Closely Held Business

A closely held business is a business whose ownership is concentrated in a few hands and whose shares or interests do not trade on a public market. In everyday use the term covers most family companies, professional practices and small partnerships, whatever their legal form. There is no single tax definition. The Internal Revenue Code uses the phrase in several places and gives it a different test in each, so the right question is never simply "is this business closely held?" but "closely held for the purpose of which rule?"

The two definitions owners meet most often are these. Section 6166, which lets an executor pay estate tax in installments, defines an "interest in a closely held business" by type and size: a sole proprietorship, a partnership interest, or corporate stock, where the partnership or corporation either had 45 or fewer owners or the decedent's estate includes 20 percent or more of it. Section 469, the passive activity loss rule, defines a "closely held C corporation" as one described in section 465(a)(1)(B), which turns on the stock ownership test of section 542(a)(2): at any time during the last half of the tax year, more than 50 percent in value of the corporation's stock is owned, directly or indirectly, by or for not more than 5 individuals.

The estate tax definition, in full. Section 6166(b)(1) reaches (A) an interest as a proprietor in a trade or business run as a proprietorship; (B) a partnership interest in a partnership carrying on a trade or business, if 20 percent or more of its total capital interest is in the gross estate or it had 45 or fewer partners; and (C) stock in a corporation carrying on a trade or business, if 20 percent or more in value of its voting stock is in the gross estate or it had 45 or fewer shareholders. Section 6166(b)(2) sets the counting rules: the test is made immediately before death, an interest held by a married couple as community property or as joint tenants, tenants by the entirety or tenants in common counts as one owner, property held through a corporation, partnership, estate or trust is treated as owned proportionately by its owners, and stock or partnership interests held by members of the decedent's family are treated as owned by the decedent. The value of passive assets held by the business is excluded both when the estate tests whether the interest is large enough to qualify and in figuring how much tax can be deferred. What the executor can then do with a qualifying interest belongs to estate liquidity planning.

The income tax definition. The passive activity loss rules apply to individuals, estates and trusts, and to two kinds of corporation: personal service corporations and closely held C corporations. The at-risk rules of section 465 reach the same closely held C corporations. A closely held C corporation that is not a personal service corporation gets one concession under section 469(e)(2): its passive activity losses may be deducted against its net active income, though not against portfolio income such as interest and dividends. The same five-or-fewer test is half of the definition of a personal holding company, whose undistributed personal holding company income bears a separate tax, and it is the test a real estate investment trust must fail, since a REIT may not be closely held.

Valuation without a market. A public company's shares have a price every trading day. A closely held interest has to be valued by appraisal, for estate and gift tax, for a buyout and in a divorce, and a minority interest that carries no control and cannot easily be sold is generally worth less than its proportional share of the whole business. That gap is the subject of valuation discounts, and it is one reason estate plans for business owners use buy-sell agreements to fix a price and a buyer in advance.

Pay and distributions. When the owners of a closely held C corporation also work in it, they have a reason to call profit compensation, because salary is deductible to the corporation and dividends are not. Whether that pay is reasonable for the work done is the question the reasonable compensation rules answer.

1. Name the rule. Identify which provision is in play: estate tax installments, the passive activity or at-risk rules, a valuation question, or something else.
2. Apply that rule's own test. Section 6166 counts owners and the estate's share; section 542(a)(2) measures how much of the stock five individuals own, counting indirect ownership.
3. Count owners the way the rule counts them. Section 6166 treats a married couple's joint or community holding as one owner and attributes family holdings to the decedent; section 542 has attribution rules of its own.
4. Value the interest independently. No market price exists, so an appraisal is needed whenever a tax, a buyout or a court requires a number.

Take an example of the estate tax count. Corrado dies owning 8 percent of the voting stock of a manufacturing company that has 48 individual shareholders on its books, none of the others related to him. Eight percent is below the 20 percent route, so the stock qualifies only if the company had 45 or fewer shareholders. Six of those shareholders are three married couples, each couple holding its stock as joint tenants. Section 6166(b)(2)(B) treats each couple as one shareholder, so the count is 48 − 6 + 3 = 45, and the company meets the 45-or-fewer test. Whether his estate can then elect to pay in installments still depends on whether the interest exceeds 35 percent of the adjusted gross estate, which is a separate test.

And an example of the income tax test. A C corporation has seventeen individual shareholders, none related to one another. Throughout the last half of its tax year the five largest own 20, 12, 10, 6 and 4 percent of the stock by value, and the other twelve own 4 percent each. The five largest together own 20 + 12 + 10 + 6 + 4 = 52 percent. Because more than 50 percent is owned by five or fewer individuals, it is a closely held C corporation, and its passive activity losses can offset its active business income but not its interest or dividend income.

Pros

• An estate built around a closely held business can qualify for estate tax installment payments that an estate of the same size held in a diversified portfolio cannot.
• A minority interest without control or marketability is generally valued below its proportional share, which matters for estate and gift tax.
• A closely held C corporation can deduct passive activity losses against its net active business income, a concession individuals do not get.

Cons

• No market price means every valuation is an appraisal that can be challenged.
• Owners can face estate tax on a business that produces no cash to pay it, which is the problem estate liquidity planning exists to solve.
• Because the tests differ by provision, a business can be closely held for one rule and not for another, which invites wrong assumptions.
• Owner-employees of a closely held C corporation face scrutiny of whether their pay is reasonable compensation or a disguised dividend.