This article was published in Transaction Advisors LLC in July 2013.
One of the most difficult issues facing the owner of any successful business is how the business, or the personal wealth that it represents, can be preserved for the benefit of his or her family after death. While it is natural for business owners to concentrate their energy and resources on developing strategies for current business growth and profitability, a lifetime’s work can quickly dissolve if insufficient attention is paid to planning for the transfer of the management and control of the business consistent with the business owner’s plans for retirement or in the untimely event of his or her disability or death.
The purpose of this outline is to summarize the numerous tax and legal considerations that the business owner must take into account in order to take steps to preserve the fruits of his or her lifetime endeavors for the business owner’s spouse or children.
The following is an introduction to a complex subject and is not intended to be an exhaustive treatment of state or federal tax or commercial law.
ESTATE AND INHERITANCE TAXES
Closely held business assets, whether in the form of corporate stock, partnership interests or ownership of a sole proprietorship, are subject to federal and state death taxes. In 2013 the federal estate tax is imposed on estates in excess of $5.25 million at a rate of 40 percent. The exemption is indexed for inflation. The federal estate tax is due nine months after death.
Many states also impose inheritance or estate taxes that impose an additional burden on the estate of a deceased business owner or his or her family. With the changes in federal estate taxes, many states have or will impose new or different estate or inheritance taxes that must be taken into account in estate planning for a business owner.
The federal estate tax is not imposed on any transfer to, or exclusively in trust for, a spouse. As a result, it is possible to defer all federal death taxes until the death of the survivor of a married couple. However, where all assets pass to the surviving spouse, the couple may lose the use of the exemption of the first to die (translating to as much as $2.1 million in unnecessary taxes). Properly designed estate planning documents will preserve the exemption of the first to die by using a trust for surviving family members. For estates in excess of $10.5 million, however, a higher level of sophistication in the planning is required to reduce the tax burden. Recent tax law changes made permanent the concept of “portability”, which permits a surviving spouse to use the unused federal estate tax exemption of the first spouse to die, but only if the estate of the first to die files a Federal estate tax return.
Death taxes imposed on business assets can easily consume a major portion of a business’ value. Moreover, the compressed time frame for paying these taxes may necessitate a “fire sale” of business assets at a price far below their “going concern” value. Where there are surviving family members who will be dependent on business income or who have the desire to continue the business, any sale at all can be undesirable.
Even where there are sufficient non-business assets to meet the tax obligations, the death or disability of a business owner can be devastating to the continued profitable operation of the business. Careful thought should be given to who will assume responsibility for management decisions in such a situation to ensure that the flow of income for family members continues unabated.
DEVELOPING AN EXIT STRATEGY
It is important that the business owner take the time to consider his or her timetable for leaving the business. Of course, it also is important that a plan be developed in contemplation of the business owner’s inability to continue in the business due to disability or death. It is never too early to begin to plan. Unfortunately, we see too many situations where a timely plan was not developed. There are a number of strategies available to transfer business ownership efficiently and effectively. In each case, the challenge is to maximize the amount that will be passed on to the heirs while maintaining security for all family members and family harmony.
Sale to a Third Party
If there are no partners or co-shareholders to continue the operation of the business, and there are no family members to step into the decedent’s shoes, the business owner (or the executor after his or her death) will be forced to sell the business to a third party. The family’s financial future will depend on a sale of the business at the best possible price and on the best possible terms. This requires proper planning, including positioning the business for sale and understanding valuation techniques and the marketplace.
Purchase by Surviving Shareholders or Partners
In many cases, it is anticipated that partners or shareholders will continue to operate the business by purchasing the business owner’s interest in the business from the business owner or his or her family. In these situations, it is important to protect a spouse or children from potentially opportunistic partners and to ensure that the business owner’s family receives fair consideration for the business interest in a manner that does not cripple the company’s continued operations. If one or more of the partners are family members and other family members are not involved in the business, fairness becomes very important to the maintenance of family harmony.
Passing the Business to the Next Generation
One or more members of the business owner’s family may wish to continue the business into the next generation, capitalizing on the fruits of the owner’s lifetime of work. Very careful planning is required in this circumstance to minimize the overall tax burden, provide the necessary liquidity to pay the tax and other settlement costs, leave the financial viability of the business intact, and provide equality with family members who are not involved in the business.
SCENARIO 1 — SALE TO A THIRD PARTY
If the business owner determines there are no present owners or family members available to continue the business, he or she should develop a plan for marketing the business to a third party. This plan should begin at least five years before the date set by the business owner for retirement.
At the same time, a plan should be developed for the possibility of the business owner’s disability or death before his contemplated retirement date or before a sale can be consummated. There are several essential business planning considerations for the owner who expects his or her business interests to be sold after death. Probably the most important is to plan for continued management to preserve the value of the business until a sale can be consummated.
Key Man Insurance
One method of helping a business overcome the loss of a vital management employee, including the business owner, is to purchase “key man” insurance. Such a policy would provide a fund to relieve any reductions in cash flow that can result from the loss of a “business generator” or a manager, or alternatively, to employ a competent replacement for the owner.
The loss of the principal owner of a business will place added emphasis on the value of those employees who have an intimate knowledge of the business operations, but are not prepared to purchase the business. In order to stabilize the estate’s investment in the business, these employees will be necessary to continue day-to-day operations and assure clients, customers and lenders that their needs will be met. Yet, at the same time, the death of the owner could serve as a force motivating the employees to look elsewhere to guarantee their own security.
In certain situations, this can be addressed through the use of carefully drafted employment agreements. The agreements might provide for a specified period of time in which the employee will remain with the business, perhaps with financial compensation or incentive for the added responsibility. There may be further incentives provided for agreeing to assist for a period of time with a new owner so as to ensure a smooth transition. Such assurance could have a beneficial effect on the value of the business for a buyer. These arrangements also could have an adverse effect on a buyer who wishes to bring his or her own employees to the business, so any arrangements should be flexible with the recognition that the business owner or his or her family may end up compensating a key employee who a buyer does not wish to retain.
Choice of Fiduciary
If a business is to survive for an adequate period of time after the owner’s death, to allow a reasonable return upon its sale, it is essential for the business owner to carefully choose who will serve as Executor of the estate. In many cases, the planner automatically assumes that the surviving spouse should serve in this role. However, the spouse may not have the familiarity with the business, or the inclination to become engrossed in the details of its operation, that would be required to ensure continued profitability. In this circumstance, it would make sense to choose a person to serve with the spouse who has the ability and willingness to manage the business. This might include either a trusted employee, a business associate, an accountant or attorney familiar with the operations of the business and the family, or a bank trust department that is equipped and qualified both to operate the business and to address the unique issues that arise in trusts and estates. Similarly, and often overlooked, is the importance of designating as an agent (under a general or limited power of attorney) an individual or bank or trust company who would be competent to act for the business owner in the event of his or her disability (a “Business Living Will”).
Granting Business Authority
It is essential that the Executor of the estate or an agent under a Power of Attorney have full authority to operate the business free from the constraints of liability under state fiduciary law. To this end, the Will or Power of Attorney should contain language expressly authorizing the operation and sale of the business as well as the hiring of agents, brokers, consultants and other experts. In addition, it is essential that the document permit the Executor or Agent to make representations and warranties that would be appropriate in selling a business, as well as to enter into escrow agreements associated with the sale of the business. At the same time, the fiduciary should be protected from liability to the business owner’s family for decisions made in good faith in the ordinary course of operating or selling the business.
Separating Business and Personal Assets
In certain circumstances, it may make sense to provide in the Will (or to have separate Powers of Attorney) that the business assets be set apart from the non-business assets in order to isolate the decision-making process among the most appropriate persons. Thus, a business associate or key employee might be empowered solely to make decisions with regard to the operation of the business and its sale, but have no authority over the sale or investment of personal assets, such as a residence or marketable securities, or to make distributions of income or principal to the beneficiaries.
In consideration for taking on the responsibility and liability involved in administering an estate or acting as an agent under a power of attorney, the non-family fiduciary will expect to be compensated. A well thought-out plan will include provisions for compensation in order to avoid disputes requiring court resolution at a later point. The compensation should be related to the time commitment involved, the level of expertise required, the opportunity cost for the fiduciary, the value obtained for the family and the liability risk undertaken. Of course, all of this should be discussed with the proposed fiduciary at the time the plan is developed.
Investing the Proceeds
Once the business has been sold, the proceeds of sale will need to be invested for the surviving family members. At this point, the individual fiduciary with special business expertise may wish to resign, leaving the funds in the hands of the surviving spouse and/or a competent professional fiduciary as co-executors.
A comprehensive tax-sensitive plan will ensure the full use of both spouses’ exemptions from federal estate tax. If there are minor children, the Will should appoint a guardian and also contain a trust arrangement to manage the funds and allow for discretionary distributions for the children’s maintenance, education, health and support until they reach an appropriate age. The guardian will be responsible for the children’s personal welfare, such as living arrangements, medical decisions, etc. The trustee will manage the funds.
SCENARIO 2 — PURCHASE BY SURVIVING SHAREHOLDERS OR PARTNERS
Persons who share the ownership of a business need to enter into agreements to determine the rights of each party (or his or her estate) when a death or disability occurs. Without a well thought-out “buy/sell” agreement, a surviving owner could be subject to interference by heirs who may have little understanding or loyalty to the business. Similarly, without such an agreement, the heirs may receive an essentially unmarketable asset that makes no contribution to their day-to-day financial needs.
There are several considerations that will go into the formulation of the death or disability provisions under a buy/sell agreement. These include who will participate in the buy-out, whether the agreement mandates a buy-out or leaves it optional, the purchase price and the terms of payment.
Mandatory vs. Optional Buy-Out
The agreement should provide whether the surviving shareholder(s) will be obligated to purchase the decedent’s shares or will have an option to purchase the shares. If the buy-out is not mandatory, there may be a right of first refusal to prevent the heirs from transferring the shares to a third party without first offering them to the surviving shareholder(s). The option/right of first refusal route will provide less security for the heirs, but in certain circumstances (such as where there are adequate other assets to provide for the family), may make sense in order to permit the heirs to participate in any future growth in the business’ value or to cash in on a subsequent public offering or third-party sale. In addition, some agreements provide for a series of “puts” and “calls” by both the estate and the surviving shareholder(s) in order to provide flexibility and a time frame for the transition in ownership.
Cross-Purchase vs. Redemption Agreement
Regardless of whether the buy-out is mandatory or optional, there are a number of considerations as to whether the surviving shareholder(s) or the company will purchase the stock from the estate. In a “redemption” arrangement, the company is the purchaser with the effect that the surviving shareholders’ percentage interests are increased pro rata. In a “cross-purchase” arrangement, the surviving shareholder(s) purchase the deceased or disabled shareholder’s interest directly.
Whether to use a redemption or cross-purchase arrangement will depend on a number of factors. The redemption arrangement is normally the easiest to administer, especially if there are more than two shareholders. However, there are certain tax advantages to the cross-purchase arrangement. In a cross-purchase arrangement, the surviving shareholders will have a tax basis in the purchased shares equal to the purchase price. In the redemption arrangement, the surviving shareholder will retain the original basis in his or her holdings, since no new shares are purchased. Instead, the original holding will become more valuable as it now represents a greater proportion of the outstanding stock. This will affect the tax incurred on the capital gain at a subsequent sale of the stock by a surviving shareholder.
Another factor to consider in the cross-purchase vs. redemption agreement is the personal liability which a surviving shareholder incurs. This personal liability may provide a larger pool of assets to ensure that the heirs receive the proceeds of sale, but jeopardizes the other assets of the surviving shareholder and his or her family. If insurance is used to fund a cross-purchase arrangement where there are numerous shareholders, each shareholder must hold a policy on the life of each of the other shareholders. This adds a significant level of complexity and a risk that one or more shareholders may fail to maintain the life insurance policies on other shareholders’ lives. The planners should also take into consideration that in a C corporation context, the receipt of life insurance proceeds to fund a redemption will be treated as a tax preference item for purposes of calculating the corporate alternative minimum tax. As a result, the corporation may be taxed on the receipt of what would otherwise be tax-free proceeds.
Setting the Purchase Price
Probably the most important element of the buy/sell agreement is the purchase price for the deceased owner’s interest in the business. There are a number of methods for determining the price, and the one included in the agreement should be determined only after carefully considering the estate tax effects of the method employed. The considerations will vary according to whether the agreement is exclusively among unrelated individuals or among family members.
One simple method for setting a price is to agree on an amount and attach a certificate to the agreement on a periodic basis as the value changes. The problem with using this technique is that the certificate may become outdated if the parties neglect to amend the amount or are unable to agree on a new price. Another common method of setting a price is to use book value, as determined from the most recent financial statements of the business. However, this may not realistically reflect the value. A more sophisticated approach is to adjust book value by substituting market values for assets used in the business, such as real estate and specialized equipment and inventory. Another alternative is to incorporate a formula that takes into account the earnings history of the business or projected cash flows, perhaps using an agreed upon multiple of the average earnings or cash flow over a set time period. Finally, the agreement may just provide for an independent appraisal or appraisals at the time of the triggering event.
Where family members are parties to a buy/sell agreement entered into or substantially modified after October 8, 1990, it is important that the price set in the agreement is the fair market value as determined under IRS regulations. Otherwise, there is a significant risk that the IRS will take the position that the fair market value for estate tax purposes exceeds the price set in the agreement and actually received by the heirs. This could have a devastating effect on what the heirs ultimately inherit. Section 2703 of the Internal Revenue Code prescribes rules applicable to determining the fair market value for purposes of related party agreements. For agreements entered into prior to October 9, 1990, and not substantially modified thereafter, whether the purchase price will set the value for estate tax purposes depends on the facts and circumstances involved.
Terms of the Sale — Funding the Buy-Out
Another consideration in preparing the buy/sell agreement is the terms of payment. Unless the business is holding sufficient excess cash, the buy-out will need to be financed either through insurance, lender financing or by an installment sale. Since the value may change from time to time, it may not be possible to tailor the face amount of life insurance to the purchase price. Also, the amount of available life insurance may be limited by the cost due to the age or medical condition of the shareholder. In the case of a disability, the cost of buyout insurance may be prohibitive. A common technique is to provide that any portion of the purchase price in excess of the insurance proceeds will be paid under a note secured by the shares of stock at issue. If the payment is not secured by personal assets of the purchasing shareholder, a disabled shareholder or the heirs of a deceased shareholder may be forced to reclaim the shares and be subject to the potential failure of the business.
As noted above, in a cross-purchase arrangement, it will be necessary for each shareholder to own a policy on the life or lives of each of the other shareholders. In a redemption arrangement, the insurance will be owned by the company. Generally, the premiums on corporate-owned life insurance are not deductible for income tax purposes, and the proceeds are not subject to income tax when received.
In the S corporation context, the cost of corporate-owned premiums will reduce the shareholders’ basis in their stock. However, insurance proceeds are deemed tax-free income to the S corporation, and therefore they will increase the surviving shareholders’ basis. The extent of the benefit of this step-up in basis to the shareholders depends on whether the corporation elects to allocate its income by closing its books on the date of the sale rather than having the income allocated in accordance with that proportion of the year each shareholder held his or her stock.
Other Triggering Events in the Buy/Sell Agreement
An adequate buy/sell agreement will address not only the issues that arise at the death of a shareholder, but also will provide that the shareholders are protected in certain other circumstances. Thus, an agreement should include a right of first refusal if a shareholder attempts to transfer his or her stock to a person outside of the class of existing shareholders. A complete agreement would provide the remaining shareholders with the option of purchasing the shares of a shareholder who has declared personal bankruptcy, or whose shares are subject to court attachment by virtue of a creditor’s claim or a divorce decree. As noted above, a buy/sell agreement shall also provide for an option or obligation to purchase the stock of a disabled or retiring shareholder.
Investing the Income
After the closing on the sale of the business interest under the buy/sell agreement, the executor will invest the sale proceeds as would be true if the business were sold to a third party rather than a co-shareholder or partner. Hence, the same considerations would apply as are discussed above.
SCENARIO 3 — TRANSFERS TO THE NEXT GENERATION
Transferring the control of a family business presents a considerable challenge in terms of the dynamics of intra-family relationships. The planner must contend with a series of emotionally charged issues, including providing adequate funds for retirement, choosing the most appropriate child to lead the business, addressing the need for equality between children who are employed both in and out of the business, smoothing over sibling rivalries and protecting family assets from interference from in-laws. As if these concerns were not obstacles enough to an orderly transition of power, when coupled with very high estate tax rates, it is not surprising that it has become more and more unusual to find a family business that is operating successfully after the loss of the founder. Without proper planning, the need to meet the tax obligations, with its drain on corporate assets, or strain on cash flow to meet the debt service arising from the tax, will by itself require what can turn out to be a disastrous liquidation of the business.
A comprehensive business succession plan will entail lifetime transfers of stock to reduce the value of the taxable estate, taking advantage of the existing estate and gift tax exemptions. It will also focus on liquidity needs to enable the estate to pay the taxes that cannot be avoided. It will involve techniques to transfer control into the hands of the next generation and to provide adequate income to the senior generation or other family members not involved in the business. Of course, all of the techniques available to meet these ends must be tailored to the particular objectives of each business owner and the unique circumstances surrounding each family.
Ensuring Adequate Retirement Income
One of the most fundamental maxims in the area of business succession planning is that the business owner must be careful not to impoverish himself or herself in order to save taxes for the children. Thus, it is essential that any long- or short-term gifting program include adequate provision for retirement income. There are several options available.
Sale of Business Interest to Children
A sale of the stock of the business to some or all of the children on an installment basis can provide the parents with an income stream for a period of time.
A sale can be for the full value of the asset or for less than the fair market value (a “bargain sale”). In the latter case, the transaction will contain a gift component that will be subject to gift tax. The parents will incur gain on the sale which will be taxable in the year of closing, or if sold by note, as each installment is paid. Thus, the interest element of each installment payment will be taxed as ordinary income and the principal element will be taxed to the extent there is capital gain. The children will obtain a new basis in the stock equal to the purchase price, which will be advantageous in the event of a subsequent sale by the children.
It should be kept in mind that if the parent dies prior to the pay-off of the note, its then-current value will be included in the parent’s taxable estate. If the note is paid off, the proceeds will be includable to the extent the parent has added the funds to savings. One variation on this theme is to use a self-canceling installment note (SCIN). Under a SCIN, the debt is canceled at the death of the parent, with the original purchase price including a premium for this feature. As a result, the note is not subject to estate tax, although there will be an acceleration of the capital gain.
A sale also may be structured as a “private annuity” so that the sale price is annuitized to provide the parent with an annuity over his or her anticipated life expectancy. Payments continue to the parent until death. Accordingly, the selling price is not fixed, but will depend on how long the parent lives.
Employment or Consulting Agreement
The parent may enter into an employment or consulting arrangement in order to receive a stream of income from the business. If the arrangement is equivalent to an “arm’s length” agreement that would be reached between unrelated parties, the payments will be deductible to the company and includable in the parent’s income. In addition, they will be subject to FICA tax and may also affect the parent’s entitlement to social security benefits. The agreement could provide for a survivorship benefit for the spouse at the death of the parent.
Deferred Compensation Plan
Another popular technique for assuring an income stream is for the company to adopt a non-qualified deferred compensation plan that pays a specified sum either for a term of years or for the life of both parents. The annual payment may be tied into an inflation adjustment factor so as to keep the parents at a set standard of living. The payments are deductible to the company as paid and taxable to the parent as received and are subject to FICA tax. There is, however, authority for treating the present value of the future stream of payments as received in the first year of the plan. As a result, the payments will be subject to the cap on FICA income. Initiating the plan payments in a year with significant earned income may therefore eliminate the FICA tax on payments under the deferred compensation plan.
Income from Passive Business Assets
It may be possible for the parent to retain certain passive assets, such as real estate or equipment, that are integral to the operation of the business in order to receive a flow of rental income. These funds will be deductible to the business and includable in the parent’s income for tax purposes. Consideration should also be given to whether these passive assets should be left at death to inactive children. One disadvantage of using such assets to equalize shares of the children is that it places the inactive children in a position to affect the fortunes of the business operation by setting fixed expenses.
Stock Bonus Program
Stock in a closely held corporation can be transferred to family members employed in the business through a stock bonus plan. The value of the shares received would be deductible to the corporation and treated as income to the recipient for income tax purposes. This may require a cash bonus to cover the additional tax due. The stock bonus program does not cause the parent to incur a capital gains tax, as would be true in the installment sale arrangement. This alternative also would not provide the parent a stream of retirement income, but as with a gift program, a consulting arrangement or unfunded non-qualified deferred compensation arrangement could be adopted by the corporation.
Transferring Equity by Gift
After assuring that competent and industrious children are ready to take on the responsibility, the most fundamental requirement for successfully passing a business to the next generation is to reduce the estate and gift tax liability associated with the transfers. Since this can be done primarily by reducing the value of the taxable estate at the business owner’s death, it is essential to implement a systematic long-term gifting program that funnels wealth down to the next generation in a tax-efficient fashion. In most cases, this transfer of wealth should begin well before the senior generation is actually ready to retire.
Basic Gift Tax Rules
Under the current gift tax rules, each person may give cash or property with a value of up to $5.25 million during his or her lifetime without incurring a gift tax (although to the extent used during lifetime, the exemption will be unavailable at death). A husband and wife may give a combined $10.5 million, regardless of which spouse owned the property given. In addition, each person currently may give $14,000 per year to any number of separate donees without using any portion of the exemption. Again, this can be increased to $28,000 per year if the spouse who does not own the property consents to applying his or her exclusion to the gift.
Using the annual exclusion over the course of a number of years may enable the business owner to transfer a significant portion of his or her stock without eroding the exemption and without transferring control. There may be reasons, however, to use the entire exemption prior to death. In businesses that are expected to significantly appreciate in value, transferring equity in the business sooner will allow that appreciation to occur in the hands of the next generation and thereby escape estate taxation at the death of the parent. One consideration that must be kept in mind is that gifted property will have the same basis in the hands of the donee as it had in the hands of the donor. On the other hand, property received at death will have a new “stepped-up” basis equal to the property’s fair market value at death. Property transferred by sale will have a basis equal to the purchase price. As a result, there will be a higher capital gain tax paid upon the subsequent sale of property received by gift rather than by inheritance or purchase. However, the cost of reducing the capital gains tax (currently at either a 15 or 20 percent federal rate depending on the taxpayer’s taxable income in the year of the sale) is a federal estate tax at a 40 percent rate. In addition, the capital gains tax will not be an issue if the business is expected to remain in the family. Thus, in most cases, the benefit of making the gift will outweigh the higher income tax on the gain should the business interest subsequently be sold by the children.
Retaining Control — The Recapitalization
If the business owner wishes to retain control of the corporation while transferring equity in the business to the next generation (a very common goal), a corporate recapitalization may be advisable to create classes of voting and non-voting stock. In a partnership arrangement, this can be done by forming a limited partnership, with the parent (or a corporation owned by the parent) as the general partner. Both classes of stock (or partnership interests) would have identical economic attributes. This type of structure is permissible in both the S and the C corporation context. Typically, a corporate recap will result in the number of outstanding voting shares being quite small in proportion to the number of shares of non-voting stock. In this fashion, considerable equity can be transferred without relinquishing control.
One of the greatest dilemmas facing a business owner and parent is how to maintain equality among all children, while preserving control for the children who are active in the business. One additional advantage of a recapitalization into voting and non-voting stock or a limited partnership is that it will permit the transfer of equity to both active and inactive children without affecting control of the business operations. However, if sibling rivalry creates tension between the voting and non voting groups, it might be necessary for the business’ welfare, as well as family harmony, to eliminate any participation by the inactive children. A method to address this issue is to provide for a buy-out by the active children of the non-voting stock (or limited partnership interests) of the inactive children at the death of the parent. This may entail the combination of a buy/sell agreement among the children with the purchase of a life insurance policy, owned by the active children, the proceeds of which will be used to fund the buy-out.
Business Valuation Techniques
An essential element of a gifting program for corporate stock or partnership interests is a professional appraisal. The values shown on the gift tax return must be supported by credible substantiation. In Revenue Ruling 59 - 60, the IRS set forth a number of factors for determining the fair market value of a business enterprise. These include a consideration of (1) the nature of the business, (2) the economic outlook in general and as to this particular industry, (3) the book value of the stock and the financial condition of the company, (4) the earning capacity of the business, (5) the dividend paying capacity, (6) the presence or absence of goodwill, (7) the size of the block of stock to be valued and (8) the market price of stock of similar businesses that are publicly traded.
An appraiser will evaluate the financial performance of the business as well as analyze the overall prospects of the industry in a local, national and international context. The valuation methodology may involve comparing the enterprise with publicly traded companies in the same line of business, or capitalizing earnings to determine fair market value from the expected future return that will be received from the business. In determining earnings, the appraiser must allow for extraordinary items in the financial statements. Hence, the appraiser will “normalize” income and expenses in order to discern an earnings trend and apply a growth factor to account for future increases in the level of earnings. At that point, the appraiser will choose a rate of return appropriate to the investment (taking into account the risk involved) to determine the fair market value of the business entity as a whole. A discount may then be applied to reflect a minority interest and/or a lack of marketability due to the closely held nature of the business.
Minority Discounts — Disappearing Value
Regardless of how an appraiser has determined the value of the business entity as a whole, the value of a particular block of stock or partnership interest that is given to the children will not necessarily be proportionate to the block’s percentage interest in the company. Rather, the value may reflect a discount for lack of control or a premium for control. The use of “minority discounts” to reduce the overall tax cost of transferring a business interest has long been sanctioned by the courts, but consistently challenged by the IRS in the context of intra-family transfers. However, in February 1993, the IRS conceded that a “minority discount” would be honored for gifts to family members of separate blocks of stock, even though when aggregated, the gifts represented a controlling interest in the company. This ruling provides a good opportunity to take advantage of discounted values when passing business assets to family members by gift rather than at death.
Forms of Gifts
Once it is determined that it is appropriate to embark on a gifting program, there are a number of forms for the gifts to take. The simplest would be an outright (i.e., not in trust) gift of voting or non-voting stock to the children. In this case, the children would receive any dividends and, unless bound by a buy/sell agreement, the right to transfer the stock to a third party. There are, however, other forms of gifts that can be tailored to a particular family situation or to achieve a greater tax advantage.
Gifts to Minors
A donor may transfer an interest in a business to a custodianship or trust for a minor, under which control of the asset is placed in the hands of a responsible custodian or trustee. If a trust is created, so long as the trust gives the minor the right to all of the income and the right to obtain the stock free of trust upon attaining age 21, the gift will qualify for the gift tax annual exclusion. If S stock is to be transferred, the trustee must distribute any dividends to the minor, or to a custodianship for the minor, at least annually.
Special Advantages of S Corporation Gifts
Gifts of stock in an S corporation can be especially advantageous in reducing the tax cost of transferring wealth to the next generation. Under the S corporation rules, the owner of the stock is deemed to receive for tax purposes his or her proportionate share of the corporation’s income regardless of whether it is distributed. When a dividend is paid, there is only one level of income tax (at the personal level).
Grantor Retained Annuity Trust (GRAT)
For a business that is expected to appreciate greatly, a more sophisticated technique for reducing the transfer tax cost is to use the grantor retained annuity trust (GRAT). Under this technique, the parent transfers stock to a trust which provides that the parent retains the right for a set term of years to receive a specified annuity payment. At the end of the term (or at the parent’s death, if that occurs first), the trust terminates and the shares pass to the next generation.
At the time of the transfer to the trust, the parent is deemed to have made a gift of the fair market value of the block of stock transferred, reduced by the present value of the stream of annuity payments he or she will receive. This discounted value represents a taxable gift, but if it is under $5.25 million ($10.5 million if the spouse consents), no current gift tax will be due. If the parent survives the term, no further tax will then be due, regardless of how greatly the stock has appreciated by that time. The longer the term of the trust, the less the value of the taxable gift. However, should the parent die during the term, the full value of the stock will be included in his or her estate as if the transfer to the trust had not been made, with the estate receiving a credit for any gift tax paid or exemption used.
The annuity payment to the parent under the GRAT would be paid first from current income received by the trust. Thus, the company would declare dividends to satisfy this amount. To the extent the current earnings are not sufficient to meet the annuity, the trustee would transfer shares of stock back to the parent. This would require an annual update of the appraisal to ensure that fair market value was received.
Sale To Grantor Trust
A grantor trust is a trust that can be created by a parent for the benefit of family members which is not treated as a separate entity for federal income tax purposes. The income earned on the assets owned by the trust is taxed to the grantor/parent. Although the assets in the trust are held for the benefit of the named beneficiaries, the income tax payment by the grantor is not treated as a gift. As a result, the parent’s estate (and therefore future estate tax) is reduced by the amount of income tax paid on the trust assets while the trust’s assets grow for the beneficiaries without being reduced by income taxes.
Under this technique, the parent would sell stock to the grantor trust and take back a promissory note. The purchase price paid by the trust would be based on the appraised value of the stock at the time of the transfer. The interest rate on the note must be commercially reasonable and not less than the rate set by the IRS for the month of the sale (1.09% in April, 2013 for a note term of up to 9 years, and 2.70% in April, 2013 for a note term in excess of 9 years).
The trust should be prefunded with cash or stock which will be a gift to the trust. The trust would make payments to the parent on the note out of the cash which the parent gifts to the trust and from distributions the trust receives on the stock.
The grantor trust technique arises out of an anomaly in the Internal Revenue Code (“Code”) whereby the grantor of a trust may be treated as its owner for income tax purposes but not for estate tax purposes. Under the Code, the grantor of a trust is taxed on the income earned by the trust (both ordinary income and capital gain) if the grantor, or any other person whose interest in the trust is not adverse to the grantor, has the power to substitute assets of equivalent value in a “nonfiduciary” capacity. Thus, if the parent creates a trust and retains an “option” to purchase at fair value any asset owned by the trust, the income earned by the trust is treated as the parent’s income for tax purposes. However, these attributes alone do not cause the trust to be included in the parent’s estate for federal estate tax purposes.
The benefits of the grantor trust can be summarized as follows:
There are some risks associated with the concept, as follows:
PLANNING FOR STOCK REMAINING AT DEATH
Regardless of the benefits of the gifting program, in situations involving valuable businesses, it is unlikely that all of the stock will be transferred during lifetime without exceeding the $5.25 million lifetime exemption and thus incurring a gift tax. Where there are significant liquid assets, paying gift tax can be advantageous over having all of the remaining business assets pass through the estate. This is because the funds used to pay the gift tax will not be included in the estate at death, and therefore will not be subject to estate tax. In order to qualify for this “tax exclusive” transfer, it is necessary for the donor to survive the transfer by three years. Even if liquid assets are available, it is important to ensure sufficient liquidity for the business owner during his or her lifetime. It may also be important to preserve liquid assets as part of the estate plan for family members who are not active in the business. If there is not sufficient liquidity to pay the entire gift tax that would be due if the entire business were gifted, some portion of the business will pass at death.
One of the major concerns at death is liquidity. As noted above, federal death taxes are due nine months after death. In light of the large proportion of the estate that is likely to be tied-up in business related assets, an outside source of liquidity will be needed to meet the tax burden.
Deferral of Payment Under Section 6166
One method of addressing the liquidity problem is borrowing from the IRS under the terms of Section 6166 of the Internal Revenue Code. Section 6166 allows a five-year deferral of tax payments with periodic payments over the following ten years. Interest is payable on a current basis at market rates. While Section 6166 can avoid the need to sell the business within nine months of death in order to raise cash to pay the estate tax liability, it extends the closing of the estate during the deferral period and may cause a significant impact on corporate operations by virtue of the cash flow requirements.
A common method to address liquidity needs in this type of planning is the use of life insurance.
Although life insurance proceeds are generally received free of income tax, they are subject to estate tax where the insured has an “incident of ownership” in the policy. However, an insurance program can be structured in a fashion so that the proceeds pass outside of the estate, creating a tax-free fund that would be available for the payment of taxes. To achieve this tax-free benefit, the policy should be owned by the children or by an irrevocable trust for the spouse or children. At death, the shares of stock would be purchased by the trust from the estate. The trust provides for the disposition to the family (following the same terms as in the Will), and the estate uses the insurance proceeds to pay the taxes.
A life insurance program can be set up on a “split-dollar” basis in order to minimize the portion of the premium payments that are treated as gifts for tax purposes. Under a split-dollar arrangement, the company pays the premium cost equal to that portion in excess of the lower of the insurance company’s premium for a term policy on the insured or a rate taken from a table of term rates published by the IRS. The IRS currently is studying how these rates should be determined, and there is a great deal of uncertainty in this technique. At the insured’s death, the owner of the policy (either a child or a trust) pays the company an amount equal to the cumulative premiums the company paid for the policy (in essence an interest-free loan) and the owner retains the balance of the death benefit. The insured must pay income tax on the cost of term insurance and also is deemed to have made a gift each year equal to the term cost, rather than equal to the entire value of the premium. The split-dollar program must be carefully structured to address the increasing term costs of the policy as the insured ages.
Mixing Life Insurance and Tax Deferral
Obviously, the feasibility of a life insurance program to meet liquidity needs at death depends on the availability and cost of the insurance. The amount of coverage required will depend on a fair estimate of the value of the shares of stock that will be in the estate at death. To the extent the cost of the insurance coverage is excessive, a combination of insurance and deferral under Section 6166 may be appropriate.
Using the Marital Deduction to Defer Estate Tax
Because gifts and bequests passing to a surviving spouse are not subject to estate and gift tax, there is considerable potential for delaying the time the tax will be due. In order to qualify for the marital deduction, the bequest must either pass to the spouse outright or pass into a trust for the spouse that meets specified requirements. A trust arrangement has an advantage in situations where the spouse is not the appropriate person to be vested with control of the corporation. In that circumstance, a trustee can be appointed who is especially qualified to make decisions with respect to business interests. There are several types of trusts that qualify for the marital deduction.
General Power Marital Trust
A general power marital trust will require that the spouse receive all of the income annually for the balance of the spouse’s life and may permit principal invasions for the spouse only. It also must give the spouse either the unlimited power to withdraw the principal during lifetime or to appoint the principal to anyone, including his or her estate or creditors at death. This type of trust gives the spouse the ultimate power to determine the disposition of the principal and is favored among couples who wish ultimate control over the assets to pass to the spouse.
Qualified Terminable Interest Property Trust
The Qualified Terminable Interest Property Trust (QTIP Trust) also must provide to the spouse the right to receive all of the income annually and may permit principal invasions for the spouse. As with the general power trust, no one other than the spouse may be a beneficiary during the spouse’s lifetime. However, unlike the general power marital trust, the spouse need not have the power to determine who will receive the assets at the spouse’s death. Instead, the trust sets forth who will be the ultimate beneficiaries. The QTIP Trust is especially useful in situations where there is a second marriage and the business owner wishes to provide for the surviving spouse and defer tax, but have the business ultimately pass to some or all of the business owner’s specified children.
Lifetime QTIP Trust
In order to take advantage of the lifetime exemption of both spouses, in the absence of lifetime gifts, each spouse must hold at least that amount of property in his or her sole name. Where there are insufficient liquid assets to ensure the spouse has an estate equal to the exemption, the business owner may wish to transfer business interests in that amount to a lifetime QTIP Trust under which the spouse will have the right to receive all of the income, but control of the shares is vested in a trustee. At the spouse’s death, by virtue of the exercise of a power of appointment, the principal will be available to pass into a trust for the donor spouse (if he or she survives) while taking advantage of the beneficiary spouse’s exemption.
Testamentary QTIP Trust
A QTIP Trust more commonly is created for a spouse at the death of the business owner. This trust will be taxed at the surviving spouse’s death subject to the surviving spouse’s available exemption.
Right to Income-Producing Assets
One of the key considerations in creating a QTIP Trust or a General Power Marital Trust is that the spouse must have the right to force the trustee to make the principal income producing. Thus, if the trust holds business assets, the spouse can require that either a dividend be paid or that the trustee sell the business assets and replace them with income-producing property. There is no set yield that is required, simply that the property in the trust return an amount of income that is reasonable in light of current investment conditions. This requirement gives the spouse some leverage over the affairs of the business.
The Estate Trust
It is possible to avoid the situation where a spouse can exert control over business assets in a marital deduction trust by virtue of the spouse’s right to require the production of income. This can be achieved by placing the business interest in a so-called “Estate Trust.” This type of trust permits the trustee to manage the assets and make distributions of income or principal at any time, at the trustee’s discretion. Thus, the spouse will have no recourse if the business assets do not pay dividends, since the spouse is not entitled to the income in any case. However, the trust principal must be payable to the spouse’s estate at the spouse’s death. The estate trust, like the general power marital trust, gives the spouse the unlimited ability to determine who will ultimately receive the business assets after the spouse’s death.
GENERATION-SKIPPING — LONG-TERM FAMILY PROTECTION
The federal transfer tax system is designed to capture a tax at each generation. As is evident from the above discussion, simply passing a business to the next generation involves considerable complexity and planning. Preventing erosion in the value of the business at each generation can seem an almost impossible task. However, long-term planning opportunities exist for those who wish the enterprise to last several generations in the family.
To the extent of the married couple’s combined $10.5 million exemption from the generation-skipping transfer tax, the business owner may create a long-term trust that escapes taxation at each generation. Such a generation-skipping exempt trust (GST Exempt Trust) provides the child with the income (and principal at the discretion of the trustee), with the principal passing to, or in further trust for, the child’s descendants without any tax at the child’s death. To provide maximum flexibility, the child can be a trustee of his or her trust, although it is advisable to have a co-trustee as well.
With proper planning, it is possible to achieve a smooth transition of business management, family harmony and significant tax savings, whether at the passing of one generation or several. However, these results will be achieved only if the business owner has the foresight to set in motion a long-term transfer program. No two businesses are alike and no two families are alike. It is only by carefully integrating the available tax savings techniques with the specific characteristics and objectives of each family and business that an effective business succession program can maximize the value of your business for your heirs.
The information in this brochure has been compiled by the attorneys in Pepper Hamilton's Trusts & Estates Practice Group.
This article is informational only and should not be construed as legal advice or legal opinion on specific facts.