Transferring a tightly held family business from one generation to another just got easier. By repealing a disputed section of the tax code, Congress will let companies save money when using a common form of passing down businesses.
The now-repealed Section 2036(c) was added to the tax code in 1987. The legislation tried to curb abuses of so-called estate freezes, but small-business interests said it went too far and made some such transfers too costly, often forcing people who inherited companies to liquidate them to pay estate taxes.
By repealing that section as part of last month's budget reconciliation package, Congress made the use of estate freezes possible again, while tightening the provisions that made abuse of them common before 1987.
Estate freezes are just one way a parent can transfer ownership of a company with growth potential to children and avoid paying some taxes. By transferring the company when it is worth less, the taxes on the transfer are also reduced. With the estate freeze method, the parents still maintain an interest in the company, albeit a frozen one, so they can go on running the company or receiving retirement income from it.
Through a recapitalization of the company, the founders create a preferred class of stock that they will keep and a common class of stock that they will give to their children. At the time of transfer, the preferred stock contains most of the value of the company, although that value will not increase over time. The common stock holds the growth potential.
When the parent dies, only the preferred stock goes into the estate on which the inheriting children pay tax. If the company has grown significantly, they will already own most of its value.
What the various rules regarding such transfers have addressed is whether the inheriting family member can be taxed on the appreciation of the company's worth after the gift is made and before the parent dies.
Before the 1987 tax act was passed, families avoided paying many taxes by claiming that the initial gift was virtually worthless. Attaching what accountants call "bells and whistles" on the preferred stock, such as high dividend rates, they depleted the value of the common stock in the eye of the tax collector. Often, these dividends were never actually paid.
Seeing a potential revenue source, Congress went after these transfers in 1987, adding section 2036(c) to the tax code, which made it impossible for parents holding such a frozen interest to be involved at all in running a company. If they were, the company's full value could be dragged back into their estate after they died -- and taxed at the top rate of 55 percent if it was worth more than $3 million.
"You get that future appreciation out of your estate but you retain rights in the property, That's what Congress didn't like," said Greg Nelson, an estate tax accountant with Arthur Andersen in the District. He explained, "If you want to give away your property, that's fine, go ahead and do it, but don't retain control or income from it," the government was trying to say.
These rules went too far, tax accountants and small-business lobbyists say. They were too broad and they affected other means of transferring property as well. And if the growth of the company was actually due to the efforts of the inheriting children, from a tax view it was still treated as though the parents had built up the firm and were giving it to their children.
"It was sort of an atom bomb approach to a very small problem," said D.J. Gribbin, a lobbyist on tax issues for the National Federation of Independent Business. "They tried to block every single possible abuse." The rules were so broad that they affected any type of transfer of property.
Finally, the government agreed the law went too far. Last month's changes replaced it with rules requiring that the company be properly valued at the time of transfer, and that gift taxes be paid on that value. If, in fact, all the value of the company is in the preferred stock because of the perks it carries, those dividends must be paid and taxed.
The small-business community was more than pleased with the change, which will simplify the estate freeze practice and keep many business owners from liquidating to pay off estate taxes. Moreover, it cleared up three years of uncertainty during which accountants and estate tax lawyers struggled to interpret the vague regulations while waiting for the rule's repeal.
"There was an expectation that the rules would be changed," said Nelson, "Very early on it became apparent that there were very serious problems with the legislation ... People were kind of in gridlock, they didn't know what to do."
In other last-minute activity, Congress approved funding for the Small Business Administration to develop, with the National Institute of Standards and Technology, an on-line computer database to enable government and university laboratories to share new developments with small companies.
And for those small companies for which complying with the Americans With Disabilities Act would be too costly, Congress also included a tax credit up to $5,000 for companies with less than $1 million in annual revenue or fewer than 30 employees. The disabilities act, passed during the summer, requires all businesses to make accommodations for access by people with disabilities.