937 / How are corporate and partnership transactions, such as recapitalizations, transfers and other changes in capital structure impacted by the Chapter 14 special valuation rules?

Effect on Corporate and Partnership Transactions

Recapitalizations and Transfers of Stock

If a parent recapitalizes a corporation into common and preferred stock and gives the common stock to his children, the value of the common stock is determined by subtracting from the value of the entire corporation the value of the preferred stock as determined under IRC Section 2701. If the parent treats the preferred stock’s right to dividends as qualified payments, the right to such payments is assigned a present value. However, the value assigned to the common stock must be at least equal to the value determined under the junior equity rule (see Q 935). If the parent does not receive the preferred dividends within four years of their due dates, the parent may be treated as making additional transfers of the accumulated, but undistributed dividends, at the time of a subsequent transfer of the preferred stock. On the other hand, if the parent does not treat the right to dividends as qualified payments; such a right is assigned a value of zero.

Similarly, if a parent owns 80 percent of a corporation and a child owns 20 percent of the same corporation and the parent’s common stock is exchanged for preferred stock, the value of what the parent has transferred and what the parent has retained are determined under IRC Section 2701.

Even if the child pays consideration for the common stock, whether the parent has made a transfer (and the value of such transfer) is determined under IRC Section 2701.

If a parent and a child each contribute to the startup of a new business and the parent receives preferred stock while the child receives common stock, the parent is treated as if he received common stock and preferred stock and then exchanged the common stock for the balance of the preferred stock. The value of what the parent has transferred and what the parent has retained are determined under IRC Section 2701.

However, a gift or a sale of stock to a child is not subject to IRC Section 2701 if the stock is of the same class as that retained by the parent. Also, a gift or a sale of stock to a child is not subject to IRC Section 2701 if the stock is proportionately the same as that retained by the parent (e.g., retained stock is entitled to $2 of dividends for every $1 of dividends paid to transferred stock), without regard to nonlapsing voting rights (i.e., parent can retain control with nonlapsing voting right).

If applicable family members receive or retain applicable retained interests at the time of a gift or a sale of stock to a child, the transaction may be subject to IRC Section 2701 even though the parent is willing to terminate his equity relationship with the corporation.¹

IRC Section 2701 could be avoided by selling the common stock to a nonfamily member, such as a valuable employee. Proceeds of the sale could then be distributed to the children.

Of course, IRC Section 2701 does not apply if either the transferred interest (common stock) or retained interest (preferred stock) is publicly traded. Also, with regard to retained distribution rights, IRC Section 2701 does not apply if the transferor and applicable family members do not control the corporation immediately before the transfer. However, with regard to liquidation, put, call, or conversion rights (other than those treated as distribution rights, see Q 935), IRC Section 2701 can apply even if the transferor and applicable family members do not control the corporation.

If the typical recapitalization is reversed (i.e., the parent retains the common stock and transfers the preferred stock), IRC Section 2701 should not apply (assuming no retention of applicable retained interests by parent or applicable family members).

Partnership Freezes

The traditional partnership freeze worked similarly to the traditional estate freeze recapitalization. It too is caught by the IRC Section 2701 special valuation rules. Most of the techniques employed to reduce the effect of, or to avoid, the valuation rules with respect to a recapitalization will also work with a partnership. Examination of the partnership agreement will be required to determine which partners hold which rights. Note that in the case of a limited partnership, “control” includes the holding of any interest as a general partner. Also, any right to receive a guaranteed payment of a fixed amount from a partnership under IRC Section 707(c) is not treated as a distribution right.

Other Changes in Capital Structure

Other changes in capital structure may also be caught by the IRC Section 2701 special valuation rules. Except as provided in regulations, a contribution to capital, a redemption, a recapitalization, or other change in capital structure of a corporation or partnership is treated as a transfer if the taxpayer or an applicable family member receives an applicable retained interest in the transaction, or as provided under regulations, holds such an interest immediately after the transfer.

Nonequity Interests

The IRC Section 2701 special valuation rules apply only to equity interests. Thus, none of the following should be treated as a retained interest for purposes of IRC Section 2701: an installment sale of an interest in a corporation or partnership, an exchange of an interest in a corporation or partnership for a private annuity, an employment contract or deferred compensation, or debt owed by a corporation or partnership to a transferor or applicable family member.² However, the total amount of debt owed the transferor or an applicable family member by the entity is a factor in the junior equity rule (see Q 935).