By Trisha J. English, Esq.
Winstead PC, Houston, TX
The U.S. Court of Federal Claims held that §2704(a) applied to a lapse in voting rights of decedent's shares of stock that occurred upon decedent's death, causing the value of the shares before the voting lapse to be included in decedent's estate.
Section 2704(a)(1) generally provides that if:
In Smith, Mr. Smith and his family owned the Atlanta Falcons NFL franchise. In 1986, when the corporation converted to an S Corporation, Mr. Smith owned both Class A shares (having 11.64 votes per share) and Class B shares (having 1 vote per share). A shareholder's agreement in 1986 provided that the Class A shares would lose their preferential voting rights if sold or redeemed. In 1991, one year before §2704(a) was enacted, the shareholders entered into a new shareholders agreement that provided that a shareholder's Class A shares would be converted to Class B shares upon a sale of Class A shares or upon the shareholder's death.
Mr. Smith died in 1997 still owning Class A shares. Upon Mr. Smith's death, the Class A shares automatically converted to Class B shares. Prior to the conversion, Mr. Smith held 81.75% of the votes; after the conversion, Mr. Smith's shares held 32.65% of the votes. Furthermore, at Mr. Smith's death, Mr. Smith's family held 55.35% of the votes, resulting in Mr. Smith's estate and Mr. Smith's family retaining 88% of the total votes. The parties stipulated that the value of Mr. Smith's Class A shares prior to the conversion was $30 million and the value of the shares after the conversion was $22.5 million.
The IRS argued for the application of §2704(a) and the inclusion of the enhanced value of the Class A shares ($30 million) in Mr. Smith's estate. The estate unsuccessfully argued that (1) the family did not have the requisite control of the corporation; and (2) the lapse of voting rights occurred during Mr. Smith's lifetime, and thus was a transfer by gift occurring more than three years prior to Mr. Smith's death.
The Smith family had control of the company before and after Mr. Smith's death. Although Mr. Smith and his family clearly held the majority of shareholder votes before and after Mr. Smith's death, the estate argued that "control" as contemplated by Congress in §2704 means control that is sufficient to create and restore the lapsed right. Because the Smith family did not have sufficient control to undo the restrictions on the voting rights without the consent of non-family shareholders, the estate argued that the Smith family did not have the requisite control for §2704(a) to apply. After reviewing the legislative history of §2704, the court rejected the estate's interpretation of the term "control." The court pointed to the plain language of §2704, as well as the Treasury regulations, to confirm that control is defined as "the holding of at least 50 percent of the total voting power or total fair market value of the equity interests in the corporation." Because it was undisputed that the Smith family held at least 88% of the total votes and market share of the corporation, the test for family control of the corporation was met.
The lapse of voting rights occurred at Mr. Smith's death. Next, the estate argued that the lapse in voting rights occurred in 1986, or alternatively in 1991, when the relevant shareholder agreements were executed and in which the restrictions were created. The court disagreed. The Treasury regulations provide that a lapse occurs "at the time a presently exercisable voting right is restricted or eliminated."2 The 1986 shareholder agreement provided that voting rights on Class A stock would lapse if the stock was sold, but there was no restriction imposed upon the shareholder's death. The court noted that following the 1986 shareholder agreement, Mr. Smith was able to continue to exercise his enhanced voting rights up to the point of his death; therefore no lapse occurred in 1986. Similarly, although the 1991 shareholder agreement created the restriction that the voting powers of a shareholder's Class A stock would lapse upon the shareholder's death, Mr. Smith's ability to vote his Class A shares were not restricted until his death. Because the voting rights were presently exercisable up through Mr. Smith's death, the lapse occurred at Mr. Smith's death and not when the restriction was first created in 1991.
Because the court found that (1) Mr. Smith and his family, both before and after his death, had control of the corporation by virtue of owning more than 50% of the voting shares; and (2) the lapse of voting rights occurred at Mr. Smith's death; §2704(a) was properly applied to cause the inclusion of the value of the unrestricted Class A shares in Mr. Smith's estate.
For more information, in the Tax Management Portfolios, see Mezzullo, 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703, and 2704, and in Tax Practice Series, see ¶6290, Valuation - Generally, and ¶6350, Estate Planning.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)