Dealing with Multiple Family Stockholders

Multiple shareholders make everything tougher. The planning for the business takes on a new dimension as multiple family members in trusts began acquiring stock in the company. Care must be exercised to avoid certain tax traps that can surface as the parents implement their stock transition plan. A buy-sell agreement between all of the shareholders becomes essential once the transition process begins. The agreement should include provisions tailored to the unique needs of the parents which are not applicable to the stock owned by the children. The agreement also must address the stock held by the kids to ensure that that stock stays in the family and that each child has a fair exit sell-out option if the child dies or needs to cash in because of a bankruptcy, a divorce, a disability, sibling discord, or some other compelling circumstance.

Buy-Sell Valuation Whipsaw

This valuation trap surfaces when the stock owned by a deceased family member is sold pursuant to the terms of the buy-sell agreement but the price paid under the agreement is less than the value of the stock sold for estate tax purposes. The decedent’s estate ends up paying estate taxes on a value that might be much higher than the amount actually paid for the stock. It can be a disaster in some situations. The key to avoiding this trap is to structure the buy-sell agreement so that it fixes the value of the company stock for federal estate tax purposes.

A special section of the Internal Revenue Code Section 2703 lays out the requirements to accomplish this, but the key requirement turning the ball game is that the terms of the agreement must be comparable to similar arrangements between persons who deal in an arm’s length transaction. This comparable arms length determination is made at the time the agreement is entered into, not when the rights under the agreement are exercised. An effort must be made by the family to determine what others in the same industry are doing. Often this will require a valuation expert to get a hand on what others are doing.

If there are no industry standards because of the unique nature of the business, standards for similar types of businesses may be used to establish the arm’s length terms of the agreement. This arm’s length requirement, the importance of it cannot be overstated.

Preferred Stock Trap

In some situations, the parents desire to use preferred stock to facilitate the stock transition process to other family members. Extreme – and I emphasize extreme – caution is required whenever preferred stock interests are considered in the design of a transition plan.

So, for example, that a C corporation has outstanding common stock valued at $ 3 million and non-cumulative preferred stock valued at $2 million, all of which is owned by the parents. If the parents were to sell the common stock to an unrelated party for $3 million, the parent would simply report capital gain income on the excess of the $ 3million purchase price received over the parent’s tax basis in the stock sold. But if the parents sold that same common stock to a child for $3 million, the parent also would be deemed to have made a $2 million taxable gift to the child. This gift tax would be an addition to the capital gains income tax just because a family member was involved.

This extreme result is mandated by Section 2701, a harsh provision that requires the preferred stock retained by the parent be valued at 0 for gift tax purposes, and the common stock sold to the child would be assigned a value of $5 million which would trigger the $2 million gift. Now there are some limited ways around this harsh result, but usually, they are all problematic. The lesson is to make absolutely certain that someone with the right training is keeping a very close eye on Section 2701 whenever preferred equity interest are part of the mix in designing a plan.

Voting Stock Trap

This trap is triggered when a parent transfers stock in a family corporation to other family members and through some means directly or indirectly retains the right to vote the stock. When this condition exists, the stock is brought back into the parent’s estate for estate tax purposes. The transfer will have done absolutely nothing to reduce the parent’s future estate tax burden. It’s as if the transfer never happened for estate tax purposes.

This trap can extend to many situations including those where the parents vote stock transferred to a trust where a parent is a general partner of a partnership that owns the transferred stock, where the parent through an expressed or implied agreement retains the right to reacquire voting authority or has the right to influence or designate how the stock will be voted. The absolute safest way to avoid this trap is to transfer non-voting stock, an option available in both C and S family corporations. That will eliminate the risk of the trap.

As other family members begin acquiring stock, the transition process needs to avoid these traps while addressing the expectations of the new shareholders. They are no longer just family members; they are now owners. Usually, there’s a need for education and dialog on a broad range of basic issues including limitations imposed by the buy-sell agreement, the rationale for using non-voting stock, cash flow prospects of the business, future stock transfers, and more. The goal is to keep all of the shareholders informed and to ensure that expectations stay in line with reality, while also ensuring the business is left to survive when the dust settles.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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