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Business Succession Planning

  • 8992. What is a buy-sell agreement?

    • Buy-sell agreements are often used in business succession planning where the business is owned by a relatively small group of owners who would otherwise have a limited market in which to sell their business interests (most commonly represented by their stock in the enterprise). A buy-sell agreement can provide the remaining shareholders or co-owners with the option of purchasing the business interests of a deceased or withdrawing co-owner before the business interest is sold to a third party. Business entities such as closely held corporations (Q 8951), LLCs (Q 8977), and partnerships (Q 8927) frequently rely upon buy-sell agreements when creating future business succession plans. A buy-sell agreement is essentially a contract to buy and sell a departing business owner’s interests in a business at some point in the future, usually upon the occurrence of one or more specified events. The most common of the events that can trigger the repurchase are the stockholder’s death or, if also an employee, retirement or the voluntary or involuntary termination of employment.1

      A buy-sell agreement is typically structured as either a cross-purchase agreement or a redemption agreement. A cross-purchase agreement is an agreement among co-owners to purchase each other’s business interests upon the death, or other withdrawal from the business, of one or more owners. These agreements typically specify a predetermined purchase price and, in some cases, are funded by life insurance purchased to insure the lives of the various business owners.

      The typical buy-sell agreement also specifies the method to be used to determine the repurchase price of the shares, selecting from such options as an agreed price with periodic revisions, a formula price based on book value or capitalization of earnings, or third party appraisal or arbitration.

      A redemption agreement allows the business entity to purchase the interest of a deceased or withdrawing business owner upon the occurrence of previously agreed upon “triggering events.” See Q 8999 for a discussion of the different considerations that apply depending upon whether the agreement is structured as a cross-purchase or redemption agreement.

      It is also possible to structure a buy-sell agreement so that it combines features of the cross-purchase agreement and redemption agreement.2 In addition, the buy-sell agreement can involve a contract to sell to a third party or another entity.

      See Q 8993 for a discussion of the importance of buy-sell agreements in business succession planning. Q 8994 outlines the primary methods for funding a buy-sell agreement and Q 8995 outlines the use of life insurance in funding the agreement. Q 8999 to Q 9001 provide an in-depth analysis of the differences between the redemption and the cross-purchase forms of agreements.


      1. Stephenson v. Drever, 16 Cal. 4th 1167 (1997).

      2. See Jacobs v. Comm., TC Memo 1981-81, Rev. Rul. 69-608, 1969-2 CB 42.

  • 8993. Why are buy-sell agreements often used in business succession planning?

    • Use of a buy-sell agreement in the business succession planning context can mean the difference between the orderly withdrawal of a partner, whether by death or otherwise, and possible loss of control over a business by the remaining co-owners.1 In general, business succession planning is intended to ensure that the following goals are met:

      (1) Preserving a deceased co-owner’s wealth and providing liquidity for the estate.

      (2) Providing the remaining owners with the security of knowing they will maintain control of the business without unwanted third-party intervention.

      (3) Ensuring business continuity, if so desired by the remaining business owners.

      (4) Fixing the value2 of the business interest for estate tax purposes to avoid potential IRS intervention.

      The courts have consistently considered the foregoing goals bona fide business reasons for entering into buy-sell agreements, as have the goals of maintaining exclusive family control over a business, assuring continuity of company management policies, and retaining key employees. However, the courts have also noted that “legitimate business purposes” are often ‘inextricably mixed’ with testamentary objectives where the parties to a restrictive stock agreement are all members of the same immediate families, and, as a result, have required taxpayers to satisfy both business purpose and nontestamentary disposition tests for purposes of valuing closely held stock for estate tax purposes.3

      Interests in closely held corporations, LLCs, partnerships and sole proprietorships can have very limited markets for sale. This is particularly problematic when a deceased co-owner either has no heirs to inherit the deceased owner’s interest or has heirs who are poorly equipped or unwilling to take over the business. If the deceased business owner passes the interests to children who are not interested in continuing the business, they may be forced to sell their inherited interests at a discounted price to a third party. Executing a buy-sell agreement ensures that the business owner controls the disposition of business interests by allowing that owner to choose the buyer in advance. This type of succession planning also protects the value of the business as a whole and ensures that this value will pass to the owner’s estate without the need for protracted post-death negotiation.

      Use of a buy-sell agreement can also ensure that the remaining business owners can continue the business without interference from a deceased owner’s heirs or the need for a third party investor following that owner’s death or early withdrawal from the business. The existence of the agreement will prevent a small business owner from selling the owner’s interests to outside investors who may not share the business vision of the remaining co-owners.

      Another individual may hold an option or contract to buy securities owned by a decedent at the time of death. The effect, if any, that is given to the option or contract price in determining the value of the securities for estate tax purposes depends upon the circumstances of the particular case, with little weight being accorded to a price contained in an option or contract under which the decedent is free to dispose of the underlying securities at any price during the decedent’s lifetime. For example, this is the effect of a shareholder’s agreement to buy whatever shares of stock the decedent may own at the time of death.4


      1. See Treas. Reg. § 20.2031-2(h); True v. Comm., TC Memo 2001-167.

      2. See IRC §§ 2031 and Treas. Reg. §

      3. Lauder II, TC Memo 1992-736, True v. Comm., TC Memo 2001-67.

      4. Treas. Reg. §20.2031-2(h).

  • 8994. How is a buy-sell agreement funded?

    • A buy-sell agreement can be funded through the use of the prospective buyer’s own funds, accumulated earnings, debt instruments or insurance (either life or disability).

      While self-funding on the part of the buyer is possible, many selling business owners may prefer the certainty that is provided through other funding methods. Self-funding presents the possibility that the buyer may be unable to obtain the funds upon the selling owner’s death or withdrawal.

      As a result, many buy-sell agreements are funded with insurance. The type of insurance that is required will depend upon the triggering events specified in the buy-sell agreement itself (see Q 8998). If a right to purchase under the agreement is triggered by the seller’s death, the buyer or business may fund the agreement by purchasing life insurance that insures the life of the selling business owner (see Q 8995). Death, however, is not the only type of event that may trigger a buy-sell agreement. If the triggering event is the selling owner’s disability or retirement from the business, funding may be provided more effectively through a disability insurance policy or a permanent life insurance policy that provides the potential for tax-free loans during the life of the insured. It is also common to treat an “involuntary transfer” as a triggering event. Essentially, this will become applicable if a creditor of an owner attempts to seize an interest in the business in pursuit of the collection of a debt. This can occur if an actual debt is owed to a third party or if one of the owners is party to a divorce (or other) proceeding and the interest in the business is being transferred to a spouse who is not an owner. In the event that an involuntary transfer is a triggering event, insurance will not likely be available to fund the purchase.

      If the parties have entered into a cross-purchase agreement, insurance funding is accomplished by the business owners purchasing insurance on the lives of each participating co-owner.

      The entity itself may also set aside accumulated earnings to fund a buy-sell agreement. In a closely held corporation, however, it might be difficult to set aside adequate funds when the operation of the business could benefit from the use of these funds. Further, in case of a C corporation, accumulated earnings above $250,000 can be subject to the accumulated earnings penalty tax (see Q 8960).1 (The limit is $150,000 in the case of a business whose principal function is performing services in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law, and the performing arts.)2 While accumulation of earnings and profits to meet the reasonable needs of the corporation is permissible, the parties must carefully evaluate the strategy to avoid the penalty tax, which may prove time consuming.3

      If insurance funding or accumulation of earnings has not been accomplished in advance, and the buying owners have insufficient cash on hand to fund the buy-sell agreement upon occurrence of a triggering event, a debt instrument can be used. The buying owners may be able to negotiate a series of payments to the selling owner or the estate. In choosing this option, the owners must consider whether the sale will be taxed under the installment sale rules4 and the possible taxation (or deductibility) of the interest payments (see Q 9007 for a discussion of the installment sale rules).5


      Planning Point: It is also important to consider the terms of the promissory notes. Examples include how long the term will extend, if there will be security for the note (i.e. a pledge of the stock being purchased) and if the note is due upon the sale of the business by the remaining owners. It is often good practice to attach a sample of a proposed note to be used for the payout.



      1. IRC §§ 535(c)(1, United States v. Donruss Co., 393 U.S. 297 (1969).

      2. IRC §§ 535(c)(2).

      3. IRC §§ 537(a)(2).

      4. See IRC §§ 453, American Taxpayer Relief Act of 2012, Pub. L. No. 112-240 (which increased the maximum tax rate for long-term capital gains from 15 to 20 percent).

      5. IRC §§ 163(a).

  • 8995. What types of insurance can be used to fund a buy-sell agreement?

    • Many business owners who structure a buy-sell agreement prefer to use insurance to fund the agreement. The insurance provides certainty that the purchase price will be funded, as it can be structured to pay out upon the occurrence of the triggering event(s), usually the death, retirement or permanent disability of the seller. A buy-sell agreement funded through insurance can raise several tax and nontax issues, however.Various types of insurance can be used to fund a buy-sell agreement, including the following:

      (1) Term life insurance. Term life insurance, which provides life insurance coverage for a set amount of time, is a possible funding mechanism, but because the insured may outlive the pre-set term of the policy, it may not present the best option for younger business owners. If the insured outlives the term, the policy may expire and the investment may be lost.

      (2) Cash value life insurance. Various types of permanent life insurance that allow for a build-up of cash value within the policy may be used to fund a buy-sell agreement, and may be especially useful where the triggering event is not the departing business owner’s death. This type of insurance provides for a build-up of cash value over time and permits the policy owner to withdraw a portion of the cash value tax-free. As a result, if the buy-sell agreement is triggered by an event such as the departing owner’s retirement or disagreement over S corporation dividend distributions, for example, the remaining owners can still access the cash value to fund the purchase.

      (3) Disability insurance. Disability insurance can be used to fund a buy-sell agreement where the triggering event is the disability of the departing business owner and, as provided in most disability policies, the owner becomes totally disabled while he is engaged in active full-time work and his ownership interest is purchased pursuant to the agreement.1

      An in-depth discussion of the tax treatment of the use of life insurance in a business context is provided in Q 8763 through Q 8785. The tax treatment of the policy from the standpoint of the insured-employee is discussed at Q 8767, and Q 8765 and Q 8766 outline the deductibility of premiums paid by the employer-business entity.

      See Q 8998 for a discussion of some of the various triggers that may be used in the context of a buy-sell agreement.


      1. See Oak Rd. Family Dentistry, P.C. v. Provident Life & Accident Ins. Co., 370 F. Supp. 2d 1317(2005).

  • 8996. Can the use of life insurance to fund a cross-purchase buy-sell agreement cause the premiums to be treated as constructive dividends to shareholders in a closely-held C corporation? How can this result be avoided?

    • Unless the transaction is properly structured, funding a cross-purchase agreement with life insurance can result in adverse tax consequences if the corporation pays the policy premiums. In the case of a cross-purchase buy-sell agreement between individual shareholders, a shareholder will often purchase life insurance on the lives of the other shareholders in order to fund the agreement (see Q 8995). In many cases, however, the premiums are paid out of corporate resources.

      In the C corporation context, these premium payments may be treated as distributions with respect to stock in the corporation for tax purposes. As a result, the shareholders will be taxed on the premiums paid as though the premiums were dividends that were constructively received by those shareholders.1

      To avoid this result, as long as the corporation itself has no ownership rights or beneficial interest in the policy, it is possible that the corporation could instead pay the policy premium to the policy owner in the form of a bonus. In this case, the shareholders can avoid the constructive dividend tax issue and the corporation will be able to deduct the cost of the premiums paid so long as the payments can be characterized as “reasonable compensation.”2 Reasonable compensation is “such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, rather than those existing at the date when the contract is questioned”.3 A salary that exceeds what is customarily paid for such services is considered unreasonable or excessive.

      If the total amount paid to and on behalf of a stockholder-employee is an unreasonable return for his or her services, the IRS may treat the premium payments as a distribution of profits or dividends rather than as compensation. This also may be the result where there is no evidence, such as board of directors’ meeting minutes, to show that premium payments were intended as compensation.4

      The deduction will be disallowed where surrounding circumstances affirmatively show that premiums were not paid as compensation. In Atlas Heating & Ventilating Co. v. Comm.,5 for example, evidence showed that premiums actually were paid to fund a stock purchase agreement between individual stockholders. Consequently, they were not compensation, but dividends. The policies were owned by the stockholder-employees and proceeds were payable to their personal beneficiaries. The insured individuals had agreed that, on each of their deaths, an amount of stock equal to the proceeds received by the deceased insured’s beneficiaries would be turned in to the corporation and then distributed pro rata to the surviving stockholders.

      See Q 8992 to Q 8999 for a discussion of buy-sell agreements in the context of C corporations generally.


      1.      See, for example, Johnson v. Comm., 74 TC 1316 (1980).

      2.      IRC §§ 162(a), Treas. Reg. §1.162-7.

      3.      Treas. Reg. §1.162-7(b)(3).

      4.      See, for example, Boecking v. Comm., TC Memo 1993-497; Est. of Worster v. Comm., TC Memo 1984-123; Champion Trophy Mfg. Corp. v. Comm., TC Memo 1972-250.

      5.      18 BTA 389 (1929).

  • 8997. What potential tax consequences arise if the corporation owns the life insurance policy on a majority shareholder’s life used to fund a buy-sell agreement, but the named beneficiary is a party other than the corporation?

    • Potential adverse estate tax consequences may result if a life insurance policy used to fund a buy-sell agreement is actually owned by the corporation itself, but the policy beneficiary is someone other than the corporation. If, at the time of death, the insured owns more than 50 percent of the corporation’s voting stock, the entire value of the death benefit paid out under the policy may be included in the insured’s estate.1 This is because, as a majority shareholder in the corporation that owns the actual policy, the insured will be deemed to have retained incidents of ownership in the policy that are sufficient to warrant inclusion of the death benefit in his or her estate.

      These adverse tax consequences only exist if three circumstances are present: (1) the corporation is the named owner of the policy, (2) the insured owns more than a 50 percent interest at death and (3) the policy beneficiary is not the corporation.

      Any proceeds payable to a third party for a valid business purpose (for example, satisfaction of the corporation’s business debt), so that the corporation’s net worth is increased by the amount of the proceeds, will be deemed to be payable to the corporation and so will not be attributed to the decedent.

      In order to avoid the inclusion of the death benefit in the insured’s estate, the corporation could name itself as policy beneficiary or could take steps to ensure that the insured owns less than 50 percent of the corporation’s voting stock upon his or her death.


      1.      Treas. Reg. §20.2042-1(c)(6).

  • 8998. When is a buy-sell agreement triggered? What are the differences between mandatory and optional buyout triggers?

    • A buy-sell agreement is triggered upon the occurrence of certain specified “triggering events.” The parties to the agreement may build one or more triggering events into their particular buy-sell agreement, depending upon the anticipated succession issues.1 Typical triggering events include the death, loss of required professional license, retirement or disability of an owner or shareholder, or an involuntary transfer.

      If the buy-sell agreement is triggered by an owner’s disability, the owners should include a definition of “disability” in the agreement to minimize disagreement between the buying and selling owners. Further, if using disability insurance to fund the agreement, the policy itself should contain a corresponding definition of disability that all parties understand.


      Planning Point: This can also be done by reference.For example, the agreement could provide that the definition of disability will be as set forth within certain specified disability insurance policies.


      This minimizes the risk that the buy-sell agreement will be triggered in the minds of the parties, but the insurance will not cover the disability that has actually occurred. Both the Uniform Probate Code and the Social Security Administration provide definitions of “disability” that may provide useful information to small business owners negotiating contract provisions.2


      Planning Point: While it may seem convenient to incorporate the definition of “disability” in a buy-sell agreement by reference to a frequently referred to government description, this approach is not always wise. For example, Section 223(d) of the Social Security Act defines disability as “inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which has lasted or can be expected to last for a continuous period of not less than 12 months.”3 While this definition may seem unequivocal, it has been the subject of litigation in a number of cases. In one case, the Plaintiff unsuccessfully argued that the position of the word “which” in the definition supported his claim that only the impairment is required to extend over the one-year period, and that this requirement does not apply to the term, “inability to engage in any substantial gainful activity.”4 Incorporation by reference is no substitute for precise draftmanship.


      Buy-sell agreements are perhaps most frequently triggered by the death or retirement of a business owner in the small business context (see Q 8993 for a discussion of the motivations behind using a buy-sell agreement to plan for these triggering events).

      A triggering event can be either mandatory or optional.After the triggering events have been determined, the parties must determine whether they wish to provide that occurrence of the event makes purchase mandatory, or merely creates a right or an option to purchase under the buy-sell agreement. Like any other contract, the parties have freedom to negotiate the contract terms in a buy-sell agreement in order to reflect the specific needs of the business. There are three common rights that are negotiated in the context of buy-sell agreements, including (1) mandatory purchase requirements, (2) “call”-type options and (3) “put”-type options.

      As the name suggests, if the parties provide for a mandatory purchase, all parties to the agreement will be obligated to complete the sale once the triggering event has occurred.5

      The agreement can also provide for a call-type option, under which the buyer is given the option to purchase upon the occurrence of the triggering event. In this case, if the buyer exercises the option, the selling owner is required to sell the interests.

      Conversely, the agreement can provide for a “put” type option, under which the seller is given the option to sell upon the occurrence of a triggering event, and the buyer will then be required to purchase the interests.

      In any of these three situations, the triggering event will be crucial to determining whether the provisions of the buy-sell agreement are activated.6 The parties must consider the fact that, as in any other option contract, if the rights are structured similarly to put or call options, the party giving the option will be free to exercise the option or not to exercise the option upon occurrence of the triggering event. On the other hand, the party who gave the option is bound to perform once the option is exercised within the terms of the agreement.7


      1.      E.g., Maxx Private Invs., LLC v. Drew/Core Dev., LLC, 24 Mass. L. Rep. 456, 2008 Mass. Super. LEXIS 298 (2008).

      2.      See Uniform Probate Code §5-103(f), Social Security Law 42 USCA §416(i)(1).

      3.      42 U.S.C. Section 423(d).

      4.      Alexander v. Richardson, 451 F. 2d 1185 (10th Circuit 1971).

      5.      True v. Comm., TC Memo 2001-167, 2001 TCM LEXIS 199 (2001).

      6.      E.g., Thomas by & Through Schmidt v. Thomas, 532 N.W.2d 676(1995).

      7.      Fries v. Fries, 470 N.W.2d 232 (1991), Wessels v. Whetstone, 338 N.W.2d 830 (1983).

  • 8999. What is the “redemption” type buy-sell agreement? How is this different from a cross-purchase buy-sell agreement?

    • A “redemption” type agreement is structured so that it is the business entity (usually a corporation), rather than the individual owners, that agrees to purchase the business interests of an owner under a buy-sell agreement.1 A cross-purchase agreement is an agreement among owners to purchase the business interests of another co-owner.2

      In many respects, structuring a redemption-style buy-sell agreement may be much simpler because there is only one buyer, the corporation or business entity.Conversely, in a cross-purchase agreement, multiple buyers may be involved, depending on the number of co-owners involved in the business. Funding a cross-purchase agreement can also prove more complicated than in a redemption context, especially if the agreement is funded by insurance policies owned by multiple shareholders, rather than the entity itself.

      Choosing between a redemption or cross-purchase style agreement may trigger many non-tax issues. For example, state laws may restrict a corporation’s redemption of its own stock3 in cases where the redemption can risk the corporation’s insolvency or impair its capital.4 Conversely, there are no similar restrictions upon the sale of one stockholder’s shares to another stockholder under a cross-purchase agreement.

      Sale of stock between the shareholders of a corporation under a cross-purchase agreement creates the same tax consequences as would the sale of the securities in any other context (see Q 8958 and Q 8790).

      However, if the corporation participates in the purchase, as it does in a redemption agreement, the purchase may be treated as a dividend distribution.5 See Q 9000 for a discussion of IRC Section 302 redemptions and Q 9001 for a discussion of IRC Section 303 redemptions.

      As a general rule, any payment by a corporation other than an S corporation to a shareholder will be treated as a dividend rather than a capital transaction even if the payment is made to redeem stock.6

      In any case where an amount received in redemption of stock is treated as a dividend distribution, the basis of the remaining stock is adjusted with respect to the stock redeemed. For example, A, an individual, buys all of the stock of Corporation X for $100,000. Thereafter, the corporation redeems half of the stock for $150,000, and it is determined that this amount constitutes a dividend. The remaining stock of Corporation X held by A has a basis of $100,000.7

      In the context of closely held corporations, characterization as a stock redemption is important for at least two additional reasons. First, if a redemption is treated as a sale or exchange, the basis of the shares retained by the seller, if any, is unaffected by the transaction. If redemption is treated as a dividend, the basis of the shares redeemed is added to the basis of the shares retained.8

      Second, if redemption is treated as a sale or exchange, the part of the distribution properly chargeable to earnings and profits is an amount not in excess of the ratable share of earnings and profits of the corporation attributable to the redeemed stock.9 If a redemption is treated as a dividend, earnings and profits of the corporation are reduced by the amount of money or other property distributed by the corporation.10


      1.      E.g., Glacier State Electric Supply Co. v. Comm., 80 TC 1047 (1983), IRC §§ 302.

      2.      E.g., Rodeo Family Enters., LLC v Matte, 2011 N.Y. Misc. LEXIS 2004 (2011).

      3.      See Revised Model Business Corp. Act. §6.40 (1984); Del. Code Ann. tit. 8, §160 (1974).

      4.      See, e.g., Fla. Stat. Ch. 607.06401, N.C. Gen. Stat. §55-6-40, 11 Vt. Stat. Ann. 11A, §6.40.

      5.      See IRC §§ 304(a)(1).

      6.      IRC §§ 301(a), Rev. Rul. 55-515, 1955-2 CB 222.

      7.      Treas Reg. §1.302-2(c) Example 1.

      8.      Treas. Reg. §1.302-2(c).

      9.      IRC §§ 312(n)(7).

      10.    IRC Secs. 312(a), 316(a).

  • 9000. What is an IRC Section 302 stock redemption?

    • One of the exceptions to dividend treatment (discussed in Q 8999) is contained in IRC Section 302(b)(3). IRC Section 302(b)(3) provides that if a corporation redeems all of a shareholder’s remaining shares so that a shareholder’s interest in the corporation is terminated, the amount paid by the corporation will be treated as a payment in exchange for the stock, not as a dividend. In other words, the redemption will be treated as a capital transaction (see Q 8604 to Q 8634).1
      There will be no taxable dividend, then, if a corporation redeems all of its stock owned by an estate. In determining what stock is owned by an estate, the constructive ownership or attribution-of-ownership rules contained in IRC Section 318 must be applied.Consequently, to achieve non-dividend treatment under IRC Section 302(b)(3), a corporation must redeem not only all of its shares actually owned by an estate, but also all of its shares constructively owned by the estate.

      One of these constructive ownership rules provides that shares owned by a beneficiary of an estate are considered owned by the estate. For example, assume that a decedent owned 250 shares of Corporation X’s stock, so that the decedent’s estate now actually owns 250 shares. Assume further that a beneficiary of the decedent’s estate owns 50 shares. Because the estate constructively owns the beneficiary’s 50 shares, the estate is deemed to own a total of 300 shares. Redemption of the 250 shares actually owned, therefore, will not affect a redemption of all the stock owned by the estate.

      Further, stock owned by a close family member of a beneficiary of an estate may be attributed to an estate beneficiary, because of the family constructive ownership rules, and through the estate beneficiary to the estate. An estate beneficiary would be considered to own, by way of family attribution rules, shares owned by the decedent’s spouse, children, grandchildren, and parents.2 There are two ways in which the family attribution rules can be addressed.

      First, the First Circuit has held that where, because of hostility among family members, a redeeming shareholder is prevented from exercising control over stock that the individual would be deemed to own constructively under attribution rules, the attribution rules will not be applied to the individual.3

      On the other hand, the IRS has indicated it will not follow this decision and has ruled that the existence of family hostility will not affect its application of attribution rules.

      If certain conditions are met, however, the IRS will not apply the ruling to taxpayers who have acted in reliance on the IRS’ previously announced position on this issue.4 The Fifth Circuit also has taken the position that the existence of family hostility does not prevent application of attribution rules, thus creating disagreement between the two circuit courts that have ruled on the question.5 The Tax Court consistently has held that hostility within a family does not affect application of attribution rules.6

      The second way in which the family attribution rules can be addressed is if the sale of the departing owner’s interest qualifies as a complete termination of the shareholder’s interest.7 A family member, as well as entities such as estates and trusts, can accomplish a complete termination by waiving the family attribution rules if (1) the departing owner has no interest in the corporation immediately after the sale, (2) the owner does not acquire any such interest within 10 years from the date of the sale (other than stock acquired by gift or inheritance), and (3) the owner agrees in writing to notify the IRS of any acquisition described in (2).8

      Constructive ownership rules are complicated and their application requires expert legal advice. It generally may be said that a danger of dividend tax treatment exists in every case involving a family-owned corporation engaging in a stock redemption. There are, however, means available in some cases to avoid the harsh operation of the rule. A partial redemption may be able to escape dividend tax treatment even in a family-owned corporation.


      1.      Rev. Rul. 77-455, 1977-2 CB 93.

      2.      IRC §§ 318(a).

      3.      Robin Haft Trust v. Comm., 75-1 USTC ¶9209 (1st Cir. 1975).

      4.      Rev. Rul. 80-26, 1980-1 CB 66; IRC §§ 7805(b).

      5.      David Metzger Trust v. Comm., 82-2 USTC ¶9718 (5th Cir. 1982), cert. den., 463 U.S. 1207 (1983).

      6.      See Cerone v. Comm., 87 TC 1 (1986).

      7.      IRC §§ 302(b)(3); see IRC §§ 302(c)(2) for situations in which constructive ownership rules of IRC §§ 318(a)(1) will not apply.

      8.      IRC Section 302(c)(2).

  • 9001. What is an IRC Section 303 stock redemption? How is a Section 303 redemption useful in the context of a closely-held corporation?

    • IRC Section 303 was enacted expressly to help solve the liquidity problems frequently faced by estates that are comprised largely of stock in a closely-held corporation, and to protect small businesses from forced liquidations or mergers due to the impact of estate taxes. Within the limits of IRC Section 303, surplus can be withdrawn from the corporation income tax-free.

      In certain instances, stock of a public corporation also may be redeemed under IRC Section 303.

      Any payments by a corporation to a shareholder generally are treated as dividends (see Q 8999). Despite this, under certain circumstances IRC Section 303 allows a corporation to redeem part of a deceased stockholder’s shares without the redemption being treated as a dividend. Instead, the redemption price will be treated as payment in exchange for the stock in a capital transaction.

      An IRC Section 303 redemption can safely be used in connection with the stock of a family-owned corporation because the constructive ownership rules (see Q 9000) are not applied in an IRC Section 303 redemption.1

      The following conditions must be met if a stock redemption is to qualify under IRC Section 303 for non-dividend treatment:

      (1)     The stock that is to be redeemed must be includable in the decedent’s gross estate for federal estate tax purposes.

      (2)     The value for federal estate tax purposes of all stock of a redeeming corporation that is includable in a decedent’s gross estate must comprise more than 35 percent of the value of the decedent’s adjusted gross estate.2 The “adjusted gross estate” for this purpose is the gross estate less deductions for estate expenses, indebtedness and taxes3 and for unreimbursed casualty and theft losses.4 The total value of all classes of stock includable in a gross estate is taken into account to determine whether this 35 percent test is met, regardless of which class of stock is to be redeemed.5

      IRC Section 303(b) provides that a corporate distribution in redemption of stock will qualify as an IRC Section 303 redemption if all the stock of the corporation that is included in determining the value of a gross estate exceeds 35 percent of the adjusted gross estate. Although most gifts made by a donor within three years of death are not brought back into the donor’s gross estate under IRC Section 2035, certain kinds of gifts are brought back. These are the “first kind of exception” gifts. Gifts of corporate stock that fall within this classification are part of a gross estate for purposes of computing the 35 percent requirement (or the 20 percent requirement discussed below) and a corporation’s redemption of this stock will qualify as a sale or exchange if all other requirements of IRC Section 303 are satisfied. IRC Section 2035(c)(1)(A) states generally that the three year rule will apply for the purposes of IRC Section 303(b). This is generally interpreted as follows: If a decedent makes a gift of any kind of property within three years of his or her death, the value of the property given will be included in the decedent’s gross estate for purposes of determining whether the value of the corporate stock in question exceeds 35 percent of the value of the gross estate, but a distribution in redemption of that stock will not qualify as an IRC Section 303 redemption unless the stock redeemed actually is a part of the decedent’s gross estate.6

      The stock of two or more corporations will be treated as that of a single corporation, provided that 20 percent or more of the value of all of the outstanding stock of each corporation is includable in a decedent’s gross estate.7 Only stock directly owned is taken into account in determining whether the 20 percent test has been met; constructive ownership rules do not apply even when they would benefit a taxpayer.8 Stock that, at a decedent’s death, represents the surviving spouse’s interest in property held by the decedent and the surviving spouse as community property or as joint tenants, tenants by the entirety, or tenants in common is considered to be includable in a decedent’s gross estate for the purpose of meeting the 20 percent requirement.9 The 20 percent test is not an elective provision, meaning that if a distribution in redemption of stock qualifies under IRC Section 303 only by reason of the application of the 20 percent test and also qualifies for sale treatment under another section of the IRC, the executor may not elect to have only the latter section of the IRC apply and thus retain the undiminished IRC Section 303 limits for later use. All distributions that qualify under IRC Section 303 are treated as IRC Section 303 redemptions in the order they are made.10

      (3)     The dollar amount that can be paid out by a corporation under protection of IRC Section 303 is limited to an amount equal to the sum of (x) all estate taxes, including the generation-skipping transfer tax imposed by reason of the decedent’s death, and federal and state inheritance taxes attributable to a decedent’s death, plus interest, if any, collected on these taxes, and (y) funeral and administration expenses allowable as estate deductions under IRC Section 2053.11

      (4)     The stock must be redeemed not later than (x) three years and 90 days after the estate tax return is filed (the return must be filed within nine months after a decedent’s death), (y) 60 days after a Tax Court decision on an estate tax deficiency becomes final, or (z) if an extension of time for payment of tax is elected under IRC Section 6166, the time determined under the applicable section for payment of the installments. For any redemption made more than four years after a decedent’s death, however, capital gains treatment is available only for a distribution in an amount that is the lesser of the amount of the qualifying death taxes and funeral and administration expenses that are unpaid immediately before the distribution, or the aggregate of these amounts that are paid within one year after the distribution.12

      (5)     The shareholder from whom stock is redeemed must be one whose interest is reduced directly, or through a binding obligation to contribute, by payment of qualifying death taxes and funeral and administration expenses, and the redemption will qualify for capital gains treatment only to the extent of that reduction.13 That is, “the party whose shares are redeemed [must actually have] a liability for estate taxes, state death taxes, or funeral and administration expenses in an amount at least equal to the amount of the redemption.”14

      The stock of any corporation, including an S corporation, may qualify for IRC Section 303 redemption. Moreover, any class of stock may be redeemed under IRC Section 303. Thus, a nonvoting stock, common or preferred, issued as a stock dividend or issued in a lifetime or post-death recapitalization can qualify for the redemption.15


      1.      IRC Secs. 318(a)-(b).

      2.      IRC §§ 303(b)(2)(A).

      3.      IRC §§ 2053.

      4.      IRC §§ 2054.

      5.      Treas. Reg. §1.303-2(c)(1).

      6.      Rev. Rul. 84-76, 1984-1 CB 91.

      7.      IRC §§ 303(b)(2)(B).

      8.      Est. of Byrd v. Comm., 21 AFTR 2d 313 (5th Cir. 1967).

      9.      IRC §§ 303(b)(2)(B).

      10.    Treas. Reg. §1.303-2(g); Rev. Rul. 79-401, 1979-2 CB 128.

      11.    IRC Secs. 303(a), 303(d).

      12.    IRC Secs. 303(b)(1), 303(b)(4).

      13.    IRC §§ 303(b)(3).

      14.    H.R. Rep. No. 94-1380 at 35 (Estate and Gift Tax Reform Act of 1976), reprinted in 1976-3 CB (Vol. 3) 735 at 769.

      15.    Treas. Reg. §1.303-2(d).

  • 9002. How are interests subject to a buy-sell agreement valued?

    • One of the most difficult areas in negotiating a buy-sell agreement is determining the purchase price for the interests that are the subject of the agreement. Advance agreement upon the purchase price, or the method for determining the purchase price, is important, because failure to include pricing terms may make enforcement of the agreement problematic. There are three common methods used in determining the purchase price. The parties may either (1) set a fixed price; (2) use a formula to determine price; or (3) obtain an independent appraisal.

      The valuation provided under the buy-sell agreement is not always determinative of the parties’ final tax liabilities, however, especially in the case of a closely-held company where the IRS could argue that the interests were undervalued and attempt to impose penalties under Section 6662.1 Use of an independent appraiser can help to alleviate this concern for some companies.

      However, if the valuation in the buy-sell agreement complies with the “price term control test,” the purchase price in the buy-sell agreement will generally control the value of the asset for estate tax purposes.2 For the terms of the buy-sell agreement to control for estate tax purposes, therefore, it is important that the agreement prohibit the decedent from transferring shares outside of the buy-sell agreement for any other price than that which is specified in the agreement. Further, the parties must be able to demonstrate that, based on the specific circumstances of the case, the buy-sell agreement represents a legitimate business arrangement, rather than a disguised scheme to pass the shares at an artificially low value to the deceased owner’s children or other natural beneficiaries. If, however, the parties fail to show that the buy-sell agreement represents such a legitimate arrangement, the price of the underlying securities may be disregarded in arriving at the value of the stock.3

      It is also necessary to address the requirements of IRC Section 2703. Under Section 2703, the IRS will disregard the price established in the buy-sell agreement for establishing the fair market value of the interest being sold unless certain requirements are met. Specifically, (i) the agreement must be a bona fide business arrangement, (ii) the agreement must not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration, and (iii) the terms must be comparable to similar arrangements entered into by persons in an arms’ length transaction.4


      Planning Point: While using a fixed price may be the simplest method for the parties, it is important that the agreement is reviewed at regular intervals to ensure that the price still accurately reflects the value of the business to avoid IRS intervention. On a practical level, clients frequently fail to update these stipulated values.


      If the parties develop a formula to determine the pricing under a buy-sell agreement5 it is important that they clearly define all terms necessary to determine the price under that formula. Further, they should be aware that the courts may set aside the formula in certain cases, including cases where the formula was not determined in an arm’s length negotiation or is found to be against public policy.6


      Planning Point: Some agreements provide for a stipulated value. However, if the stipulated value is not updated with a specified period of time (i.e., two years), then a formula is used to determine the value.


      See Q 9003 for a discussion of the use of so-called “showdown clauses” in pricing under a buy-sell agreement.


      1.      See also True v. Comm., 2001 TCM LEXIS 199 (2001) for an illustration of understatement penalties that may apply.

      2.      See Treas. Reg. §20.2031-2(h); True v. Comm., above.

      3.      Treas. Reg. §20.2031-2(h).

      4.      IRC §§ 2703(b).

      5.      See e.g., Anderson v. Comm., 1970 TCM LEXIS 10 (1970).

      6.      See e.g., Hendrix v. Comm., TC Memo 2011-133 (in this case the pricing was upheld, but the court discussed the circumstances that might cause it to be set aside).

  • 9003. What is a “showdown clause” in the context of a buy-sell agreement? When should one be used?

    • A showdown clause, also known as “shoot out,” “slice-of-the-pie,” “Russian roulette” or “Chinese wall” clauses, essentially allows one party to name a price upon the occurrence of a triggering event under a buy-sell agreement. Upon occurrence of the triggering event, one party specifies a price at which the party would buy (or sell) the business interests at issue, and the others decide whether to buy the interests (or sell their interests) to the naming party.

      When a business owner invokes a showdown clause, this is essentially expressing a decision to exit the business. This provision works best if both sides are in an equal financial position because, if the parties are on unequal footing, the clause may provide a route for one owner to unjustifiably “chase out” a co-owner from the business. A showdown clause is frequently invoked in a situation where a deadlock in management or another similar issue exists among the various business owners that cannot be resolved through other methods.1

      In Wilcox v. Styles,2 a showdown clause was enforced by the courts, leading to an eventual dissolution of the business due to a deadlock over management issues that occurred between the two business owners of a closely-held corporation. The court upheld both the agreement containing the showdown clause and the pricing specified under the agreement, which was supported in part by an independent expert appraisal. The court in this case emphasized the importance of the written agreement—a mere oral agreement would be insufficient.3

      Generally, offers made pursuant to a showdown clause cannot be used to establish the value of the business interest for estate tax purposes. By their nature, showdown clauses involve voluntary lifetime transfers of property, and do not prevent the interests from being sold at a higher price than that specified in the buy-sell agreement (see Q 9002).


      1.      RS & P/WC Fields Ltd. Partnership v. BOSP Invs., 829 F. Supp. 928 (1993).

      2.      127 Or. App. 671 (1994).

      3.      Bruce v. Cole, 854 So. 2d 47 (2003).

  • 9004. How can the fact that a business owner holds a minority or majority interest in an entity impact the use of a buy-sell agreement?

    • Control premiums and minority discounts are especially important in the small business context where the business is owned by a small group of individuals who may also be significantly involved in the day-to-day operations of the business. Control and minority issues may be important in establishing the value of business interests that are subject to a buy-sell agreement.

      Normally, an interest in a business is valued in proportion to the entire value of the business. However, application of a premium that reflects one owner’s (or a group of owners’) ability to control business affairs, including the ability to withdraw business assets, has been recognized in many cases.1 In other cases, premium pricing has been found appropriate in a context where one owner functions as the “swing vote” within the business, in recognition of the substantial influence that the owner has over the business’ affairs.2

      A premium is not always available, however in the swing vote context, as it involves a fact-intensive analysis. For example, the Ninth Circuit did not allow a premium for swing vote status in the case of Simplot v. Commissioner, reversing the Tax Court’s determination of value that was based largely on scenarios constructed by the court to prove the value of the particular owner’s influence and control. The Ninth Circuit found that it was an error for the Tax Court to base value on fictional potential purchasers, rather than concrete facts.3

      A valuation discount has often been applied in the context of minority ownership interests in order to reflect the lack of control that these owners may influence over business affairs.4 In certain cases, a minority discount is combined with a discount for lack of marketability that is generally found in the small business context.5 (It should be noted that the discount for lack of marketability is often available even for majority interests in a closely-held business.)6

      Minority discounts will generally be disallowed, however, in the context of larger companies, where securities are marketable and there are multiple business owners.7


      Planning Point: It becomes a client decision as to whether or not the valuation approach should account for any premiums or discounts associated with a minority or controlling interest in the business. For example, the agreement can be drafted to determine a value for the overall business, with this value to be multiplied by the percentage interest in the business being sold. This approach does not reflect any premium or discount. In the alternative, the valuation can be calculated to reflect the value of a specific percentage interest of the business (i.e. the fair market value of a 30 percent interest in the business). This approach will take into account discounts or premiums.



      1.      On control premiums generally, see Estate of Bright v. United States, 658 F.2d 999 (1981); Estate of Desmond v. Comm., TC Memo 1999-76 (majority stock interest in an S corporation was subject to a control premium); Rakow v Comm., TC Memo 1999-177 (controlling interest in corporation was subject to a control premium).

      2.      Estate of Winkler v. Comm., TC Memo 1989-231 and Let. Rul. 9436005.

      3.      Estate of Simplot v. Comm., 249 F.3d 1191 (2001), rev’g 112 TC 130 (1999).

      4.      See, e.g., Knott v. Comm., TC Memo 1987-597; Estate of Berg v. Comm., TC Memo 1991-279; Moore v. Comm., TC Memo 1991-546 (minority interest in a general partnership). But see also Ahmanson Found. v. United States, 674 F.2d 761 (1981); Estate of Curry v. United States, 706 F.2d 1424 (1983); Citizens Bank & Trust Co. v. Comm., 839 F.2d 1249 (1988) (no discount for nonvoting interest if the same decedent held majority of voting interest).

      5.      Estate of Hecksher v. Comm., 63 TC 485 (1975); Estate of Titus v. Comm., TC Memo 1989-466; Moore v. Comm., TC Memo 1991-546 (minority discount); Mandelbaum v. Comm., TC Memo 1995-255 (lack of marketability discount) and McCormick Estate v. Comm., TC Memo 1995-371 (minority discount and lack of marketability discount); Gross v. Comm., TC Memo 1999-254 (minority interest in S corporation was given a combined minority and lack of marketability discount).

      6.      Estate of Bennett v. Comm., TC Memo 1993-34; Estate of Andrews v. Comm., 79 TC 938 (1982).

      7.      Snyder v. Comm., 93 TC 529 (1989); Estate of Dougherty v. Comm., TC Memo 1990-274; Citizens Bank & Trust Co. v. Comm., 839 F.2d 1249 (1988).

  • 9005. What is a right of first refusal? What is the difference between a right of first refusal and a buy-sell agreement?

    • A right of first refusal requires that a selling business owner give his or her co-owners or the business entity itself the opportunity to purchase certain business interests at the same price that he or she is able to obtain from a third party investor.1 The co-owners will be given the option of matching the terms of the competing offer before the selling owner is able to sell his or her interests to a third party. Though the agreed upon price may not fix the value of the interest for estate and gift tax purposes,2 it can be considered as one of the factors that could determine its value. Likewise, the depressive effect of a restrictive agreement such as a right of first refusal is one of the factors that should be considered in valuing a gift of stock.3

      While a right of first refusal may provide comfort to all business owners in that they know they will have a right to purchase a departing business owner’s shares before third parties are given the right, business owners must remember that in the context of a closely-held business, there is often a very limited market for the shares. Even if a business owner is able to find a third party buyer, the remaining business owners will then be forced to come up with a matching purchase offer, which may prove difficult in the small business context when funds are more limited.

      Further, a right of first refusal often gives a departing business owner the power to find a willing buyer that the remaining business owners may be forced to accept in the event that they are unable to match the purchase price. As the departing business owner will no longer be involved in the business’ operations, he or she may not be the person best suited to choose a replacement owner.

      In the context of a buy-sell agreement, if the triggering event is the withdrawal of one business owner, only the remaining owners or entity itself have the right to purchase the departing owner’s interests. The price or method for determining the price will be fixed by the agreement, and the agreement has often been pre-funded with insurance or accumulated earnings in order to ensure that the remaining owners are able to make the purchase. Therefore, the buy-sell agreement is often the more advantageous method for planning a departing business owner’s transition.


      1.      See True v. Comm., 390 F.3d 1210 (2004); Oldcastle Materials, Inc. v. Rohlin, 343 F. Supp. 2d 762 (2004).

      2.      Fry Est. v. Comm., 9 TC 503 (1947).

      3.      James v. United States, 148 F.2d 236 (1945).

  • 9006. What special considerations apply when an S corporation uses a buy-sell agreement?

    • Owners of S corporations, like C corporations, can execute buy-sell agreements to provide for the transition of a business owner’s interests based upon one or more triggering events. The S corporation also may choose to structure the agreement as either a cross-purchase or redemption agreement. In addition to the factors that are important to any business, S corporations must consider the following factors: (1) preservation of the S corporation status; (2) requiring distributions to ensure shareholders have adequate funds to pay for the S corporation’s income taxes at the shareholder level; and (3) protecting its fiscal year.

      When an S corporation1 fails to qualify as an S corporation, it automatically becomes a C corporation.2 Because S corporation qualification is tied to the number and types of shareholders, the use of a properly structured buy-sell agreement may be critical to protecting the business’ qualification as an S corporation.3 Provisions prohibiting certain transfers and acts should be included in the buy-sell agreement, including:4

      (1)     prohibitions on the transfer of stock to a prohibited S corporation shareholder, such as a corporation, foreign individual or ineligible trust; and

      (2)     prohibitions on the transfer of stock to an additional new shareholder if the transfer would bring the total number of shareholders above the permitted number (currently 100).

      Further, an S corporation buy-sell agreement may contain different triggering events than those commonly used for a C corporation or partnership. An S corporation must make a variety of elections that can impact all of its shareholders. The fact that an S corporation is limited to issuing one class of stock (see Q 8975) often means that rights to liquidation proceeds and distribution requirements must be uniform for all shareholders so that variances are not found to create a second class of stock and disqualify the S corporation. A corporation is treated as having only one class of stock if all of the corporation’s outstanding shares confer identical rights to distribution and liquidation proceeds 5 A buy-sell agreement could be structured so that remaining business owners have the right to purchase the interests of a shareholder who disagrees with the rights created with respect to the S corporation’s single class of stock.

      Because S corporations are taxed at the individual shareholder level, rather than at the entity level, regardless of whether the S corporation actually distributes dividends, a buy-sell agreement can be used to ensure the shareholders’ ability to pay their income tax liabilities.6 A provision that triggers a buyout upon failure of the S corporation to meet its dividend obligations could be used to protect the interests of less wealthy shareholders.

      Buy-sell agreements may also be useful in protecting the fiscal year of the S corporation. Generally, an S corporation is required to observe a calendar year as its tax year unless it can establish a valid reason for adopting a fiscal year.7 If more than 50 percent of the S corporation’s shares are transferred, it must change to a calendar year or reestablish its entitlement to a fiscal year.8 To prevent this occurrence, an S corporation’s buy-sell agreement should contain provisions that would prevent shareholders from transferring enough shares to disqualify the S corporation from its current use of a fiscal year, if desired.


      1.      IRC § 1361(b).

      2.      IRC § 1362(d).

      3.      Hunt v. Data Mgmt. Resources, Inc., 26 Kan. App. 2d 405, 985 P.2d 730 (1999).

      4.      See Minton v. Comm., TC Memo 2007-372 (example of binding shareholder agreement).

      5.      Treas. Reg. § 1.1361-1(l)(2)(iv), (Ex. 6).

      6.      IRC §§ 7519, 444.

      7.      IRC § 1378. See also Rev. Proc. 87-57, 1987-2 CB 687, Rev. Proc. 87-32, 1987-2 CB 396, regarding what constitutes a sufficient business purpose for adopting a fiscal year that does not end on December 31.

      8.      Tax Reform Act of 1986, Pub. L. No. 99-514, § 806(e).

  • 9007. How can an installment sale be used to “fund” a buy-sell agreement?

    • Any disposition of property where at least one payment will be received after the close of the tax year of disposition may be treated as an installment sale.1 Generally, however, the installment method of taxation (see below) is not available for sales between certain related parties unless they can clearly establish that the transaction was not intended to avoid tax.2

      Gain on an installment sale is required to be reported under the installment method unless the taxpayer “elects out” of using the method by the due date for filing a return (including extensions) for the year of the sale. Taxpayers may elect out by reporting all the gain as income in the year of the sale on Form 4797 (Sales of Business Property), or on Form 1040, Schedule D (Capital Gains and Losses), and Form 8949 (Sales and Other Dispositions of Capital Assets).3

      Installment sales are often used in the context of a buy-sell agreement where the business owners have not planned in advance to fund the purchase through the use of insurance or otherwise (see Q 8994 and Q 8995). Though installment sales may be used to purchase the interests of a departing business owner, they do not provide the immediate liquidity to the retiring owner or deceased owner’s estate that can be realized through a life insurance strategy or by using accumulated earnings to purchase the interest outright.


      Planning Point: Practically, an installment sale may be the only means of purchasing a departing business owner’s interests if the buy-sell agreement was not funded in another manner.


      Essentially, an installment sale requires the corporation (or shareholders if the buy-sell agreement is structured as a cross-purchase agreement, see Q 8999) to purchase the interests of the departing business owner using a note, under which it will pay for the interests over time. The departing business owner (or that owner’s estate) reports gain on the sale using the “installment method,” which means that the gain for any given year equals the part of the gain that is actually received (or considered to have been received) during that tax year. The departing business owner must also report as income the amount of the payments received in the year that are deemed to represent interest income. The portion that is deemed to be a return of the owner’s adjusted basis in the interests is excluded as in any other sale.4 See Q 8609, Q 8936 and Q 8959 for a discussion of determining basis in various contexts.

      The departing owner can elect out of the installment sale method and report the entire amount of gain in the year of sale, even though he or she has not yet received all of the proceeds.

      The installment method cannot be used if the business interests at issue are securities that are publicly traded on an established market.5


      1.      IRC § 453(b)(1).

      2.      IRC § 453(g)(2). If the buyer disposes of the asset within 2 years of the purchase, there are additional restrictions in IRC § 453(e), also called the anti-Rushing Rule, see Rushing v Comm., 441 F.2d 593 (5th Cir. 1971).

      3.      IRS Tax Topics 705 (May 28, 2015).

      4.      See IRS Publication 537.

      5.      IRS Pub. 537, above.

  • 9008. What are the tax consequences of using an asset sale to liquidate a C corporation, rather than transitioning the business through some other form of succession planning?

    • Liquidation is the winding down of a corporation’s affairs until it is completely divested of all assets. A status of liquidation exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to shareholders.1

      If a corporation decides that the best option is to liquidate, rather than transition ownership of the company through another form of succession planning, there are a variety of methods that can be used in such liquidation.

      Similarly to the corporation’s taxation while operating as an active business, the liquidated company is generally subject to double taxation because both the corporation and shareholders will be liable for taxes on the sale proceeds. In an asset sale, the corporation sells all of its assets to a buyer, recognizing gain on the transaction as the difference between its basis in the assets and the amount realized.2 After taxes and expenses, the corporation distributes any excess to its shareholders, who are then subject to tax at the individual level.3

      The asset sale can also be structured as an installment asset sale, which allows the buyer to purchase the company over a period of time using a note or other debt obligation (see Q 9007 for a discussion of the installment method of taxation).4 Despite this, if the entire business is sold through an installment sale, a special rule applies that requires the business to allocate the selling price and payments between three classes of assets: (1) assets sold at a loss, (2) real and personal property eligible for the installment method of taxation, and (3) property that is ineligible to be sold in an installment sale, such as publicly traded securities and inventory. Gain on the sale of property that is ineligible for the installment method of taxation must be reported in the year of sale, rather than over the time period in which the installment payments are made.5


      1.      Treas. Reg. § 1.332-2(c).

      2.      IRC § 336(a).

      3.      IRC § 331(a).

      4.      IRC § 453B(a).

      5.      See IRS Pub. 537.

  • 9009. What tax considerations make the liquidation of an S corporation different than the liquidation of a C corporation?

    • IRC Section 1371 provides that an S corporation is subject to the same rules that apply in the context of a C corporation unless there is a specific rule that has been developed for S corporations. Despite this, one of the primary differences between an S corporation and a C corporation is their basic tax treatment, which has an important impact upon the issues that the entity will face during liquidation. Because S corporations are taxed at a single level, taxation of a sale or other liquidation of the business will usually occur only at the individual level, unlike in the context of the C corporation, where the corporation itself will be required to pay taxes on any gain before passing the profits through to shareholders, who will also be taxed on the amounts they receive.

      Many S corporation shareholders will have a higher stock basis than that of a C corporation shareholder. This is because the basis of an S corporation shareholder’s stock is increased by any earnings of the S corporation that are passed through for tax purposes.1 Depending upon how long the corporation had existed as an S corporation, and the level of earnings that were passed through to shareholders, S corporation shareholders may have substantially higher tax bases upon sale. Because tax basis decreases the amount of gain that the shareholders are required to recognize upon sale, the S corporation shareholder’s total tax liability will often be lower than the C corporation shareholder’s upon liquidation of the company.

      If the S corporation was ever a C corporation, however, the S corporation will be required to account for any built-in gains, which are taxed at the highest rate applicable to C corporations (see Q 8955).2 The tax on built-in gains is designed to preserve a part of the double tax structure for certain S corporations that were formerly C corporations. The built-in gains tax applies if the S corporation sells an asset within a five year period (formerly 10 years) following its S corporation election.3 The tax on built-in gains is imposed at the S corporation level, in addition to any taxes that are paid by the S corporation’s shareholders. This tax will only apply in situations where the S corporation was formerly a C corporation and liquidates within 10 years of making its S election.


      1.      IRC §§ 1367(a), 1366(a)(1)(A).

      2.      IRC § 1374(b)(1).

      3.      IRC § 1374(d)(7), as amended by PATH.

  • 9010. What gift tax concerns apply in the family business context when planning for business succession?

    • In many cases, the retiring business owner in a family owned small business will want to transition the business to the owner’s children using a gifting strategy, rather than a traditional sale. Because the American Taxpayer Relief Act increased the top estate and gift tax rate to 40 percent for tax years beginning after 2012, avoiding this tax will often be a top priority for small business owners.1

      Each taxpayer is allowed to exclude $13.61 million in 2024 (projected) (up from $12.92 million in 2023), (up from $11.7 million in 2021 and $12.06 million in 2022) from transfer taxation during the taxpayer’s lifetime (gifts made during life and post-mortem are aggregated for purposes of determining the exempted amount).2

      Further, a $18,000 (in 2024 projected) annual exclusion is available for present interest gifts on a per donor/donee basis. This exemption was $17,000 in 2023 and $16,000 in 2022.

      Establishing value for purposes of the exemption and exclusion amounts will be a primary concern for many exiting business owners because, in the small business context, there is often no established market value for the interests being transferred. In the context of the family owned business, the transfer of business interests from one generation to the next is often not accomplished as a result of arm’s length negotiations that result in a purchase price that reflects any actual market value of the company.

      Thus, when a business owner transfers his ownership interests, a valuation will be required to determine the worth of company shares and the applicable amount of taxes upon the transfer of those shares. Often, however, the lack of established market makes it difficult to accurately determine the value of the transferred interests, opening the business owner to an IRS challenge and potential future gift tax liability for undervalued shares.

      Wandry vs. Commissioner was a case where taxpayers were able to establish the value of business interests that were transferred to their children by creating a transaction that capped the annual gift at the annual exclusion amount, rather than specifying a percentage or number of interests subject to transfer. Because the value of the business had not yet been ascertained, the taxpayers specified that the gifts were not to exceed the annual exclusion amount in the documents governing the transfers of the business interests. The taxpayers used their existing gift tax exemption in making the gifts. In Wandry, the court approved a formula gift clause that viewed the gift as being of a fixed dollar amount with this fixed dollar amount being expressed as a percentage of the business value. To the extent that the valuation was not correct, the gifted interests were reallocated among the owners of the business. Part of the significance of the case is the court’s finding that, with respect to the reallocation of the partnership interests, it did not matter if some of the reallocated interests reverted to the grantor.

      Outright gifts are not the only type of transaction that can give rise to gift tax concerns in the family business context, however. Shareholders of nonparticipating preferred stock in profitable family held corporations have been held to have made gifts to the common stockholders (typically descendants of the preferred shareholder) by waiving payment of dividends or simply by failing to exercise conversion rights or other options available to a preferred stockholder to preserve his position.3 The Tax Court has held that the failure to convert noncumulative preferred stock to cumulative preferred stock did not give rise to a gift, but that thereafter a gift was made each time a dividend would have accumulated. However, the failure to exercise a put option at par plus accumulated dividends plus interest was not treated as a gift of foregone interest.4

      A transaction involving the nonexercise of an option by a son under a cross-purchase buy-sell agreement followed by the sale of the same stock by the father to a third party when the fair market value of the stock was substantially higher than the option price was treated as a gift from the son to the father.5 Also, a father indirectly made a gift to his son to the extent that the fair market value of stock exceeded its redemption price when the father failed to exercise his right under a buy-sell agreement to have a corporation redeem all of the available shares held by his brother-in-law’s estate and the stock passed to the son.6


      1.      American Taxpayer Relief Act of 2012, Pub. Law No. 112-240, § 101, IR 2015-118 (Oct. 21, 2015), Rev. Proc. 2018-57.

      2.      Rev. Proc. 2021-45, Rev. Proc. 2022-38.

      3.      TAMs 8723007, 8726005.

      4.      Snyder v. Comm., 93 TC 529 (1989).

      5.      Let. Rul. 9117035.

      6.      TAM 9315005.

  • 9011. How can a grantor retained annuity trust be used in family business succession planning?

    • Trust entities can be useful in business succession planning, whether the trusts are revocable or irrevocable. The two forms of trust are not mutually exclusive, and in many instances, a succession plan may contain more than one trust entity. The decision to have one or both depends on the business owner’s goals, how much control the senior generation wants, when the assets will be transferred to the heirs and other restraints that are imposed.

      A grantor retained annuity trust (GRAT) is an irrevocable trust to which the business owner transfers shares in his business while retaining the right to a fixed annual annuity payout for a stated term of years.


      Planning Point: In response to a comment on the IRS’s proposed GRAT regulations, the final regulations include and use interchangeably both the term “GRAT” (which does not appear in the statutes or the regulations) and its Treasury Regulation citation, §25.2702-3(b).1


      At the end of the term, the property remaining in the GRAT (the appreciation and income in excess of the annuity amount that is to be paid to the business owner) will pass to the trust beneficiaries (often the owner’s children or grandchildren). Only the value of the remainder interest is subject to gift tax.

      The amount of the taxable gift to the beneficiaries can be reduced by structuring the trust with a larger annuity payout or a longer stated term. Further, the value is dependent on the IRS Section 7520 interest rate in effect at the time the trust is established—a lower interest rate can also reduce the value of the taxable gift.

      A GRAT may be structured so that there is little or no gift tax payable on the value of the remainder interest that passes to the trust beneficiaries. For gift tax purposes, this is known as a “zeroed-out” GRAT. If the zeroed-out GRAT produces a return in excess of the annuity amount payable to the business owner, the GRAT will succeed in passing on the reminder interest (the trust’s excess income and appreciation) to the trust beneficiaries at little or no gift tax cost to the business owner. If the zeroed-out GRAT fails to produce a return in excess of the annuity amount and the remainder beneficiaries receive nothing, there is minimal downside risk since there was little or no gift tax cost to the business owner upon establishing the zeroed-out GRAT. The primary risk of using a GRAT (especially a short term GRAT) to transfer business interests is that if the business owner fails to survive the stated term, the GRAT may be included in his estate and subject to estate taxes.

      The Ninth Circuit recently confirmed this result. In a case where the GRAT creator died before the GRAT terminated, the court held that there was no actual transfer of the trust property. She had created the GRAT structure to transfer interests in a family business to her daughters, receiving a $302,529 annuity payment annually for 15 years. The business generated enough income so that the value of the partnership interest was not decreased by the monthly annuity payments. Under IRC Section 2036(a), because the decedent was still enjoying the economic benefit of the property at death, the entire GRAT value was included in her gross estate. The court rejected the argument that the value should be excluded because the statute does not specifically list “annuities” as property that may be pulled into the estate.2

      See Q 9012 for a discussion of the use of intentionally defective grantor trusts in family business succession planning.


      1.      TD 9414, 2008-35 IRB.

      2.      Badgley v. U.S., Case No. 18-16053 (9th Cir. 2020).

  • 9012. How can an intentionally defective grantor trust be used in family business succession planning?

    • A trust structure called an intentionally defective grantor trust (IDGT) is another trust structure that can be used by a small business owner to transfer business interests to the next generation. In using this strategy, the business owner actually sells all interests in the business to the IDGT, naming the children or other heirs as beneficiaries of the trust.

      An IDGT is an irrevocable trust that is valid for estate tax purposes, but “defective” for income tax purposes. This means the business owner (as the grantor of the IDGT) is the owner of the IDGT for income-tax purposes, but is not treated as the owner of the IDGT for estate tax purposes. Since the business interests are sold to the IDGT, there are no gift taxes.

      Further, there are no capital gains taxes to the business owner because sales between a grantor and an IDGT are disregarded for income tax purposes. Typically, the business owner will structure the sale so that there is no down payment by the IDGT, annual interest payments are at the lowest rate permitted by the IRS, and a balloon principal payment is due in nine or more years. This technique is similar to a GRAT, but without the mortality risk. The value of the business is taken outside of the business owner’s estate for estate tax purposes, because future appreciation and interest are sheltered within the IDGT. The business owner’s estate is also reduced by the income and capital gains taxes to be paid on the IDGT’s income. In other words, the business owner is not taxed separately on the interest payments but instead is taxed on all of the capital gains and income realized by the IDGT. The taxes paid by the business owner on the IDGT’s income and capital gains are effectively tax-free gifts to the beneficiaries of the IDGT.

      The viability of IDGTs as wealth transfer vehicles is supported by the IRS in Revenue Ruling 2008-22,1 although in a somewhat different context. In the ruling, a grantor of an inter vivos trust retained the power, exercisable in a non-fiduciary capacity, to acquire property held in the trust by substituting other property of equivalent value. The ruling provides that, for estate tax purposes, the substitution power will not, by itself, cause the value of the trust corpus to be includible in the grantor’s gross estate, provided the trustee has a fiduciary obligation (under the local law) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.


      1.      2008-16 IRB (Apr. 21, 2008).

  • 9013. What are self-cancelling installment notes (SCINs)? How can SCINs be used in family business succession planning?

    • Under a self-cancelling installment note (SCIN), the selling business owner agrees to sell property to a buyer (often, the owner’s children or other beneficiaries) in exchange for an installment note that expires either when the seller receives the maximum price for the property or upon the occurrence of a cancellation event, such as the seller’s death. This is a form of installment sale transaction (see Q 9007). It allows the seller to secure the purchase for the business interest, while still retaining the ability to defer part of the gain.1 In turn, the buyer can claim an interest deduction with respect to the payments made.2 See Q 8027 for a discussion of the new rules governing the deduction for business interest under the 2017 tax reform legislation.

      Under a SCIN, if the cancelling event is the selling business owner’s death, all remaining payments under the note are canceled upon the seller’s death, similar to a private annuity. Typically, the purchaser pays a premium for this cancellation feature in the form of either a higher interest rate or a larger purchase price. Gain under a SCIN is recognized by the selling business owner as payments are received. However, when the seller dies, any unrecognized (i.e., cancelled) gain at the seller’s death under the SCIN is reportable either on the seller’s final IRS Form 1040 or on the seller’s estate’s IRS Form 1041.

      In order for the IRS to recognize the SCIN, the term of the note must be shorter than the seller’s life expectancy at the time of the sale, based on IRS mortality tables.3 The advantage of using a SCIN, as opposed to other installment sale methods or an intentionally defective grantor trust (see Q 9012), is that the unpaid balance is not included in the seller’s estate.4

      However, if no payments are made under the SCIN before the death of the seller, the IRS may argue that the value of the SCIN is zero and should only reduce the value of the note.5 A SCIN signed by a family member is presumed to be a gift rather than a bona fide transaction.6

      SCINs are particularly useful if the seller has a relatively short remaining life expectancy because if the selling owner outlives the term of the note, the estate tax benefit will have been lost and the owner may actually have incurred additional expenses in the form of higher income taxes or gift tax liability.


      1.      IRC § 453(f)(3).

      2.      IRC § 163(d)(5); Treas. Reg. § 1.163-8T(b)(3) (investment expenditure).

      3.      GCM 39503.

      4.      See Frane vs. Comm., 998 F.2d 567 (8th Cir. 1993); Moss v. Comm., 74 TC 1239 (1980).

      5.      See Estate of Costanza v. Comm., 320 F.3d 595 (6th Cir. 2003); Robert Dallas, TC Memo 2006-212.

      6.      Estate of Costanza v. Comm., 320 F.3d 595 (6th Cir. 2003); Estate of Labombarde v. Comm., 58 TC 745 (1972).

  • 9014. Are there any special provisions available to allow the estate of a small business owner to defer payment of estate taxes?

    • Section 6166 was added to the Internal Revenue Code to allow estates to pay estate taxes attributable to substantial closely-held business interests in installments. Prior to that time, the IRS had discretion to permit installment payments, but such discretion was rarely exercised. Consequently, Congress acted to provide certain estates with the right to defer estate tax payments if the requirements of Section 6166 were met.

      In general, IRC Section 6166 provides for an elective five-year deferral, 10-year installment payment method of liquidating the estate tax liability. An estate is eligible for the Section 6166 election if the value of a closely-held business that is includible in the gross estate exceeds 35 percent of the adjusted gross estate.1

      If the Section 6166 election is made, no payments of the tax are required for an initial five-year period, though interest payments must be made.2 The estate tax liability itself may then be paid in 10 equal annual installments in years six through 15, with interest continuing to run on the unpaid balance. Interest on the deferred amount is 2 percent (subject to a limitation discussed below).

      This deferral treatment is allowed only for estates comprised of “interests in a closely-held business.” Whether or not the business interests contained in an estate meet this standard is determined by the “business interest test,” which is satisfied as follows:

      (1)     If the decedent was a sole proprietor the business interest test is satisfied.

      (2)     If the business was a partnership, the business interest test is satisfied only if:

      (i)   there were no more than 45 partners in the partnership, or

      (ii)  the decedent’s interest in partnership capital was at least 20 percent.

      (3)     If the business was a corporation, the business interest test is satisfied only if:

      (i)   there were no more than 45 shareholders, or

      (ii)  the decedent’s ownership of voting stock was at least 20 percent.

      Interests or shares owned by the decedent’s spouse, siblings, ancestors, and descendants are treated as owned by the decedent for purposes of applying the 45 partner or shareholder test. Interests owned jointly by two spouses are counted as one partner or shareholder.

      In applying the 20 percent interest test, the estate may elect to have interests owned by the decedent’s spouse, siblings, ancestors, and descendants counted as part of the decedent’s interest. However, if this is the method through which decedent’s interest qualifies for the deferral, then

      (1)     the five-year deferral period is lost (i.e., the 10-year payment period starts immediately), and

      (2)     the favorable 2 percent interest rate is not available on deferred amounts.

      The value of the business interest must be more than 35 percent of the “adjusted gross estate.” The adjusted gross estate is the gross estate minus deductions for expenses, debts, taxes, and losses.


      1.      IRC § 6166(a)(1).

      2.      IRC § 6166(a)(3), (f)(1).

  • 9015. What issues arise when a family partnership is considering its small business succession strategy?

    • The preferred solution to the problem of transferring family partnership interests at death depends upon the particular type of family partnership and the circumstances surrounding it. A family partnership may be between two spouses, a parent and his or her adult child or children, the entire family, or the parent and a trustee or trustees, the latter acting for minor children. In some instances, disposition of the partnership interests by will may be a satisfactory solution. In most instances, a buy-sell agreement will be the preferred solution. Except in the case of two spouses, the income tax savings that result from the family partnership, by reason of spreading the business income, will more than pay the premiums on the life insurance used to finance the agreement.

      When a family partnership has been formed by two spouses, it is sometimes assumed that there is no need for a buy-sell agreement to take effect at death. The spouse-partners may take the position that a buy-sell agreement is unnecessary because the survivor (assuming there are no children or other heirs) will take the interest in the business from the first-to-die under the intestacy laws of the state in the absence of a will. Moreover, in most states, each has a statutory right to one-third of the property owned at death by the other, and this right cannot be eliminated even by a will to the contrary.

      Notwithstanding the circumstances that exist so far as inheritance is concerned between the spouses, a buy-sell agreement is practical and in some instances may be necessary in order to avoid serious problems upon the death of the first-to-die. See Q 9016 for a detailed discussion of the use of buy-sell agreements in the context of a family partnership.

      Where two spouses are partners in a partnership business, they may execute wills leaving their interests in the business to each other. This procedure will sometimes eliminate any liquidation problems at death because the surviving spouse will own the entire business by virtue of the duly executed will, and it eliminates any doubts or problems so far as the surviving spouse’s rights are concerned.

      There are several major problems, however, that require serious consideration, even though the spouses have executed wills leaving their business interests to each other. The decedent may have personal creditors pressing claims against the estate. Such claims must be satisfied before the surviving spouse can take over the decedent’s business interest.

      Aside from personal creditors of the decedent, the business itself may be faced with substantial liabilities. Any such claims, if pressed for settlement, will need to be satisfied by the surviving spouse.

      There is always the chance that the decedent’s will may be contested by other potential heirs, and if set aside will leave the surviving spouse in the same position as if no will had ever been executed. Consequently, if the will is set aside for one reason or another, the surviving spouse will then take under the intestacy laws of the particular state involved, which may give a large portion of the decedent’s business interest to heirs other than the surviving spouse. And if any of these heirs are minors, liquidation of the business could become necessary.1


      1.      Spivak v. Bronstein, 79 A. 2d 205 (Pa. 1951).

  • 9016. How can a buy-sell agreement be useful in transitioning a family partnership?

    • If a family partnership is formed between two spouses, in order to eliminate the possible problems and uncertainties that may arise, a buy-sell agreement should be formed between the partners. Moreover, each spouse should be assured there will be ample capital in order to purchase the decedent’s business interest. This may become necessary through failure of the decedent’s will (see Q 9015), if no will had been executed, through a change in a previously executed will, or because of creditors’ claims.

      Family members (or any other person) will be recognized as partners only if one of the following requirements is satisfied: (1) if capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest; (2) if capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner.1

      One of the advantages of the buy-sell agreement is that the value of the business may be established through a valuation formula contained in the agreement (the valuation of shares is a frequent subject of litigation, with the IRS often taking the position that the estate has undervalued the reported value). If properly established, the stated value should be accepted for federal estate tax purposes. A recommended method in the case of a family partnership is to have an independent certified public accountant establish and certify the true value, and to attach this certificate to the buy-sell agreement. See Q 9026 for a detailed discussion of valuation issues that arise in the context of a buy-sell agreement.

      Adequate life insurance is as essential in financing the buy-sell agreement, as would be the case were the parties unrelated. Since the spouses are partners in the business, each should carry life insurance upon the life of the other.

      If the surviving spouse is to carry on the business after the death of the first-to-die as legatee, rather than as purchaser under a buy-sell agreement, insurance on his or her life payable to the surviving spouse for business purposes is advisable, if not essential. Without a special fund available to satisfy partnership creditors and to hire the assistance necessary to do some of the work previously performed by the first-to-die, the surviving spouse may find it difficult to continue the business. With adequate life insurance proceeds at his or her disposal, and with adequate experience in the business gained as an active partner, the surviving spouse is given an opportunity to continue the business successfully.


      1.      IRS Publication 541 (Rev. February 2019).

  • 9017. What special considerations arise when developing a business succession plan for a family partnership that is formed between a parent and adult children?

    • In this type of partnership, disposition of partnership interests by will on the death of a partner is seldom a satisfactory solution. In the case of a married child, a bequest of his or her partnership interest often would be made to a surviving spouse, and in many instances might lead to the liquidation of the business as being preferable to taking the surviving spouse into the firm. The same result could follow should the parent bequeath his or her partnership interest to the surviving spouse. On the other hand, if the parent bequeaths his or her interest to the children and such interest comprises the major part of the estate, the surviving spouse may be able to elect to take against the will and thereby upset the bequest of the partnership interest.

      A specially designed buy-sell agreement usually will be a desirable solution. Under such an agreement the children will agree to purchase their parent’s partnership interest upon death and to maintain insurance on the parent’s life with which to finance the purchase. The insurance proceeds will be collected by the children, or by a trustee acting for them, and paid over to the executor of the parent’s estate to meet the cash needs of estate administration and to fulfill bequests to the surviving spouse of the balance of the funds.

      Thus, the surviving spouse will be assured adequate income and will not be able to upset the plan, even though there is little other estate property. Where division of the estate is not a problem and the parent wishes to leave something to the children, the plan may be modified by giving the children a bargain price in the agreement, or by having them purchase a portion of the parent’s interest while he or she bequeaths the remaining portion to them.

      In the case of a partnership between a parent and his married child, in most instances there should be a traditional cross-purchase agreement (see Q 8992 to Q 8999). Where there are at least two children as partners with their parent, the parent may not desire to increase his or her interest in the firm if a child dies first. In this case, the agreement should provide for a cross-purchase between the children in the event of the death of one of them.

  • 9018. 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 can 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.1 Second, 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.2

      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 is retained) 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 the 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.3 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.4

      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).5 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 corporation 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.6

      Definitions

      An “applicable retained interest” is any interest in an entity with respect to which there is (1) a distribution right and the transferor and 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).7

      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).8 The value assigned to a right for which an election is made cannot exceed fair market value (determined without regard to IRC Section 2701).9

      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.10 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.11 An individual is treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.12 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.13 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.14


      1.      IRC § 1361(b)(1)(D).

      2.      IRC § 2701(a)(3).

      3.      IRC § 2701(a)(3)(B).

      4.      IRC § 2701(a)(3)(C).

      5.      IRC § 2701(a)(2).

      6.      Treas. Reg. § 25.2701-1(c)(4).

      7.      IRC § 2701(b).

      8.      IRC § 2701(c)(3).

      9.      Treas. Reg. § 25.2701-2(c)(2).

      10.    IRC § 2701(e)(1).

      11.    IRC § 2701(e)(2).

      12.    IRC § 2701(e)(3).

      13.    IRC § 2701(b)(2).

      14.    IRC § 2701(b)(2)(C).

  • 9019. How can the existence of voting stock create adverse estate tax consequences in the context of a transfer of stock in a controlled corporation?

    • When a taxpayer transfers property in which certain rights are retained, the value of that property will be included in the estate for estate tax purposes.1 IRC Section 2036 specifically provides that retaining the right to vote shares in certain corporations constitutes a right that will generate estate tax inclusion even if the shares themselves are actually transferred. This is the case whether the right to vote is retained directly or indirectly (such as through the use of a trust entity or informal agreement).2

      In order for the value of transferred voting stock to be included in the original shareholder’s estate, the corporation must be considered a “controlled corporation.” A corporation is a controlled corporation if, at any time after the transfer and during the three-year period ending on the date of the decedent’s death, the decedent-transferor owned at least 20 percent of the combined voting power of all classes of the corporation’s stock. In determining the 20 percent ownership test, the family attribution rules of IRC Section 318 apply.3

      As a result, the transferring owner will be treated as though he or she owns (1) any stock owned (either directly or indirectly) by the spouse, children, grandchildren or parents, (2) a proportionate share of any stock owned by a partnership or estate in which the transferor is either a partner or beneficiary, (3) a proportionate share of any stock owned by a trust of which he or she is a beneficiary or grantor and (4) stock owned by a corporation if the transferring owner owns 50 percent or more of the value of that corporation. These broad attribution rules expand the reach of IRC Section 2036, making the transfer of nonvoting stock the most effective way to avoid the risk that the value of the shares will eventually be included in the transferor’s estate.


      1.      IRC § 2036(a).

      2.      IRC § 2036(b).

      3.      IRC § 2036(b)(2).

  • 9020. Can a qualified terminable interest property (QTIP) trust be useful in reducing the estate tax burden in a family business’ succession plan?

    • Yes. In the context of a family-owned business owned by one spouse, a qualified terminable interest property trust is a tool that may be used in reducing the estate tax burden upon the death of the first-to-die spouse if the business interests would otherwise be included in the taxable estate. Essentially, this strategy is used to remove a portion of the first-to-die spouse’s interests from his or her estate so that the value of that estate is reduced to below the applicable estate tax exemption amount ($12.06 million in 2022, $12.92 in 2023 and $13.61 million in 2024 projected).

      A qualified terminable interest property trust is a trust containing “qualified terminable interest property” (QTIP), which is property (1) which passes from the decedent, (2) in which the surviving spouse has a “qualifying income interest for life,” and (3) as to which the executor makes an irrevocable election on the federal estate tax return to have the marital deduction apply.

      The surviving spouse has a “qualifying income interest for life” if (1) the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, and (2) no person has a power to appoint any part of the property to any person other than the surviving spouse unless the power is exercisable only at or after the death of the surviving spouse.1 Apparently, the last requirement is violated even if it is the surviving spouse who is given the lifetime power to appoint to someone other than the surviving spouse.2

      An executor can elect under IRC Section 2056(b)(7) to treat an individual retirement account and a trust as QTIP if the trustee is the named beneficiary of decedent’s IRA and the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually and to distribute that amount to the spouse. No person can have a power to appoint any part of the trust property to any person other than the spouse.3

      Importantly, this strategy allows the spouse who actually controlled the business to direct how the principal (the actual business shares) will be disposed of after the death of the surviving spouse. However, if the QTIP trust is funded with a minority interest in the business, and the estate contains a controlling interest, it is possible that a control premium and minority discount (see Q 9034) may impact the valuation of the shares for estate tax purposes. In this case, the shares that form the controlling interest may be given a higher value than anticipated (and the shares included in the QTIP trust may be given a lower value than anticipated), thus increasing the estate value while correspondingly decreasing the value of the martial deduction that will result from the use of the QTIP strategy.

      As a result, the business owner should consider the impact of the control premium and minority discount valuation issues, and either (1) transfer additional assets from the estate to the QTIP trust in order to reduce the value of the estate to below the exemption level or (2) ensure that sufficient shares are transferred into the QTIP trust so that the estate will not be deemed to hold a controlling interest in the business.

      See Q 9021 for a discussion of the implications of using a QTIP trust to transfer small business interests in the context of a buy-sell agreement.


      1.      IRC § 2056(b)(7).

      2.      TAM 200234017.

      3.      Rev. Rul. 2000-2, 2000-1 CB 305.

  • 9021. Can a qualified terminable interest property (QTIP) trust be used in a family business succession plan if the business interests at issue are subject to a buy-sell agreement?

    • Using a qualified terminable interest property (QTIP) trust where the business interests at issue are subject to a buy-sell agreement can create estate tax problems if the stock value set by the buy-sell agreement does not meet the requirements of IRC Section 2703 (see Q 9026). Generally, if the requirements of Section 2703 are satisfied, the price specified under the buy-sell agreement will control for estate tax purposes.1

      If the requirements are not satisfied, however, the price may be adjusted so that it reflects the true fair market value of the stock. As a result, if the value is adjusted upward, the shareholders who are subject to the buy-sell agreement may be deemed to have received an economic benefit from the surviving spouse’s QTIP because those shareholders were granted the right to purchase the shares at a lower price.

      To qualify as QTIP property, no person may be given a power to appoint any part of the property to any person other than the surviving spouse unless the power is exercisable only at or after the death of the surviving spouse (see Q 9020).2 If a third party is given the power to purchase shares that would otherwise be QTIP at a price that is eventually found to be lower than fair market value, the QTIP trust may be ineligible for QTIP treatment because, effectively, the difference between the lower price specified in the buy-sell agreement and the higher true fair market value is treated as income that is derived from the shares and granted to a party other than the surviving spouse.3

      Similarly, if the buy-sell agreement prohibits the QTIP trust from selling the stock without the consent of a third party, the shares will likely fail to qualify as QTIP. One of the essential requirements of a QTIP trust is that it must entitle the surviving spouse to receive all of the income derived from the trust principal. In order to give effect to this requirement, the regulations provide that the surviving spouse must be given the power to require that the trustee convert any unproductive property into income-producing property. Such a power will not disqualify the property as QTIP so long as applicable trust administration rules require the trustee to use the judgment and care in the exercise of the power that a prudent man would use if he were owner of the property. What’s more, a power to retain a residence or other property for the spouse’s personal use will not disqualify the interest passing in trust,4 If stock contained in a QTIP trust cannot be sold without the permission of a third party, the surviving spouse’s income rights are not absolute and the property may fail to qualify for the marital deduction.5


      1.      See, for example, Slocum v. U.S., 256 F. Supp. 753 (S.D.N.Y. 1966).

      2.      IRC § 2056(b)(5).

      3.      See TAM 9147065, where it was found that the first-to-die spouse granted an option for his sons to grant themselves the excess of the fair market value of the shares over the option price, thus defeating the property’s QTIP status.

      4.      Treas. Reg. § 20.2056(b)-5(f)(4).

      5.      TAM 9147065.

  • 9022. Should the transfer of stock to a successor generation pursuant to a family business succession plan be structured as gifts or compensation?

    • While each small business is different, many family-owned businesses prefer to structure the transfer of stock to the next generation as compensation, rather than making the transfer by gifts.

      The compensation structure, while generating taxable income for the successor generation, offers a tax deduction to the company that will often offset any income tax liability that is created.1 While the income tax liability may be deferred under IRC Section 83 if the transferred stock is subject to a substantial risk of forfeiture, in the family business context, the income tax liability incurred by the successor-employee can often be eliminated through a bonus or other additional compensation.

      The compensation structure may be preferable to transferring stock to the successor generation via gifts because the successor-employee will receive a basis in the stock that is equal to its fair market value on the date of transfer.2 Conversely, if the transaction is structured as a gift, the successor-employee will receive a basis in the stock that is equal to its basis in the hands of the transferor (a carryover basis).3 For stock that has appreciated with time, this can reduce any gains that the successor would be required to recognize should the stock eventually be transferred again in the future.

      Further, the compensation structure eliminates any gift tax liability that would be incurred if the transfer were made through gifts. By structuring the transfer of company stock as compensation, the parent generation is not required to use up any of its gift tax annual exclusion or lifetime exemption amount by making the transfer—leaving it free to reduce its taxable estate further by making other gifts of property to the successor generation.

      However, as a practical matter, the higher estate and gift tax exemptions are reducing the number of individuals who will have difficulties in transferring their business free of estate and gift tax. Also, with respect to the compensation approach to transferring the business, the taxpayer is essentially trading the estate tax for the income tax. Since the estate tax rate is currently 40 percent and the income tax rates are less, this approach can be viable to the extent the federal estate tax is applicable.


      1.      IRC §§ 83(a), 83(h), 162(a).

      2.      IRC § 1012; Treas. Reg. § 1.83-4(b).

      3.      IRC § 1015(a).

  • 9023. How can a three-year grantor retained income trust (GRIT) be used in family business succession planning?

    • A grantor retained income trust (GRIT) is an irrevocable trust created by the grantor allowing the grantor to retain an income interest for a term of years. At the end of the term, the property held in trust is distributed to, or remains in trust for, the named beneficiaries. If the grantor survives beyond the retained income term, then the property transferred in trust—the remainder interest in the trust property—is not included in the grantor’s estate. Although the transfer of a remainder interest is a taxable gift—a gift tax is due when the transfer is made—a GRIT can reduce a grantor’s overall transfer tax liability because the gift tax is based on the value of the remainder when transferred. Thus, any appreciation in the remainder property (from the date of the gift to the date of the grantor’s death) is effectively transferred estate tax-free.

      However, if the grantor dies before the retained income period expires, the trust property is included in the grantor’s estate and will be subject to estate tax.A three-year GRIT is simply a GRIT whose specified term is three years—a time period that stems from the general rule that gifts that are made within three years of a donor’s death will be brought back into the donor’s estate.1 In this context, a gift of stock is transferred to a GRIT that provides that all income from the trust will be paid to the parent generation for a period of three years. Because this income right is not a fixed amount or fixed percentage of the fair market value of the stock transferred, it is not a “qualified interest,”2 so that the value of the income interest—or the “retained interest”—will be zero.3 This means that, for gift tax purposes, the value of the interest that remains at the end of the term will be the entire value of the stock transferred.4 Effectively, this strategy is most valuable when the parent generation has determined that it is willing to pay the gift taxes on the stock transfer currently in order to avoid the inclusion of the appreciated stock in their estate.

      At the end of the three-year period, the stock will pass to the next generation. The risk of this strategy is that, if the parent generation dies within the three-year period, the value of the stock (including any appreciation that occurs within the three-year period) and all gift taxes paid will be included in the parent’s estate (although the estate will receive a credit for the gift taxes already paid). If the parent outlives the three-year period, this risk is eliminated and any appreciation in the stock is transferred estate tax-free.

      The ability to use this technique has been limited with the advent of IRC Section 2702. This section provides that the retained interest is valued at zero, unless the retained interest is a “qualified retained interest.” The rules of Section 2702 apply with respect to transfers to family members.5 Therefore, the ability to implement a GRIT is limited to those parties that are not family members within the statutory definition. This technique may have applicability to same sex couples who do not get married and other unrelated parties within the definition.


      1.      IRC § 2035.

      2.      Treas. Reg. § 25.2702-3(b).

      3.      Treas. Reg. § 25.2702-1.

      4.      IRC § 2702; Treas. Reg. § 25.2702-1(b).

      5.      Treas. Reg. § 25.2702-2(a)(1) for definition of “member of the family.” This regulation defines member of the family as the individual’s spouse, any ancestor or lineal descendant of the individual or the individual’s spouse, any brother or sister of the individual, and any spouse of the foregoing. However, there are a few exceptions which will permit these transfers with retained interests among family members. These are GRATs and GRUTs, personal residence trusts and the qualified personal residence trusts.