As you know, the Internal Revenue Service closely scrutinizes transfers between family members of stock, units, and partnership interests (“Stock”) in any corporation, limited liability company, or partnership that is family-owned (a “Family Business”). The Service has announced proposed regulations that eliminates the use of valuation discounts that would otherwise decrease the estate and gift tax value of such Stock when transferred by sale or gift to family members. If you are considering a gift or sale of Stock in a Family Business, you may want to consider taking action right away to implement your planning.
When Stock in a Family Business is transferred between family members, valuation discounts are commonly applied for, among other things, lack of marketability and lack of control. The lack of marketability discount is based on the fact that a Family Business cannot easily be sold on the open market and is not publicly traded; so, the true value of the Stock is actually worth less than a pro rata portion of the total value of the underlying assets. The lack of control discount is based on the fact that a non-voting interest or a minority interest that does entitle the owner to a vote (but not unilateral control of the entity) is worth less to an arm’s length purchaser than if they could control the entity. These discounts are designed to reflect the true economics of a Family Business from the view point of a third party purchaser.
Valuation discounts have been an effective tool to reduce or eliminate federal estate and gift taxes on transfers of Stock in Family Businesses for many years. The Service, however, has long sought to limit the benefit of this tool. This has been especially true when the Service determines that the Family Business in question has no legitimate “business purposes.” The proposed regulations address the Service’s concerns by eliminating all discounts. We expect attorneys, accountants, appraisal experts, and other planners to comment in the next ninety (90) days about the validity and public policy implications of the proposed regulations. However, the very real possibility is that the proposed regulations will be effective when the final version is published, which might occur in as little as one hundred and twenty (120) days.
The new regulations do basically two (2) things. First, when valuing Stock in a Family Business certain restrictions on liquidation rights are disregarded when such rights lapse after a transfer (for instance if the General Partner of a partnership dies) or if after a transfer the restrictions may later be removed by the transferor or the transferor’s family. Second, any lapse of voting or liquidation rights is deemed to be a transfer to the other family member/owners in the Family Business. Both rules only apply if one (1) or more members of the family has control of the Family Business both before and after the transfer or lapse. Control may occur when certain voting or equity thresholds are met; furthermore, ownership by a particular family member will be attributed to related family members, making it hard not to pass the threshold of control. In plain English, this means that valuation discounts will no longer be available for transfers of Stock in a Family Business to family members.
Existing Family Businesses would not be “grandfathered” under the proposed regulations. Only gifts or sales completed prior to thirty (30) days after the effective date of the final regulations would be exempt from the new rules. It is also very likely that regardless of how broad or narrow the final regulations may be, the ultimate validity of the regulations will be determined through taxpayers litigating this issue in the Tax and Federal Courts. Therefore, once the new regulations are made final, we may not have any certainty in this area for the next several years while legal battles are fought with the Service.
Because of the uncertainty of the new proposed regulations, we recommend that our clients who may be inclined to transfer Stock in a Family Business, whether by gift, sale, or both, consider all of their planning options as soon as possible to determine if they should go ahead with some transfers prior to the issuance of the final regulations. We would be happy to sit down with you and discuss all of your planning options.
One of the most common errors parents can make when doing their estate planning is not making the hard choice as to who they want to serve as their fiduciary. Specifically, parents make the mistake of choosing among their children to serve as their fiduciary instead of choosing a bank or brokerage company with trust powers, or other non-family member.
Parents naturally do not want to show favoritism with regard to their children or indicate they lack any confidence in any particular child. Often, the parent kicks the can down the road by simply choosing both of their kids, or even multiple siblings as co-fiduciaries, even knowing that they may have great difficulty working together. This is a disastrous road to take. Parents should not set their children up for failure if they know their children are not likely to be able to work together.
The following is the most common scenario. Mother, being the last to die, changes her will to make her two daughters co-personal representatives of her estate and co-trustees (replacing her deceased husband who she had named in her prior will). One daughter is strong-willed, the other is mild mannered. The daughters often had problems working together and even routinely fought as youngsters. The mother, however, simply cannot bring herself to choose between her daughters. As such, she wants to “recognize” both by making both daughters co-fiduciaries of her estate or trust. The result? The daughters, predictably, cannot work together and worse, actively take action to hamper and frustrate the other when they need to work together the most. After the mother dies, all gloves are off and the daughters start litigating. The result? Tens of thousands of dollars of the mother’s estate intended to go to the benefit of her daughters is squandered in legal fees—all because the daughters were set up for failure by the mother in her estate plan.
What is the solution? If your estate exceeds $1,000,000, a bank or brokerage company with trust powers is a good solution. A professional fiduciary such as a bank or brokerage company can offer professional fiduciaries familiar with Florida law and who know how to navigate an estate administration and/or trust administration. Having lost a parent is difficult enough, but having to administer an estate or a trust by a person unfamiliar with fiduciary responsibilities can be a burden that may not be appropriate for your children. Moreover, by picking a bank or brokerage company, the parent avoids having to choose between their children so that no one is upset. In essence, you will have given your kids a final gift of having a professional navigate the administration of your estate plan.
If your estate is less than $1,000,000, there are many smaller trust companies and/or certified public accountants that are willing to act as your trustee and/or personal representative. Family harmony can be an important legacy that you leave by considering the simple realities of your family dynamics. If in doubt, choose a third party fiduciary, not your family.
Orlando, FL – Often when a closely-held business (i.e. a non-publicly traded LLC, Partnership, or Corporation, hereinafter “Family Business”) is created there is a single shareholder who owns 100% of the voting units and thus makes all of the decisions concerning the business (hereinafter the “Founder”). As time goes on and this person ages, they will begin to think about their goals for estate planning, as well as what they would like to happen with the business when they are gone.
Generally people tend to favor splitting up all of their assets equally among their descendants. However, when the largest asset is the Family Business, resolving these matters may become very complicated. For instance, it is common that certain children will be involved in the Family Business, while others have nothing to do with it. Further, between the children who are involved in the Family Business, there will often be different degrees of involvement, skill, and dedication. Other issues that frequently arise involve children who have substance abuse problems, or mental health issues. Additionally, there is always the possibility that one or more children will go through a divorce, which could create the risk of ownership of the company being transferred to an ex-spouse. It is also not uncommon for a non-family member to be involved in the Family Business. The Founder may wish to reward their hard work and dedication with partial ownership and/or control of the company.
The purpose of creating a unified Estate and Succession Plan, including a Shareholder Agreement (or Operating Agreement or Partnership Agreement, as the case may be), is to avoid as many of these issues as possible on the front end. Doing so is both good for the family and good for the business. By and large the most important issue for the continued success of the Family Business comes down to who controls the company. Therefore, it is often advisable for the Founder to recapitalize the Family Business into voting and non-voting units. This helps to facilitate the goal of the children having “equal” inheritances in terms of value, while ensuring the Family Business will continue to operate and prosper by allowing control of the company to be separated from the right to income generated by it.
The Shareholder’s Agreement is important because it creates the rulebook for governing the company and will be the foundation moving forward. Dividing control of the Family Business will depend on a variety of factors including the nature of the business, and the experience, age, education, and responsibility of the family members. There are many different ways to define control. On one end of the spectrum, one child will have total control of the Family Business (i.e. control of day-to-day business operations, and the right to do anything with the business that they please). This model works as a continuation of the one created by the Founder. However, the success of the company will depend solely on that one child, and this situation is very likely to create disharmony and friction among the family members. When voting power is shared among family members there can be many different arrangements.
Toward the middle of the spectrum, one child may have a majority of voting power, and thus that child will have control of day-to-day business operations. Other issues may be left to a majority vote, which that child would solely determine, giving them an additional level of control but not total control. And, certain “Issues of Major Importance” will require a “super majority” vote, so that at least one other child joins and agrees with the majority holder.
At the other end of the spectrum, one child may be given 50% or less voting power, and have control of day-to-day business operations as president or director, but other items will be put to a majority or super majority vote, depending on the particular issue.
There can be many Issues of Major Importance, depending on the nature of the business and how the voting control is divided, but often the issues that will be put to a majority or super majority vote include the following:
- Sale or disposition of substantially all of the company’s property, or of any property in excess of a certain value;
- Entering into a lease;
- Creating, modifying , or terminating any agreement affecting compensation of an officer or manager of the company;
- Incurring or refinancing debt;
- Mergers and joint ventures;
- Amendments to the Operating Agreement;
- Filing bankruptcy;
- Dissolution or Liquidation of the company;
- Issuing additional units in the company;
- Hiring of family members;
- Changing the nature of the business;
- Purchasing property in excess of a certain amount; and
- Making distributions or payments to owners or employees of the company in excess of a certain amount, or percentage of book value.
Other issues that the Shareholders Agreement addresses include what events trigger rights to a put or call on voting and/or non-voting units. These can include:
- The permanent mental disability of a shareholder;
- The death of a shareholder (the terms can vary depending on whether life insurance was purchased to facilitate a buyout or not;
- Divorce or separation of a shareholder;
- Retirement of a shareholder;
- Involuntary transfers of units; and
- Transfers of units in breach of the Agreement.
Additionally, the Shareholders Agreement may contain provisions known as “Drag Along / Come Along” rights. The former allows the majority holder to force the minority holder(s) to agree to a sale even if they do not wish to sell. While the latter allows a minority holder who does want to sell to benefit from the same terms that the majority holder has agreed to, even if the buyer is otherwise uninterested in purchasing the minority interest.
The Shareholders Agreement is important due to the wide variety of issues it addresses and because it has the ability to act as a referee among the family members. Thus, no one family member has to “be the bad cop;” the rules are simply the rules and the whole family must follow and respect them. In addition to creating the Shareholders Agreement, it is often advisable for the Founder of the business to begin transitioning control and/or decision making authority away from themselves while they are still alive. This method will allow the people succeeding to control of the company to have a safety net, as well as to allow suppliers, contractors, employees, and clients to get to know the new players in the game. The ultimate goal is for a seamless transition of the Family Business upon the death of the Founder and for its continued success thereafter.
To further expand on my blog post Planning for Succession in your Business dated June 26, 2013, I have outlined the seven steps to a successful business succession plan.
I FAMILY RELATIONSHIP PLANNING
Understanding family issues plays a key role in the implementation of a business succession plan. The business owner must decide who, if any, of the family members will be involved in and potentially become leaders in the business and to what extent such family members should be rewarded differently than other family members because of their contribution of “sweat” equity to the business. It is important to recognize that children who sit on the sidelines will often develop distrust of their siblings working for the business and will desire to be “cashed out” of the business on an equal basis to obtain their fair share of their parents’ estates. If not properly planned for, that desire may place an unreasonable burden on the business. The business owner must also decide the extent of participation of his or her spouse, often of a second marriage, in the business, both financially and as part of management. With an understanding of these planning issues, the owner can proceed with creating the strategic business succession plan.
II BUSINESS STRUCTURE AND OWNERSHIP PLANNING
The foremost planning area involves the structure of the business itself. The business should be structured to facilitate succession planning and to minimize liquidity concerns and potential income and transfer taxes. While an owner may believe that an ongoing business is precluded from changing its structure and ownership due to tax consequences or business considerations, this is not always the case. A business will consider the following vehicles in formulating its preferred structure and ownership for purposes of its strategic business succession plan:
- Is the business structured as a limited liability company, limited partnership, S corporation or other favorable entity and how can the business be restructured, if necessary, without significant adverse tax consequences?
- Do the ownership interests consist of voting interests and nonvoting interests for purposes of control? Even an S corporation can have both types of interests. Is the business owner providing family members that are not active in the business with nonvoting interests, debt instruments, fixed assets subject to a long-term lease or other similar assets that do not provide such members with control of the business?
- Do the minority interest owners or the family members not active in the business have any rights of control over the other participating family members or have rights to “cash out” their ownership interests? These rights must be documented in a shareholders agreement, operating agreement or partnership agreement to which all owners and family members are subject. The agreement should also provide for the rights of family members to acquire ownership interests in the event of divorce, death or termination of employment and should fix a value for the interests.
III BUSINESS MANAGEMENT PLANNING
The business succession plan should contain a strategic plan for the future management of the company. The plan should identify the key employees, whether or not family members, who will contribute to the successful growth of the company as future leaders. The business should obtain their participation in the formulation of the business succession plan and should attempt to secure the continued employment of these key leaders through employment agreements and through incentive compensation vehicles, such as stock options, bonuses, deferred compensation and partial ownership of the business entity. The owner should take such steps as are necessary to ensure that management can continue operating the company without being required to surrender to the demands of family members unrelated to the business.
The owner may also decide not to give management unfettered control of the business. This may be especially true if management consists of certain children who would have the ability to pay themselves significant compensation to the exclusion of the remaining children. If family members were not ready for control, the business owner could designate a transition management group, through a voting trust, family trust or similar vehicle, for the period of time the owner feels is necessary for such members to mature into responsible business managers.
IV RETIREMENT PLANNING
The family should not implement the business succession plan unless it creates a mechanism to provide the owner with financial security for his or her retirement. This aspect of the plan should normally take on greater significance if the founder transfers control of the business during his or her lifetime. To achieve financial security, the family should consider nonqualified retirement arrangements, such as an executive deferred compensation retirement plan, or qualified arrangements, such as pension or profit sharing plans or an ESOP. The owner should also consider installment sales of ownership interests in the business, potentially with a self-canceling feature, and leases of real and personal property necessary to operation of the business, as additional sources of retirement income.
V LIQUIDITY PLANNING
Liquidity issues arise both for the business itself and for the family members who are involved in the business. Liquidity is necessary for the business to meet future contingencies and to create reserves for ongoing capital needs. It may be necessary for either the business or the business partners to meet obligations under a buy/sell agreement. It may also be necessary for the family of the owner at his or her death to meet estate tax obligations and after his or her death to provide additional security and liquidity for other needs. The strategic business succession plan will incorporate planning to meet each of these objectives. If the owner has entered into a buy-sell, operating or partnership agreement with the other business partners, they as a group should consider funding these obligations with key-man life insurance. However, the owner must ensure that any buy-sell provisions in such agreements, which are just as important as the liquidity itself, facilitate the transition of ownership so as to prevent the disruption of the business.
In deciding upon the level of additional liquidity necessary for the family, the owner should estimate the liquidity that will be available after his or her death. This liquidity may arise from the sale of assets other than the family business or from other income-producing assets. This liquidity may also arise from life insurance. The family should also consider implementing an irrevocable life insurance trust (“ILIT”) or a life insurance partnership (“LIP”) as the vehicle to hold the life insurance policies for the benefit of the family. With an ILIT or LIP, the family can shield the life insurance itself from estate taxes (and avoid paying potentially half of the insurance to Uncle Sam) to further increase the liquidity needs arising when they are needed most – the death of a loved one. The ILIT or LIP should be an integral consideration in formulating every business succession plan.
VI TAX PLANNING
Taxes are an important area of discussion for every business succession plan. The family business owner must consider the federal and state income and transfer taxes applicable to the business and the family in creating and implementing the plan. As discussed in the section below, there are several vehicles available to reduce or potentially eliminate estate taxes.
VII ESTATE PLANNING
As a final stage of its business succession planning, the family should revisit its estate plan. The estate plan should serve to compliment the objectives of the business succession plan. It should first contain the standard family and marital shares to take into account the remaining available exclusion from estate and gift tax at death. It may also include trusts or gifts utilizing the federal generation-skipping transfer tax. This latter planning is implemented to pass $5,000,000 of property to future generations without subjecting such property to transfer taxes in those generations.
The estate plan should carry through with the business objectives of transferring ownership during life or at death in a manner that causes minimal disruption in the operation of the business. If the transfers will take place during life, the business owner should determine the optimal manner of gifting business interests, whether outright, in trust or through a family business entity. The estate plan could also be used by the business owner to equalize, whether with business interests or other assets, the “fair” shares of the children of the owner.
The family business owner should also consider more advanced planning techniques, such as a family business entity. This is an excellent vehicle to create a structure for the selective control of assets while allowing all family members to realize income from such assets. The owner should also consider installment sales of business interests and other assets, including sales to trusts, and grantor retained annuity trusts.
Finally, if charitably inclined, a family business owner might consider the charitable remainder trust. This vehicle is a powerful tool that has estate and income tax benefits for the grantor of the trust. The business owner may also consider charitable lead trusts and a family private foundation to further enhance their philanthropic interests.
Family businesses comprise approximately 90% of the businesses in the United States. Yet only about one in three survive to the next generation and one in ten to the third generation. Why? The closely-held family business often fails for the same reason that it originally succeeded. It relies on its uniqueness – the compassion and loyalty among the family members not present in other companies – to generate a dynamic viability to the company. Yet this uniqueness may also lead to distrust within the family and disruption of the family business as an ongoing entity.
To prevent the demise of the business, the family should create and implement a strategic business succession plan. This plan should integrate business, tax and liquidity considerations with the emotional and financial needs of the family and the needs of the business to achieve continuity and growth for the future.
The goals of a business succession plan for each family are unique to that family, but center around several core determinations. The family must decide:
- Who will be the future owners? Will they include key employees? Will they include only family members participating in the business? Who of the owners will retain control?
- How and when will the owner transfer control? Will the business be transferred to the next generation? Are there capable leaders, whether or not family members, to own and manage the business in the future? Or will it have to be sold? Will the business survive the imposition of estate taxes at the death of the owner?
- How will the family harmonize business and family needs? Does the family recognize that the needs of the business to grow, adapt to changes in the marketplace and aggressively face challenges are different from the needs of the family to remain compatible and unified? Will the family remain compatible if certain members receive greater rewards for their participation in the business and what can be implemented to equalize, to the extent possible, the rewards?
- How will the family successfully integrate its personal values and relations into the business without disrupting the ongoing needs and growth of the business? Do the family members communicate among themselves regarding these values and business goals?
- Who will manage the business in the future? Who will control the selection of management personnel and what rights will exist to change management? Will management have too much control? Will management be able to continue operating the business as a viable, successful entity without interruption or demands from family members not involved in the business?
With a general consensus on these core determinations, the family can begin to create its strategic business succession plan. It is often in this planning process that the family will flesh out the answers to some of these questions.
In the wake of the media hype surrounding the fabled “fiscal cliff”, Congress and the President have passed the American Taxpayer Relief Act of 2012 (the “Act”). To assist you in understanding the implications of the Act, the following is a brief yet comprehensive summary of the landscape for federal income, estate, and gift taxes beginning January 1, 2013.
- For single taxpayers with taxable income in excess of $400,000 and for joint filers with taxable income in excess of $450,000, the maximum tax rates for qualified dividends and capital gains will now be 20% (factoring in the 3.8% Medicare tax attributable to Section 1411, the effective rate will be 23.8%) instead of 15%. The maximum tax rate for all other taxpayers remains at 15%; moreover, a zero-percent rate will continue to apply to qualified capital gains and dividends to the extent income falls below the top of the 15% tax bracket.
- A 39.6% rate will apply to joint filers with taxable income in excess of $450,000 and for single taxpayers with taxable income in excess of $400,000 (up from 35% in 2012). Otherwise, the Act preserves all of the tax rates from 2012.
- The Act did not affect the 3.8% Medicare tax which went into effect January 1, 2013. Thus, for single taxpayers with taxable income in excess of $200,000 and for joint filers with taxable income in excess of $250,000, the 3.8% Medicare tax applies to interest, dividends and other investment income as well as income from trades or businesses in which the taxpayer is a passive investor. For example, if a single taxpayer had $150,000 of W-2 income and $125,000 of net investment income, the tax would be assessed against $75,000 which is the excess of the $275,000 AGI over the $200,000 threshold amount for single taxpayers, and would result in an additional $2,850 tax liability.
- The Act results in a permanent increase in the Alternative Minimum Tax (“AMT”) exemption amounts. The AMT exemption amount for the 2013 taxable year is $80,800, less 25% of AMTI exceeding $153,900(zero exemption when AMTI is $477,100) for joint filers and surviving spouses, and $51,900, less 25% of AMTI exceeding $115,400 (zero exemption when AMTI is $323,000) for single taxpayers. For all periods following the 2012 taxable year, the AMT exemption amounts will be indexed for inflation.
- The Act sets the estate and gift tax exemption amount permanently at $5,000,000 per person, adjusted annually for inflation for all periods following the 2011 taxable year. Current inflation data suggests an estate and gift tax exemption amount equal to $5,250,000 for the 2013 taxable year.
The Act continues the reunification of the gift tax and estate tax established in 2010 but increases the maximum gift tax rate and estate tax rate from 35% to 40%.
The Act results in a permanent ability of estates to elect to transfer any of the decedent’s unused exemption amount to the surviving spouse, which unused exemption amount can then be applied against any tax liability of the surviving spouse attributable to subsequent inter-vivos gifts and testamentary transfers.
- The Act extended certain tax benefits including (i) the exclusion of cancellation of indebtedness income resulting from discharged qualified principal residence indebtedness; (ii) treatment of mortgage insurance premiums as deductible qualified residence interest; (iii) two (2) year extension of ability to elect to deduct state and local sales and use taxes instead of state and local income taxes; (iv) non-taxable IRA transfers to eligible charities; (v) two (2) year extension of above-the-line deduction for qualified tuition and related expenses for higher education; and (vi) the $1,000 child tax credit.
- Due to the expiration of the 2% payroll tax cut, the Social Security withholding tax rate on wages earned by employees has increased from 4.2% to 6.2%. For single taxpayers earning wages in excess of $200,000 and joint filers earning wages in excess of $250,000, the Medicare surtax withheld from wages has increased by 0.9% (from 1.45% to 2.35%).
Due to the exigencies of the circumstances and the fact that most of the changes were rate-driven, the Act does not contain much ambiguity. Thus, the Act itself does little to create new opportunities for creative tax planning. However, the new and separate 3.8% Medicare tax might present some planning opportunities.