Estate Planning For Closely Held Business Owners

As a business owner, often your major asset and greatest source of income is the closely held business.  And, in many cases, your concern is to pass that productive asset to younger generations and provide a livelihood for family members.  Such an objective, however, entails numerous tax and non-tax considerations

Consequently, deliberate planning of tax and non-tax considerations is paramount in order to unlock value for your use and to facilitate the transfer of the business to successor generations.

Establishing A Buy-Sell Agreement

Regardless of the type of entity (e.g., corporation, partnership, limited liability company, limited liability partnership or professional corporation), an agreement should be considered between or among the owners that concerns:

  1. management of the entity;
  2. rights to transfer interests in the entity.
  3. transfers during an owner's lifetime due to voluntary or involuntary withdrawal of employment from the entity;
  4. transfers due to death;
  5. transfers due to disability;
  6. payment terms; and
  7. other issues related to the entity.

Importantly, the agreement also dictates the method of valuing the business interest.

Entering into such an agreement at the time the business is formed or shortly thereafter (which can be amended at a later date to address subsequent issues) offers significant benefits.

If there is a dispute between co-owners or a deceased owner's family and other owners, or if an owner wishes to transfer his or her interest in the entity to a fellow owner, the agreement provides for a predetermined price or formula to determine the price.  This prearranged price exists to promote an amicable resolution if an owner desires or needs to leave the business or dies.  In the event of death, a "bargain sale" can be avoided.  Finally, the Internal Revenue Service is more likely to accept the purchase price as the value for income and/or estate tax purposes if the value represents a negotiated, arm's-length transaction.

A buy-sell arrangement can also protect ownership interests from an estranged spouse's claims in the event of a divorce or marital separation. In most cases, the courts will honor an agreement restricting the transfer of a business interest to a person not involved in the business and will award other assets to the spouse.

Once a buy-sell agreement is established, you as an owner can better plan the transfer of your interests to other family members.

Tax Issues In Business Succession Planning
There are significant tax considerations in transferring interests of a closely held business to family members.  Proper planning is essential to ensure that the entity stays intact for the younger generation.  Lack of planning or improper planning can have disastrous estate and gift tax results that might even require the sale of the business in order to pay these taxes.  This is especially true if the estate taxes attributable to the business exceed any available liquid funds to pay them.

There are numerous estate planning techniques that can be utilized in order to safeguard the closely held business and to help transfer the property to younger family members while minimizing any estate and gift tax consequences.

One technique is to use the "marital deduction". A business owner can transfer an unlimited amount of assets to his or her spouse (a U.S. citizen) without incurring any gift or estate tax if the transfers are made outright or in a marital trust during their lifetime or at death. (However, at the death of the surviving spouse, the property will be subject to estate tax.) Second, an owner could choose to utilize all or any portion of his or her Lifetime Gift Tax Exclusion Amount of $1 Million. This effectively permits the gift/transfer of property of $1 Million in value by a business owner during his or her lifetime to his or her family members without incurring gift or estate tax. And finally, a business owner may use his "annual gift tax exclusion" to transfer up to $12,000.00 of property each year to each donee (which is increased yearly based upon inflation). (This annual gift tax exclusion amount is in addition to the Lifetime Gift Tax Exclusion Amount of $1 Million.)

Choosing to transfer a portion of your interest in the closely held business during your lifetime involves issues of control, which must be addressed directly and honestly. If you are agreeable to transferring part or all of your interest in the business, then certain planning techniques can be initiated. One virtue of a transfer during your lifetime is that, if you expect the business to appreciate in value, then all the appreciation after the gift is made will not be subject to estate or gift tax.

Lifetime Transfers Of Business Interests
Begin by obtaining an appraisal from a qualified business appraiser or a qualified certified public accounting firm to better determine the value of the business, which affects the tax consequences of any transfer.  There are numerous options available for transferring gift interests in the family business.  These options can take the form of:

  1. outright gifts equal to the annual exclusion ($12,000 to each person or $24,000 if the business owner has a consenting spouse which is increased yearly based upon inflation);
  2. outright gifts greater than the annual gift tax exclusion which would reduce the Applicable Federal Estate Tax Exclusion Amount available at death;
  3. gifts in trust to family members which would reduce the Applicable Federal Estate Tax Exclusion Amount available at death (unless the beneficiaries had certain rights to withdraw property from the trust);
  4. Gifts of interests in a family limited partnership (FLP) or limited liability company (LLC);
  5. transfers of all or a portion of the business interest into a Grantor Retained Annuity Trust ("GRAT");
  6. transfers of all or a portion of the business interests into a common law Grantor Retained Income Trust ("GRIT") if the beneficiaries are not the owner's descendants or spouse.

There can be considerable flexibility with lifetime gifting programs. The interest in the business can be transferred outright or placed in trust for the benefit of a younger family member. The trust can be either an inter vivos trust (established during the owner's lifetime) or a testamentary trust (set up under the owner's Last Will and Testament). The inter vivos trust can either be revocable or irrevocable. In a revocable trust, the transfer is not considered a completed gift since the owner can amend or revoke the trust. If the trust is irrevocable, the transfer may be considered to be a completed gift, and the property may be subject to gift tax.

Your desire to continue to maintain control of the business may dictate whether the property is placed in an inter vivos or a testamentary trust. If you are willing to forfeit control of the property, then the property can be transferred into an irrevocable inter vivos trust with any post-transfer appreciation passing free of estate and gift tax (in most circumstances).

Discounting
When a business owner gifts partial interests in the business to family members, the value of those interests may be reduced by lack of marketability and/or minority discounts.  A lack of marketability discount is a reduction in the value of the property due to the difficulty or inability of the owner to sell the property to a third person.  A minority discount is a reduction in the value of the property since the interest does not provide for control of the entity.

By way of example, if a business owner transfers an interest in the business valued at $18,000, the business owner may use lack of marketability and minority interest discounts and reduce the value of the gift for gift tax purposes from $18,000 to $12,000.  The gift originally valued at $18,000 is reduced to $12,000 and thus qualifies for the annual exclusion.  If the property was transferred at death to the younger family member, the property interest would not be reduced by the discounts, and the entire $18,000 interest would be subject to estate tax - an argument in favor of making lifetime gifts.  Such a gift-giving plan can be used on a much larger scale to derive greater benefits.

Family Limited Partnerships (FLPs) And Limited Liability Companies (LLCs)
An effective estate planning device for closely held businesses is the FLP.  A general partner and limited partners form the limited partnership.  Typically, a senior generation family member and business owner transfers assets to a FLP.  Typically, one or two percent of the business is owned by the general partner with the balance of the business transferred to the limited partnership interests.  The general partner, controlled or owned by the senior generation family member, manages the limited partnership.  Since the general partner typically is a corporation or LLC, the senior family members are insulated from personal liability but can also control the flow of income to the limited partners.  In addition, as general partner and original owner of the limited partnership interests, the senior members can restrict transfers to younger family members.  Furthermore, the limited partnership agreement and applicable state law restricts the transfer of the limited partnership interests so the limited partnership interest cannot be attached by creditors.  Consequently, when senior family members gift their limited partnership interests to younger family members, they can utilize substantial discounts for lack of marketability as well as lack of control (minority discount).  The limited partnership interest can be discounted by as much as 20% to 40% depending upon various factors such as assets owned by the FLP and restrictions on transferability of partnership interests.

Not only can the business interest be transferred into a FLP but real estate owned by the business owner may be placed into a Limited Liability Company (LLC).  This can also be an effective way of transferring wealth to a younger generation, again especially due to the use of discounting. 

The use of LLCs are becoming more prevalent in both business and estate planning.  As with FLPs, a senior family member can gift non-voting and non-management interests to younger generation members and receive discounts for gift tax purposes while maintaining control of the entity.

Grantor Retained Annuity Trusts (GRATs)
If a closely held business interest is transferred to a GRAT, the business owner will receive income for a specific term of years, and at the end of the term the business interest will be transferred to the younger generation.  The benefit of the GRAT is that the value of the gift is discounted by the present value of the annuity interest retained by the business owner during the term of years.  In addition, any appreciation in the business interest after the property has been placed in the trust will escape gift and estate tax when the GRAT terminates.  The grantor of the trust must survive the trust term to obtain the gift and estate tax savings.

Grantor Retained Income Trusts (GRITs)
A common law GRIT is not available for spouses and descendants, but it does have fewer restrictions and can provide greater discounts than the GRAT.  Consider using a GRIT to transfer business interests to nieces and nephews, cousins, or other more remote family members.

Special Concerns With GRATs and GRITs
Note:  There are special concerns when using GRATs and GRITs, especially if your business is an "S" corporation.  Please consult with an experienced tax attorney and accountant before transferring "S" corporation interests to a GRAT or GRIT.

Transfers Of Business Interests at Death
Often a buy-sell agreement provides for the disposition of the business interests upon death of a business owner and not just during lifetime.  Typically, an agreement will provide for a specific procedure for transferring the property to family members or non-family members and the amount to be paid for the business interests, if any.

The Efficacy Of Life Insurance
In most cases, the buy-sell agreement will provide that the business interest is purchased with life insurance proceeds.  Typically, the business owners all own life insurance on each other's lives.  The surviving owners use the life insurance proceeds to buy out the deceased owner's interest.  This is known as a "Cross-Purchase" plan.  An alternative approach, the "Entity" plan, involves the business owning life insurance on the deceased owner's life.  At death, the business then purchases the deceased's interest using the insurance proceeds.

If the corporation receives the life insurance, special care may be needed to avoid unwarranted income tax effects.  For instance, in a "C" corporation, an alternative minimum tax may be imposed depending upon the corporation's pretax profits and preference items for income tax purposes.  Suppose, for example, a $150,000 alternative minimum tax will be paid on $1,000,000 of life insurance proceeds.  This unexpected additional tax might create a hardship for the corporation that has to buy the deceased's $1,000,000 interest with only $850,000 available from the life insurance.

A major concern at death is the effect of estate taxes and the family's ability to pay those estate taxes attributable to the value of the business interest.  In a worst case scenario, the family might have to sell the business in order to acquire sufficient liquid funds to pay the estate taxes.  Fortunately, there are strategies that may help avoid this problem.

  1. Under certain circumstances, a legal representative of an estate can make an election under Section 6166 of the Internal Revenue Code that specifically applies to closely held businesses.  In general, if your closely held business interest is greater than 35% of your gross estate (minus certain deductions), and if the business interests remain with the family, then the Internal Revenue Service will allow the deferral of estate taxes over an additional fourteen year period (instead of 9 months after death).  This deferral gives family members additional time to obtain funds to pay the estate taxes.  However, the Internal Revenue Service charges interest over this deferral period.

  2. Another election is available under Section 303 of the Code, involving shares of a closely held corporation.  This election is known as the "303 redemption".  If the closely held business interest is greater than 35% of your gross estate (minus certain deductions) and the business interests remain with the family, then the legal representative may elect to have the stock redeemed in order to pay estate taxes without incurring income tax liability on a partial redemption of the stock.

Each of these strategies, however, contains negative aspects. The installment plan adds an additional burden of interest payments. The "303 redemption" exposes one to market risk and may not be available if the corporation has insufficient capital surplus.

Insurance on the life of the owner, owned by and payable to a trustee of a life insurance trust, can avoid these problems. Upon the death of the business owner, the trustee of the life insurance trust receives life insurance proceeds that should not be subject to estate tax. The proceeds can be used to pay the estate tax attributable to the interest in the closely held business. If the business owner is married then a "second to die" or "last to die" insurance policy on the life of the business owner and his or her spouse can be purchased by and payable to a trustee of a life insurance trust to provide the liquidity needed to pay estate taxes attributable to the closely held business interest at the death of the surviving spouse. This approach can even be used in conjunction with the elections under Section 6166 or 303 of the Code.

The benefit of combining the use of life insurance proceeds and electing the deferral of payment on estate taxes under Section 6166 is that the life insurance proceeds can be invested and made available for the payment of the estate taxes as they come due.

If a legal representative of the estate elects a 303 redemption, life insurance proceeds can help pay the estate taxes rather than relying solely on the corporation's capital surplus. In the absence of sufficient surplus, life insurance can help pay the balance of the estate taxes due.

Conclusion
Whatever plan or plans are used, during lifetime or in conjunction with planning after death, you should take deliberate measures in order to minimize the estate and gift taxes so that your closely held business interest does not create hardships for the remaining family members.  The plan should offer the greatest potential for an integral succession and the business owner must always consider the following:

  1. Determine family objectives.
  2. Have business interests valued if interests are transferred consistent with a buy-sell agreement or are to be gifted.
  3. Enter into a "buy-sell" agreement, as appropriate.
  4. Make gifts either outright, in FLPs, LLCs or in trust.
  5. Evaluate life insurance needs.  Have insurance held in an irrevocable life insurance trust.