Family business consulting revisited.

• Author: Zwick, Gary A.
• Position: Tax planning

EXECUTIVE SUMMARY

* The SBJPA and the TRA '97 have enormously liberalized the use of ESOPs by S corporations.

* Estates and beneficiaries are now related parties for Sec. 267 purposes.

* There has bee increased IRS scrutiny of discounts on transfers of FLP interests between family members.

The widespread existence of family-owned businesses mandates that practitioners keep up with developments in this area, including family aggregation, valuation discounts, qualified plan testing, split-dollar life insurance and employee stock ownership plans. This article highlights recent law changes in these areas as they affect family business consulting.

This article is a sequel to one published in The Tax Adviser in 1993 titled "Family Business Consulting,"(1) which explored many of the related-party rules affecting family business transactions. Since the publication of that article, several critical developments have occurred, including the following:

* The issuance of Rev. Rul. 93-12,(2) in which the IRS acquiesced in a long line of cases holding that the value of business interests in property transferred to family members must be determined without regard to the relationship between the buyer and seller or whether the business or other property is controlled by the family as a unit; there is no family aggregation when determining the value of gifted property.

* The Small Business Job Protection Act of 1996's (SBJPA's) repeal of family aggregation rules for most purposes in qualified plans, having both positive and negative effects when planning for retirement benefits in family businesses.(3)

* The addition of an "estate and its beneficiaries" to the list of related parties to or from whom loss recognition on the sale of depreciable property is disallowed under Sec. 267.(4)

* The issuance of Letter Rulings 9636033(5) and 9745019,(6) sanctioning the use of split-dollar life insurance arrangements in intrafamily transactions.

* The liberalization of the ESOP rules for S corporations and the planning implications for family businesses.(7)

* Increased IRS scrutiny of discounts on transfers of family limited partnership (FLP) interests between family members.(8)

Why Are Family Businesses Different?

Although much has been written about conflict in family businesses and the problems of perpetuating a business from one generation to the next, Congress continues to believe that close personal relationships between family members allow them to "collude" for tax savings in ways that unrelated parties cannot. For this reason, the Code contains a ceaseless array of related-party rules. Although some rules--particularly Secs. 318 and 267--are multipurpose, many Code sections have their own aggregation rules. This creates tremendous complexity, which makes it difficult to plan for transactions between and among family members and between family members and their business. On rare occasions, a showing of family hostility can negate the effect of family attribution(9); however, most family attribution is statutory and not subject to mitigation.

Valuation and Family Aggregation

The Service has long been hostile to the use of lack of marketability and lack of control discounts when the transferor and the transferee are family members. Its position has been that there is no lack of control if the transferor controlled the entity before the transfer and transfers are solely to family members.

The courts have almost uniformly held otherwise. For example, in Bright(10) and its progeny, the courts noted that the concept of a willing buyer and a willing seller (found in Rev. Rul. 59-60(11)), which governs valuation issues for tax purposes, does not contemplate whether the parties are related. The appropriate way to value business interests under that ruling is to ascertain what a willing buyer in the market would pay for the asset being transferred and what a willing seller, not under any compulsion to sell, would sell it for. After a long string of government losses, and the possibility of having to pay attorney's fees and costs to taxpayers litigating this issue, the IRS issued Rev. Rul. 93-12.

That ruling, however, is not a complete capitulation. Ever since its issuance, the IRS has sought other ways to deny discounts on transfers between family members. In Murphy(12) and Letter Ruling (TAM) 9723009,(13) among others, gifts were made by a parent to children very shortly before the former's death. In Murphy, the decedent had owned 51% of a closely held corporation. For years, she had been counseled by her advisers to gift sufficient shares to her children to bring her ownership to under 50%. Finally, 18 days before death, she made gifts bringing her ownership down to 49.65%; on her estate tax return, the executor claimed a significant discount for the decedent's remaining minority interest. The court viewed this as a tax move with no business purpose; it concluded that the discounts for lack of control and minority interest were invalid in light of the late date of the transfers.

Murphy was decided before the issuance of Rev. Rul. 93-12. The IRS subsequently issued Letter Ruling (TAM) 9736004,(14) among others, in which it followed Murphy to bar deathbed discounts. However, Frank(15) shows that this issue is far from settled.

Swing-Vote Theory

Having failed to introduce a family attribution concept to the valuation of gifts and other transactions in property between and among family members, the IRS has put forth a new theory; if a gift carries "swing vote attributes," no discount applies. In Letter Ruling (TAM) 9436005,(16) a parent had made gifts to each of his three children of approximately 30% of the voting common stock of a family business; he also transferred 5% to his spouse and retained 5%. The parent fried a gift tax return claiming minority and marketability discounts for the gifted shares. The IRS determined that because two children together could effectively control the company, each had a "swing vote" that was more valuable than the typical minority interest; thus, it concluded that there should be no lack-of-control discount. Additionally, if the gifts had been made serially, rather than simultaneously, by putting two children in a position of having a "swing vote" a gift to the second child would constitute a gift to the first child of the discount taken on the first gift. In support of this theory, the IRS cited Winkler.(17)

In extreme situations, a swing-vote attribute could negate a minority interest discount. For example, if all ownership interests carry the same relative voting rights and there are two 48% owners, a transfer of a 2% voting interest may not be entitled to a discount because of its leverage value in dealing with either 48% owner. Whether a transfer...