Inadvertent Gift Consequences of Transfer to Family in a Business Succession Plan
If you are planning a business succession and the transfer of interest in a closely held business, you should be certain that you don’t run afoul of the special valuation rules of §2701 of the Internal Revenue Code.
Section 2701 applies when there is a transfer of an interest of a partnership or corporation to a member of the transferor’s family, if after the transfer, the transferor, or a family member of the transferor, holds an applicable retained interest. If §2701 applies, the amount of the gift to the family member may not be the fair market value of the interest transferred, but the fair market value of transferor’s entire interest in the corporation or partnership immediately before the transfer. To further complicate the application of these rules, this gift results even when transfers are made for full and adequate consideration.
As is often the case when considering tax consequences, the definitions of this section of the Code will dictate its applicability. For §2701 to apply, there must be a “transfer.” For this purpose, a transfer is generally a direct transfer, to or for the benefit of a member of the transferor’s family, or where there is a change in the capital structure of the corporation or partnership, unless the capitalization change is a capital contribution. The transferee must be “member of the transferor’s family.” A member of the transferor’s family is the spouse of the transferor, lineal descendants of the transferor and lineal descendants of the transferor’s spouse, and the spouses of such lineal descendants. The transferor, or applicable family member, must also retain an “applicable retained interest” in the corporation or partnership. The applicable retained interest is broadly defined as a right to receive distributions from the controlled corporation or partnership because of the transferor’s retained equity interest. Also included in this definition is any put, call, conversion right, right to compel liquidation, or any similar right which, by way of its exercise or non-exercise, affects the value of the transferred interest.
Although perhaps not obvious, §2701 of the Code applies to limited liability companies as well. This is because under the “check-the-box” regulations of §7701, a multi-member limited liability company is taxed either as a corporation or a partnership for federal tax purposes.
Any business owner considering any transfer of his or her interests in a controlled entity, even for adequate consideration, should carefully consider whether §2701 will trigger an inadvertent gift of the entire interest owned by the transferor. Further information on business succession planning and related topics can be answered by one of our experienced attorneys.