchase is that the purchasing shareholders' stock bases are increased by the purchase price. Below are some additional considerations for each technique.

Generally, buy-sell agreements should list redemptions first, even if a cross-purchase is expected. If the shareholders decide not to do a cross-purchase when the buy-sell provision is actually triggered, and a cross-purchase is listed first, the IRS could assert that the redemption relieved the would-be buyers of their obligations and therefore made a distribution to the would-be buyers, followed by the cross-purchase. While the IRS' position might not necessarily be harmful, it is a good idea to avoid tax uncertainty, all other things being equal. We generally draft our agreements providing for an optional redemption first, followed by an optional or mandatory cross-purchase, and then a mandatory redemption if the cross-purchase is optional.

Whether a redemption of Scorporation stock under state law is treated as a redemption under tax law is governed by the same rules that apply to C corporations, generally 26 U.S.C. §§302-303. 26 U.S.C. §302 has many exceptions, tricks and traps that are beyond the scope of this article. These provisions should be considered in planning for any redemption, whether it involves Sstock or Cstock.

If a redemption under state law does not qualify as a redemption that is an exchange under tax law, two issues arise. First, it could be considered a disproportionate dividend that makes the redeemed stock an impermissible second class of stock. Second, the distribution is deemed to come from the following sources:

1. "Accumulated Adjustments Account" (AAA). A distribution comes first out of the corporation's AAA,⁵¹ unless the corporation elects for it to come out of any earnings and profits it may have accumulated as a prior Ccorporation.⁵² A distribution from AAA simply reduces the shareholder's adjusted basis in his stock to the extent possible,⁵³ with any excess treated as a sale or exchange of property.⁵⁴

2. Earnings and profits (E&P). If the corporation had been a Ccorporation and had accumulated E&P, any part of the distribution not from AAA is a dividend.⁵⁵

3. Return of basis. Any distribution not treated as from E&P simply reduces the shareholder's adjusted basis in his stock to the extent possible,⁵⁶ with any excess treated as a sale or exchange of property.⁵⁷

If a state law redemption is taxed as a redemption, that is an exchange:

a. It may reduce E&P.⁵⁸ Reducing E&P is good not only to reduce the possibility of dividend treatment on future distributions (see above) but also may help avoid termination of Sstatus if the corporation has excessive passive income.⁵⁹

b. It would allow the shareholder to use basis that may reduce taxation on the proceeds. The tax effects of a redemption can cut either way. If the corporation has E&P, a redemption for tax purposes avoids taxation as a dividend and instead provides for capital gain treatment, which may be a much lower rate, depending on the year. On the other hand, suppose the taxpayer holds 100 shares in a corporation that has been an Scorporation from its inception. Her shares have a value of $10 per share and a basis of $4 per share. The corporation redeems 40 shares. If the redemption is treated as a redemption for tax purposes, her gain is $240 (40shares multiplied by the $6excess of the $10per share value over the $4basis per share). If the redemption is treated as a distribution for tax purposes, she reports no gain or loss, because the distribution of $400 (40 shares multiplied by $10 per share) does not exceed her tax basis of $400 (100 total shares multiplied by $4 per share).

c.The remaining shareholders do not receive basis on account of the money the corporation pays. However, see below regarding redemptions funded by life insurance.

Redemptions funded by life insurance can be much more beneficial for Scorporations than for Ccorporations. Life insurance proceeds may be subject to alternative minimum tax ("AMT") if received by a Ccorporation, but not if received by an Scorporation. Such proceeds are a permanent difference between the corporation's earnings for financial accounting purposes and its taxable income. For Ccorporations only, such permanent differences generate an AMT preference.⁶⁰ For S corporations, life insurance proceeds simply increase each shareholder's stock basis.⁶¹

Timing receiving life insurance proceeds is critical. Generally, the deceased insured shareholder does not need a basis increase from the collection of life insurance proceeds, because his stock basis already increased due to his death.⁶² Thus, the redemption should be made with a promissory note before the corporation collects the insurance proceeds. The promissory note would provide that principal is accelerated if and to the extent that the corporation collects insurance proceeds on the deceased shareholder's life. That way, when the proceeds are collected, only the remaining shareholders will receive the increased basis; however, in Letter Ruling 200409010, the IRS took the position that this strategy does not work for corporation on the accrual method. If the proceeds are collected in the same year as the redemption, an election will need to be made to cut off the taxable year as of the date of the shareholder's death or the date of redemption;⁶³ otherwise, the deceased shareholder⁶⁴ and his beneficiaries will be apportioned a share of the basis increase based on how long during the taxable year they owned the redeemed stock.⁶⁵

C. Fixing Inadvertent Terminations

An Selection can terminate if the corporation has an ineligible shareholder⁶⁶ or fails the passive investment income test described above. The IRS can waive inadvertent terminations.⁶⁷

One fundamental requirement is universal to requests to fix inadvertent terminations. The corporation, and each person who was a shareholder in the corporation at any time during the period for which inadvertent termination relief is granted, must agree to make such adjustments as the IRS may require for that period.⁶⁸ Therefore, the buy-sell agreement should include an agreement by each shareholder that irrevocably⁶⁹ appoints the corporation as her attorney-in-fact to make such consents as the IRS may require under 26 U.S.C. §1362(f).

VI. Trusts As Shareholders: QSST vs. ESBT, Including How To Fix A Late Election And Regulations Dealing With ESBTs

This section focuses on irrevocable trusts, including trusts created by bequests under a revocable trust. Revocable trusts are taxed as grantor trusts,⁷⁰ so they automatically qualify as Sshareholders⁷¹ whose grantors are treated as the shareholders for all tax purposes,⁷² including the 100-shareholder limitation. ⁷³

To qualify as Scorporation shareholders for any length of time,⁷⁴ generally⁷⁵ an irrevocable trust must either be a grantor trust or an electing small business trust (ESBT). An irrevocable trust may qualify as a grantor trust under the normal rules of 26 U.S.C. §§671-678 or may be treated as a grantor trust through a QSST election made by the beneficiary.⁷⁶ If a beneficiary has a withdrawal right with respect to all gifts to the trust (a Crummey trust),⁷⁷ the trust might be taxable to the beneficiary under 26 U.S.C. § 678.⁷⁸ The rest of this section focuses on the features of QSSTs and ESBTs.

A QSST may have only one beneficiary who may receive income or corpus during the beneficiary's lifetime, and all of its income must be distributed currently to that beneficiary (who also must be a U.S. citizen or resident).⁷⁹ However, a trust that has substantially separate and independent shares, each of which is for the sole benefit of one beneficiary, may qualify as a QSST with respect to each separate share.⁸⁰ For example, a grantor sets up an irrevocable trust for the benefit of his four children. Each child receives one-fourth of the income and corpus distributions. Each child would be considered the owner of one-fourth of the stock owned by the trust. This could also work well for a vested trust for a grandchild, which qualifies for the GST annual exclusion.⁸¹

An ESBT may have more than one beneficiary.⁸² However, each potential current beneficiary is treated as a shareholder for the purposes of the 100-shareholder limitation.⁸³ A "'potential current beneficiary' means . . . any person who at any time during [a particular taxable year] . . . may receive[] a distribution from the principal or income of the trust," whether the distribution was mandatory or discretionary.⁸⁴ An open-ended inter vivos power of appointment violates the 100-shareholder limitation.⁸⁵ If he were ever again to use an inter vivos power of appointment, the author would probably reduce the class of appointees or provide that an inter vivos power of appointment is effective only on or after January1 of the year after the year of exercise. This means that a power-holder may never exercise an inter vivos power of appointment to be effective as of a date that falls within the current year. However, the holder of an inter vivos power of appointment cannot curtail the holder's powers in this manner; instead, the holder must release the inter vivos power of appointment completely.⁸⁶

ESBT income taxation is complicated. The income from the scheduleK-1 that the Scorporation files for the trust is separately taxed to the trust at the highest individual income tax rate.⁸⁷ Very few deductions are allowed against this income, and the income distribution deduction is not available.⁸⁸ Complications arise if the ESBT is a grantor trust in whole or in part, or if the trust is a charitable lead trust or other trust eligible for a charitable income tax deduction, to name some of the most common problematic areas.

A QSST is best used when:

1. The trust is a marital trust or other trust, with income required to be distributed currently to one beneficiary with no other current beneficiary. Under the marital trust rules,⁸⁹ all income must be distributed annually, which means that, under normal trust rules, the income that the spouse is required to receive is taxable to her, just as with any other mandatory income beneficiary.⁹⁰

2. The beneficiary's income tax rate is lower than the trust's income tax rate. Because trusts are taxed at the highest possible rates applicable to individuals,⁹¹ a beneficiary in a lower bracket should save taxes.

A QSST is not the best for trusts intended to accumulate their income, including trusts with multiple current beneficiaries. In most such cases, such trusts should be ESBTs.

Neither a QSST nor an ESBT is a good tool for purchases made out of earnings. In QSSTs, all income must be distributed to the beneficiary rather than being used to repay the principal on a promissory note. In ESBTs, interest on the promissory note is not deductible.⁹² A better solution is a trust taxable to its beneficiary under 26 U.S.C. §678.⁹³

The beneficiary must make a QSST election no later than 15 days and two months after the trust received the stock.⁹⁴ The trustee of an ESBT must file the ESBT election within the same timeframe. A late ESBT or QSST election may be made within 24 months of the original due date of the election, without the $6,000 fee required for letter rulings under 26 U.S.C. §9100.⁹⁵ The late election requires the consent of all the shareholders.

VII. Conclusion

Planning for Scorporations is more complicated, but also more flexible, than one might otherwise think. Please be sure to consider the various tax restrictions on ownership, but also consider the opportunities in estate planning and incentive compensation.

Footnotes

¹ Steven B. Gorin is a partner in Thompson Coburn LLP. He chairs the group of committees on business planning for the Probate & Trust Division of the Real Property, Probate & Trust Law Section of the American Bar Association and is a past chair of the Business Law Section of the Bar Association of Metropolitan St. Louis.

² 26 U.S.C. §1361(b)(1)(D). All references to a "code" section are to the Internal Revenue Code, 26 U.S.C.

³ 26 U.S.C. §1361(c)(4).

⁴ Treas. Reg. §1.1361-1(l)(1). All references to a "Reg." section are to U.S. Treasury Regulations promulgated under the Internal Revenue Code.

⁵ 26 U.S.C. §2701(a)(2)(C) provides that 26 U.S.C. §2701 does not apply to such a capital structure.

⁶ 26 U.S.C. §301(a) taxes only "a distribution of property," and refers to the 26 U.S.C. §317(a) definition of "property." 26 U.S.C. §317(a) provides that "property . . . does not include stock in the corporation making the distribution."

⁷ Treas. Reg. § 20.2036-1(a).

⁸ 26 U.S.C. §1361(d)(3).

⁹ 26 U.S.C. §1361(d)(1)(B).

¹⁰ This is just a summary of certain features of a GRAT that help determine its financial success. The technical requirements are beyond this article's scope.

¹¹ 26 U.S.C. §2702(b)(2).

¹² Treas. Reg. §25.2702-3(b)(1)(ii)(B).

¹³ Treas. Reg. §25.2702-3(b)(2).

¹⁴ 26 U.S.C. §2702(a)(2)(B).

¹⁵ Walton v. Commissioner, 115 T.C. 589 (2000), acq.IRS Notice 2003-72. See IRS proposed regulations, § 25.2702-2(a)(5), (6), REG-16379-02, 69 Fed. Reg. 44,476 (July 26, 2004).

¹⁶ The trust should not grant withdrawal rights to the beneficiaries. To do so may call into question whether the grantor owns all of the trust for all purposes. 26 U.S.C. §678(b) provides that a grantor's rights to income supersede a beneficiary's right to income for grantor trust purposes, and many tax advisors are concerned whether a grantor's rights to principal supersede a beneficiary's right to principal for grantor trust purposes.

¹⁷ If somehow the IRS successfully recharacterizes the note described below as equity, then the 26 U.S.C. §2701 rules come into play. 26 U.S.C. §2701(a)(4)(A) assigns at least a 10% minimum value to the junior equity, which would be represented by the initial gift to the trust. For example, if the property to be sold is worth $9 million, then the gift would be $1 million, so that the junior equity would be worth 10% ($1 million divided by the $10 million total in the trust). This 1/9 funding also provides more substance to the trust. Finally, the trust should make all interest payments on time, and the 1/9 funding provides funding in case corporate cash flow to the shareholders is insufficient (due to a temporary downturn in business, for example).

¹⁸ A sale to an irrevocable grantor trust can include a price adjustment clause, but it is unsettled whether the IRS and courts would respect such a clause.

¹⁹ If the stock to be transferred is worth $18 million, then the gift would be $2 million, which will be the gift tax applicable exclusion amount for the foreseeable future for a married couple that splits gifts. Any larger initial gift would trigger gift tax. However, when an irrevocable grantor trust starts building equity, the grantor can make additional sales to the trust, so long as the trust always has at least 10% equity.

²⁰ A sale uses the applicable federal rate (26 U.S.C. §1274), and a GRAT uses the 26 U.S.C. §7520 rate, which is 120% of the annual mid-term rate (rounded to the nearest 0.2%). A sale can have interest-only payments with a balloon payment upon maturity, with optional principal prepayments. A GRAT must have relatively even payments, with any year's payment no greater than 120% of the prior year's payment. Treas. Reg. §25.2702-3(b)(1)(ii). Thus, a GRAT requires higher payments up-front, which leaves less in the trust to grow.

²¹ If the promissory note is considered an interest in the trust and is worth less than the stock sold, the IRS could argue that the sale was not for adequate and full consideration and attempt to include the trust in the grantor's estate under 26 I.R.C. §2036(a)(1). If the grantor dies while receiving payments from a GRAT, then all or part of the GRAT will be included in the grantor's estate under 26 I.R.C. 2036(a)(1). In FSA 200036012, the IRS took the position that all of a GRAT is included under 26 I.R.C. §2039, but the better view is that 26 I.R.C. §2039 should not apply.

²² 26 I.R.C. §2642(f).

²³ For the lack of income tax on payments using appreciated property, see Rev. Rul. 85-13.

²⁴ Rev. Rul. 2004-64, Situation 2.

²⁵ 26 I.R.C. §1361(b)(1)(D).

²⁶ Treas. Reg. §1.1361-1(l)(1).

²⁷ Treas. Reg. §1.1361-1(l)(2)(i).

²⁸ Treas. Reg. §1.1361-1(l)(2)(v), Example (3). Disparate employee fringe benefits are similarly acceptable. Id., Example (4).

²⁹ Treas. Reg. §1.1361-1(l)(4)(iii)(B)(2).

³⁰ Treas. Reg. §1.1361-1(l)(4)(v), Example (2).

³¹ Treas. Reg. §1.1361-1(l)(4)(iii)(C).

³² Treas. Reg. §1.1361-1(l)(2)(iii)(B).

³³ Treas. Reg. §1.1361-1(l)(2)(vi), Example (9).

³⁴ Treas. Reg. §1.1361-1(l)(2)(iii)(A) provides (emphasis added):

Buy-sell agreements among shareholders, agreements restricting the transferability of stock, and redemption agreements are disregarded in determining whether a corporation's outstanding shares of stock confer identical distribution and liquidation rights unless -

(1) A principal purpose of the agreement is to circumvent the one class of stock requirement of section 1361(b)(1)(D) and this paragraph (l), and

(2) The agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock.

Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights. For purposes of this paragraph (l)(2)(iii)(A), a good faith determination of fair market value will be respected unless it can be shown that the value was substantially in error and the determination of the value was not performed with reasonable diligence. Although an agreement may be disregarded in determining whether shares of stock confer identical distribution and liquidation rights, payments pursuant to the agreement may have income or transfer tax consequences.

³⁵ 26 U.S.C. §1361(b)(1).

³⁶ 26 U.S.C. §1361(c)(2)(A)(i) (emphasis added).

³⁷ 26 U.S.C. §1361(c)(2)(B)(i).

³⁸ 26 U.S.C. §1361(d)(1).

³⁹ 26 U.S.C. §1361(c)(2)(A)(ii) (emphasis added).

⁴⁰ 26 U.S.C. §1361(c)(2)(B)(ii).

⁴¹ 26 U.S.C. §1361(c)(2)(A)(iii) (emphasis added).

⁴² 26 U.S.C. §1361(c)(2)(B)(iii).

⁴³ Treas. Reg. §1.1361-1(h)(1)(iv)(B).

⁴⁴ 26 U.S.C. §1361(c)(2)(A)(iv) (emphasis added).

⁴⁵ 26 U.S.C. §1361(c)(2)(B)(iv).

⁴⁶ 26 U.S.C. §1361(c)(2)(A)(v) (emphasis added).

⁴⁷ 26 U.S.C. §1361(c)(2)(B)(v).

⁴⁸ 26 U.S.C. §511(a)(1), 26 I.R.C. § 501(a).

⁴⁹ 26 U.S.C. §512(e)(1).

⁵⁰ 26 U.S.C. §512(e)(3).

⁵¹ 26 U.S.C. §1368(c)(1).

⁵² 26 U.S.C. §1368(e)(3).

⁵³ 26 U.S.C. §1368(b)(1).

⁵⁴ 26 U.S.C. §1368(b)(2).

⁵⁵ 26 U.S.C. §1368(c)(2).

⁵⁶ 26 U.S.C. §1368(b)(1).

⁵⁷ 26 U.S.C. §1368(b)(2).

⁵⁸ 26 U.S.C. §1371(c)(2).

⁵⁹ S status terminates if, for three consecutive years, a corporation has any E&P and has gross receipts more than 25% of which are passive investment income. 26 U.S.C. §1362(d)(3).

⁶⁰ 26 U.S.C. §56(g).

⁶¹ 26 U.S.C. §§1367(a)(1)(A), 1366(a)(1)(A), 101(a)(1).

⁶² 26 U.S.C. §1014.

⁶³ 26 U.S.C. §1377(a)(2). It may be wise for the shareholder agreement to provide that each shareholder irrevocably appoint the corporation as his attorney-in-fact for the purposes of signing consents to such an accounting cut-off so that the company can compel obstinate shareholders to agree to this accounting cut-off.

⁶⁴ Unless the deceased shareholder faces limitations on losses due to insufficient basis under 26 U.S.C. §1366(d)(1) or receives distributions that otherwise would have been in excess of basis, this increased basis might be of no benefit to anyone, because the basis would already be adjusted to the stock's date of death value under 26 U.S.C. §1014 without regard to pre-mortem basis adjustments.

⁶⁵ 26 U.S.C. §1377(a)(1)(A).

⁶⁶ 26 U.S.C. §§1362(d)(2), 1361(b)(1). An ineligible shareholder is not the only way the corporation can fail the tests under §1361(b)(1), but it is the most common. Involuntary transfers by shareholders, or just plain carelessness by the company in allowing disqualifying transfers to occur, has led to many letter rulings granting relief.

⁶⁷ 26 U.S.C. §1362(f)(2).

⁶⁸ 26 U.S.C. §1362(f)(4).

⁶⁹ Most powers of attorney are revocable. However, a power coupled with an interest (the interest being stock ownership) may be irrevocable. The attorney who drafts the agreement would determine whether this is permitted under state law, but the author suggests including it if there is any doubt. The main point to having an attorney research it would be to find a case or statute in which such a power of attorney was upheld, so that the agreement could be drafted to track that case or statute. The author is not aware of any disadvantage to including such a provision in a shareholder agreement.

⁷⁰ 26 U.S.C. §676.

⁷¹ 26 U.S.C. §1361(c)(2)(A)(i).

⁷² 26 U.S.C. §671. Grantor trusts may use their deemed owners' Social Security numbers as their taxpayer identification numbers. Treas. Reg. §1.671-4(b)(2)(A). However, a QSST must file Form1041 and attach a statement of the items treated as having been received directly by its beneficiary. Treas. Reg. §1.671-4(b)(6).

⁷³ 26 U.S.C. §1361(c)(2)(B)(i).

⁷⁴ Trusts can qualify as S shareholders by electing to be taxed as an estate under 26 U.S.C. §645 (which election has a limited duration under 26 U.S.C. §645(b)(2)), by being a continuation of a grantor trust under 26 U.S.C. §1361(c)(2)(A)(ii), or a testamentary trust under 26 U.S.C. §1361(c)(2)(A)(iii) (see text accompanying footnotes 39-43).

⁷⁵ A voting trust does not have time limits on how long it is an eligible shareholder under 26 U.S.C. §1361(c)(2)(A)(iv).

⁷⁶ See text accompanying footnotes 36-38.

⁷⁷ Crummey v. Commissioner of Internal Revenue, 397 F.2d 82 (9th Cir. 1968).

⁷⁸ See discussion of IRS Letter Rulings in 730-2nd T.M., S Corporations: Formation and Termination, II.E.1.b(3) and in James Eustice & Joel Kuntz, Federal Income Taxation of S Corporations par. 3.03[10] (4th ed., Warren, Gorham & Lamont).

⁷⁹ 26 U.S.C. §1361(d)(3).

⁸⁰ Id.

⁸¹ 26 U.S.C. §2642(c)(2) provides that the GST annual exclusion applies to a trust that uses Crummey withdrawal rights only if the grandchild (or other skip person) is the sole beneficiary of the trust, and the trust's assets must be includible in the beneficiary's gross estate upon her death. 26 U.S.C. §2654(b) provides that "substantially separate and independent shares of different beneficiaries in a trust shall be treated as separate trusts" under the GST rules. Suppose a grantor sets up an irrevocable trust for the benefit of his four grandchildren. Each grandchild receives one-fourth of the income and corpus distributions, the trust distributes all of its income each year, and each of the four living grandchildren would be considered the owner of one-fourth of the stock owned by the trust. If a grandchild who dies before or after trust termination holds a general power of appointment over one-fourth of the trust's assets, the trust will qualify for the GST annual exclusion and as a QSST.

⁸² For all of the electing small business trust (ESBT) requirements, see 26 I.R.C. §1361(e)(1).

⁸³ 26 U.S.C. §1361(c)(2)(B)(v).

⁸⁴ 26 U.S.C. §1361(e)(2).

⁸⁵ Treas. Reg. §1.1361-1(m)(4)(vi)(A).

⁸⁶ Treas. Reg. §1.1361-1(m)(4)(vi)(B).

⁸⁷ 26 U.S.C. §641(c)(1).

⁸⁸ 26 U.S.C. §641(c)(2).

⁸⁹ 26 U.S.C. §§2056(b)(1) and 2523(b)(2).

⁹⁰ 26 U.S.C. §651.

⁹¹ 26 U.S.C. §1(e)(2).

⁹² Treas. Reg. § 1.641(c)-1(g)(3).

⁹³ See fn. 78.

⁹⁴ Treas. Reg. §1.1361-1(j)(6)(ii)(C).

⁹⁵ Rev. Proc. 2003-43, 2003-1 C.B. 998.

JOURNAL OF THE MISSOURI BAR
Volume 61 - No. 2 - March-April 2005