Applying the estate freeze special valuation rules to S corporations.

• Author: Ellentuck, Albert B.

While S corporations are often viewed as being taxed similarly to partnerships, the Code applies C corporation tax concepts to S corporations. Subchapter C provisions (governing corporate formations, reorganizations, redemptions and liquidations, among other areas) specifically apply to S corporations and their shareholders, except to the extent inconsistent with other provisions in subchapter S; see Sec. 1371(a).This means that an S corporation can participate as a corporate entity in a reorganization; see the Committee Reports to the Small Business Job Protection Act of 1996, Section 1310. Thus, S corporations have a substantive advantage over partnerships: S corporations and their shareholders can accomplish stock exchanges, corporate divisions, mergers and the many other forms of transactions known as "tax-flee reorganizations" while partnerships cannot.

Rules on Valuing Retained Interests

In addition to ensuring that a reorganization qualifies for tax-deferred treatment and does not unintentionally terminate an S election, a corporate reorganization may also have to comply with the Sec. 2701 special valuation rules, under which, on the transfer of stock to a "member of the transferor's family," most rights retained by the transferor will be valued at zero for estate and gift tax purposes. For this purpose, the word "transfer" can, under certain circumstances, include a recapitalization or other change in the corporation's capital structure; see Sec. 2701(e)(5) and Regs. Sec. 25.2701-1(b)(2).

Example 1: Sam is the sole shareholder of an S corporation with one class of voting common stock that has a $100,000 fair market value (FMV). The corporation is recapitalized to create a class of voting preferred stock and a class of nonvoting common stock (thus terminating S status). Sam transfers the common stock to his daughter Mattie; for gift tax purposes, he assigns a $65,000 value to the retained preferred stock and a $35,000 value to the transferred common stock.

If Sec. 2701 applies to the retained preferred stock, it is valued at zero. The gift of common stock is valued at $100,000, instead of $35,000.

Exceptions to the Special Valuation Rules

Two exceptions to these special valuation rules can apply to reorganizations or recapitalizations involving S corporations. The first involves the issuance or exchange of only common stock; the second involves no shift in ownership among the family group.

Common Stock

According to Sec. 2701(a)(2)...