As the end of 2020 approaches, along with the possible end of an $11.58 million per taxpayer estate and gift tax exclusion, planners and their clients must decide whether and how to make transfers by gift, sale or a combination thereof, especially given the possibility of a presidential victory for Joe Biden and Democratic congressional candidates. Planners have many options, but Notice 5000-20057 (the Notice), issued on Oct. 2, 2020 by the Small Business Administration (SBA), may limit the ability of Paycheck Protection Program (PPP) loan borrowers to take advantage of these transfer strategies.
Biden 2-Step
In view of the risk of a lower estate tax exemption, which could take place effective Jan. 1, 2021,1 many planners are in the process of designing or implementing what’s been referred to as the “Biden 2-Step,” whereby assets, which may include ownership interests in business and investment entities, are sold to grantor trusts in exchange for long-term low interest promissory notes so that on or about Dec. 31, 2020, the taxpayer will own a large promissory note in lieu of assets that are more difficult to transfer in value at year-end:
Step 1: Transfer assets to a defective grantor trust that’s disregarded for income tax purposes, but separate and apart from the grantor for estate and gift tax purposes. This trust may be a spousal limited access trust that can benefit the grantor’s spouse for his lifetime. The spouse may even have a power to direct that trust assets be held for the benefit of the grantor after the surviving spouse’s death, if the exercise of such power isn’t agreed to in advance or necessarily considered likely to be exercised.
Step 2: Transfer or forgive the note prior to the end of the year if it appears the estate tax exemption may be decreased during 2021 and made retroactive to Jan. 1, 2021 so that the client is able to benefit from and use the current estate tax exclusion amount of $11.58 million. Such a transfer or forgiveness may take into account that a 9-year or long-term and low interest note may be worth significantly less than its face amount, even if its face amount was determined under Internal Revenue Code Section 7520, as established under Frazee v. Commissioner.2 That is,
$10 million worth of assets may be transferred in exchange for a $10 million note bearing interest at 1% and payable interest only for 15 years, which may be the life expectancy of the grantor. While the issuance of that note in exchange for $10 million worth of assets isn’t considered to be a gift for gift tax purposes, the note may only be worth $8 million.3
Other Transfers Implicated
Other taxpayers with outstanding PPP loans may wish to sell significant ownership in a business or investment entity, take on new investors, sell the business or investment entity and assets themselves or otherwise make changes that may be needed to best serve the entity or its owners. Further, taxpayers may make transfers for income tax planning, such as when it’s appropriate to gift S corporation (S corp) stock or partnership interests to lower tax bracket individuals or entities that will pay less income tax than the
original owner. Taxpayers may also want to take advantage of IRC Section 199(A) income tax planning.
PPP Borrowers
Under the Coronavirus Aid, Relief and Economic Security Act, there have been over 5.2 million PPP loans made to small business and investment entities.4
The vast majority of borrowers that have received PPP loans expect to have the loans confirmed as forgiven. These borrowers have spent the borrowed money on permitted expenses that facilitate forgiveness. However, it will take some time before the forgiveness will be confirmed.
Under the SBA interim final rules published Aug. 11, 2020, banks will have 60 days from receiving an application to confirm that it appears to be acceptable and to forward the application to the SBA. The SBA will then have 90 days to review the application and remit the loan forgiveness amount requested (plus interest) to the lender, but there’s no way to predict whether the banks or SBA will be able to keep this mandated schedule.
PPP loans have all been made by banks that were authorized to do so. The loans bear interest at 1%, but no interest will be due or payable if the loan is forgiven in the normal course of the process. It’s noteworthy that loan forgiveness applications must be submitted within 10 months after that last day of the borrower’s covered period; otherwise, interest will become due and payable by the borrower until an application is submitted and the loan forgiveness amount is determined.
The SBA provided the money to facilitate making the loans and guarantees that the bank will be paid in full by the SBA if the borrower’s obligation isn’t forgiven or otherwise repaid, and the banks received loan fees from the SBA for every loan closed. Each bank crafted its own PPP loan documents based loosely on SBA-provided sample forms. Some of these documents prevented assignment of ownership or transfer of borrower assets without lender consent, while others didn’t prevent transfers or assignments in their loan documents.
SBA Notice 5000-20057
The SBA didn’t issue any regulations, questions and answers or other guidance to indicate that a PPP borrower wouldn’t be able to transfer or assign PPP stock or allow for the transfer or assignment of ownership in the borrower without SBA or bank consent until it issued Notice 5000-20057, which surprised many borrowers and their advisors (and even lenders).
The Notice provides that certain consent, documentation and possibly even escrow requirements must be complied with if a PPP borrower transfers assets or ownership exceeding a certain threshold. These restrictions apply even if the borrower has spent all of the PPP money on permitted expenses that presumably would result in full forgiveness, as the Notice provides that the restrictions apply until the note is “fully satisfied,” which means meeting one of the following requirements:
1. The borrower has repaid the PPP note in full.
2. The SBA has remitted funds to the lender in full satisfaction of the note (which could take as long as 150 days as discussed above).
3. The borrower has repaid any remaining balance on the PPP note after the SBA remits funds to the lender as part of the loan forgiveness process.
See “Ownership Interest Transfer Rules,” p. 42 and “Asset Transfer Rules,” p. 43.
Four Options
Given the above restrictions, and the time constraints for year-end planning, what options remain available for borrowers wishing to engage in year-end estate planning (such as installment sales to defective grantor trusts) or income tax planning without triggering the requirements of the Notice? Here are four possibilities:
Option agreements. A borrower may consider selling up to 20% ownership or 50% of business assets and giving the purchaser an option to purchase the remaining ownership or assets based on a reasonable option payment and a reasonable exercise price that’s in substance an option and not considered an installment sale. The borrower may accomplish this by setting the option price high enough so that there’s a substantial risk that the option holder won’t exercise the option and will lose the deposit. This might occur if the option holder believes that the business won’t recover when the COVID-19 virus pandemic has ended.
Under IRC Section 2703, for an option and its exercise price to be respected for estate and gift tax purposes, the deal:
1. Must be a bona fide business arrangement.
2. Can’t be considered a device to transfer property to an owner’s family for less than full and adequate consideration.
3. Must have terms that are comparable to similar arrangements entered into by an individual in an arm’s-length transaction.
Common/preferred partnership freezes. It may be possible to recapitalize the entity into common and preferred interests like a partnership freeze, assuming that the entity isn’t an S corp. If the entity is an S corp, then the second class of stock rules will be violated by such an arrangement. But, an S corp may convey its assets into a subsidiary entity, and another individual or entity could convey other assets, such as another business, to that subsidiary entity, which may be taxed as a partnership, and a common/preferred arrangement may be established between the two entities, although this can be complicated and partnership tax rules must be carefully reviewed.
A typical recapitalization will involve having an amount equal to 90% or less of the value of the entity be considered to be a preferred return interest that might, for example, be entitled to receive a 6.5% minimum annual coupon rate. Any growth in excess of 6.5% would inure to the common interest.
Structuring must be handled very carefully with a preferred interest partnership/limited liability company (LLC) arrangement. If the arrangement doesn’t qualify under IRC Section 2701, then any gift or transfer of the common interest may trigger a gift tax event based on the entire value of the entity, even if the common interest transferred is 10% or less of the value of the entity.
This can be useful for taxpayers who aren’t certain whether they want to make an irrevocable gift in 2020 that would use their entire remaining estate tax exclusion, because the Section 2701 rules would allow the exemption used on gifting to be applied in a later year as a credit, even if the estate tax exemption is reduced.
For example, an individual with a $9 million estate and gift tax exemption remaining could put $10 million into an LLC that’s borrowed PPP funds and recapitalize it into a 90% preferred interest that may be entitled to a 6.5% per year return, but the 6.5% may not be paid out annually and may instead accrue to some extent. The common interest may be worth $1 million.
If the $1 million common interest is gifted to an irrevocable trust, then the individual would be considered to have made a $9 million gift under Section 2701, and if the preferred interest is still owned by the individual on death, then the individual’s estate tax exclusion allowable against the partnership interest can be as high as $9 million, even if the exclusion has been reduced by legislation or the scheduled 2026 50% reduction in the exemption amount, based on the Section 2701 rules.5
Transfer maximum amount allowed while staying under the thresholds provided in the Notice. Another planning idea to avoid having to notify the SBA would be to transfer up to 50% of the assets of a company and then 20% of the ownership of the post-transfer company. This will result in transferring approximately 60% of the value of the company. Planners will need to analyze the potential income tax effects of this type of transfer, and this won’t be an effective planning technique if significant income taxes have to be paid on the sale of the assets of the entity.
Use of a management company. Another potential planning idea is to set up a separate management company that can operate the business and receive a significant management fee. For professional service companies and small businesses, like insurance agencies, case law has recognized that most, if not all, of the goodwill of the entity may be owned by the individual or individuals that work with the entity, assuming there aren’t non-competition covenants or long-term employment agreements that would give the entity itself the goodwill.
In these situations, the individual can establish a management company and give it significant rights that will allow it to manage for a long period of time and to receive profits attributable to the goodwill of the individual owner or owners. The individual owner or owners can be the initial owner of the management company and sign long-term employment agreements to give the management company contractual rights and genuine value.
The management company can then be sold, or a 99% nonvoting interest in the management company can be sold, for an installment note to complete year-end planning. The buyer can be a defective grantor trust to avoid having to pay short-term capital gains tax on the sale if the management company hasn’t existed for a full year before the sale. This shouldn’t be considered a transfer under the PPP rules.
It’s important to determine what a client’s PPP obligations are before entering into a transaction but not to allow a PPP loan arrangement to get in the way of appropriate planning. Using time-tested techniques such as those enumerated above can be the solution to how best to serve those involved with today’s challenging world.
Endnotes
1. See Quarty v. United States, 170 F.3d 961, 969 (9th Cir. 1999). The U.S. Court of Appeals for the Ninth Circuit ruled that a retroactive tax increase doesn’t violate the U.S. Constitution. The court held that the increase in the estate and gift tax rates was a rational means to raise revenue, noting that an increase in tax rate was merely an increase of an existing tax, not a wholly new tax, citing other court decisions as precedent. Similarly, reducing the exemption isn’t a new tax.
2. Frazee v. Commissioner, 98 T.C. 554 (1992).
3. See Michael S. Strauss and Jerome M. Hesch, “A Noteworthy Dichotomy: Valuation of Intrafamily Notes for Transfer Tax Purposes,” 45 Bloomberg Tax Management Estates, Gifts and Trust Journal (Jan. 3, 2020).
4. “SBA Paycheck Protection Program (PPP) Report—Approvals through Aug. 8, 2020,” https://home.treasury.gov/system/files/136/SBA-Paycheck-Protection-Program-Loan-Report-Round2.pdf.
5. See Stephen M. Breitstone, Mary P. O’Reilly and Joy Spence, LISI Estate Planning Newsletter #2827; Jonathan Blattmachr and Carlyn McCaffery, LISI Estate Planning Newsletter #2820.