8878. How can the existence of preferred stock complicate business succession planning in the context of a family-owned business?Alexis Longrcline202015-07-30T16:12:00Z2015-07-30T16:12:00Z410686088Summit Business Media50147142148878. How can the existence of preferred stock complicate business succession planning in the context of a family-owned business?In the context of a family-owned business, many business owners may consider creating a class of preferred stock to help provide for a smooth transition of business ownership to the next generation of family members. This can actually create problems that will actually complicate the transition process.First, small business owners must be advised that the creation of a second class of stock can cause a currently existing S corporation to lose its S corporation status, because S corporations are only permitted to issue a single class of stock..IRC Sec. 1361(b)(1)(D). Secondly, if a currently existing corporation wishes to convert to S corporation status in the future, the existence of the class of preferred stock will make the conversion impossible unless all existing preferred shareholders agree to exchange those shares for a single class of stock that is generally available to all shareholders.Further, the rules contained in IRC Section 2701 can thwart a business owner’s plans to transfer interests gift tax-free to family members by setting the value of any retained preferred business interest (known as an “applicable retained interest,” see below) that does not contain a right to receive a “qualified payment” at zero if there is a transfer of a common equity interest in the business to a family member..IRC Sec. 2701(a)(3). Essentially, these rules require that the transferring family member treat the retained preferred stock interests as a taxable gift to the family member to whom the common stock interests are sold. The rules imposed under IRC Section 2701 are designed to prevent a scenario where the older generation creates a class of preferred shares (which he or she retains) in order to avoid paying gift taxes on common shares (which he or she transfers to the younger generation). For example, before the enactment of Section 2701, a business owner may have created a class of preferred shares with a value that was equal to the current value of the business, retaining these preferred shares. The business owner could then transfer a class of common shares to his or her child that had no current value, and thus generated no gift tax liability. By fixing the value of an applicable retained interest at zero (in the absence of a qualified payment right), Section 2701 seeks to prevent this result. Essentially, the rules provide that the taxable gift can only be avoided if the parent who retains the preferred stock receives a qualified dividend payment (which will establish the value of the preferred stock) on a fixed basis (either as a set amount or specified percentage of the stock value) going forward, and that such dividends are actually paid. This can create additional tax liability for the parent and also reduce the operating capital of the company itself. Where an applicable retained interest includes a distribution right which consists of the right to receive a qualified payment and there are one or more liquidation, put, call, or conversion rights with respect to such interest, the value of all such rights is to be determined by assuming that each such liquidation, put, call, or conversion right is exercised in a manner which results in the lowest value..IRC Sec. 2701(a)(3)(B). IRC Section 2701 does not apply to distribution rights with respect to qualified payments where there is no liquidation, put, call, or conversion right with respect to the distribution right..IRC Sec. 2701(a)(3)(C). The rules imposed under IRC Section 2701 also do not apply if, for either the transferred interest or the applicable retained interest, market quotations are readily available (as of the date of transfer) on an established securities market. Further, the rules do not apply if the applicable retained interest is of the same class as the transferred interest, or if the applicable retained interest is proportionally the same as the transferred interest (disregarding nonlapsing differences with respect to voting in the case of a corporation, or with respect to management and limitations on liability in the case of a partnership)..IRC Sec. 2701(a)(2). An exception from the rules is also provided for a transfer of a vertical slice of interests in an entity (defined as a proportionate reduction of each class of equity interest held by the transferor and “applicable family members” (defined below) in the aggregate).For example, Section 2701 does not apply if John owns 50 percent of each class of equity interest in a corp. and transfers a portion of each class to his child in a way that reduces each of John’s interests, as well as the aggregate interests held by any applicable family members, by 10 percent. This is so even if the transfer does not proportionately reduce John’s interest in each class .Treas. Reg. §25.2701-1(c)(4).DefinitionsAn “applicable retained interest” is any interest in an entity with respect to which there is (1) a distribution right and the transferor and his or her family members control the entity immediately before the transfer, or (2) a liquidation, put, call, or conversion right (i.e, rights commonly granted to holders of preferred stock)..IRC Sec. 2701(b).A “qualified payment” means any dividend payable on a periodic basis at a fixed rate (including rates tied to specific market rates) on any cumulative preferred stock (or comparable payment with respect to a partnership). With respect to the transferor, an otherwise qualified payment is to be treated as such unless the transferor elects otherwise. With respect to applicable family members, an otherwise qualified payment is not to be treated as such unless the family member so elects. A transferor or a family member can make an irrevocable election to treat any distribution right (which is otherwise not a qualified payment) as a qualified payment, payable at such times and in such amounts as provided in the election (such times and amounts not to be inconsistent with any underlying legal instruments creating such rights)..IRC Sec. 2701(c)(3). The value assigned to a right for which an election is made cannot exceed fair market value (determined without regard to IRC Section 2701)..Treas. Reg. §25.2701-2(c)(2). A “member of the transferor’s family” includes the transferor’s spouse, lineal descendants of the transferor or transferor’s spouse, and the spouse of any such descendant..IRC Sec. 2701(e)(1). An “applicable family member” with respect to a transferor includes the transferor’s spouse, an ancestor of the transferor or transferor’s spouse, and the spouse of any such ancestor..IRC Sec. 2701(e)(2). An individual is treated as holding interests held indirectly through a corporation, partnership, trust, or other entity..IRC Sec. 2701(e)(3). In the case of a corporation, “control” means 50 percent ownership (by vote or value) of the stock. In the case of a partnership, “control” means 50 percent ownership of the capital or profits interests, or in the case of a limited partnership, the ownership of any interest as a general partner..IRC Sec. 2701(b)(2). When determining control, an individual is treated as holding any interest held by an applicable family member (see above), including (for this purpose) any lineal descendant of any parent of the transferor or the transferor’s spouse..IRC Sec. 2701(b)(2)(C).