BY RAYMOND J. SETO AND BRIAN R. BRANDLIN
Note: The following article was published in three parts in California Business Law Practitioner, in the Fall 2008, Winter 2009, and Spring 2009 issues, published by the California Continuing Education of the Bar (“CEB”). Elements of the article were subsequently included in the two volume treatise “Business Succession Planning,” also published by CEB, which provides in depth and expanded coverage of the subjects addressed below. Although the article was written for an audience of business lawyers, non-lawyers with backgrounds in business and finance should have no difficulty in understanding the concepts and methods described
Readers are also cautioned to read the Closing Note at the end of the article which summarizes dramatic changes in the estate and gift tax laws that have occurred since the article was first published. In particular, increases in the gift and estate tax exemption amounts which became effective on January 1, 2011 under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, would substantially change the illustrations contained in the article if they were applied to them.
SUCCESSION PLANNING FOR THE CALIFORNIA FAMILY BUSINESS
The title and subject matter of this article were originally published in CEB California Business Law Practitioner in Spring and Summer of 1994, at a time of increasing need and demand for lawyers with knowledge of business law and estate planning techniques to assist business owners in transitioning the ownership and control of their enterprises to the next generation of family members. Since that time the field of “Business Succession Planning” has evolved into a specialty practice of its own, one involving not only lawyers but accountants, insurance advisors, tax and financial experts, and even family counselors. The lawyer for a business is usually the first person the owners will ask for advice in regards to a succession plan and when the occasion arises it will be essential for the business lawyer to have a strong grasp of estate tax and planning techniques in order to properly advise the client, to recognize when it is necessary to bring other professionals into the process and to lead the succession planning team. The purpose of this article is to provide the business attorney an overview of the principals and mechanics of estate planning and a framework with which they may be integrated with the mechanics of business law of which the practitioner is already familiar.
This author wrote in the 1994 article, “California, as well as the rest of the nation, presently is experiencing the greatest intrafamily wealth transfer in its history. More wealth will pass from parents to their children in the next 20 years than in the previous 200 years.” This statement, then directed more toward the post World War II era of business owners, is more true now than when it was first written, especially in California where a whole generation of creative entrepreneurs have since spawned new businesses and wealth in various high-tech, bio-tech, as well as old-tech and no-tech enterprises.
Most of the millionaires in the United States own and control privately held businesses. Of persons with net worths of $1 million or more, almost 70% own businesses or are self employed. Consequently, a large portion of the wealth being transferred is comprised of interests in closely held businesses. The interest of children of family business owners in entering, continuing with , or returning to the family business environment is also on the rise, especially given the increasing uncertainties and insecurities of a careers in “big business.” However, it has been estimated that only 30% of family owned businesses are successfully transitioned to the second generation of owners while the odds of passing the business to the third generation are even worse; only 10% to 20%.
Family-owned businesses range from proverbial “mom and pop” retail operations to knowledge and skill-intensive service companies to multimillion-dollar manufacturing and technology enterprises. All share the need to establish a plan for the succession of ownership and control of the business. Frequently, the owners are too preoccupied with sustaining the success and growth of their businesses to plan for succession; retirement is in the distant future, disability is a low-level risk, and mortality is too difficult to confront. Because of failure to plan for succession, relatively few family businesses survive the death of the founder. Conventional wisdom holds that only 30 percent of family businesses survive beyond the first generation. Surveys estimate that only 20 percent of family businesses have a plan for succession of the company’s ownership and management.
Family businesses and their owners constitute the primary client base for most business lawyers. Therefore, business lawyers not only provide valuable counsel by encouraging these clients to establish and periodically review a succession plan, they also enhance the health of their client base.
This article first addresses the reasons for and factors that affect formulation of a succession plan for a family business owner. Second, various methods of accomplishing the plan are reviewed: (1) direct gifts, (2) installment sales, (3) private annuity sales, (4) self-canceling installment notes, (5) corporate reorganizations, (6) corporate recapitalizations, (7) buy-sell agreements, (8) use of insurance, (9) employee stock option plans, (10) trusts and generation skipping transfers, and (11) deferred benefits plans. Part I of this article covers the factors affecting the plan and methods (1)-(5). Part II will cover methods (6)-(11). Following part I is a business succession planning checklist to use when initially interviewing your client.
Although this article provides an overview of various business succession planning methods, it does not address the detailed tax compliance and qualification rules or the intricacies of drafting the required trust and transaction documents. For assistance in these areas, see California Will Drafting (3d ed Cal CEB), Business Buy-Sell Agreements (Cal CEB 2007), Drafting California Irrevocable Living Trusts (3d Ed Cal CEB), Drafting California Revocable Living Trusts (4th Ed Cal CEB 1984), and Funding a Revocable Trust (Cal CEB Action Guide October 2007).
Because most family-owned businesses are S or C corporations, this article is written from the perspective of a corporate form of organization. In fact, business owners frequently decide to incorporate a proprietorship or partnership for the specific purpose of succession planning because of the flexibility with which the corporate format enables transfers of ownership and control interests. However, much of the information also applies to transfers of proprietorship and partnership interests. In the case of limited liability companies, structuring the issuance of membership interests in the form of LLC shares will provide the same flexibility as the use corporate stock for transferring interests in the business.
In many cases the owners of a business may not have family members who wish to succeed to the ownership and control of the enterprise and in these circumstances an ultimate sale of the assets or the equity business is the best exit strategy. The years between 2002 and 2007 were a window during which profitable small to mid-sized companies well positioned in particular markets were attractive targets for strategic acquisitions by large companies and investments funds.
This article is directed toward lawyers whose clients have as a specific objective the transfer of their business to the next generation of family members, either as a continuing legacy or for the purpose of positioning the business for the next window of liquidity opportunities.
II. FOUR BASIC REASONS FOR SUCCESSION PLANNING
The first step and one of the most important services a business lawyer can perform is to conduct a systematic review of the client’s business and personal needs and objectives for the succession plan. Each business has its distinctive characteristics, and each client may have definite ideas and objectives based on his or her unique family circumstances and dynamics. The review process will often raise issues the client has not previously considered, and may modify the precepts with which the client initiates the planning process.
Given the reticence many business owners have about succession planning and the tendency to procrastinate even when they have acknowledged the need for such planning, the business lawyer should reinforce to the client as often as necessary the basic reasons for succession planning: providing liquidity for owners, minimizing estate taxes, providing for the continuation of the business, and providing for family members.
A. Providing Liquidity For the Owners
Some business owners may have generated sufficient wealth during the operations of their enterprises to enable them to simply turn over their businesses to the next generation. However, for most owners the majority of their wealth and cash flow is derived from their business. Therefore, preserving and enhancing the value of the business and its ability to provide liquidity and generate cash flow to fund the retirement of the owners is a principal reason to establish a succession plan. A systematic plan of gifts and sale of the stock in the family business from the owners to the successors over a period of years will benefit both generations. Without a plan in place, the unexpected death or disability of an owner might dramatically diminish the value of a business and the ability of successors to sustain it for the time necessary to acquire ownership and control.
B. Minimizing Impact of Estate Tax
The most compelling concern of the client whose estate consists primarily of a family-owned business is retaining the value and viability of the business to be passed to the next generation. Frequently clients fear that their family will be forced to sell the business to raise funds to pay estate taxes.
This concern of business owners is legitimate. Without proper planning, federal estate taxes, which have a rate of 45 percent for taxable estates in excess of $2 million, can substantially reduce the assets of their businesses. As a result, successors to the business might be scrambling for cash to pay the estate taxes during a difficult period when their energies are most needed during the transition. There is some consolation in the lack of an estate tax burden at the state level. The California inheritance tax was repealed in 1982, although an estate tax is still imposed by the state, which simply collects a tax that would otherwise go to the federal government. This “pick up tax” is the portion of the allowable federal credit for state taxes that is attributable to property located in California. Rev & T C 1330l-l4302.
C. Continuity of Business
It is important for the owner to designate those persons he or she wishes to succeed as managers, officers, or directors in the event of the owner’s death or disability. A struggle for leadership among family members, employees, and even advisers to the company and its principals, can be extremely destructive to the business, and can misdirect the energy of all persons involved. A simple statement by the business owner designating the successor to the management and control of the business may be enough to avert an internal power struggle.
Customers of a business, especially those who have or who are considering entering into a long-term contract or relationship with a family firm, similarly want assurance that the family has a succession plan. One of the key roles of the business owner in such a plan is to transfer personal business relationships to his or her successors. In addition, it is reassuring to the employees of the business to know that there is an orderly plan for the continuity of the organization.
Often a business owner will have a very simple succession plan: leave everything to the surviving spouse. This may be a viable solution when the surviving spouse has been active in managing the business. It also defers estate tax problems, because no gift or estate tax is due on transfer of property to a spouse due to the unlimited marital deduction. However, the results can be disastrous if the surviving spouse has not participated in the business or is otherwise not prepared to assume leadership and control. In addition, the surviving spouse must handle two deferred problems: estate taxes and transferring the business to the next generation.
The business owner can avert the uncertainty that threatens the survival of a business by clearly articulating who succeeds to positions of leadership and control. The business lawyer assists by establishing the mechanisms for fulfilling the client’s objectives.
D. Fairly Providing for Family Members
Some family-related considerations are quantitative in nature, such as determining the level of financial support to provide for the surviving spouse and other family members from the family business. However, most family issues are qualitative. The business attorney can assist in resolving family issues by asking the difficult questions. Although being fair and equal to all the children will be a great concern, owners must consider which members of the successor generation have expressed a strong interest in taking over the business. Do they have the requisite knowledge, skill, aptitude, or experience? Which members have “paid their dues” and are most “deserving”? The difficulties of achieving fairness and equality are compounded when the successor generation includes .stepchildren and in-laws.
Intertwined with the problem of fairly providing for family members is the potential problem of the owner letting go of ownership and control, even when plans are effective only after his or her death. Business owners, especially company founders, invariably have a high degree of emotional attachment to and identification with the business. It is not unusual for business owners to identify so closely with their companies that they become morbid at the prospect of separating from their businesses to any great extent.
Although it is difficult to identify and resolve family issues, it is in the best interest of the business to deal with them as rationally and systematically as possible through the succession-planning process.
E. Basic Objectives of Succession Planning
The objectives of most family business succession plans can be summarized as follows:
• Owner’s Exit Strategy: Maintain an income stream and asset base for the business owner that meets his or her anticipated financial requirements both while in active control and ownership of the business and on retirement.
• Wealth Transfer: Convey ownership of the business to the succeeding generation with the least amount of tax liability and the highest asset value.
• Business Continuity: Transfer control of the business to the succeeding generation in a manner that preserves and enhances the continued profitable operation of the business.
III. BEFORE YOU BEGIN
A. When Not To Plan for Succession On initial discussion, it may become apparent that for certain clients a succession plan is not indicated as much as is an “exit strategy” or “harvest” plan. For example, the business owner may not have or desire family members to succeed to the company, or the value of the business may be sufficient only to sustain an income stream or provide an asset base adequate to support the client’s retirement needs.
In a harvest plan, the business owner simply extracts as much income as possible from the business with minimal resources being reinvested to fund future growth. The business owner operates the business to maximize and distribute net profits. When he or she no longer wants to continue operations, the business is sold or closed.
In an exit strategy, the owner operates the business to enhance value rather than to distribute income, which is appropriate when a business holds substantial potential for growth or is an attractive target for acquisition or merger. While the business owner may continue to distribute earnings sufficient to fund his or her current financial requirements, substantial income is reinvested in the company to finance growth and development of products or services. The business owner frequently exits the business through a tax-advantaged exchange of stock.
B. Resolve Potential Conflicts of Interest
The owner of a business may expect that his or her lawyer will represent all the parties involved in or affected by the business succession plan. However, the business lawyer should make clear to the client that when multiple parties are involved there is always the potential for the interests of the parties to diverge. Conflicts are most likely to arise when a business owner’s putative successors already own some interest in the family enterprise and the various stakeholders in the business have expressed divergent views on its current management, future direction, control, or ownership. If this is the case, the attorney should represent only the owner. Moreover, in some circumstances, e.g., when minority interests must be asserted or protected, the entity may need separate legal counsel from that of the majority owner.
On the other hand, in many business succession plans, the successors are the ultimate beneficiaries of the plan and will not perceive themselves as adversaries, either to the business owner or among themselves. This is the case when the size and scope of the business is relatively small, or when the business owner owns 100 percent of the business and his or her successors are entirely dependent on the owner’s largesse to come into ownership. If the attorney perceives the parties’ interest in a common plan and no sense of disunity or dissension, the attorney may feel competent to represent multiple parties within the parameters of ethical conduct.
Representation of multiple parties, including family members and business associates, is possible if the practitioner makes full written disclosure of the possible effect of such representation on the exercise of his or her independent professional judgment on behalf of each party and all parties consent in writing. The disclosure must also advise the parties to seek the advice of independent counsel before waiving the conflict of interest. Cal Rules of Prof Cond 3-310; ABA Model Rules of Prof Cond 1.7, 2.2. In such cases of multiple representation, a practitioner is not vigorously representing or advancing the interests of a single client exclusively, but trying to achieve a balancing of interests of all of the clients.
C. A Multidisciplinary Approach to Business Succession Planning
The scope of a business succession plan often will encompass management, accounting, insurance, business, and family matters that are beyond the scope of the legal expertise of the business attorney. It is important for the business law practitioner to identify his or her role and that of other professionals. Frequently, the business lawyer will play a principal role as the person the client trusts to direct and coordinate the work of other professionals in the process.
Business lawyers are thoroughly familiar with drafting buy-sell agreements involving the control and equity ownership of corporations, limited liability companies and partnerships, and this Article will not address the intricacies of these traditional types of agreements. For details in this area see Business Buy Sell Agreements, Cal CEB 2007. Buy sell agreements are equally important in family business planning. In this context the equity holder is more likely to be the trustee of a revocable or irrevocable trust. However, business succession planning is substantially more complicated than adding an estate planning overlay to a buy-sell agreement. Effective succession planning involves matching the financial and human resources of the business with the economic objectives and emotional needs of the owners, the family and key employees.
Business succession planning involves the careful orchestration of four basic elements: business resources, estate planning, tax and financial planning, and family counseling. The relative importance of these elements will vary with the facts and circumstances of each case.
1. Business planning addresses the issues and transactions affecting the financial and human resources of a business and the manner in which the business can best exploit its competitive advantages to achieve its short and long-term business objectives in the context of economic trends in its industry. The threshold questions which must be addressed in any business succession plan is whether or not the business has adequate resources and potential to carry it to the next generation of owners. If not, can they be realistically developed? If not, should the client be implementing a plan of orderly sale and liquidation for the business rather than a succession plan?
2. Estate planning is concerned with the manner in which the owners of a business manage all of the various assets in their estates, not simply the business, to achieve their financial, family, and lifestyle objectives during their working and retirement years, and to transfer the residual wealth to family and non-family beneficiaries. In the estate planning context, the client’s use of instruments such as revocable trusts, irrevocable trusts, and charitable trusts to own and control the equity interests of a business require the business law practitioner to be familiar with their use.
If the client does not already have an estate planning attorney, it may be appropriate for the business lawyer to recommend a certified specialist in the area. If the client’s business succession plan is a simple and direct transfer of ownership and control of interests in the family business, the business lawyer will be the lead person, and the need for an estate planning attorney will be minimal. If a key objective of the client’s plan is wealth transference, close cooperation between the estate planning attorney and business attorney is essential. The estate planning attorney’s role in structuring complex trusts and drafting their intricate implementing documents is as important to the succession plan as the business attorney’s role in structuring the client’s business operations to include the successor generation.
3. Tax planning is undertaken to minimize the impact of local, state, and federal taxes on business and estate planning transactions, to preserve the growth and income producing capabilities of the business, and to preserve as much wealth as possible in the business owner’s estate. The resulting financial resources of the business owner, net of tax considerations, will dictate the alternatives available for transferring ownership and control to the successor generation after assuring that the owner’s personal financial requirements have been secured.
4. In formulating a business succession plan, there are many issues that are not purely legal in nature. Regardless of how effectively the business, estate, tax and financial elements of a plan may be designed, their implementation is often frustrated when psychological and emotional issues are not adequately addressed.
The current owners of the business may have problems relinquishing control, they may need advice in assuring that family members and employees are treated fairly, and conflicts may arise between family members who disagree with or are insecure over the decisions made by the owners. A trusted legal advisor may be well situated to advise a client on issues such as determining which of a business owner’s children should succeed to leadership of the business, the portion of the business each child should have, the extent to which stepchildren or in-laws should be allowed to participate in the business, or the timing and phasing of the transfer of control from the business owner to his or her successors. Practitioners who have a close relationship with a client, detailed knowledge of the client’s business, and insight into the circumstances of the prospective successors to the business may feel comfortable in advising the client on various family and business issues surrounding the plan. But the business lawyer must exercise discretion in determining the extent to which it is appropriate for him or her to advise the client on such matters and should consider calling on family counselors or management consultants who specialize in family business matters when issues arise that are beyond the practitioner’s level of comfort or expertise.
The conduct of a business is often described as a marriage between the people running it and a counselor can be no less important to the health of a business, including its succession, than to a marriage. In recent years, many psychologists and family counselors have developed a specialty in family business transitions and in many circumstances a family counselor may become a key player in devising a succession plan and especially during the implementation of the plan when substantial conflicts arise, for example:
• When a business owner is conflicted as to which of his or her family members should be included in the plan to transfer control and ownership of the business, which conflict is compounded when there are multiple potential successors from multiple marriages;
• Between a business owner and his or her children/successors as a result of the owner’s problems relinquishing control;
• Because successors expect to exert influence and control over the business before the owner believes they are ready: or
• Because of rivalries between prospective successors.
Moreover, family businesses create unique barriers to communication and conflict that are not present in non-family businesses.
A family counselor or management consultant experienced in family business succession can be invaluable in resolving conflicts and concerns so that a succession plan can be structured, and in facilitating problem resolution during the plan’s implementation.
D. Succession Planning Checklist
To begin the succession plan, the business lawyer should develop the underlying personal and business information by completing a planning inventory with the client.
The business succession planning checklist in the appendix following this article may be used as a guideline for gathering information during the initial planning interviews and discussions with a client. Consider developing the checklist into a form for the client to complete before your meeting. If this is not practical or would result in procrastination and delay, then at least the form can be used as an agenda for the meeting.
However it is accomplished, the process of completing the inventory is important not only for gathering facts and establishing planning baselines; it also may help your client develop new insights and resolve problematic situations.
IV. DIRECT TRANSFERS: ESTATE TAX AND GIFT TAX EXEMPTIONS
Direct transfers of interests in the family business, commonly in the form of corporate stock or membership interests in limited liability companies, are the simplest and most direct method of transferring ownership and control of the family business from one generation to the next. It is a good place to begin the planning process, because the vast majority of business owners prefer simple succession plans, and a gift plan is likely to be implemented. A general rule of estate planning that applies to business succession planning is that the more complicated a planning option may be, the less likely it is to be adopted and implemented by the client.
Direct transfers or gifts from the business owner to his or her children or other designated successors may be made during the lifetime of the owner or on his or her death. The federal estate and gift tax rules are a primary consideration in making direct gifts from one generation to another, and it is important for the business lawyer to review these rules with the client. Even when a family business owner prefers that his or her successors earn or purchase their interest in the business, understanding the rules is nonetheless important, because the transfer of the estate’s assets will trigger application of estate and gift tax rules.
The Federal Tax Act of 2001 created “applicable exemption amounts” for gift taxes and estate taxes. The “exemption amount” is a dollar amount which each taxpayer may apply toward each type of tax, meaning that estate taxes or gift taxes will not be assessed until the value of the assets transferred exceed the exemption amount. For estate taxes, the applicable exemption amount is $2 million for 2008 and increases to $3.5 million in 2009. Under the current law the estate tax will disappear in the year 2010 but unless Congress takes further action to make the lifting of estate tax permanent, the estate tax it will return in 2011 with an exemption amount of $1 million. Presently, the best guess of estate and tax law practitioners is that the estate tax will continue after 2010 but with a higher estate tax exemption amount, perhaps in the $3 to $5 million range. The applicable exemption amount for gift taxes is fixed at $1 million. When the exemption amount is applied against gift taxes it is also reduces the exemption amount that will be available for estate tax purposes. To illustrate how these separate exemption amounts are applied consider the following example:
Mr. Candalaria owns corporate stock in a family owned construction company in which his son and daughter have been working for the past 12 years. In 2007 Mr. Candalaria made a gift of corporate stock to his son and daughter. The gift was valued at $700,000. No gift tax was paid because $700,000 of the gift tax exemption amount was applied. In 2008, Mr. Candalaria makes another gift of stock to his son and daughter which is valued at $800,000. After applying the remaining $300,000 of available exemption, there is a gift tax due on the remaining $500,000 value of the gift. The applicable gift tax rate will be 45%. If Mr. Candalaria dies in 2009, leaving the balance of his corporate stock to son and daughter, valued at $4,000,000, the applicable exemption available for estate taxes will be $2.5 million, after subtracting the previous “taxable” gifts from his available estate tax exemption of $3.5 million.. After applying the available estate tax exemption, Mr. Candalaria’s taxable estate will be $1,500,000. This simple example assumes that Mr. Candalaria has made no other taxable gifts and has no other assets in his estate.
V. DIRECT TRANSFERS: ANNUAL EXCLUSION GIFTS
A. Internal Revenue Code 2503(b)
Business owners may also transfer substantial interests in the family enterprise to their children by means of annual gifts. In addition to the lifetime gift tax exemption of $1 million, each person has an annual per-donee exclusion of $12,000 under IRC §2503(b). An individual may make a gift of a present interest in property worth up to $12,000 to an unlimited number of donees each year. A husband and wife together can gift $24,000 per donee under the exclusion and the lifetime gift exemption amount will not be applied to any of these annual gifts. The proportion of a family business or estate that can be transferred in this manner can be quite dramatic over a period of several years.
If Mr. Candalaria had implemented an annual gifting program two years after his son and daughter joined him in the business, the subsequent ten years of stock gifting would have substantially reduced the size of his taxable estate. A total of $108,000 in exclusion gifts could have been made to each child, or $216,000 in total: four years at the former annual gift exclusion limit of $10,000, four years at the exclusion limit which increased to $11,000 in 2002, and two years at the $12,000 exclusion limit which has been in effect since 2006. Equally important, as gifts of stock were made to son and daughter each year the appreciation in the value of the stock would have occurred in the estates of son and daughter and not Mr. Candalaria. At an annual growth rate of 5%, the $108,000 in exclusion gifts to each child would have compounded to $141,362 in value in the estates of son and daughter, or $282,724 for both. As a result, Mr. Candalaria’s gross taxable estate in 2009 would have been reduced to $1, ______ instead of $1,500,000. At a marginal estate tax rate of 45 percent, the taxes due on Mr. Candalaria’s estate would have been reduced by approximately $127,226.
B. Gift Must Be a Present Interest
The business lawyer should make clear to the client that in order to qualify for the annual exclusion any gifts to children (or any other person) must be of a “present interest” which is defined as an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property. Reg 25.2503-3(b). Therefore, if the donor retains any “strings” to the property conveyed, or if the gift is revocable, the gift will be “incomplete” and the property may be pulled back into the donor’s gross estate.
C. MAINTAINING CONTROL
Use of the annual exclusion gift (or the lifetime gift exemption amount) to transfer interests in a closely held business from one generation to the next in small increments not only has the benefit of reducing the taxable estate of the grantor/business owner, it also enhances the enthusiasm of the successors for the business by giving them a current stake in it while giving the grantors an opportunity to observe how well their grantees participate in ownership, control and management. Any concerns that a client may have about relinquishing control of the family business can be alleviated by explaining the distinction between ownership of stock in the business and control of that business.
The capital structure of a C corporation can be reorganized to create common stock and non-voting preferred stock, or different classes of stock can be created that have tiered ratios of voting power. Membership interests in a limited liability company may defined in classes in a way to emulate this structure. By transferring the non-voting stock to successors, and holding onto the majority of stock with voting power, the owner can maintain corporate control. Although an S corporation may issue only common stock, it may be designated as voting and non-voting as long as all shares have equal distribution and liquidation rights. IRC §1361(c)(4). The business owner may also maintain control through voting trust or shareholder agreements without modifying the capital structure of the business.
V. TRUST CONSIDERATIONS
Most business law practitioners have at least a passing acquaintance with trusts and many are thoroughly familiar with their intricacies. In order to provide a baseline for the references to trusts throughout this article, the following is a brief summary of how revocable and irrevocable trusts operate.
A. Basic Characteristics of the Revocable Living Trust
If a business owner does not already have a revocable living trust in place by the time a business succession plan is considered, it will be important for the business practitioner to review the basic characteristics of a living trust with the business owners and, if the practitioner is not sufficiently knowledgeable and experienced in preparing trusts, to refer the client to a certified specialist in trust law.
A person who creates a trust is referred to as a grantor, settlor, or trustor. All that is needed to create a trust is for the grantor to “declare” that certain assets (the trust “estate” or “corpus”) are to be held in trust by a designated trustee for the benefit of a designated beneficiary. The grantor’s declaration of trust is usually in the form of a written trust instrument. The grantor typically serves as the trustee during his or her lifetime; husbands and wives typically serve as co-trustees of their trust with the surviving spouse serving as sole trustee upon the death or disability of one of them. Trusted family, friends or institutional trustees are often designated as successor trustees.
Although the grantor’s power to amend or revoke a living trust is usually reserved in the trust instrument, California law provides that a voluntary trust is revocable unless the trust instrument expressly states that it is irrevocable. Probate Code § 15400. A revocable living trust is “tax neutral,” having no current impact on the grantor, who is taxed on any income generated by the property used to fund the trust. Because the income flows through directly to the grantor, and the grantor usually serves as a trustee of his or her own living trust, management of the trust is simple and straightforward, entailing only nominal costs in its administration. Assets held in a revocable trust are not subject to probate upon the death of the grantor(s) because the assets are owned by the trust which continues its existence after the death. Clients generally have a high degree of comfort in using the living trust because of its flexibility and their ability to amend or revoke it at will.
There are several variations of a revocable living trust, but the typical form for a married business owner is referred to as an “A,B,C Trust” because upon the death of husband or wife the revocable living trust becomes three separate trusts which are commonly referred to as the “Bypass Trust” (also known as the “Credit” or “Exemption” Trust), the “Marital Trust” and the “Survivor’s Trust.” The trust will usually provide that upon the death of the first spouse, all of the separate and community property of the decedent shall be allocated to the Bypass Trust to the extent that the decedent has available estate tax exemption. For this reason, the Bypass Trust is also commonly referred to as the “Exemption Trust” as the assets are “exempt” from the estate tax upon the death of each spouse. The beneficiaries of the Bypass Trust are typically the children of the grantors, but other persons may be designated as well. The terms of this trust typically provide that the surviving spouse may receive distributions from the trust only under an objective “ascertainable standard” (see illustration below), and upon the death of the surviving spouse, the assets of the Bypass will be distributed to the designated beneficiaries.
As to the separate or community property of the decedent that is valued in excess of the available estate tax exemption, that property is allocated to the “Marital Trust” which qualifies for the 100% marital deduction. In this manner, estate taxes are entirely avoided upon the death of the first spouse. However, while the assets in the Bypass Trust are exempt from estate tax, the value of the assets in the Marital Trust remain taxable in the estate of the surviving spouse upon his or her death. Until such time, the surviving spouse is typically entitled to distributions from the Marital Trust in accordance with an ascertainable standard. Any assets remaining in the Marital Trust upon the death of the surviving spouse is contributed to the Bypass Trust to be in administered and distributed in accordance with the terms of that Trust. Because the Bypass Trust and the Marital Trust are irrevocable upon their creation at the time of the first spouse’s death, husband and wife are able to exert a fair amount of control in determining the disposition of their separate property and their half of the community property.
The separate and community property of the surviving spouse are allocated to the Survivor’s Trust, which continue to be subject to amendment or revocation by the surviving spouse. The terms of the Survivor’s Trust will typically provide that any assets remaining in the trust will be contributed to the Bypass Trust, upon which the available amount of the surviving spouse’s estate tax exemption will be deducted from the estate. The value of the surviving (or second to die) spouse’s estate in excess of the available estate tax exemption will be taxable at the prevailing estate tax rate.
Illustration: The Bypass Trust
The objective of the Bypass Trust is to preserve the full amount of the decedent spouse’s exemption from estate tax, thus assuring that as much property as possible passes to the next generation free of estate tax. If the decedent spouse has not made any taxable lifetime gifts, the full availability of the exemption amount will enable a tax-free transfer of $2,000,000 in property in 2008. In 2009, the tax free transfer of $3,500,000 will be possible upon death.
The beneficiaries of the irrevocable Bypass Trust are typically members of the next generation. The property allocated to the Bypass Trust will not be included in the surviving spouse’s estate. The income and principal of the trust may be made available to a surviving spouse if the decedent spouse makes such a provision in the trust agreement, but only under certain restricted circumstances. Internal Revenue Code §2041(b)(l)(A) requires that distributions to a surviving spouse be made only in accordance with an “ascertainable standard,” such as the spouse’s health, maintenance, education, and support. Otherwise, the entire trust corpus would be includible in the gross estate of the surviving spouse and the purpose of the Bypass Trust would be defeated.
In contrast, the surviving spouse is the sole beneficiary of the Marital Trust during his or her lifetime. Accordingly, when the portion of the decedent spouse’s property in excess of the available estate tax exemption is allocated to the Marital Trust, that transfer is also free of estate tax upon the first spouse’s death because of the unlimited marital deduction under IRC §2056. Under IRC §2056, interspousal transfers of property, whether by lifetime or testamentary gift, are entirely deductible from the decedent’s gross estate, hence there is no tax imposed on such transfers. Although, the value of any property remaining in the Marital Trust upon the death of the surviving spouse will be included in the gross estate of the surviving spouse on his or her death for purposes of calculating estate tax, the terms of the Marital Trust typically provide that any assets remaining in the trust will be contributed to the Bypass Trust and managed in the manner described in that trust.
The Survivor’s Trust is the surviving spouse’s trust, which is funded with the surviving spouse’s separate and community property. Typically, the surviving spouse may freely amend or revoke the Survivor’s Trust during his or her lifetime but upon the death of the surviving spouse the terms of this trust typically provide that any assets remaining will also be contributed to the Bypass Trust.
The gross taxable estate of the surviving spouse, comprised of the assets Marital Trust and Survivor’s Trust (plus any assets of surviving spouse held outside these trusts) will be reduced by the estate tax exemption then available to the surviving spouse. In this manner the estate tax exemption for both spouses may be preserved for the benefit of the successor generation.
The use of a Bypass Trust not only preserves for the business owner the value of the combined estate of both spouses to the extent to the extent of the decedent spouse’s estate tax exemption, it also gives the business owner more control over the disposition of his or her assets than simply leaving everything to the surviving spouse. For example, if the business owner were to leave his or her entire estate to the surviving spouse, not only would the estate tax exemption of the decedent spouse be lost, the assets transferred directly to the surviving spouse may become commingled, dissipated, or diverted (e.g. in the event the surviving spouse remarries).
The business and estate planning affairs of Mr. and Mrs. Baker in the following hypothetical illustrate various successorship planning objectives and methods discussed in this article.
Mr. and Mrs. Baker are the sole shareholders of a small injection-molded plastics manufacturing business, Dynasty Plastics, Inc. This hypothetical company will be used throughout this article to illustrate various succession planning options that are available to the family business owner at different phases of a company’s growth.
Phase I: Value of Fundamental Estate Planning
Dynasty Plastics, Inc. is operated in the form of an S corporation. The Bakers hold 100 percent of the stock as community property, which has a fair market value of $7 million. Their joint estates also include $2 million in non-business community property assets. Mr. Baker, age 65, and Mrs. Baker, age 55, have four children, two who are active in the business and two who are not. Neither Mr. Baker nor Mrs. Baker have made any lifetime gifts; therefore the full amount of the gift and estate tax exemptions are available to both of them.
Although the size of the business is relatively small, there are substantial benefits to be gained from even simple planning. In some respects, the consequences of failure to plan at this phase can be more critical than when a company is larger, because a smaller business has fewer planning options and the estate of the business owner has fewer resources to absorb the impact of estate taxes and the costs of making a transition in the management of the business.
Scenario 1: No Planning
If Mr. Baker were to die unexpectedly in 2008, without implementing any business succession or estate plan, or even a will, the entirety of his estate were to go to Mrs. Baker under the intestate succession statute Cal. Prob. Code §6401. There would be no immediate federal estate tax consequence because of the unlimited marital deduction (IRC §2056) through which Mrs. Baker would receive the entire estate of Mr. Baker free of gift or estate tax. However if Mrs. Baker were then succeed Mr. Baker in death, also in 2008, leaving a $9 million estate to the children, the tax on her estate would be calculated as follows:
Mrs. Baker’s Gross Estate $9,000,000
Estate Tax Exemption ($2,000,000)
Taxable Estate $7,000,000
Federal Estate Tax (45%) ($3,150,000)
Net Estate Passing to Children $5,850,000
Scenario 2: Use of Revocable Living Trust and Bypass Trust
If Mr. and Mrs. Baker had instead utilized a revocable trust to hold their assets (as described in the foregoing illustration), upon the death of Mr. Baker in 2008, the Bypass Trust would have been created into which the full amount of his estate tax exemption would have been used to shelter assets of equivalent value for the benefit of his children, with the following net result:
Upon Mr. Baker’s Death
Mr. Baker’s Gross Estate $4,500,000
Property Passing to Bypass Trust ($2,000,000)
Using Estate Tax Exemption
Property Passing to Marital Trust ($2,500,000)
Estate Tax on Mr. Baker’s Death -0-
Upon Mrs. Baker’s Death
Mrs. Baker’s Assets in Survivor’s Trust $4,500,000
Plus Assets in Marital Trust $2,500,000
Mrs. Baker’s Gross Estate $7,000,000
Estate Tax Exemption ($2,000,000)
Mrs. Baker’s Taxable Estate $5,000,000
Federal Estate Tax (45%) ($2,250,000)
Net Estate to Children via Bypass Trust $$6,750,000<
By using a Bypass Trust, the Bakers would be able to save $900,000 in federal estate taxes, a substantial amount in itself, and even more so if the Bakers’ children must overcome an estate liquidity problem in attempting to continue the business.
If the Bakers were so inclined, they could achieve similar results, without gift tax consequences, by each spouse making a lifetime gift of $1,000,000 to their children, and by using annual gifts of $12,000 per person under IRC 2503(b). These gifts could be made directly to their children or indirectly though use of an irrevocable trust. The advantage of making such gift, particularly in the case of rapidly appreciating stock in a business, is that the appreciation in the assets transferred will accrue to the successor generation and will not build up in the estate of the older generation.
B. Basic Characteristics of Irrevocable Trusts
1. Direct Gifts Versus Gifts in Trust
In situations in which a business owner feels comfortable making direct gifts of stock in the family business to his or her children or other successors, the use of trusts may not be indicated. However, in situations in which client does not have this level of comfort, there is the option of using an irrevocable trust to impose additional or alternative means of control over gifts of corporate stock, LLC membership or other forms of equity interest instead of making direct gifts to children or other successors. A benefit of using an irrevocable trust to gift and hold business interests is that while the transfers of stock or other equity in the closely held business continue to be held for the benefit of their children (or other successors) the asset are less subject to dissipation by: (a) judgment of successors whose judgment has not fully developed; (c) creditors of the successors; (d) estate taxes; and (e) marriage, divorce or other events in their children’s lives.
For example, by gifting assets to an irrevocable trust, the grantor can ensure that those assets will not pass “out of the family” in the event of a successor’s divorce. Also, the grantor may provide for the successor generation’s use and enjoyment of the income from the trust, while retaining the principal of the trust for the benefit of the successors’ children. Or a grantor may place limitations on the manner in which the income or principal of a trust may be applied for the benefit of a beneficiary, as in the case of minor children or successors who have not attained a specified age of maturity.
In creating an irrevocable trust, the business owner grants corporate stock to the trust and designates a “friendly” party as trustee who will have the power to vote the shares within the constraints of specific provisions in the trust regarding the operations of the family business and general fiduciary standards. When the trust is properly implemented and maintained, the assets held in the irrevocable trust are the property of the trust and its beneficiaries and are removed the estate of the grantor and therefore beyond the reach of the grantor’s creditors and are not subject to tax in the donor’s estate.
In contrast to revocable living trusts, irrevocable trusts are extremely difficult to modify once they have been declared. Therefore, substantially more thought and care must be expended in devising them, not only because they generally cannot be amended, revised or revoked once they created, but also because their administration is more complex and expensive. Notwithstanding these factors, very compelling benefits can be obtained from using an irrevocable trust as a vehicle to make gifts of interest in a family business.
The irrevocable trust may have one or more beneficiaries for whose sole benefit the assets of the trust must be used. Once a gift has been made to the trust, the grantor cannot take it back or use the assets of the trust for the grantor’s benefit. Generally, the income generated by assets gifted to the trust is no longer taxed to the grantor, but is taxed to the trust or the beneficiary of the trust, depending on the particular trust provisions. In certain sophisticated estate plans an irrevocable trust might intentionally be created to be “defective” for income tax purposes so that the grantor continues to be taxed on the income from the trust while the principal is held for the beneficiaries. This is commonly done to avoid recognition of income tax upon the sale of stock by the grantor to the “defective” trust.
Some types of irrevocable trusts, such as Life Insurance Trusts, Grantor Retained Annuity Trusts (GRATs) and Generation-Skipping Trusts (GSTs) enable the grantor to leverage the size and impact of a present gift or include family members beyond the immediate successor generation in a gifting plan. GRATs and GSTs will be described in detail in Part 2 of this article.
2. Using an Irrevocable Trust for Annual Exclusion Gifts
Irrevocable trusts are particularly useful for making annual exclusion gifts. To qualify as an annual exclusion gift, the beneficiary must be notified of the gift and have the power and opportunity to withdraw the property gifted to the trust, referred to as “Crummey power” (Crummey v Commissioner (9th Cir 1968) 397 F2d 82). Trust instructions provide for the power to gradually lapse over time or after a specified period, such as 30 days, after which the property may be managed only as the trust specifies. It is unusual for beneficiaries to exercise their Crummey powers against the wishes of the grantor, because doing so generally discourages the grantor from manifesting similar generosity in the future.
The practitioner should reinforce to the client that all gifts made to the irrevocable trusts must be completed gifts; the beneficiaries must have the present use and enjoyment of the transferred property in the manner specified by the trust. The grantor must not retain any control over the beneficial interests in the trust. Reg 25.2511-2(c). Otherwise, the grantor may be taxed on the income of the trust (IRC §674) and the trust property will remain in the grantor’s estate (IRC §§2036, 2038).
If the property being gifted to a trust is stock of an S corporation, exercise caution. Unless an irrevocable trust fulfills the requirements of a qualified Subchapter S Trust under IRC § 1361(d), the corporation’s S election will terminate.
3. Gifts of C Corporation Stock Must Produce Dividend Income
If the client’s gifting program includes shares of stock of a closely held corporation, the stock realistically must be expected to produce dividend income. In Stark v U.S. (8thCir 1973) 477 F2d 131, the court held that the parents’ gift of stock in a closely held business to their children was ineffective because dividends had not been distributed on the stock for more than 23 years, and therefore the stock had no “ascertainable value.” Because the court determined that the stock had no ascertainable value, the value of the stock gifted to the children was included in the gross estate of the parents, which defeated their purpose in making the gift of stock, i.e., to reduce their taxable estates by transferring ownership of the shares in the closely held business to their children. It is important for the client to understand that the transfer of stock in the family business must have economic substance if the purpose of the gift is to be achieved. The distribution of stock dividends to the transferees is a strong indication of the economic substance of the stock gift. The problems the grantors experienced in Stark should not arise with an S corporation, because shareholders are taxed on the corporation’s earnings regardless of the distribution of dividends, and economic substance is demonstrated by the increased basis in the shareholders’ stock.
As the foregoing trust considerations illustrate, the expertise of an estate planning attorney is important when irrevocable trusts are part of the client’s business succession plan.
4. Role of Trustee
The only party that may exercise any discretion with respect to distributions from the trust will be the trustee. The trustee may be a bank or other professional fiduciary, but in the context of family business transactions, the grantor usually appoints as trustee a family member with business experience and good judgment, or a trusted family friend or advisor. Any practitioner representing the business, the grantor, or the beneficiaries should not be appointed as trustee because of the obvious ethical conflicts. The grantor may serve as trustee of an irrevocable trust, but only if the grantor/ trustee’s powers are extremely limited. Otherwise, the tax advantages of the trust may be lost. Likewise, a beneficiary may serve as trustee, but the powers of the beneficiary/trustee must be carefully limited in order to avoid compromising the objectives of the trust and the tax benefits to any of the parties. A common arrangement is for a beneficiary to serve as co trustee with the grantor or with another beneficiary in order to provide the appropriate limitations.
VI. GIFTING CONSIDERATIONS
Although impressive aggregate estate tax reductions may result from a client’s lifetime and annual exclusion gifts to children, before undertaking a gifting plan, the business attorney should ensure their appropriateness by reviewing with the client: (1) his or her economic position, age and health, and family circumstances; (2) the basis in property that will constitute his or her estate; (3) the special benefits for closely held business assets; and (4) how to value interests in the business.
A. Economic Position of Client
The client’s economic position is one of the most important factors in evaluating the desirability of a gift program. A gift is and must be irrevocable, and cannot be relied on for the client’s support. Consider the client’s net worth and liquidity in view of his or her income, age, health, family obligations, and the extent to which the client’s future security is dependent on continuing income from the family business, insurance plans, retirement funds, and other sources. The client’s available lifetime exemption for gift taxes and ability to pay gift taxes in the event gifts are made in excess of the available exemption are important factors in the planning process.
B. Age and Health
A client’s age and health are also significant factors to consider. The younger and healthier a client is, the greater the risk that at some point he or she will incur economic losses, suffer illness or disability, or assume substantial increases in family obligations. An older client in an equivalent economic position is generally in a better position to make substantial gifts.
C. Family Circumstances
A client should exercise care in making substantial outright gifts to persons who have little or no experience in handling finances, managing assets, or managing a business, if the gift is stock in a family business. Additionally, disproportionate gifts among family members may cause discord regardless of the justification for such gifts. The financial needs of family members may vary, and with respect to a family business, some family members may have more aptitude, experience, or desire than others to fully exploit a gift of an interest in the business.
D. Client’s Emotional Attachment to the Business.
The client should evaluate the degree of his or her emotional attachment to the property being gifted, especially in the case of an interest in a family business that the client has spent a lifetime in building. Giving up the challenge and the responsibility of owning and operating a business, or even seeing it diluted, could have a morbid effect on the client if he or she is not prepared to let go.
E. Basis Considerations
Property of a decedent which is includible in the decedent’s estate receives a step up in basis to its fair market value on the date of death. IRC 1014. To take advantage of this potential tax savings, advise your married client not to include in a gifting program any low-basis property that might be sold shortly after a person’s death (e.g., to provide liquidity). That property can be transferred to the surviving spouse under the unlimited marital deduction and therefore receive a “free” step up in basis, reducing gain on sale.
C. Special Benefits for Closely Held Business Assets
Before your client transfers interests in a family business, whether by inter vivo gift, sale, or other means, be sure to advise him or her of the planning opportunities presented by IRC 6166 and 303.
Under IRC 6166, when a closely held business constitutes more than 35 percent of the value of a decedent’s gross estate, the proportion of estate tax attributable to the business may be deferred for a period of five years and paid in installments over a period of ten years thereafter. Interest is charged at an annual rate of 4 percent on the estate tax imposed on the first $1 million in value of the closely held business; a variable rate of interest is charged on the estate tax assessed on value of the business in excess of $1 million. IRC 6601(j).
If the stock of the corporation constitutes at least 35 percent of a decedent’s estate, IRC §303 allows the redemption of a limited amount of stock to be treated as a sale or exchange, rather than as a dividend, and gain treated as capital, rather than ordinary income. The amount of stock redeemable under 303 is limited to the sum of state and federal death taxes, and funeral and administrative expenses. Because the estate’s basis for the stock will be equal to the fair market value of the stock on the date of the decedent’s death (IRC § 1014(a)), usually little or no gain is realized. Therefore, the income tax cost of withdrawing funds from a closely held business to pay estate taxes and expenses is minimal.
The opportunities for capital gain treatment of stock redemptions under IRC § 303 and for deferral of estate taxes and payment of them on an installment basis under IRC §6166 are valuable ones that should not be lost inadvertently. If a client does not meet the 35-percent threshold, he or she might consider transferring non-business assets to the successor generation to enable his or her estate to qualify for these benefits.
D. Valuation, Minority Interest Discounts, and Lack of Marketability Discounts
The issue of valuation of the business arises throughout the process of business succession and estate planning. For estate and gift tax purposes, the fair market value is generally used, defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Reg 20.2031l(b), 25.2512-1. Determining that fair market price is best documented by an appraisal using various techniques, such as earnings analysis, shareholder equity, asset liquidation value, industry trends, comparable sales, and value of comparable publicly traded companies.
For guidance on valuing a closely held business, see:
• Rev Rule 59-60, 1959-1 Cum Bull 237 (sets forth the factors to be considered when valuing closely held stock);
• Marriage of Hewitson (1983) 142 CA3d 874, 881, 191 CR 392 (California case applying Rev Rule 59-60);
• Laro, David, Business Valuation and Taxes, John Wiley and Sons, 2005.
• Pratt, Shannon P., Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th Ed., McGraw-Hill 2007.
• Reilly, Robert F., The Handbook of Business Valuation and Intellectual Property Analysis, Irwin, 2004.
Clients may be reluctant to pay for the cost of a professional appraisal of the value of a business, but a formal appraisal is invaluable when a plan is scrutinized by the Internal Revenue Service. This may not occur until years after the transfers have been made from one generation to the next.
A key factor in persuading clients to authorize a formal appraisal may be that a discounted value is often justifiable for a transfer of a minority interest in a business. The standard valuation measure is the fair market value that a willing buyer would pay for the interest, and the courts have acknowledged that a minority interest in a closely held business has a lesser value than a share comprising a controlling interest, allowing a that a greater proportion of the business is transferable within the limitations of the lifetime exemption for gift tax, the annual gift tax exemption, and the owner’s exemption for federal estate taxes.
For example, if a family business owner were to make a present gift to his or her children of a 50% interest in a company with a fair market value of $3 million, that interest would have a proportional value of $1.5 million. All of the owner’s $1 million lifetime exemption from gift tax would be used in making the gift, and gift taxes would be payable on the remaining $500,000 of the gift. A formal appraisal may support a minority interest discount of 33.33%, decreasing the value of the gift to $1 million and eliminating any gift taxes.
Previously, the position of the IRS has been that when voting control exists within a family unit, intrafamily transfers of stock are not entitled to minority interest discounts. However, in 1993 the IRS abandoned this position and now applies the willing-buyer standard without regard to family relationship in determining whether a transfer of a minority interest in stock is entitled to a valuation discount. Rev Rule 93-12, Cum Bull 1993-1. The appropriate amount of a minority interest discount varies according to the facts and circumstances of each transfer. Discounts in the range of 15 to 40 percent are commonly recognized. The more facts that exist to discourage an arm’s-length buyer, the greater the discount.
In addition to supporting a minority interest discount, a well-documented appraisal may also support a lack-of-marketability discount. This discount is often warranted because no ready market exists for the sale of an interest in a closely held business, in contrast to the established markets for publicly traded stock. Tax Court cases have allowed lack-of-marketability discounts of as high as 36 percent. Estate of Gallo, TC Memo 1985-363. Rates of 10 to 25 percent are more the norm. Estate of Dougherty, TC Memo 1990-274.
A professional appraiser evaluates not only the characteristics of the individual company, but also market surveys and empirical studies to determine the fair market value and discounts. To obtain names of local appraisers experienced in performing valuations of closely held businesses, contact:
• American Society of Appraisers (800) 272-8258, www.appraisers.org
• Business Valuation Review (415) 986-1057, www.bvappraisers.org
• American Business Appraisers (800) 882-2600, www.businessval.com
The foregoing considerations for making gifts of stock apply equally to the next most common succession planning technique, installment sales.
VII. INSTALLMENT SALES
A program of direct gifts to children and other successors may constitute the sole or primary transfer technique for smaller family businesses, or it may comprise one facet of a more complicated succession plan for larger businesses. The installment sale of interests in the business is a common feature of more complicated succession plans.
Many business owners prefer to sell percentage interests in the family business to their children (or to irrevocable trusts created for their children) rather than gifting them because they feel their successors should earn their ownership interests and will have a greater appreciation and commitment to the business as a result.
A. Benefits to Owner and Successors
The installment sale of a percentage interest in the family business for full and adequate consideration will effectively freeze the value of that portion of the business in the estate of the business owner/seller in the form of an installment obligation. Any future appreciation in the value of the interest sold will accrue to the purchasing successor generation while the value of the obligation under the promissory note remains fixed in the estate of the owner/seller. The owner/seller also benefits by exchanging business property for a future cash flow, thereby funding his or her retirement. That cash flow can be secured by the seller retaining a security interest in the stock or other property sold.
An installment sale benefits members of the successor generation, because they will receive a basis in their interest equal to the amount of the purchase price and because the installment obligation may be satisfied by the expected future cash flows from the successors’ newly acquired interests. If the successors purchase a minority interest in the business, there will be an opportunity to apply a minority interest discount to the purchase price, which would enable the successors to purchase a greater proportion of the business for less than the proportionate fair market value. Purchasers may deduct interest payments made in connection with an installment sale, subject to the personal interest limitations of IRC §163(h). Furthermore, if the sale from the grantor is to an intentionally “defective” irrevocable grantor trust, the sale to that trust will not be subject to income taxation to the seller and the assets of that trust will not be subject to estate taxation in the seller’s estate.
B. Maintaining Control
As when making direct gifts of stock, the owner may retain control while selling ownership interests in the business. The owner may maintain control by retaining a majority ownership interest in a single class of common stock or by creating and selling non-voting common stock to the successor generation while retaining the voting stock.
C. How Installment Sales Work
A common approach to an installment sale is to use a promissory note calling for a fixed number of installment payments over a specified period of time at a designated rate of interest. The standard installment method (assuming the sale is not to an defective grantor trust) spreads the reporting and payment of tax on any gain over the years during which payments are to be received because the obligation of the owner/seller to pay tax on any gains from the sale will arise only as installment payments are received on the principal balance. IRC 453. A fraction of each payment, the gross profit ratio-which is the gross profit on the sale divided by the selling price-will be included in the seller’s income in each year installment payments are received.
D. Subsequent Dispositions
When an installment sale is between related parties, a sale or disposition of the property by the purchasing party within two years of the installment sale transaction triggers the recognition of gain by the original transferor. IRC 453(e). Gain will be recognized to the extent that the amount realized on the resale exceeds the total payments made on the original transaction.
Almost any disposition of the installment obligation by the original transferor, other than by death, may also accelerate unrecognized gain on the sale. For example, the transferor’s gift of the installment obligation or use of the note as collateral for a loan will trigger the reporting of deferred gain. IRC §453B, Rev Rule 67-167, 1967-1 Cum Bull 107.
E. Contingent Price
Due to the uncertain value and earnings potential of a business, the owner and successors may have difficulty agreeing on a selling price. A contingent price arrangement may be structured, based on a measure of performance such as future revenues or earnings of the business. If a contingent price is used, the practitioner should make sure to advise the client that the selling shareholder will encounter some difficulties, uncertainties, and additional costs in complying with the regulations allocating his or her basis among the contingent payments. Reg 15A.453-1(c).
F. Original Issue Discount Rules
The terms of the installment obligation must provide for an adequate rate of interest, otherwise the imputed interest rules of IRC 483 and the original issue discount rules of IRC 1272-1275 will apply. These rules are designed to prevent parties from converting ordinary interest income into capital gain by decreasing or eliminating the interest charge and increasing the purchase price of the property correspondingly. An installment note bears an adequate rate of “stated interest” if the present value of all the payments under the note is not less than the stated principal amount of the note. The discount rate used to calculate the present value of the payments is the Applicable Federal Rate (AFR) in effect as of the date of the loan. The AFR tables are published monthly in the Internal Revenue Bulletin and set forth rates for short-term (three years or less) mid-term (over three but less than nine years) and long-term (more than nine years) obligations. If the interest rate of a note is less than the applicable AFR, the stated interest will be inadequate and the excess of the note’s stated principal amount over the present value of the payments will be treated as interest that must be reported by the parties as it accrues over the term of the loan.
In Phase I, the Bakers did nothing more than establish a living trust, in the form of an A-B-C trust, because their estate, consisting primarily of the value of the business, was too small to support inter vivos transfers of stock. However, Dynasty Plastics, Inc., has been growing at a rate of more than 15 percent a year for the past four years, and now has a value of $10 million, based on annual earnings of $1,000,000. The Bakers’ estate has reached the size where there are many more planning options available to them. In addition, Mr. Baker has started planning to withdraw from daily management to assume the role of sage and elder statesman of his enterprise.
Phase II: Exclusion Gifts, Lifetime Gift Exemption and Installment Sale
Mr. Baker has been grooming Mary and Mike, the two of his four children who are active in the business, to succeed him. Mary and Mike have in fact been responsible for much of the company’s growth, by expanding into high technology product lines. Mr. Baker believes the business will continue to grow at a strong pace and has decided to sell a portion of the business to Mary and Mike, both as a reward for their performance and to shift some of the appreciation in the value of the business out of his and his wife’s estate. Mr. Baker has also decided to create a high technology product division for Mary and Mike to jointly manage in order to take advantage of each of their strengths and to further develop their management skills.
To reduce the amount and rate of growth of their estate assets, and to give the inactive children ownership interests in the business, Mr. and Mrs. Baker have decided to make annual exclusion gifts of stock to each of their four children. Mr. and Mrs. Baker have decided to create a class of non-voting common stock and to make gifts of that stock. They will retain absolute voting control of the corporation at present. They will also retain control in the event they decide to accelerate their stock gifts by making lifetime gifts using their lifetime gift tax exemption, or by including other family members in an annual gift program. All other distribution and liquidation rights of the stock are equal, and therefore S corporation status is preserved.
Using the installment sale method, the Bakers sell 15 percent of the voting common stock of Dynasty Plastics to Mary and 15 percent to Mike. The nominal or proportional value of each 15-percent interest is $1,500,000, based on an appraised value of the business of $10 million. However, the appraisal supports a combined minority interest discount and lack of marketability discount of 30 percent, resulting in an appraised value of each 15 percent interest of $1,050,000.
In order to structure the sale in a manner that will enable Mary and Mike to each service the installment sale loan from a combination of annual exclusion gifts and distributions of corporate earnings, Mr. and Mrs. Baker will each gift $250,000 of the value of the stock and will each allocate $250,000 of their lifetime gift tax exemption so that no gift taxes result. The use of the lifetime gift tax exemption at this time will enable a higher percentage of transfer of a rapidly appreciating asset to their children so that more of the appreciation in the value of the business will be occurring in their children’s estates.
After the applying the total $500,000 in gift exemption, Mary and Mike will each pay $550,000 for the balance of their stock in the form of a ten-year installment note. To avoid imputed interest problems, the installment note will provide for a rate of interest equal to the long-term AFR as of the date of the sale, which is 4.91 percent. Mr. Baker believes, and the corporation will likely agree, that a reinvestment of 50 percent of the company’s earnings each year is adequate to sustain the company’s growth and has agreed to distribute 50 percent of the company’s earnings to the shareholders each year. Assuming an average state and federal tax burden of 40 percent which will enable Mary and Mike to each combine one-half of their annual dividend distribution with annual exclusion gifts from their parents, they have developed the following projection:
DYNASTY PLASTICS: INSTALLMENT SALE OF STOCK VIII A
Percentage Distributed Annual Installment Company Stock After Tax Exclusion Annual Interest Principal Loan Year Earnings, Owned Earnings, Gift Payment Allocation, Allocation Balance 0 1,000,000 15.00% – – – – – -500,000 1 1,000,000 15.00% 0 24,000 24,000 0 24,000 -524,000 2 1,000,000 15.00% 0 24,000 24,000 0 24,000 -548,000 3 1,000,000 15.00% 0 24,000 24,000 0 24,000 -572,000 4 1,000,000 15.00% 0 24,000 24,000 0 24,000 -596,000 5 1,000,000 15.00% 0 24,000 24,000 0 24,000 -620,000 6 1,000,000 15.00% 0 24,000 24,000 0 24,000 -644,000 7 1,000,000 15.00% 0 24,000 24,000 0 24,000 -668,000 8 1,000,000 15.00% 0 24,000 24,000 0 24,000 -692,000 9 1,000,000 15.00% 0 24,000 24,000 0 24,000 -716,000 10 1,000,000 15.00% 0 24,000 10,104 0 10,104 -726,104
The foregoing static analysis assumes that all other factors of the business will remain the same. Because that seldom occurs, Mary and Mike have hedged their projections by using an annual earnings growth rate of 9% percent as a planning premise rather than the 15 percent that the company has experienced in recent years. In the event the company’s earnings growth falls short of the premise, an additional hedge can be provided in the form of an option to cap the annual payments at an agreed amount and extend the loan term. If the company’s actual performance meets or exceeds the projections, the value of each of Mary’s and Mike’s interests in Dynasty Plastics will have grown to approximately $3.5 million by the end of the ten-year term, growth which would otherwise have occurred in the estate of their parents. At the same time, Mr. and Mrs. Baker will not have realized an appreciable change in their cash flow since the annual exclusion gifts they would be making to Mary and Mike and the corporate earnings they would otherwise have realized but for the sale, will be paid back to them from the installment note payments.
A financial model such as this is very effective in illustrating to the family business owner the benefits of using an installment sale to transfer ownership of the business. The successors to the business have a strong incentive to work to continue the positive earnings curve on which they will rely to pay off the installment obligation. The senior generation is able to secure an income stream for a substantial period of time by ex-changing a portion of its stock distributions for a series of payments consisting of interest income, recovery of basis, and capital gain. Finally, the appreciation in the value of the stock sold can be shifted to the successors rather than building up in the estates of the senior business owners.
VIII. PRIVATE ANNUITY SALE
A variation on the standard installment note, the private annuity provides the selling family member with periodic payments of a specified amount for a specified period, usually for the lifetime of the seller. When the terms of a transaction provide for a maximum payout that will be achieved in a period less than the life expectancy of the seller, the transaction will be characterized as an installment sale with a contingent sale price. General Counsel Memorandum 39503 (June 28, 1985).
A. How Annuity Sales Work
An individual may purchase an annuity from an insurance company by paying a specified premium amount in exchange for a future income stream based on the annuitant’s actuarial life expectancy. Likewise, a family business owner may sell his or her interest in the business to the successor in exchange for the successor’s promises to pay the seller a specified periodic amount based on the seller’s actuarial life expectancy, the value of the business interest, and an implicit interest factor. Private annuity sales are complicated but are an option that is worth reviewing with the client for the sake of completeness, if nothing else.
B. How Annuity Payments Are Taxed
The annuity payments the seller receives during his or her life expectancy are divided into three parts: (1) a basis recovery component, which is determined by allocating the basis of the seller’s shares over his or her life expectancy under the income tax annuity tables; (2) a capital gain component, which is the excess of the value of the annuity under the gift tax actuarial tables over the basis of the shares, also allocated over the seller’s life expectancy; and (3) an interest income component, which is determined by subtracting the basis recovery and capital gain components from each annuity payment, using the lower of the fair market value of the family business or the present value of the annuity to measure the payment.
If the selling family member lives beyond his or her life expectancy, all subsequent payments are taxed as ordinary income. If the selling family member does not live to his or her life expectancy, the estate will be entitled to a loss deduction on the final income tax return for the amount of the unrecovered basis.
Purchasing successors should be aware that they will not be entitled to any interest deduction on the interest component of the annuity payments made to the seller. Instead, the purchasers receive an initial basis in the business interest equal to the actuarial value of the annuity obligation. The purchasers’ basis is later adjusted up or down according to the actual payments made.
C. Benefits to Owner and Successors
Some clients may be attracted to an annuity because of the assurance of receiving periodic payments for life even when they live beyond their actuarial life expectancy. The corresponding advantage to the purchasing successors is that they may pay less for the business than it is worth if the seller dies before his or her actuarial life expectancy. Clients may be indifferent to this result when their family members would succeed to their estates anyway.
A private annuity purchase is not subject to the limitations that apply to installment sales, such as the interest, original interest discount, and resale rules. For example, the purchasers may resell their business interests at any time without triggering a taxable disposition of the property. A countervailing consideration is that a private annuity obligation may not be secured, and therefore the seller has only the purchasers’ unsecured promise to continue making the annuity payments.
IX. SELF-CANCELING INSTALLMENT NOTE (SCIN)
A SCIN is a hybrid between a standard installment note and a private annuity. It combines the fixed payment term of the installment note with the cancellation-on-death feature of the private annuity. The seller receives periodic payments of a specified amount for a maximum payment term. The maximum payment term places a cap on the amount the purchasing successors will pay. However, because the note is canceled on the death of the seller, the purchasers will pay less than the cap if the seller dies before the payment term expires. Because of the economic risk and uncertainty created by the termination feature, a SCIN must provide greater interim and potential total payments than a standard installment note in order to provide economically equivalent value to the seller.
Use of a SCIN may be indicated when the owner does not need payments for his or her entire life, and the total of payments during the maximum payment term provides adequate value. A particular advantage of the sale of a family business interest using a SCIN is that it immediately removes the value of the business from the seller’s estate, and on cancellation of the note on the seller’s death there is no value in the note to include in the seller’s gross estate.
However, the transaction must be documented carefully to avoid the inclusion of unpaid gain from the sale of stock in the seller’s estate under IRC §691(a)(5) (A)(iii). In Frane v Commissioner (8th Cir 1993) 998 F2d 567, the taxpayer sold all of his shares in a closely held corporation to his children in exchange for SCINs equal to the appraised value of the stock. The court did not challenge the exclusion of the unpaid balance of the notes from the decedent taxpayer’s estate even though he received only two installment payments before his death. The court stated that because the notes carried an interest rate of 12 percent, which was higher than the then-prevailing average rate, adequate consideration was paid for the cancellation feature of the notes. The value of the business was thus excluded from the estate. However, the court held that the decedent’s estate must recognize the remaining unpaid gain from the sale of the stock under IRC 691(a)(5) (A)(iii). This result might be avoided by structuring the SCIN as a contingent payment sale and clearly stating in the note and transaction documents that each payment under the note is contingent on the seller being alive on the payment date. See also Constanza v. Commissioner Internal Revenue, T.C. Memo 2001-128.
X. SPIN-OFFS, SPLIT-OFFS, AND SPLIT-UPS
When a family-owned business is enjoying strong earnings growth and corresponding appreciation in the value of its stock, a primary objective of business succession planning, as well as estate planning, is to shift the value of the appreciating property out of the estate of the senior generation owners and into the estates of the succeeding younger generation.
To accomplish this, one approach is to undertake a tax-free divisive reorganization under IRC 368(a)(l)(D) to create a parent corporation and a controlled subsidiary. The older and more stable portion of the business remains in the parent, while the appreciating portion is transferred into the controlled subsidiary. The divisive reorganization is then followed by a distribution of the controlled subsidiary’s stock under IRC §355. The approaches to distributing the stock of the subsidiary under the provisions of IRC §355 are generally labeled as follows:
The stock of the controlled subsidiary is distributed pro rata to the shareholders of the distributing parent corporation.
The stock of the controlled subsidiary is distributed to the shareholders of the parent corporation in exchange for stock of the parent corporation on either a pro-rata basis involving all of the shareholders or a non-pro-rata basis involving only some of the shareholders.
A spin-off has the effect of segregating a distinct line of business from a company’s primary activities and may be a useful vehicle for developing and grooming successors. However, because all of the shareholders of the parent continue to hold stock of the controlled subsidiary on a pro-rata basis, a spin-off does nothing to transfer ownership or control to the successors.
A split-up is sometimes used in succession planning, usually when two factions of successors permanently split by each taking a portion of family business. However, succession, not divorce, is the focus of this article, and the split-off is the most commonly used method of reorganization for succession.
Through a split-off, the appreciating portion of the family business, as well as ownership and control, may be transferred to the successors. A split-off can achieve the same result as the classic preferred stock estate freeze, which has become much more difficult to accomplish since the advent of the Chapter 14 rules (see Part II of this article, which will appear in a future issue of the Practitioner).
B. Requirements for a Tax-Free Distribution
To qualify for a tax-free distribution of stock under IRC §355 and its accompanying regulations, the transaction must meet five major requirements:
1. Active Conduct of a Trade or Business
Both the parent distributing corporation and the controlled subsidiary corporation must be engaged in the “active conduct of a trade or business” before and after the distribution. A corporation is treated as engaging in a trade or business if it conducts its activities to make a profit. A business is considered “active” if the corporation performs its own management and operational functions. Holding stock, securities, land, or other property for investment purposes does not qualify. The business that is actively conducted by both the distributing corporation and the controlled subsidiary must have been conducted for at least five years before the distribution. IRC 355(b).
The distributing corporation must control and distribute to its own shareholders stock constituting control of the subsidiary within the meaning of IRC §368(c). Control requires ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock and at least 80 percent of the total number of shares of all other classes of stock. IRC 355(a)(1)(D).
3. Not a Device
The transaction must not have been “used principally as a device for the distribution” of earnings and profits of either the distributing or the controlled corporation or both. An indication of such a device would be a pro-rata distribution of the subsidiary’s stock to the shareholders of the parent, fol1owed by a sale of the parent or subsidiary stock shortly after the distribution. An indication that the transaction is not a device is the existence of a legitimate business purpose. IRC 355(a)(l)(B).
4. Business Purpose
There must be a valid corporate business purpose for the creation of separate corporations to conduct business operations formerly conducted by a single corporation, and there must be a business purpose for the distribution of the stock of the subsidiary. This is probably the most difficult of the 355 requirements to meet when one of the reasons for the split-off is to achieve estate planning objectives of the shareholders, because a shareholder purpose does not qualify as a business purpose.
Regulation 1.355-2(b)(2) states that the business purpose must be the corporate purpose of the distributing parent corporation. However, although the regulations warn that the personal planning purposes of a shareholder are not a corporate business purpose, they also acknowledge that when a shareholder purpose is “so nearly coextensive with a corporate business purpose as to preclude any distinction between them,” the business purpose requirement will be satisfied.
One well-established valid business purpose is a dispute among shareholders regarding the direction and management of a business. For example, one shareholder group, perhaps consisting of younger and more active shareholders, wants the business to expand aggressively, requiring substantial reinvestment of earnings, while another group, perhaps consisting of older and inactive shareholders, wants the business to distribute its profits even at the cost of remaining small. When a single business can be divided into two separate lines of business, to serve the objectives of each group of shareholders, the operations of each business will benefit, because the shareholders will be able to devote their entire attention and resources to their own business, thus establishing a valid business purpose. Reg 1.355-2(b).
5. Continuity of Interest
After the distribution of the stock of the subsidiary to the shareholders of the parent corporation, one or more of the historical pre-distribution shareholders of the parent must maintain a continuity of interest in both the parent and the subsidiary. It is not necessary for each shareholder to continue to hold stock in both the parent and the subsidiary. The requirement is met if the pre-distribution shareholders of the parent retain, in the aggregate, sufficient stock of the parent corporation, and retain, in the aggregate, sufficient stock of the subsidiary, to establish continuity. The regulations indicate that if the historical shareholders of the parent maintain at least 50 percent continuity of interest in both the parent corporation and the controlled subsidiary, the continuity requirement will be satisfied. Reg 1.355-2(c); Rev Proc 86-41, 4.06, 1986-2 Cum Bull 716. The shareholders used to count toward the continuity-of-interest requirement should ideally have held the stock for at least two years. ‘This is not mandated by the Code or regulations but is generally considered a sufficiently long period to avoid challenge.
C. S Corporations and Reorganizations
A company’s status as an S corporation does pose a problem. Although an S corporation cannot own an 80-percent stock interest in a subsidiary without losing its S status, the IRS has ruled in Rev Rule 72-320, 1872-1 Cum Bull 270, that if an S corporation transfers assets to a subsidiary momentarily for the purpose of distributing the subsidiary’s stock in a transaction qualifying under IRC 355, the transitional ownership of the subsidiary wi11 not terminate the distributing corporation’s Selection.
D. Split Off: A Valuable Long-Range Planning Device
The split-off technique works best with good long-range planning to achieve both business and estate planning objectives.
An essential element of a divisive reorganization and a 355 distribution is that the members of the successor generation own stock in the business. Therefore, the first step is for the business owner to gift or sell stock in the family business to his or her successors, preferably at least two years before undertaking a split-off.
Because of the five-year active business rule for both parent and subsidiary, if a family business operates only one type of business, the client should be encouraged to expand the business into a related area or to use any excess cash in the corporation to start or acquire a new business. Many family business owners are attracted to the idea of expanding into a related line of business, or at least separating the business into discrete operations, because it creates a career path and training environment for the successor generation to develop their management and leadership skills under the mentoring of the senior generation. Starting or acquiring a new business under the auspices of the family corporation provides the same advantages with the added possibility of attracting additional family members who otherwise might not be interested in the family business. Again, long-range planning is important, because a newly started or acquired business must be actively conducted as a trade or business for at least five years before a divisive reorganization and 355 split-off can result.
Separating a successful business into constituent operations is a sensitive proposition, because the value of the whole may be greater than the sum of its parts. The hazards of dividing one’s kingdom among family members have been well documented since the time of King Lear. But when the personalities and circumstances are favorable and the client feels comfortable with a divisive reorganization, a split-off will shelter the senior generation business owner from the risks and worries inherent in a growing and expanding business, and provide him or her with the option to remain actively involved in at least one aspect of the family business.
HYPOTHETICAL Phase III: Split-Off
The saga of Dynasty Plastics, Inc. continues. Five years after the sale of stock from Mr. Baker and Mrs. Baker to their children Mary and Mike, Mr. Baker decides to undertake a divisive reorganization and split-off. The growth of the business has remained strong and Dynasty Plastics now has a value of approximately $20 million, based on annual earnings of $2 million and revenues of $25 million. The two children who are not active in the business, Sam and Dave, increasingly vocalize their concerns that not enough of the company’s earnings are being distributed to the shareholders, and that Mary and Mike can accept low distributions because of their high salaries and bonuses. Mary and Mike believe that not only must more of the company’s earnings be invested in the business in order to maintain the working capital necessary to sustain a 15% annual rate of growth, but that substantial debt should soon be taken on to finance the creation of a foreign subsidiary to service the company’s customers at foreign production sites. Although Mary and Mike have been very successful in managing their high technology division thus far, Mr. and Mrs. Baker, and Sam and Dave are very concerned over the risks of a highly leveraged expansion. The Bakers believe that a split-off is the best way to resolve the disagreement among the shareholders. It will also create an opportunity for Sam and Dave to assume active roles in Dynasty Plastics.
Dynasty Plastics, Inc., will first create a controlled subsidiary corporation, Dynastic Tech, Inc., and transfer all of the assets of the business related to the design and manufacture of its computer-related plastic products to the subsidiary in exchange for all of the subsidiary’s stock. Fortunately the assets and operations of their division have been separately accounted for by Mary and Mike since acquiring their shares in the company five years previously, so the requirements of IRC §355(b) will be satisfied. Dynasty Plastics, Inc., will then distribute all of its stock in Dynastic Tech, Inc., to Mary and Mike, who will then convey their 30 percent of Dynasty Plastics, Inc., voting common stock back to the parent corporation in a non-pro-rata distribution of the subsidiary stock. Dynasty Plastics and Dynastic Tech will continue a close working relationship not only because of the family and operating interconnections but also because Mike and Mary will each continue to hold a portion of the equity of Dynasty Plastics, through the non-voting common stock they have received as gifts and which they will continue to receive as part of the Bakers’ estate planning.
Mr. and Mrs. Baker have decided to create four irrevocable trusts for each of their four children and to fund the trusts with non-voting common stock of Dynasty Plastics, Inc. to the full extent of their lifetime gift tax exemption. Because Dynasty Plastics, Inc. is an S corporation, the trusts created must qualify as S corporation shareholders, in this case by using a Qualified Subchapter S Trust, which permits only one current income beneficiary. IRC 1361(d)(3).
The Bakers are taking this action because they now have adequate income from various sources and sufficient other assets to forego the earnings distributions and also wish to shift the appreciation in the value of their interests in Dynasty Plastics, Inc. to their children’s estates.
XI. CORPORATE RECAPITALIZATIONS
A. Recapitalizations Modify the Capital Structure
Part I of this article concluded with a discussion of split-offs, a type of corporate reorganization under IRC 355. This is a technique for splitting off a portion of a business as a subsidiary for a group of family successors to own and operate. Although a split-off may be a very viable option under circumstances such as those described in the Dynasty Plastics, Inc., hypothetical included in Part I, in many other instances the technique will not be available, e.g., the family business cannot be divided into two or more separate trades or businesses, the separate lines of business have not been operated for at least five years, there is not a sufficient business purpose to undertake a reorganization, or one of the other five major threshold requirements is not satisfied. In some cases, the owner of the family business simply may not want to divide his or her enterprise, either for personal or strategic reasons.
When a split-off is not possible or desirable, consider a corporate recapitalization. In contrast to reorganization, which may result in a business split-up, spin-off or split-off, in a recapitalization the owner’s business and succession planning objectives are achieved by continuing the business as a single intact entity with modifications made to the capital structure of the corporation. The U.S. Supreme Court has described a recapitalization as a “reshuffling of a capital structure within the framework of an existing corporation.” Helvering v Southwest Consolidated Corp. (1942) 315 US 194,202, 86 L Ed 2d 789,796,62 S Ct 546. Regulation §1.368-2(e) describes a recapitalization as occurring whenever a stockholder transfers his or her stock to the issuing corporation in exchange for another kind or class of the corporation’s stock or corporate security. Recapitalizations are generally tax-free to both the stockholder and the corporation, provided a valid business purpose exists for it. Reg 1.368-1(c). An example of a recapitalization in Reg 1.368-2(e)(3) is when a corporation issues preferred stock, previously authorized but unissued, for outstanding common stock.
B. Effecting an Estate Freeze With a Preferred Stock Recapitalization
1. Before Enactment of Chapter 14
Before 1987, preferred stock recapitalizations were commonly used by business and estate planners to effect a freeze for estate tax purposes of the value of a family business by having the corporation authorize and issue preferred stock to the senior generation of business owners in exchange for some or all of their common stock. The preferred stock provided for sufficiently high dividend rates to absorb a substantial portion of the then-current value of corporation. Most, if not all, of the common stock of the corporation, which held the remaining minimal value, would then be transferred by gift or sale to the successor generation. In this manner, the common stock would carry the appreciation in the value of the business to the successor generation. As the revenues and earnings of the business increased, the benefits would accrue to the common stock held by the successors, while the value of the preferred stock was effectively fixed or frozen to the amount of the dividends paid on the preferred stock. The technique was well suited for providing the retiring senior generation of business owners with an assured income stream while encouraging the successor generation to invest their energies in growing the family business.
However, Congress perceived numerous abuses of recapitalization freezes, primarily in the area of valuation, and in 1987 enacted IRC 2036(c) as part of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) (Pub Law 100-647). Section 2036(c) operated to pull back into a transferor’s estate the fair market value of previously transferred interests in family-owned businesses where the transferor retained a disproportionate interest in the income or rights of the business and the transferees were entitled to a disproportionate share in the appreciation of the business. Section 2036(c) was heavily criticized for its extraordinary complexity and difficult and uncertain application. It was retroactively repealed 1990 by the Revenue Reconciliation Act of 1990 (Pub L 101-508, 107 Stat 416) and replaced by a new Chapter 14 (IRC 2701to -2704).
2. Recapitalization Under Chapter 14
Chapter 14 changes the approach of a traditional corporate stock freeze by imposing a gift tax at the time of the transfer. Contrast this with former IRC §2036(c), which imposed an estate tax on the death of the transferor. The provisions of Chapter 14 (IRC 27012704), focus on establishing an accurate value for the interest being retained by the transferor (e.g., preferred stock) and the resultant value of the common stock being conveyed to the transferees.
Generally, a recapitalization is subject to the valuation rules of IRC 2701 when there is a “capital structure transaction” in which a transferor or an applicable family member (Reg 25.2701-1(d)(2)-transferor’s spouse, ancestor of transferor or transferor’s spouse, or the spouse of such ancestor) conveys a subordinate or junior equity interest in a corporation (or partnership) to a member of the family (Reg 25.2701-I(d)(1) spouse, lineal descendant of the transferor or the transferor’s spouse, or the spouse of such lineal descendant)-while retaining a superior or senior equity interest in the entity. The transferor’s retained interest is defined as an “applicable retained interest” if it contains an extraordinary payment right, or in the case of a controlled entity (e.g .. a corporation in which the transferor and the transferor’s family own 50 percent or more of the total voting power or the total fair market value of the equity interests before the transfer), a distribution right. Reg 25.2701-29(b)(l).
When IRC 2701 applies to a recapitalization transaction, the value of the transferred interest (the gift) and the retained interest is determined by the subtraction method under Reg 25.2701-3, computed in four steps:
Step 1: Determine the fair market value of all family-held equity interests in the corporation immediately after the transfer, by assuming that the interests are held by one individual, using a “consistent set of assumptions.” The assumptions refer to valuation assumptions-e.g., revenue, earnings, book value-that remain consistent when applied to various scenarios. Reg 25.2701-3(b)I). “Family-held equity interests” are those directly or indirectly held by the transferor, applicable family members, and lineal descendants of the parents of the transferor or the transferor’s spouse. Reg 25.2701-3(a)(2).
Step 2: Subtract the fair market value of all family-held senior equity interests from the value of all family-held equity interests determined in Step 1. Senior equity interests are interests that carry a right to distributions of income or capital that is preferred as to the rights of the transferred interests. Reg 25.2701 3(a)(2), (b )(2).
Step 3: Allocate the value remaining after Step 2 among the transferred interests and other subordinate interests held by the transferor, applicable family members, and members of the transferor’s family. Reg 25.2701-3(b)(3).
Step 4: Determine the amount of the gift by reducing the amount allocated to the transferred interests in Step 3 by certain amounts specified in Reg 25.2701 3(b)(4), such as minority interest discounts, retained interests, and consideration received by the transferor.
The value of an applicable retained interest must be determined under the gift tax rules of Chapter 12, e.g., fair market value under IRC 2512. Reg 25.2701-2(a). It is important to note that in the case of a family controlled entity using preferred stock as “the retained interest,” the distribution right of the stock must be a qualified payment right, which requires that the dividends payable under the preferred stock be cumulative and payable at a fixed rate or as a fixed amount on a periodic basis (at least annually). Reg 25.2701-2(b)(6). Otherwise, the distribution right, and, in the absence of any other payment rights, the entire applicable retained interest, will have a value of zero (Reg 25.2701.-2(a)(2), and the value of the entity will be allocated entirely to the transferred interest (common stock), See Reg 25.2701-1(e), Example 2. This would subject the entire value of the entity to gift tax payable by the transferor.
Upon completion of the transfer of the interest it is important that a gift tax return be filed by the client which contains an “adequate disclosure” of the terms of the gift. Otherwise, the statute of limitation on the gift tax (and the right of the IRS to challenge the valuation assigned to the gift) does not begin to run. The elements of “adequate disclosure” are set forth at Reg. 301.6501(c)-1(e)(2).
The objective of the senior generation of family business owners is to structure the recapitalization so as to maximize the assignment of value to the “retained senior equity interest” (preferred stock) in order to freeze as much of the value of the business as possible in their estates and to assign as small a value as possible to the subordinate equity interest (common stock) being transferred to the successor generation. This will minimize the amount of gift tax that will be paid on the transfer and shift the future appreciation in the value of the business to the successors.
Mr. Avila owns a chain of restaurants with combined annual sales of $12 million and earnings of $1.8 million. The company, Quetzalcoatl Grill, Inc. is an S corporation. Mr and Mrs. Avila are the sole shareholders of 10,000 shares of common stock. Step 1: An independent appraisal has established the fair market value of the business at $9 million. Mr. Avila, who is 60 years old, has built his business over the last 20 years with the help of his wife. His two children, Peter and Mary, have worked full time in the business for the past five years and have been largely responsible for doubling the company’s revenues and earnings during that time period. Peter and Mary have, demonstrated their commitment and capability in managing the company and the prospects for the company’s continued growth are very good. Mr. Avila is comfortable with relinquishing control of the company to his two children while he phases into retirement with a consulting relationship to the corporation.
Mr. Avila wishes to freeze the value of his estate for estate tax purposes and cause the future appreciation in the company’s value to occur in Peter’s and Mary’s estates, while continuing to receive an income stream from the company to fund his retirement.
Mr. and Mrs. Avila decide to recapitalize the corporation, creating 10,000 shares of preferred stock with a par value of $600 per share and an annual cumulative dividend of 10 percent. They exchange 5,000 shares of their common stock for issuance of the 10,000 shares of cumulative preferred stock and transfer by gift the remaining 5,000 shares of common stock to Peter and Mary. Step 2: Six million dollars of the entity’s fair market value is attributed to the applicable retained interest held by Mr. and Mrs. Avila by virtue of the $600 par value and 10 percent cumulative dividend features of the preferred stock, the senior equity interest. Step 3: Under the subtraction method, the value of the gift to Peter and Mary is $3.0 million, determined by subtracting the value of the retained senior equity interest from the value of the entity before transfer ($9 million). Quetzalcoatl Grill, Inc., is now a C corporation because it has more than one class of stock. Step 4: Since the gift comprises 100% of the common stock of the corporation, no minority interest or lack of marketability discounts are applied. If Mr. and Mrs. Avila each have the full $1,00,000 of lifetime gift tax exemption available to them, combined with the $12,000-per-donee annual gift exclusion, a gift tax will be imposed on $952,000 of the gift. Refer to Part I of this article for information on the lifetime gift tax exemption and annual gift exclusion.
A threshold consideration for the business owner is the corporation’s status as a C or an S corporation. Because a corporation that is recapitalized will have two or more classes of stock, it will not qualify as an S corporation. All other factors being equal, switching to a C corporation will deplete the value of the corporation over time, because of the deferred tax liability associated with the earnings and profits that a successful C corporation will accumulate. The tax costs of the loss of S corporation status is one of the factors a client must consider in deciding whether to recapitalize.
A related consideration is whether the business has sufficient income-generating and dividend-paying capabilities. As a C rather than an S corporation, the business will be subject to a tax at the corporate level and the shareholders will be subject to tax at the personal level on earnings distributed to them as dividends. For a recapitalization to make economic sense, the business must be able to generate sufficient after-tax earnings to pay the preferred stock dividends and to fund future growth. In the case of Quetzalcoatl, Inc., assuming a combined federal and state corporate effective tax burden of 38 percent on $1.8 million in pre-tax earnings, $1,116,000 in after-tax earnings would be available to pay the $600,000 annual preferred stock dividend and to fund future growth.
Under the current Chapter 14 rules, following the repeal of former IRC 2036(c), recapitalizations provide a viable method to divide the ownership of a family business into different categories of capital to meet the different needs of the senior and successor generations of owners.
XII. OTHER CORPORATE REORGANIZATIONS
A business owner may consider other types of reorganizations, depending on the facts and circumstances of the family business. A merger with another company may be appropriate when the products or services are complimentary and competitive advantages can be achieved from the combination, or when the companies can benefit from the particular attributes each one may have, e.g., cash, management expertise, marketing and distribution networks, product lines. For example, the owner’s family members may wish to participate in ownership and control of the business but may not have the full complement of skills and resources necessary. If the owner is able to identify a synergistic merger opportunity, the owner may be able to satisfy the needs and interests of the successors to continue in the family enterprise while at the same time protecting and perhaps enhancing the value that has been built up in the business.
A merger may be structured in a manner in which all equity holders of the family business receive stock for stock (or assets) or part stock and part cash, with the successors receiving stock in the merged entity and the cash being used to provide liquidity to the senior family members. Under the rules of reorganization rules of IRC §238 the merger may be structured in a tax advantageous manner.
In the experience of the authors, the high volume of merger activity in the years between 2004 and 2006 created many opportunities for well run family companies, in fields ranging from high-tech to low-tech to no-tech, to merge their businesses with larger entities, often to competitors in their own industry. Although the level of merger activity began tapering off in 2007, mergers remain a viable succession option for family businesses well positioned in their market with strong financial statements. The readers of Business Law Practitioner may already be familiar with the techniques and intricacies of merger transactions, further details of which are beyond the scope of this article. For a comprehensive treatment of the subject, the authors refer the readers to the CEB Publication Sales and Mergers of California Businesses.
C. Public Offerings
During the decades of the1980s and 1990s, “going public” was a viable business succession planning option for closely held companies that were of sufficient size with a product or service that would be attractive to public investors. But since the burst of the “dot.com bubble” in 2000, initial public offerings have become a rare and difficult source for obtaining capital and liquidity even for high growth companies. As an alternative for family business succession planning it is no longer a viable option. A NASDAQ Small Cap listing requires a minimum of $5 million in shareholder equity and a market float of $15 million. However, the key to any public offering of stock is finding strong underwriters and market makers, and their typical requirement is a market float of at least 25% which translates to a minimum total capitalization of $60 million. Furthermore, given the high costs and risks of public offerings, underwriters will rarely consider taking a company public for less than a market float is less than $100 million.
While there are alternative methods of going public such as OTC and Pink Sheet listings, reverse mergers into “public shells” and direct public offerings (which have gained increasing popularity as a result of the ubiquity of the Internet), in the opinion of the authors these options have little or no utility for purposes of succession planning for the typical family business.
Excellent resources on the subject of public offerings include: Petillon, Rep-resenting Start-Up Companies (3d Ed. 1999), published by Clark Boardman Callaghan; Venture Capital and Public Offering Negotiations(2d Ed. 1992), published by Prentice Hall; and Raising Capital: Private Placement Forms & Techniques (2002), also published by Prentice Hall.
XIII. GRANTOR RETAINED ANNUITY TRUSTS AND GENERATION-SKIPPING TRANSFER TRUSTS
The use of trusts in succession planning was introduced in Part I of this article. A bypass trust, or credit shelter trust, and an irrevocable trust were used to illustrate the transfer of shares in a family business using the lifetime gift tax exemption per donor ($1,000,000) and the annual per-donee gift exclusion ($12,000) credits that each taxpayer has. Two other types of trust that play a critical role in estate planning as wel1 as in business succession planning are grantor retained annuity trusts (GRATs) and generation-skipping transfer trusts (GSTTs).
A. Grantor Retained Annuity Trust
1. How a GRAT Works
By using a grantor retained annuity trust, a family business owner may give stock in the business to the successor generation while retaining an income stream from the transferred stock. The business owner, the grantor, creates an irrevocable trust and makes a gift of stock in the family business to the trust, designating his or her successors as beneficiaries, while retaining the right to annual fixed (or formula) payments (the annuity) from the trust for a specified number of years. When the specified term of the income stream expires, the grantor’s interest in the trust terminates and all of the income and principal of the trust inure to the benefit of the trust beneficiaries in accordance with the terms of the trust agreement, e.g., funds are distributed to beneficiaries or held in trust.
2. Calculation of Gift and Gift Tax
The grantor’s transfer of assets to the GRAT is a current gift. The value of the gift is the present value of the remainder interest, determined by subtracting the present value of the grantor’s retained annuity interest from the current fair market value of the assets transferred to the GRAT. IRC 2702; Reg §25.2702-1. The discount rate used to determine the present value is 120 percent of the midterm applicable federal rate in effect on the date of the gift. This rate is referred to as the §7520 rate, because it is mandated by that section of the Internal Revenue Code. The lower the §7520 rate, the higher the present value of the grantor’s retained annuity and the lower the value assigned to the remainder interest, which means that more assets may be conveyed to the beneficiaries of the GRAT without higher gift taxes.
Returning to the case of Quetzalcoatl, Inc., assume that instead of using a recapitalization to transfer stock to Peter and Mary, Mr. and Mrs. Avila use a GRAT to transfer by gift 40 percent of the common stock of the corporation, retaining a right to annual payments of $360,000 for seven years. Assume further a §7520 rate of 10 percent, and a 25-percent discount for lack of marketability and minority interest status. The value of the 40-percent minority interest would be $2.7 million ($6 million X 40 percent X (1-.25), from which the present value of the annuity, $1,752,630 [using an Excel function of =PV(rate, periods, payments)], would be subtracted to obtain the value of the remainder interest, $943,370, which would be subject to gift tax. Mr. and Mrs. Avila may apply their available lifetime gift tax exemption against this amount to avoid paying gift tax. Practitioners must use the minority discount cautiously, because the existence of or amount of the discount may be challenged by the IRS.
The GRAT is entitled to 40 percent of the annual earnings generated by the corporation (e.g., $720,000), which would presumably distribute dividends sufficient to cover the $360,000 annual payment. Whether the corporation distributes dividends in excess of the annual payment or retains earnings to invest in the company’s continued growth, the value accrues to the benefit of the GRAT beneficiaries. If the company’s revenue and earnings growth outpace the 7520 rate, the value of the gift is leveraged through the appreciation in the value of the common stock. For example, if Quetzalcoatl’s revenues and earnings grow at an annual rate of 15 percent, as they have done during the preceding five years, by the time the GRAT expires in seven years, the value of the 40 percent interest in the corporation will have appreciated over two and a halftimes to $9.58 million, which is more than 10 times the amount subject to gift tax at the creation of the GRAT.
3. Risks of Using a GRAT
The potential benefits of a GRAT must be weighed against the risks, the greatest being the risk of the grantor’s death before the completion of the term of the trust. If the grantor dies before the term of the trust is completed, the value of the assets transferred into the trust will be included in the grantor’s gross estate and subject to estate tax at the date-of-death value of the assets. Essentially, the grantor is gambling with the IRS that he or she is going to outlive the term of the GRAT. If the grantor loses, the IRS wins, and if the grantor wins, the IRS loses. This particular risk can be mitigated by providing in the trust that the remainder interest be transferred to the surviving spouse if the grantor dies before the trust terminates. Assets transferred to the survivor’s trust qualify for the unlimited marital deduction for estate tax purposes.
A GRAT is most useful when the trust assets are able to consistently and predictably generate income, e.g., stock in an established and growing business. If a company is a marginal or inconsistent income generator and fails to earn and distribute sufficient funds to enable the trust to make its annual payments, there is a risk that the trust may have to pledge stock on a loan, or sell or transfer stock back to the grantor to fulfill the pay-out requirement. This would defeat the underlying purpose of reducing the grantor’s estate by transferring assets to the beneficiaries.
Special consideration must be given to using the stock of an S corporation to fund the trust. A GRAT will qualify as an eligible S corporation shareholder because it is a grantor trust. However, to preserve the S election, on completion of the trust term the trust provisions must provide for distribution of the stock to eligible S corporation shareholders, such as individual shareholders or Qualified Subchapter S Trusts. See IRC 1361(c), (d).
4. Grantor Taxed on Trust Income
Finally, it is important to note that as a grantor trust, the grantor will be taxed on all of the income of the trust under IRC 671. Therefore, depending on the grantor’s other sources of income, it is likely that he or she will want to provide for an annuity that is at least sufficient to cover the income tax on the earnings attributable to the trust. If the grantor so chooses, he or she may structure the GRAT to provide that the grantor shall be paid an annual sum sufficient to pay the income taxes on the trust’s earnings, in addition to other desired payment amounts. However, the higher the total annual pay-out to the grantor, the less value will build up in the GRAT.
B. Generation-Skipping Transfer Trust
When a business owner wishes to transfer interests in the business to family successors two or more generations removed from the owner’s generation, it is important for the attorney to consider the implications of the generation-skipping transfer tax.
1. Evolution of Generation-Skipping Transfer Tax
Before 1976, it was possible to convey by will or trust a life estate in stock to a child and a remainder interest to a grandchild with the stock subject to only one level of estate tax on the death of the owner. No estate tax was imposed when the grandchild received the remainder interest on the death of the child. However, since the Tax Reform Act of 1976, a generation-skipping transfer (GST) tax has been imposed on such transfers of property that bypass or skip a generation. Now under the GST tax rules, as revised under the Tax Reform Act of 1986, the stock in a family corporation is subject to transfer tax not only on the conveyance of the life estate to the child at the death of the owner, but also a second time on the transfer of the remainder interest in the stock to the grandchild many years in the future. Because the GST tax will be assessed on the fair market value of the stock at the time of the child’s death, the impact of the second tax may be quite stunning if the value of the stock has substantially appreciated over the years.
2. What Triggers the GST Tax
A GST tax is assessed whenever a transfer is made to a “skip person.” A skip person is (1) a person assigned to a generation two or more generations below that of the transferor, or (2) a trust in which all interests are held by skip persons or in which no non-skip person holds an interest or may receive a distribution. IRC 2613(a).
A GST tax is imposed on the occurrence of anyone of three events: a direct skip, a taxable distribution, or a taxable termination. IRC §2612; Prop Reg §26.2612-1. A “direct skip” occurs when a person makes a transfer of property to a skip person, without a person from any intermediate generation having an interest in the property transferred. The tax on a direct skip is paid by the transferor. A “taxable distribution” occurs when property is distributed to a skip person from an arrangement, usually a trust, that has beneficiaries who are non-skip persons not subject to the tax. For example, if a business owner creates a trust, funds it with stock of the family corporation, and grants a life estate in the trust to his daughter and a remainder interest in the trust stock to his daughter’s son and daughter, a distribution from the trust (e.g., cash) to either grandchild during the lifetime of their mother will be a taxable distribution. Only the property distributed to the skip person is subject to the tax, payable by the recipient of the distribution. A “taxable termination” occurs when the last interest of a non-skip person terminates and only skip persons subject to the GST tax remain to receive the property. Continuing the previous example, on the death of the business owner’s daughter, the termination of her life estate in the corporate stock causes a taxable termination, because no other non-skip persons will benefit from the stock and only a skip person, the grandson or granddaughter will receive the benefits of the stock as the remainder beneficiaries. All trust assets as of the date of the taxable termination, valued at their fair market value, are subject to the GST tax, payable from the trust assets.
3. GST Tax Exemption Provides Planning Opportunities
Every person is allowed, under IRC 2631 (a), a GST tax exemption of $2 million, which he or she, or the executor, may allocate to any property transfer. As is the case with the lifetime exemption from gift tax and annual gift exclusion (refer to Part I), a married couple may make a “gift split.” By using a gift split, the couple may allocate $4 million of GST tax exemption to a single gift or multiple gifts, because each spouse is treated as making one-half of the transfer. IRC 25l3, 2652(a)(2). The property to which the exemption applies, and all future appreciation of that property, is exempt from GST tax. However, once the GST exemption is allocated it is irrevocable. Therefore, if the GST exemption is allocated to a trust and all of the skip person beneficiaries pre-decease the non-skip person beneficiaries, the exemption is lost and may not be reallocated.
The term “inclusion ratio” is used to describe the portion of a trust that is subject to GST tax. It is determined by subtracting from the number one (1) a fraction, the numerator of which is the amount of GST exemption allocated to the trust and the denominator of which is the total fair market value of the property used to fund the trust. IRC §2642(a)(1); Prop Reg §26.2642-1. For example, if a business owner funds a trust with $5 million of corporate stock, and the owner and spouse allocate $4 million of GST exemption using a gift split, the portion of trust assets protected by the exemption is 4/5 and the inclusion ratio is 1/5, or 20 percent, resulting in GST tax of 20 percent of the maximum federal estate tax rate on any GST distribution. IRC 2641(a). Under IRC §2641 (b), the GST tax rate is the maximum applicable federal estate tax rate under the rate schedules at IRC §2001(c), e.g., 45 percent).
HYPOTHETICAL: Generation-Skipping Transfer Trust
Returning to the succession plan for the Avila family, assume that the previously discussed recapitalization has been completed. Mr. and Mrs. Avila made a gift of $3 million in common stock to Peter and Mary and now own $6 million worth of preferred stock in Quetzalcoatl Grill, Inc. A typical trust plan for Mr. and Mrs. Avila would be for them to fund an inter vivos trust with their preferred stock, retaining a life estate in the assets. The trust provides that when the last of them dies, the trust becomes irrevocable, with Peter and Mary having life estates in the stock, and with the remainder to be distributed to their children, the grandchildren of Mr. and Mrs. Avila. The trust further provides that the life beneficiaries may receive distributions of income only and may not invade the principal. Under this arrangement, the grandchildren are skip persons. Assume that Mr. and Mrs. Avila each allocate their $2 million GST exemption to the trust. The inclusion ratio will be 1/3 percent, determined by subtracting from the number one a fraction, the numerator of which is the amount of the GST exemption allocated ($4 million) and the denominator of which is the total asset value transferred ($6 million). Any distribution to a skip person from the trust will be subject to a GST tax determined by the amount of the distribution multiplied by the product of the inclusion ratio and maximum federal estate tax rate. For example, on the death of the last of the life beneficiaries (Peter and Mary), a taxable termination will occur because their children, as skip persons, are the only persons who have an interest in the trust. The $6 million in preferred stock will he multiplied by the product of the inclusion ratio (1/3) and the GST tax rate of 45 percent to determine the amount of GST tax. At an effective rate of 15 percent, GST tax is $899,100, leaving $5,100,900 million in after tax assets to the grandchildren.
To make better use of the leveraging potential of the GST exemption, an alternative plan would be for Mr. and Mrs. Avila to use a split trust arrangement, under which the $6 million in preferred stock assets would be divided into two trust funds, one to which assets in the amount of the combined $4 million GST exemption of Mr. and Mrs. Avila are allocated and the other in the amount of the $2 million ba1ance. The entire GST exemption fund would have an inclusion ratio of zero, while the other would have an inclusion ratio of 100 percent. The income from the GST exemption fund ($600,000 annual preferred stock dividend) would not be distributed but reinvested annually. Peter and Mary would receive the income from the other fund and could access the GST exemption fund income only under very limited circumstances. Over a period of ten years, with an average after-tax compounded reinvestment rate of as little as 5 percent, the GST exemption fund will have appreciated to approximately $16.1 million, net of taxes. If a taxable termination of the split trust were to occur at that time, no GST tax would be imposed on the exemption trust because of the zero inclusion ratio. The entire $2 million of the other fund would be subject to tax because of the 100-percent inclusion ratio, which would result in a GST tax of $900,000 million at a 45-percent GST rate. The result would be a total of $17.2 million in assets being distributed to the grandchildren. For purposes of illustration, the above example simplifies the mechanics of using the GST exemption in a split trust arrangement by not considering the consequences of the deaths of each of the spouses on the allocation of the GST exemption.
The objective of GST planning is to use the $2 million exemption to transfer as much property as possible free of GST tax. That means allocating the exemption to transfers that provide maximum leverage. If a rapidly appreciating asset, such as common stock of Quetzalcoatl Grill, funded the second trust in the foregoing hypothetical, even greater amounts could be passed to the grandchildren. Whenever possible, the succession planning attorney should attempt to freeze the value of skip property transfers so that all future appreciation will occur in the estates of the skip generation beneficiaries.
XIV. EMPLOYEE STOCK OWNERSHIP PLAN
A. Use of ESOP to Effect a Tax-Deferred Rollover of Stock
An Employee Stock Ownership Plan, commonly referred to by its acronym “ESOP,” can be a very important element of an integrated business succession plan, as it can be used to purchase some or all of the stock of family business owners. The owners have a market for their stock and can defer tax on long-term capital gains. Under IRC § 1042, business owners may sell the stock in their closely held business to the company’s ESOP and use the proceeds to purchase qualified replacement property, such as stocks and bonds of domestic operating companies, without the recognition of gain. In this manner, the retiring owners of a family business may effect a tax-deferred “rollover” of some or all of their closely held stock into a diversified and liquid portfolio of securities. Tax is deferred until a subsequent disposition of the newly acquired securities.
Generally, for the transaction to qualify for tax deferral, the selling stockholder must have owned the stock for at least three years before the sale and must not have received the stock as compensation. IRC § 1042(c)(1)(B). In addition, immediately after the sale, the ESOP must own at least 30 percent of either the total value of outstanding stock of the corporation or of each class of outstanding stock. IRC 1042(b)(2).
B. Benefits and Limitations of ESOPS
ESOPS are an attractive deferred compensation vehicle because the employer’s contributions to the benefit plan are tax deductible (IRC §404(a)(9)) and the income earned by ESOPs are exempt from tax (IRC §50l(a)). A corporation is also entitled to a deduction for dividends paid on shares held by an ESOP. IRC §404(k).
However, there are risks to using an ESOP. One major risk is that faced by the owners as fiduciaries of an ESOP, which is an ERISA defined contribution pension plan. Whether the owners of a corporation with stock in an ESOP that has declined in value are accountable for breach of fiduciary duty is an open issue.
Additionally, a limitation and major consideration for most family business owners is the ESOP requirement that participation be available to a broad cross-section of the company’s employees and not just to key executives. In addition, although benefits under the ESOP may be allocated in proportion to the compensation of participating employees, they may not be provided in a manner that discriminates in favor of officers, shareholders, or highly compensated employees. IRC §401 (a)(5).
The participants in an ESOP do not recognize taxable income until they receive distributions of benefits from the plan, which generally must commence within one year after the year of retirement, disability, or death of the participant. IRC §409(o)(1). When an employee-participant is terminated, distribution of benefits may be deferred for a period of five years. Distributions from an ESOP may be in the form of cash, but participants are entitled to demand that benefits be distributed in the form of the employer’s securities. The employer may require that the participant resell distributed securities to the employer under a fair valuation formula, and when an employer’s securities are not readily tradable on an established market, the participant may require the employer to repurchase distributed securities. IRC §409(h).
The primary distinction between an ESOP and other employee benefit plans is that an ESOP is designed to invest primarily in the securities of a qualifying employer. IRC §4975(e)(7). An ESOP is otherwise similar to other benefit and profit-sharing plans in that the employer’s contributions to the plan are made to a trust fund that is administered for the exclusive benefit of the plan’s employees. IRC §404(a)(3). ESOPs are subject to the same general fiduciary rules and prohibitions that apply to other tax-qualified benefit plans. IRC §4975(c). An important exemption for ESOPs is that the sponsoring corporation is allowed to provide loans and loan guaranties to an ESOP. IRC §4975(d)(3). This exemption enables the use of a technique known as a “leveraged ESOP,” by which a corporation guarantees a loan by the ESOP trust from a commercial lender, the proceeds of which are used by the ESOP to purchase shares of the corporation’s stock. The corporation in turn makes tax-deductible contributions of cash to the ESOP in amounts sufficient to pay the interest and retire the principal of the loan. By using this leveraged financing device, an ESOP is able to acquire a larger quantity of shares from the selling stockholders than it would be able to solely from employer contributions.
C. An ESOP Does Not Change Corporate Control
The adoption of an ESOP seldom results in a change of management or control of the company, because ESOPs usually hold less than 50 percent of the outstanding stock of the sponsoring employer. Although the ESOP must own at least 30 percent of the outstanding stock of the corporation to qualify for a tax-deferred rollover, if the principal owners of the family business want, they can assure that their desired successors retain absolute control by selling or gifting to them a sufficient amount of common stock. In addition, unless the stock of the company is publicly traded, the stock that is purchased by or contributed to the ESOP may be voted by the plan’s trustee, who may be a principal officer of the company. The voting rights of the plan’s participants may be limited to extraordinary transactions such as mergers, consolidations, and liquidations.
HYPOTHETICAL: Adoption of an ESOP
With its strong earnings growth, currently at $1.8 million annually, and its fair market value of $9 million, an ESOP is a viable succession planning tool for Quetzalcoatl Grill, Inc. Moreover, the company’s owners, Mr. and Mrs. Avila, are very open to sharing the success of their business with their employees. In addition, they and their successors, Peter and Mary, anticipate that the positive effects of an employee incentive plan such as an ESOP will facilitate the continued high performance of the company.
The Avila’s decide to create an ESOP for the company. The corporation funds the ESOP with a $600,000 tax-deductible cash contribution. The ESOP leverages the purchase by borrowing 80 percent of the purchase price with a loan guaranty from the corporation, and purchases one third of the outstanding shares of the corporation for $3 million. The corporation will make annual contributions, which are deductible from gross income, in an amount sufficient to pay the interest and principal on the loan. In addition, any dividends paid to the ESOP may also be deducted from income under IRC §404(k), if they are used to payoff a loan that was incurred to acquire the stock from which the dividends arise. Because the ESOP is not a qualified S corporation shareholder, Quetzalcoatl Grill, Inc., will become a C corporation. However, the Avila’s believe the tax advantages exceed the costs of being subject to the double tax.
The Avila’s reinvest the $3 million in proceeds from the sale of their stock in a diversified portfolio of investment grade stocks and bonds of U.S. operating companies. All tax is deferred under IRC § 1042. To complete their succession plan under this scenario, the Avila’s may gift $1,024,000 worth of stock to Peter and the same amount to Mary, using their lifetime gift tax exemption and annual exclusion, which results in no gift tax. The Avila’s may then transfer the remaining $3,952,000 in stock to their successors through a combination of gifts and installment sales over the next several years using techniques discovered in Part I of this article.
ESOPs are very complicated to create and maintain, entailing legal and accounting costs commensurate with that complexity. However, when a family business is of sufficient size and value, has regular and predictable earnings growth, and the owners are open to sharing the appreciation in the value of the business with employees, the use of an ESOP should be given serious consideration.
XV. BUY-SELL AGREEMENTS Buy-sell agreements are a common element of corporate and partnership planning. Their ability to restrict ownership and control of a business is particularly useful in the context of succession planning as they enable a senior generation of business owners to assure that the business is maintained within the group of successors they designate. Buy-sel1 agreements:
• Limit the persons who may own stock in a corporation or an interest in a partnership;
• Specify events that will trigger the sale of a person’s interest;
• Establish a method for valuing interests in the entity; and
• Set forth mechanics for the purchase.
• Buy-sell agreements are used for the same purposes in succession planning, and additionally:
• May contain provisions for voting and control of the corporation on terms beyond prorate shareholder ownership (e.g. voting agreements and trusts, guaranteed board positions, etc.).
• Assure that control of the business is passed to the owners’ designated successors; and
• Minimize gift and estate tax consequences on transfer of the principal owners’ interests.
Furthermore, a company’s shareholders are better able to formulate their own estate and personal financial plans when a buy-sell agreement is in place.
A. Shareholder and Buy-Sell Agreements as a Succession Planning Tool
Business law practitioners will be familiar with using shareholder agreements to address issues such as voting control, officer positions, compensation of shareholder-employees, and restrictions on transferability. The buy-sell agreement, which may be a stand alone agreement or incorporated as covenants within shareholder agreement, is a contract entered into by the stockholders of a corporation among themselves or with the corporation itself and it may be structured in a manner which will enhance its utility as a succession planning tool, primarily to limit stock ownership to specified persons as successors to the business. The agreement would provide for the purchase of the stock by either the corporation (redemption) or the other shareholders (cross purchase) on occurrence of designated triggering events. Typically, the buy-sell requirements are triggered by the death of a shareholder, an attempt by a shareholder to transfer the shares to a third party, retirement, disability, insolvency of shareholder, voluntary or involuntary termination of employment, and similar specified circumstances. In addition to specifying the triggering events, the buy-sell agreement also describes the manner in which the value of the share holder’s stock and the sale price will be determined, and the terms of payment of the purchase price. This is important not only to determine the amount the shareholder or his or her successors will receive under the buy-sell. it is also useful in determining the value of the stock for the shareholders’ estate tax purposes or for other purposes that require a valuation of the company’s stock.
Under Reg §25.2703-1(b)(1), the valuation method contained in a buy-sell agreement will be disregarded unless it is a bona fide business arrangement, it is not a device to transfer property to the natural objects of a transferor’s bounty for less than full and adequate consideration, and at the time the agreement is entered into its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction. The requirements of Reg §25.2703-1(b) target family-owned businesses. There is a presumption that if two people who are unrelated to each other enter into a buy-sell agreement, the value agreed on will be arm’s length.
To conform with legal requirements, buy-sell agreements generally use a formula for valuing the stock. Because the value of a company’s stock will inevitably change before a triggering event arises, using a fixed purchase price is inappropriate, unless a provision is made for periodic adjustment of the price. A valuation formula should be multi-factor, considering, e.g., book value, net earnings multipliers, earnings averages and trends, and price-earnings ratios of publicly traded companies in comparable lines of business.
The terms of the buy-sell agreement in general, and the valuation method in particular, should compare favorably with arrangements in a fair bargain among unrelated parties in the same business dealing with each other at arm’s length. Reg §25.2701-1(b)(4). Where buy-sell agreements with formula pricing provisions are used between shareholders of companies with long operating histories, especially those in which minority interests are gifted or sold by senior family members to their children, it is important to consider to include a provision which periodically re-evaluates the pricing terms. Failure to include such re-evaluation may contribute to a challenge by the IRS that a buy-sell agreement is a testamentary substitute rather than a true arm’s length provision. Estate of True v. Commissioner of Internal Revenue (10th Cir. 2004) 390 F.3d 1210. Using a valuation method that satisfies there standards will minimize uncertainty in the estate and succession planning process.
For further information on valuations and buy-sell agreements in general, see Business Buy-Sell Agreements (Cal CEB 2000); Zaritsky, Structuring Buy-Sell Agreements: Analysis with Forms (2008), published by Warren Gorham Lamont.
B. Cross-Purchase Agreements
A cross-purchase agreement is entered into among the shareholders and provides for purchase of the subject shares by other shareholders on the occurrence of a triggering event. One advantage of a cross-purchase agreement is that purchased shares have a basis to the purchasers equal to their cost. Stock purchased by the corporation under a redemption agreement does not increase the basis of shares of corporate stock owned by the remaining shareholders, although the shareholders indirectly bear the cost of redeeming the shares.
It is important for the attorney to discuss funding of the obligation under the agreement. Insurance usually is used to provide the shareholders with sufficient means to purchase the selling shareholder’s stock. Shareholders cross-insure each other. Cross-insurance is most feasible when the number of shareholders is small, e.g., four or less, and may be preferable to redemption. However, the larger the number of share holders, the more cumbersome it is for each to obtain life insurance policies on the others. When the greater portion of a family corporation’s stock is owned by the senior generation, the burden is lessened because only the junior successors carry life insurance policies on the seniors. The seniors frequently do not bother insuring the lives of the juniors because they have fewer shares to purchase and can independently fund the purchase. The senior business owners may assist their successors in acquiring insurance by using an insurance trust, discussed in the following section.
When stock ownership in the family corporation is concentrated in the senior owners, a redemption agreement may be preferable to a cross-purchase agreement.
C. Redemption Agreements
A redemption or entity agreement is an agreement between the corporation and the shareholders that provides for redemption of the subject shares by the corporation rather than the shareholders when the buy-sell is triggered. Completing a redemption is simpler and easier than across purchase, and may be more economical, because only the corporation acquires insurance on each of the shareholders. Moreover corporate funds, pre-tax dollars, are used to purchase the stock of the selling shareholder and to pay the premiums on any life insurance policies.
It is important to consider that, in the case of C corporations, the annual increase in value of life insurance policies and payment of death benefits in excess of the policy’s basis will have alternative minimum tax implications. IRC §56(g)(4)(B)(ii); Reg § 1.56(g) l(c)(5)(v). The impact on accumulated earnings taxes under IRC §§531 and 535 must also be weighed.
D. Hybrid Method
A buy-sell agreement may combine the redemption and cross-purchase methods, granting the corporation a first option to purchase or redeem the shares of the selling shareholder, and if not exercised, granting the shareholders the right to purchase the shares.
Tax Consequences of Redemption
As discussed in Part I of this article, if the stock of the corporation constitutes at least 35 percent of a decedent’s estate, IRC §303 allows the redemption of a limited amount of stock to be treated as a sale or exchange, rather than as a dividend. The redemption may be pursuant to a buy-sell agreement. The amount redeemable under IRC §303 is an amount equal to the total state and federal death taxes, funeral expenses, and administrative expenses. Because the estate’s basis for the stock will be equal to the fair market value of the stock on the date of the decedent’s death (lRC §1014(a)(1)) usually little or no gain is realized. Therefore the use of §303 minimizes the income tax cost of withdrawing funds from a closely held business to pay the death taxes incurred by a deceased shareholder ‘ s estate.
The redemption of additional shares will be treated as a dividend distribution unless the redemption results in a complete termination of the decedent shareholder’s interest in the corporation. The same is true when the shares of stock owned by a decedent shareholder constitute less than 35 percent of the shareholder’s gross estate. IRC §302(b)(3). Therefore, in drafting the buy-sell agreement, the terms of the buy-sell should provide for complete redemption of all the shares held by shareholders whose stock constitutes less than 35 percent of their respective estates. Otherwise, unnecessary tax will result.
For further information and forms of buy-sell agreements, see Business Buy-Sell Agreements (Cal CEB 2000).
XVI. LIFE INSURANCE
A. How Insurance Is Used
To fund a cross-purchase agreement, shareholders generally will purchase term life insurance policies, because term insurance is pure insurance with no investment element and therefore has the lowest cost. A corporation may follow the same rationale in funding a redemption agreement, but when the company is closely held, the corporation’s insurance plans are usually coordinated with those of its principal shareholders.
When the primary asset of a business owner’s estate is the stock of the closely held business, the owner’s estate frequently experiences liquidity problems in the event of the owner’s death. Life insurance is the most common method of providing the liquidity necessary to pay estate taxes and support the family or the business. It is generally advisable for the life insurance policies on the owners of the business to be held by parties other than the insured.
The family business owner may relieve the insurance burden to some degree by having the corporation assume some of the costs. For example, a corporation may adopt a group term life insurance plan to cover its employees on a non-discriminatory basis. Internal Revenue Code §79(a)(1) provides that an employee will not be taxed on the cost of the first $50,000 of group term insurance. The corporation may also pay premiums on term or whole life insurance policies for individual employees and deduct the costs as compensation, if they are reasonable. The premiums will be taxable income to the employee, but the life insurance proceeds will be tax free. IRC § 101.
If the combined value of the gross estate of a client and spouse is less than $2 million there is less urgency for a complex life insurance plan, at least from the standpoint of providing immediately liquidity, because no estate tax will be due on the death of either spouse. When the couple’s estate increases in value to $4 million, they may use the unlimited marital deduction to avoid estate tax on the first death, but should consider using a bypass trust, also know as a credit shelter trust, to utilize the full amount of each spouse’s unified credit and avoid having all assets included in the surviving spouse’s gross estate. (Part I of this article discusses the exemption credit and bypass trusts.) Unless a bypass trust is used, only the surviving spouse’s estate tax exemption amount will be available to cover the combined estate of client and spouse, in which event an insurance policy on either spouse or both spouses (e.g. a “second to die” policy) may be critical to providing the necessary liquidity to the estate.
B. Life Insurance Trusts
Because the proceeds of a life insurance policy owned by the insured will constitute a portion of the insured’s gross estate in the event of his or her death, and will be subject to estate taxes, a common estate planning practice is to arrange for some party other than the insured to own the policy. This removes the cash value of the policy from the insured’s estate. The other party may be the insured’s spouse, child, or other close relative, but greater flexibility and tax benefits are achieved by the use of a trust created by the insured.
In the context of business succession planning, the owner of a closely held corporation may use an irrevocable insurance trust to fund the purchase of his or her stock by the children following the owner’s death. The children would be the named beneficiaries, and, as long as the trust is irrevocable and the owner does not retain any “incidents of ownership,” the value of the insurance policy and its subsequent proceeds are not included in the owner’s estate. IRC §2042. It is essential that the business owner not have any incidents of ownership in the insurance policy, nor retain any interest in the trust. An interest such as any rights to trust income or the ability to use trust assets to discharge an obligation of the grantor will cause the assets of the trust to be included in the grantor’s gross estate. IRC §2036.
With a properly structured trust, the business owner may make tax-free annual exclusion gifts of cash (e.g .• up to $12,000 per donor to each donee/beneficiary in 2008, which shall increase to $13,000 per donor per year in January 2009) to the trust, which may in turn use the cash to pay the annual policy premiums. In this manner, proceeds from the policy will avoid both estate and income taxes. Although the benefits of a life insurance trust are substantial, the cost of life insurance sufficient to fund the cross-purchase agreement may be significant. For example, currently a $6 million permanent (e.g. universal) life insurance policy for a 55 year-old business owner would cost approximately $100,000 a year. A business owner, even when making a split-interest annual exclusion gift with spouse (refer to Part I) may not have sufficient beneficiaries of the life insurance trust to cover the amount of the premiums required to fund the desired amount of insurance. An alternative to consider is entering into an agreement with the family business in which the funds of the business may be used to pay a portion or all of the premiums.
C. Split-Dollar Insurance
If a corporation were to pay the premiums on an ordinary whole life insurance policy for a shareholder or employee, the full amount of the annual premiums would be taxable as ordinary income to the shareholder or employee. Under a split-dollar insurance arrangement, a corporation is able to pay for personal insurance coverage for its shareholders or employees, who are taxed only on the term insurance cost for such coverage. The costs of the insurance are shared, or split, with the corporation, and the corporation is repaid the cost of the premiums from the policy proceeds.
Under a typical split-dollar life insurance plan, a corporate employer enters into an agreement with a shareholder or employee (often through means of a life insurance trust) to pay some or all of the premiums for the life insurance of the employee/shareholder. The employer and employee or shareholder join in purchasing a life insurance policy having a substantial investment element, usually a whole life policy, but sometimes other types of policies that build up cash value, e.g., universal life, variable life, adjustable life. The corporation recovers the amount of its premium payments from the death benefit of the policy or, if the policy is terminated or surrendered, from the cash value of the policy.
The Treasury Department re-wrote the rules on split dollar insurance arrangements with the adoption of the final regulations, Treasury Regulations Sec. 7872, et. sq. which became effective on September 17, 2003, and apply to all split-dollar arrangements entered into or “materially modified” after that date. Split-dollar plans in effect prior to the adoption of the final regulations will be governed by IRS Notice 2002-8. While the final regulations resolved many open issues on the subject of split-dollar insurance, the rules are quite complex.
In adopting a split-dollar plan, the corporation and the employee must follow either an “economic benefit regime,” in which the employer owns the policy and pays the insurance premiums while allowing the insured the employee to designate the beneficiary, or a “loan regime,” in which money is loaned by the employer to the to the insured employee who owns the policy, pays the premiums, and pledges the policy as collateral for the loan.
Under the economic benefit regime, the value of the life insurance coverage, net of the premiums paid by employer, is taxed to the employee as imputed income, based on annual renewable term insurance rates. The employee pays income tax on the imputed income. The employer owns the entire cash surrender value of the policy. If the employer transfers the life insurance policy to the employee, the transfer will be taxed as additional compensation.
Under the loan regime, the employer and employee enter into agreement which typically provides that the insurance premiums paid by employer will be treated as an accumulating loan to the employee with the loan to be paid off in the future either from the cash value of policy (which belongs to the employee) or from the proceeds of the policy in the event of death. In the meantime, interest is not charged on the loan but is instead imputed at an interest rate equal to the applicable federal rate (“AFR,” published monthly) based on the term of the loan, under the rules of IRC §7872. The insured employee pays income tax on the imputed interest on the loan.
Mr. Clark owns 60 percent of the common stock of Clark Family Enterprises, Inc., a distributor of industrial hardware. The remaining shares are owned equally by his brother and sister. Mr. Clark, who is 55 years old, would like his son to join the family business after he graduates from college, and eventually to succeed him in the family business. However, because his son’s career goals are uncertain and he and the other shareholders have not yet discussed business succession issues in any detail, Mr. Clark is not prepared to take specific planning actions at this time. Mr. Clark believes that purchasing a $6 million universal life insurance policy will be sufficient to cover his present estate planning needs and decides to do so using a split-dollar arrangement, electing a loan regime method under which the life insurance policy is pledged to Clark Family Enterprises, payable upon the death of Mr. Clark or during his life if sufficient value accumulates in the policy.
Mr. Clark creates an insurance trust to own the policy on his life, designating his two children as beneficiaries. The annual premium is $100,000, the total premium to be paid by the corporation under the split-dollar arrangement. If Mr. Clark were to die after five years, the insurance trust would collect the $6 million in insurance proceeds and repay the corporation the premiums it has paid, which total $500,000, after which it would have $5.5 million, tax free, to be used for estate liquidity.
In the meantime, Mr. Clark will have paid income taxes on the economic benefit he received during the five years. Because the loan is payable on death of the insured, Reg. Sec. 1.7872-15(e)(5) will apply, in which case imputed interest income will be calculated like a demand loan with a fixed interest rate. The AFR term will be based on the life expectancy of Mr. Clark under the tables set forth in Reg. Sec. 1.72-9., with a life expectancy of 21.7 years, the long term AFR will apply.
If Mr. Clark creates an irrevocable life insurance trust (“ILIT,” refer to Part I) to own the policy, with his son and daughter as the beneficiaries, the company will be deemed to be making an indirect loan to the ILIT as if the funds were first loaned to Mr. Clark who then re-loaned the funds to the ILIT. Mr. Clark will pay tax on the imputed income and the imputed income will be treated as a gift to the ILIT beneficiaries by Mr. Clark. Since the gift in this case would not be a direct gift of cash it could be construed as a gift of a future interest which would disqualify it under the annual gift exclusion, the consequence being that a portion of Mr. Clark’s lifetime exclusion might have to be applied in order to avoid a gift tax (refer to annual exclusion gifts in Part I).
Given the complexity of the split dollar final regulations, there are numerous variations on the above theme, each of which have varying income, gift and estate tax consequences. Close coordination between the lawyers, accountants and financial advisors is therefore essential.
Reverse Split-Dollar Insurance
In a “reverse split-dollar” arrangement, the roles of the corporation and shareholder are reversed and the corporation, with the assistance of the shareholder, is the primary recipient of the insurance proceeds on the death of the insured. The corporation may use this technique to provide insurance coverage for a key person to fund a redemption type of buy-sell agreement. Under this type of plan, the shareholder, or his or her insurance trust, owns the policy, pays the premiums, and “rents” all or a portion of the death benefit to the corporation. The corporation pays rent in the amount of economic benefit of the insurance coverage provided. This arrangement was previously beneficial to the employer in instances where the shareholder’s after-tax cost for the insurance was less than the corporation’s cost.
However, this technique was for nullified for all practical purposes upon the adoption of the Final Regulations, Sec. 1.61-22(f)2(ii), which provides that any amount paid by a non-owner to the owner of a life insurance policy for current life insurance protection is includable in the owner’s gross income.
While business succession planning draws upon techniques with which the business law practitioner is familiar, it differs from the usual stand-alone transaction based practice by being drawn out over longer periods of time and the need to periodically re-visit and modify the plan according to the financial and wealth distribution objectives of the senior generation of business owners as well as the changing relationships between the members of the senior and successor generations.
It is important to start the process early and to monitor it continuously in order to optimize the chances for making a successful transition of the business from one generation to the next.
At the time this article was published in 2008, the authors were aware that substantial changes in the estate and gift tax laws were imminent because of the provisions of Economic Growth and Tax Relief Reconciliation Act of 2001 then in effect which “repealed” the federal estate tax and generation skipping transfer tax for 2010 and which provided for a return of these taxes in 2011 unless Congress took other action. The EGTRRA-2001 created a window of opportunity in 2010 by which large estates could be passed from one generation to the next without estate tax and in fact a number of wealthy and prominent people died in 2010 and their estates are now positioned capitalize on it.
Under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (PL 111-312, “TRA 2010”), which became effective on January 1, 2011, the estate tax was restored but the amount the of a taxpayer’s estate exempt from tax was increased to $5 million per person with a maximum estate tax rate of 35%. IRC §2010. In the case of husband and wife, a surviving spouse is now entitled to apply any unused portion of the deceased spouse exemption to the surviving spouse’s estate, the so called “portability rule” (IRC §2010(c)) which enables a married couple to transfer up to $10 million of their estate without the imposition of estate tax.
Since the estate and gift tax exemptions are unified, a $5 million gift tax exemption per person is available, also at a maximum gift tax rate of 35%. The exemption from Generation Skipping Transfer Tax is also set at $5 million at a tax rate of 35%.
All of which substantially expand the options for estate and business succession planning. although the $5 million exemption amount ($10 million for husband and wife) substantially increases the size and number of businesses that can be passed free of estate tax, important non-tax reasons remain for business owners to establish and implement a plan.
In addition, under circumstances which promise to repeat the uncertainty that existed in 2010, the provisions of TRA-2010 will be in effect for only two years, which make it all the more important for business owners and their advisors to take advantage of planning opportunities which presently exist. After 2012 it is possible that the exemption amounts for estate, gift and GST taxes will decrease and that the applicable tax rates will increase.