Extracting value from closely held corporations.

• Author: Diamond, Irving F.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) has provided an opportunity to revisit and revise planning for small business owners with significant locked-in corporate asset value, especially when an active trade or business has wound down and the tax costs of liquidation are prohibitive. New options are available.

Background

A particularly thorny facet of financial planning for owners of closely held corporations is extracting asset value, to facilitate and implement retirement and estate plans without expensive tax consequences. Such individuals may be faced with one of the following situations and, thus, need to distribute value from the corporation:

1. Retirement needs.

2. Pre-death estate planning to gift assets to the next generation, some or all of whom may not desire continued ownership.

3. Postmortem planning to distribute the value among beneficiaries. Even though the stock ownership receives a basis step-up at death (See. 1014), the corporation retains its original basis in its assets. Thus, death is not a solution to the taxation of appreciated assets reside the corporation.

   Typically, these situations arise in one of the following ways:

   Situation 1: A C corporation with an active trade or business sells or winds down the business. The corporation could not be (or was not) liquidated without double taxation. In some cases (usually family situations), liquidation may not have been pursued because the founder and/or principal owners desired continued control of the assets. The corporation continues, but its activities are now passive (i.e., investments in securities, real estate rentals, etc.). After some time, the corporation still has earnings and profits (E&P) from its original business and from its investment activities and has substantial unrealized appreciation in its remaining assets. Because of the substantial C E&P an S election has not been appropriate.

   Situation 2: A corporation whose business activities have always been investments, or one as described in the previous paragraph, has accumulated E&P and substantial unrealized appreciation in its investment assets. The corporation may be a personal holding company (PHC) if it meets the complex ownership and income tests of Sees. 542 and 543. Because its activities have always generated "passive investment income" (see Sec. 1362) and because of the C E&R the shareholders have never made an S election.

   Situation 3: A corporation with an active trade or business accumulated substantial C E&P. It makes an S election and continues to operate an active trade or business, but for various planning purposes, its owners want to distribute the E&P. In many cases, corporations may also have a second class of stock, usually preferred as to dividends, which prevents an S election (see Sec. 1361). The issuance of preferred stock frequently happens during the financial or succession planning...