Assignment
Estate Taxes
You are an entry-level CPA at Ernst & Old LLP, and you impressed your managers a couple of weeks ago on the Jan, Franklin, and Terry projects. They are now testing your knowledge of S corporations and a little bit of gift and estate tax planning.
The McNally family owns McNally Motors (an S Corporation), operating as a Ford dealership in Elport, NJ. It is owned by three brothers-Floyd, Harold, and Kevin-each holding 400 shares. Floyd is the eldest of the brothers, and he desires to sell his shares to his son Floyd II. Harold has no children and plans to hold his shares until his death. The other owners will have the first right of refusal to acquire his shares and have utilized a life insurance policy to provide for the proceeds necessary to buy out his estate's shares. Kevin, the youngest, is in no rush to get out of the business. Kevin does have two daughters, however, who are interested in purchasing a nearby auto body shop because it would be a great ancillary business to the dealership. They all have the basis of $500K in McNally Motors; a recent business valuation shows the FMV of McNally Motors to be $3M.
As you can see, they each want to dispose of (or hold onto) their shares in a different manner. They each need help understanding what the income, gift, and/or estate tax consequences are of their anticipated actions. It's your chance to impress yet again and seek a promotion. It's time for you to decide.
Floyd McNally: Chairman of the Board, pictured with his son Floyd Jr.
A. Married
B. Ready to retire; age 67
C. Desires to sell his shares (at a 25% discount) to his son Floyd Jr.
Harold McNally: General Manager, McNally Motors
A. Single man, age 65
B. No children
C. Plans to hold his shares and work in some capacity until his death. This dealership is his life!
D. Estate to sell shares to other shareholders for life insurance proceeds (under the buy-sell agreement) at FMV
Kevin McNally: Married, father of two daughters
A. Married man, age 55
B. Has long-term business plans and has no current plan to retire
C. Wants to gift his daughters $2M to purchase an existing auto body shop
Given the scenario provided and having received an introduction to the players, it is your time to decide what Floyd, Harold, and Kevin should do. Their initial questions include the following.
A. Does the fact that McNally Motors is organized as an S corporation provide any limitations on their decisions regarding the transition of ownership?
B. What are the consequences to Floyd McNally if he sells his shares to Floyd II in a bargain sale (say 75% of the FMV)? What are the income tax consequences to Floyd? To Floyd II? What will Floyd II's basis be in the shares?
C. Harold wants to know if his estate will have to pay estate tax when he dies. In addition to his shares in McNally Motors, he has $3M in his 401(K) and $1M in his brokerage account. Beneficiaries of his estate are his nieces and nephews. Will his estate be liable for the estate tax?
D. Can Kevin take a cash distribution out of McNally Motors (his two brothers taking nothing at this time) to give to his daughters to acquire the auto body shop? What are the consequences of this distribution? Will he owe gift tax if he outright gifts the cash to them? Does he have any options to minimize the gift tax?
Memo to Floyd, Harold, and Kevin addressing the four aforementioned issues.
Provide support for your recommendation and decision by citing a section of the Internal Revenue Code (IRC).