Freezing stock value with a corporate recapitalization.

• Author: Hackett, Trenda B.

One business succession strategy to consider is a corporate recapitalization. A recapitalization is a form of reorganization that involves changes in the class of stock a shareholder possesses. It occurs when a shareholder exchanges some or all of his or her stock for another class of stock in the corporation (i.e., a recapitalization results in the shareholder's acquiring a new class of stock in return for giving up all or some of his or her original stock). Generally, recapitalizations are not taxable events for the shareholders (however, they may create gift tax considerations between the shareholders) or corporation as long as the exchange has a business purpose and the value of the stock given up equals the value of the stock received.

A corporate recapitalization can freeze the value of the owner's stock, potentially reducing the owner's estate tax liability by removing future appreciation in the value of stock from the owner's estate. However, with the increased exclusion amount, planners must weigh the benefits of freezing the stock's value versus holding the stock until death and receiving a step-up in basis for income tax purposes.

Shifting control using a recapitalization is especially useful when:

* A stock sale would result in substantial tax;

* A redemption does not qualify for capital gain (exchange) treatment because it is not substantially disproportionate or the redeemed shareholder does not or cannot terminate his or her interest completely;

* The value of existing stock is too high to allow purchases by other family members, shareholders, or employees; or

* A shareholder wishes to protect the interests of children actively involved in a corporation while providing some benefit for those with no active involvement.

Recapitalizing with common and preferred stock

In a typical recapitalization, one class of voting common stock is exchanged for two classes of stock (usually voting preferred with a cumulative dividend feature and nonvoting common). The owner retains the voting preferred stock and, therefore, control of the business operations. Because the preferred stock does not participate in the growth of the corporation's value, the owner's stock value is frozen.

The common stock created in the recapitalization is transferred to the owner's children. Because the total value of the corporation's stock does not change as a result of the recapitalization (i.e., new preferred + new common = old common), the value of the new common stock transferred to the children is reduced by the value attributed to the preferred stock retained by the owner. The recapitalization allows the owner to transfer ownership and future appreciation in the corporation at a reduced gift tax cost without giving up control of the business operations.

Understanding stock freezes and the Sec. 2701 rules

Under current rules, the retained preferred stock would be assigned a value of zero, unless certain requirements are met (Sec. 2701(a)(3)(A)). The gifted interest (usually common stock) would be assigned the entire value of the corporation. This could create a gift tax liability for the donor.

The valuation provisions of Sec. 2701 apply when there is a transfer of...