Many of our clients are faced with a dilemma: how best to plan for a rapidly appreciating asset in an uncertain estate tax environment. Given that any significant estate tax reform is unlikely until after the 2008 elections, clients want to avoid possible estate tax on future appreciation but are reluctant to make significant gifts lest they pay a gift tax that later turns out to be unnecessary. Owners of an appreciating business or appreciating real estate want to avoid estate tax yet continue to receive the income from the asset for the near term. This article will review a recapitalization freeze, one of the three common methods for accomplishing an estate freeze. Other estate freeze methods employ family limited partnership or a sale of assets to a trust created for the benefit of the grantor’s descendants.
The strategy requires a recapitalization of an existing corporation to create two classes of stock – common and preferred. Both classes of stock are voting. The preferred shares generally have a cumulative preferred dividend; the dividend is established by reference to interest rates at the time of the recapitalization. The preferred shares, by definition, do not share in the appreciation of the value of the company’s assets. After creation of the two classes of shares, the owner makes a gift either in trust or outright of the common shares; he retains the preferred shares. Because the preferred shares are voting shares, the owner retains the right to vote the shares and thereby retain control of the corporation. Because the common shares represent the appreciation in the value of the company, the owner will avoid estate tax on any appreciation in the value of the shares after the date of the gift.
Consider this illustration. Smith is the owner of tool and die company, Smithco. He started the business 30 years ago with an investment of only $5,000. Because there is high demand for US tool and die services, Smith believes his company may be worth at least $1 million. He also believes that the future appreciation of his company will be significant. Smith’s son and daughter work in the business and have expressed an interest in continuing the business after Smith retires. Smith has saved sufficient monies during his lifetime so that he will have a taxable estate. He also desires to leave the business to his children in such a way that estate taxes will not require them to sell the business to pay the estate taxes.
After consulting with his advisors, Smith decides to accomplish an estate freeze. Smith first exchanges his common shares of Smithco for 500 preferred shares of a new company, NewSmith. (This exchange is structured as a tax-free reorganization.) The preferred shares are voting shares, which ensures Smith will continue to have operating control of the business. The preferred shares may also be sold back to Smithco at any time for $2,000 per share, thus giving Smith the opportunity to cash out at any time. The preferred shares further provide for a cumulative preferred dividend. Smith’s son and daughter each purchase 100 common shares in NewSmith. If, five years after the reorganization, the value of NewSmith has increased to $1,500,000, the value of Smith’s preferred shares will still be $1 million, and the children’s common shares will be worth $500,000. By having the foresight to transfer the future appreciation value of NewSmith to his children, Smith will avoid any estate tax on the $500,000 of value attributable to the common shares.
If you have a business or real estate asset that has the potential to appreciate rapidly, please contact us to discuss whether an estate freeze may be appropriate for you.