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Generally
Many people have existing businesses, and business succession is an
important planning objective. For assets not held in an existing
business entity, sometimes the formation of a corporation, partnership,
or limited liability company can help accomplish estate-planning
objectives, including asset management, asset preservation, and even
estate reduction. Business entities require that certain legal
formalities be observed and that separate accounting records be
meticulously maintained. Creating a business entity is relatively
inexpensive, but maintaining it can be expensive. It can be even more
expensive if it is not done right.
Corporations
Corporations are frequently used to shelter personal assets from the
liabilities of a business. Gifting stock in a family corporation is a
relatively simple way to make gifts. Gifts of minority interests and
nonvoting stock are not only entitled to valuation discounts, but they
entitle the recipient to retain control of the corporation and its
assets. Corporations are separate taxpayers ("C corporations")
unless their shareholders elect to be taxed individually on their pro
rata share of corporate profits ("S corporations").
Limited Partnerships
Limited partnerships can be formed to allow you to make gifts of
partnership interests to family members while maintaining control over
the underlying assets. Partnerships do not pay taxes and do not have to
make special elections in order to be taxed individually on partnership
profits. Partnership interests are usually subject to transfer
restrictions that can justify even more significant valuation discounts
for gift-tax purposes.
Limited-Liability Companies
Limited-liability companies ("LLC's") are relatively new, and
combine the best characteristics of corporations (limited liability of
all members) and partnerships (pass-through of tax benefits). For most
purposes, planning with LLC's is very similar to planning with limited
partnerships.
Giving
Gifts of interests in a family business are usually entitled to
valuation discounts because of lack of voting control and the lack of
marketability. By making lifetime gifts, it is often possible to reduce
a person's interest to a minority share (especially for married couples
owning equal interest), entitling the estate to a valuation discount for
estate-tax purposes.
Gifts of business interests are attractive because the value of such
interests for gift-tax
purposes is less than the pro-rata value. In other words, a 5%
business interest has a fair-market value of less than 5% of the
business' assets because of certain valuation "discounts" that
apply, including a discount for lack of voting control and a discount
for lack of marketability.
A qualified business appraiser is required to determine the extent of
the discount applicable in each situation.
This is more fully discussed in an article entitled "Gift Giving
Using Limited Partnerships and Limited-Liability Companies", which
is in Adobe Acrobat's "portable document format" and requires
the Adobe Acrobat Reader program to view.
Buy-Sell Agreements
Generally
Buy-sell agreements can alleviate disputes that can arise between or
among other business owners and can provide for payments to the deceased
owner's family without disrupting the ongoing business.
Binding on the IRS
If the buy-sell agreement is properly structured, the agreement can
determine the value of the business interest for estate-tax purposes. In
order to be binding on the IRS for estate-tax purposes, the agreement
must be a fair agreement that has an enforceable buyout price that is
fixed or determined in a way that is reasonably calculated to produce a
fair-market price. In other words, a buy-sell agreement cannot be used
to create an artificially depressed price just to save estate taxes. An
"agreed-upon price" is rarely sufficient for estate tax
purposes, so the agreement will usually provide for a price determined
by a formula or by formal appraisal.
"Funding" a Buy-Sell Agreement
A well-designed buy-sell agreement will be "funded" with life
and/or disability insurance to the greatest extent possible, but it will
also address the payment of the purchase price to the extent not funded
by insurance.
Business Succession Planning
One of the most difficult planning decisions relations to the transfer
of an operating closely-held business at death. Sometimes it is
necessary to sell a family business in order to pay the federal estate
tax. A buy-sell agreement (discussed above) can be a useful tool to
provide liquidity at death, but it is not the only tool.
Estate Freezing
The use of installment sales, private annuities, and death-terminating
promissory notes are discussed briefly in the article entitled
"Estate Freezing Techniques".
Charitable Trusts
Some times charitable trusts can be used to carry out a sale of a
business with reduced tax consequences. Read the example in the
"Charitable Trusts" article as though a business were
involved. As mentioned in that article, life insurance is required to
replace the value that passes to charity upon the settlor's death. This
technique will not work unless the deal can be arranged so that the
charitable trust does not receive "unrelated business taxable
income" and so that there is no prohibited "self-dealing"
between the charitable trust and its settlor (or persons and entities
related to the settlor).
Gift Combined with a Sale to a Grantor Trust
For clients who want to transfer a business to their children or other
beneficiaries, it is possible to transfer part as a gift and part as a
sale. This works best with a business that is organized as a
"pass-through" entity for federal income tax purposes, such as
an S corporation, a partnership, or a limited-liability company.
Step One
Create nonvoting interests. The company should be reorganized with a
nonvoting class of ownership. For limited partnerships and
limited-liability companies, this step may be unnecessary because state
law provides that transferees are not substitute partners or members,
and they automatically have no vote.
Step Two
Create a "grantor trust". Establish a trust that is considered
a "grantor trust" for federal income tax purposes but that
will not be included in the settlor's estate for federal estate tax
purposes. A "grantor trust" is a trust over which the settlor
(grantor) has some powers that cause the trust to be ignored for income
tax purposes. The settlor pays all income taxes on the income of the
trust, even if the trust is either accumulated in the trust or
distributed to other beneficiaries. [NOTE: Some commentators call this
an "intentionally defective grantor trust", but I dislike that
term because there is nothing "defective" about it. It is
simply a grantor trust that was intentionally designed to be so.]
Step Three
Give cash or business interests to the trust. The trust should be funded
with cash or other assets so that he has some of its own assets. A rule
of thumb is to contribute 10% of the value of the business that is going
to be purchased. So, if your business has a net worth of $1 million,
make a gift of $100,000 to the trust. If the gift involves business
interests, because to have a business appraiser establish a fair market
value of the gift using a valuation discount based on lack of voting
control and lack of marketability.
Step Four
Sell the nonvoting business interest to the trust. To establish the
purchase price, be sure to use a qualified business appraiser establish
a fair market value of the interest being sold based on a valuation
discount based on lack of voting control and lack of marketability. The
trust will provide a promissory note to the settlor, and the trustee
will make payments on the note until the note is paid off. [The note
should not be forgiven or ignored. The IRS will ignore the note and
treat the entire sale as a gift unless the note is paid under reasonable
terms.]
For businesses with a cash flow that is sufficient to pay its operating
expenses and to pay income to the owner (the trust), this technique will
allow the next generation (or whoever the beneficiaries are) to receive
part of the business at a discounted gift-tax valuation and to purchase
the balance of the gift at the same discounted price.
 
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