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Redemptions to Pay Death Taxes and Administrative Expenses
Since much of the money to fund this estate tax liability would come from redemption of company
stock, if Morris had not previously cashed it in, Morris might well fear the combined effect of
dividend treatment and estate taxation. Of course, if Morris‟s estate turned in all his stock for
redemption at death, dividend treatment would appear to have been avoided and redemption treatment
under Section 302(b)(3) would appear to be available, since this would amount to a complete
termination of his interest in the company, and death would appear to have cut off Morris‟s
relationship with the company rather convincingly. However, if the effect of Morris‟s death on the
company, or other circumstances, made a wholesale redemption inadvisable or impossible, Morris‟s
estate could be faced with paying both ordinary income and estate tax rates on the full amount of the
proceeds.
Fortunately for those faced with this problem, Code Section 303 allows capital gain treatment for a
stock redemption if the proceeds of the redemption do not exceed the amount necessary to pay the
estate‟s taxes and those further expenses allowable as administrative expenses on the estate‟s tax
return. To qualify for this treatment, the company‟s stock must equal or exceed 35% of the value of
the estate‟s total assets. Since Morris‟s holdings of company stock will most likely exceed 35% of his
total assets, if his estate finds itself in this uncomfortable position it will at least be able to account for
this distribution as a stock redemption instead of a dividend. This is much more important than it may
first appear, and much more important than it would have been were Morris still alive. The effect is to
allow payment at long-term capital gain rates (rather than ordinary income tax rates), for only the
amount received in excess of the taxpayer‟s basis in the stock (rather than the entire amount of the
distribution). Given that the death of the taxpayer increases his basis to the value at date of death, the
effect of Section 303 is to eliminate all but that amount of gain occurring after death, thus eliminating
virtually all income tax on the distribution. However, unless Congress acts, this step-up of basis will
be significantly less generous for taxpayers dying after 2009.
Assuring sufficient liquidity to pay taxes due upon death is one thing; controlling the amount of tax
actually due is another. Valuation of a majority interest in a closely held corporation is far from an
exact science, and the last thing an entrepreneur wishes is to have his or her spouse and other heirs
engage in a valuation controversy with the IRS after the entrepreneur‟s death. As a result, a number of
techniques have evolved over the years that may have the effect of lowering the value of the stock to
be included in the estate, or at least making such value more certain for planning purposes.
Family Limited Partnerships
One such technique that has recently gained in popularity is the so-called family limited partnership.
This strategy allows individuals to decrease the size of their taxable estates through gifts to their
intended beneficiaries both faster and at less tax cost than would otherwise be possible, while at the
same time retaining effective control over the assets given away. Were Morris interested in
implementing this strategy, he would form a limited partnership, designating himself as the general
partner and retaining all but a minimal amount of the limited partnership interests for himself. He
would then transfer to the partnership a significant portion of his assets, such as stock in the company,
real estate, or marketable securities. Even though he would have transferred these interests out of his
name, he would be assured of continued control over these assets in his role as general partner. The