In estate planning, this phrase refers to planning to transfer business ownership and control to the right persons while minimizing the tax cost. The concept usually applies to closely held family-owned businesses.

A business is owned by a father whose wife will probably survive him, or both spouses own it in a typical situation. They have children who they wish to share equally in their wealth after their deaths. However, not all of the children can run the business, nor are they interested in doing so. The company comprises most of the parents’ assets.

The parents want to retain control of the business up to the date of their death or at least up to the date of their retirement. After they give up control, they want to retain a right to income. Since the children have to share equally and the business is the bulk of the estate, they will all get an interest in the company. However, maybe only one of them should be put in control. That one, however, may pay him or herself very well and not distribute any funds to the other children. If they are all in control, they may fight over the business.

One way to solve all these problems is for the parents to sell the business while they are alive. If none of the children can run the company, this may be necessary anyway unless plans can be made to hire a qualified manager. The cash from a sale is easier to divide. On the other hand, it (or the securities it is invested in) will be valued in the parents’ estate market. Transferring business interests to children allows for some estate tax savings by using lower values for tax purposes. If the children are going to wind up owning the business, then consideration must be given to how it will be structured to allow one or more to run it while the rest are protected. Voting and non-voting interests can be used to allow equal ownership but not equal control. Contractual arrangements can be instituted, such as a shareholder’s agreement. This can set restrictions on the transfer of the stock, provide for buyouts, call for income distribution, and provide a framework for handling a variety of business issues.

Another technique is to give the business to one child and require him to pay the other children for it. The assets of the business can also be divided and given to the children in different proportions – or with different control mechanisms. For instance, all the children may be given equal voting interests in the real estate used by the business. But, at the same time, only one may have control over the business itself (while the other children have equal non-voting interests). Or one child may be given the real estate while another gets the company.

Provisions can be made so that the voting stock goes to only one child on the death of both parents. Other assets could go to the other children to equalize their inheritances. Life insurance, for insurable parents, can sometimes be useful. It is an ideal asset to remove from a parent’s estate because it can be given away to an irrevocable trust for the children at its cash value (or close to that) instead of its face value. When a policy is new, that cash value is low. The insurance proceeds can be used to pay estate taxes. For example, they can be paid to children who didn’t get the business. Or the proceeds can be used to purchase company stock from the parents’ estate.

The transfers of the interests can be made by gift while the parents are alive or at death. Or they can be transferred by sale. Lifetime gifts and sales both result in post-transfer appreciation in value of the interest being removed from the parents’ estates. However, the gifts require the gift tax to be dealt with. The sales do not. There are two tax-free categories of gifts. One is the annual exclusion gift. In 2009 $13,000 per year per donee is excluded. If a spouse joins, this is doubled. This means parents can give $26,000 per year to each child with no gift tax consequence.

The other is the $1,000,000 tax-free amount under the gift tax. This is a lifetime amount, and any of it used is subtracted from the amount that passes tax-free under the estate tax. Using annual exclusion gifts and the one-time tax-free amount, a substantial share of a business can be tax-free to children. In addition to these two tax-free opportunities, minority and non-voting interests in businesses or business assets can be given away at discounted values. For instance, a 10% non-voting interest in an operating company may be valued at only 7% of the value of the whole business under the theory that the lack of control makes it worthless.

These features of the gift tax are ideal for some business-owning parents. They make a large gift of non-voting stock in the business to their children, to begin with. The appreciation in value after that is out of the parents’ estates. Then they give $26,000 of non-voting stock to each child each year. They retain control with voting stock. For each gift, they get an appraisal of the value of the stock, which will usually show a discounted value for the stock.

Several other techniques are also used to transfer business interests while the owners are alive and minimize taxes while still maintaining an income for the parents. One is the GRAT or grantor retained annuity trust. The business or part of it is transferred to a trust which in return promises to pay a set yearly amount to the transferor for a set term. The set yearly amount is like an annuity. At the end of the term, the children get the business interest. This involves no gift, and if the transferor survives the term of the trust, no estate tax. For this type of trust, the transferor is treated as the owner of the trust for income tax purposes, so there is no sale and no capital gains tax.

In a variant of this, the trust does not pay an annuity. Instead, the stock is sold to the trust for a promissory note, and the trust makes payments on the note to the transferor. The grantor is still treated as the owner of the trust for income tax purposes, so payments on the note are not taxable. However, all trust income is taxable to the grantor. For estate tax purposes, the grantor no longer owns the stock. Therefore, it is not in his or her taxable estate at death, although the note is. And the grantor does not have to survive the term of the trust to achieve this result. One drawback of this device is that the grantor will have to give the trust 10-20% of the purchase price to use as a down payment in order for the IRS to agree that there is an actual sale. In addition, this will be a taxable gift, and exemptions must be used.

Both of these trust devices allow parents to give away stock with a variety of tax benefits while still maintaining an income stream. A similar device is a plain and ordinary sale to the children. Or a sale to one child. There is no gift, and appreciation is renewed from the estate. The sale can be paid for with a promissory note, so no down payment cash is needed. All that is left in the parent’s taxable estate is the note. The note can be given to other children on the parents’ death. It is even possible for the note to be self-canceling on the death of the parent. Then there is nothing in the parent’s estate. However, the note will have to call for higher payments to give full value for the stock in this instance.

An ESOP can also be used in business succession planning. An ESOP is an employee stock ownership plan. This is an employee benefit plan designed to invest in employer securities. The owner of the company sells some or all of his or her stock to the ESOP. The ESOP gets the money to pay for the stock from a bank loan. Either the ESOP borrows the money, and the company guarantees the loan, or the company borrows the money and gives it to the ESOP. There are exemptions to the usual benefit plan rules to allow this. The ESOP pays back the loan with dividends on the stock and contributions from the company. Contributions by the company to the plan are fully tax-deductible (up to limits specified in the law). The result is that principal, as well as interest payments on the loan, are deductible.

The owner’s sale proceeds can also be tax-free. Suppose the company is a non-public C corporation. The sale proceeds are invested in securities of publicly traded U.S. companies. The ESOP owns 30% of the company stock after the sale. In that case, there is no tax on the sale proceeds. The owner’s basis in company stock carries over to the new securities. This means that when the securities are sold, the gain gets taxed in full. Therefore the gain does not escape tax; the tax is merely deferred. An exception to this exists if the replacement securities are held until death. The basis is then stepped up to the date of death value in the hands of the estate or heirs, so when they sell, all the pre-death gain escapes tax.

One way to use the ESOP is to sell only some of the stock to the ESOP. The owners can then give the stock he or she retains to the child who will run the business and the money to the other child.
If a majority interest or even all the stock is sold to the ESOP, there are various ways for the owner’s family to retain control. For example, the owner or family members can be the trustee of ESOP, and a management contract can be used. Even if the ESOP has an independent trustee, that trustee is not likely to try to run the company or get another manager if a qualified child is available to run the business.

One benefit of selling a majority interest is that stock retained by the owner may qualify for a discounted value in their estate because it is a minority interest. The use of the ESOP device allows a business interest to be sold tax-free while a child can be placed in control. It also allows an owner to sell a minority interest, something that is usually not possible.

Why not just sell the company to the child who will operate it? That may be preferable for someone who doesn’t want to deal with an ESOP and all its rules, but the sales proceeds are taxable and paid with after-tax dollars (the company cannot deduct the principal.)

A variety of other more complicated techniques are used, but usually only when complications in the fact pattern require them.

What is a buy-sell agreement?

These are often used in estate planning when businesses or farms are involved, especially if there are other owners. All the owners agree to buy out the interest of any owner who dies. This provides cash to the estate of the dead owner for what might otherwise be an unsalable asset and protects the other owners against having to deal with a new owner who they may not want. Sometimes these agreements provide for carrying life insurance to pay for the buy-outs. Buy-outs are also frequently provided for under these agreements if one of the owners wants to sell to an outsider or becomes disabled. These agreements are also sometimes used to fix the price at which business shares are valued in the dead owner’s taxable estate.

Financing of Estate Tax Generated by Closely Held Businesses

Suppose over 35% of a decedent’s adjusted gross estate consists of an interest in a farm or closely-held business. In that case, the estate may qualify for deferred payment of the estate tax generated by that interest. These provisions for deferred payment do not apply to the gift tax, income tax or, with some exceptions, the generation-skipping transfer tax. The maximum amount of tax that can be deferred is determined by multiplying the total tax by the value of the closely held business interest and dividing the result by the value of the adjusted gross estate. The decedent must own 20% by value of the business, and the business must have no more than 45 owners. In addition, the business must be an active one. The management of passive assets will not qualify.

The first installment can be deferred for up to 5 years, and after that, the payments can be made in 10 equal annual installments.

The interest rate is 2% on the portion of estate tax attributable to the business, which is deferred up to $1,000,000, adjusted for inflation. For decedents dying in 2011, this rate applied to tax generated by the first $1,360,000 in taxable value of the interest and the tax on the first $476,000 of value could be deferred at this rate. For 2014 the maximum tax that can be deferred at this rate is $580,000. The amount is adjusted annually for inflation. Any other taxes generated by the business interest are deferred at 45% of the rate applicable to underpayment of tax. The underpayment interest rate is 3% over the short-term federal rate for the previous calendar quarter.

If 50% or more of the business is sold or 50% more of its assets are withdrawn, the deferral ceases, and all unpaid tax is due in full.

IRS can require a bond as a condition of granting the deferral. Alternatively, the estate may give IRS a lien on the business interest.

If the closely held business is a C corporation, the estate may also be able to cause redemption of stock it holds in the corporation to get cash for payment of estate tax. Ordinarily, partial redemption of a large shareholder’s interest in a closely held corporation results in a dividend (ordinary income). Still, the Code allows non-dividend treatment if the value of the stock held by the decedent exceeds 35% of the modified gross estate (includes all transfers for less than the full value within three years of death).

What is a Special Use Valuation?

Assets in the taxable estate are ordinarily valued at their highest and best use at a full fair market value. In other words, in valuing them, it is assumed they will be used in a way that produces the most value. Thus, for instance, 40 acres near a large city may be more valuable as a residential subdivision than as a farm.

The Internal Revenue Code allows an election to be made to value a limited amount of real estate used for farming, held for farming or used in a closely held business at its current use value rather than its highest and best use.

The value reduction under this election is limited to $1,000,000. The amount is indexed for inflation.

The real estate must comprise at least 25% of the adjusted value of the gross estate, and the real estate and personal property used in the business must comprise at least 50% of the value of the adjusted gross estate. In addition, the real estate must pass to the surviving spouse or ancestors or descendants of the decedent.

If the property is sold within ten years of the decedent’s death or the use is changed to a non-qualifying use, the tax avoided can be recaptured.

To qualify for the reduction, the property must have been devoted to the qualifying use for 5 out of 8 years before the decedent’s death. In addition, there must have been material participation in the activity by the decedent or a member of his or her family.

If special use valuation is elected, then other discounts, such as a minority interest discount, do not apply.

This method of valuation is not available for gift tax purposes.

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