If all you see in the new tax law is less deductions and higher rates, you might want to take another look at the fine print. Included in the legislation you'll find a provision that qualifies as good news to small-business owners. After disallowing so-called estate freezes" for three years, the Congress has reversed itself once again, allowing entrepreneurs to use this popular method of passing business interests to their heirs.
Put simply, an estate freeze permits a business owner to transfer part ownership of his business to his children, while avoiding a big estate tax bill.
In a typical arrangement, a company is recapitalized into two classes of stock, common and preferred. The founder or current owner retains the preferred shares and gives the common stock to his children.
"This allows the founder to retain an income interest through the dividends on the preferred shares," says Sam Starr, a partner with the accounting and consulting firm of Coopers & Lybrand.
"For their part the children gain most of the future appreciation of the company, which is reflected in the value of the common stock," Mr. Starr explained. "That's the reason recapitalizations can be so attractive: Those who will be building the business in the future are in a good position to claim the fruits of their efforts.
"Until the passage of the tax act of 1987, the tax laws favored this type of transaction. That's because for estate tax purposes, the value of the founder's interest in the business was frozen at the time the stock was transferred to the next generation.
"Any future appreciation was for the benefit of the heirs rather than being taxed in the founder's estate."
But the 1987 act rewrote the rules, requiring that the founder's interest in the appreciated value of the business at the time of his death be included in his estate. This was potentially devastating because it made the founder's estate subject to an enormous tax at the time he died, to the extent that the heirs might have to sell the business simply to pay the estate taxes.
"Take the case of Smith Inc., a company worth $1 million," says Walter Bailey, a partner with the law firm of Rogers & Wells. "Before the '87 tax act, founder Smith recapitalized the business, keeping preferred shares worth 99 percent of the company -- in this case $990,000 -- and giving his children common stock worth 1 percent or $10,000.
"Let's say the business then grew in value to $2 million by the time of the founder's death. Because the value of founder Smith's stake was frozen at the time of the recapitalization, his estate would be taxed on only $990,000 and his children would get $1 million in appreciation estate-tax free."
But the '87 tax act prohibited this type of freeze, holding that the founder's estate would be taxed on the full value of his interest in Smith Inc. at the time of this death. In founder Smith's case, an estate tax would be levied on 99 percent of $2 million, or $1,980,000. This placed an enormous burden on the heirs.
"The 1990 tax act makes it possible to lift that burden," says Rogers & Wells partner John Dadakis. "That's because the value of the founder's interest in the business can once again be frozen at the time of the recapitalization, thus excluding the appreciation in the business from his estate."
For this to work, certain new provisions must be met:
* The preferred shares must carry a market rate dividend.
* If the dividend payments are not made in a given year, the obligation carries over and must be paid cumulatively.
Should the founder die before this payment is made, the outstanding dividends will be included in his estate.
* The value of the common stock given to the heirs must reflect at least 10 percent of the value of the company.
* The value of the shares should be determined by an independent appraisal company.
The new rules apply to transactions completed after Oct. 8, 1990. Work with tax and legal professionals in structuring a recapitalization. They can help steer you through the rules and regulations surrounding these complex transactions.