11. Business Planning

Question 1

Estate freeze rules

Answer 1

can help senior family members of a family corporation or partnership (where family members hold the majority interest) who would like to retain PV and control of the business and pass the baton gradually to the younger generation, by retaining the preferred stock and passing on the business appreciation to the successors

Family Corporation: use voting preferred stock with a fixed liquidation value,*(usually par value).
One or more classes of common stock are created either by forming a new corporation OR recapitalizing an existing one. The recapitalized common stock may be nonvoting or at least have limited voting rights. All or part of this common stock is sold or gifted to the next generation.

Family Partnership/LLC: forming new partnership OR restructuring existing partnership interests that control management and can elect to receive preferred profit distributions but interest must have fixed liquidation value. Remaining non-control partnership interests may be sold/gifted to next generation

Question 2

IRC Chapter 14 (10/8/1990)

Answer 2

how to value interests in corporations and partnerships that are controlled by family members, where the family holds >50% of the value of the corporate stock or partnership interest.

affects the gift tax valuation for lifetime transfers made to family members when partial interests are transferred

Question 3

IRC Section 2701/“Special valuation rules in case of transfers of certain interests in corporations or partnerships”

Answer 3

determines the value of the remaining interest, and whether or not the transfer of interest is a gift for tax purposes

Total value of corporation/partnership-Retained interest= value of residual interest transferred to family member

Question 4

IRC Section 2701 Terms

Answer 4

-Applicable family members: transferor’s spouse, lineal descendant of the transferor or spouse, and the spouse of any descendant.

-Applicable retained interest: A “distribution right,” if immediately after the transfer the transferor and “applicable family members” “control” the entity, or Liquidation/put/call/conversion rights.

-Distribution right: right to distributions from a corporation with respect to its stock or a partnership with respect to a partnership interest, except:
-“junior equity interests” rights, defined as common stock or partnership interests under which rights to income and capital are junior to all other equity interests
“Liquidation, put, call, or conversion rights,” defined as any such right, or similar right, which affects the value of the transferred interest. However, the term does not include any right, which must be exercised at a specific time at a specific amount.
Rights to guaranteed payments from a partnership defined in IRC section 707(c), which are certain payments determined without regard to partnership income.

-Control: at least 50% interest in corporation by vote/value of corporate stock or at least 50% capital/profits in a partnership/holding of any partnership interest as a general partner

-Extraordinary payment rights: retained put, call, conversion rights, and rights to compel liquidation, or similar rights if it affects the value of transferred interest

Question 5

Applicable Retained Interest

Answer 5

-Extraordinary payment rights: discretionary liquidation, put, call, conversion and rights to compel liquidation.
-Distribution rights: Right to distributions from a corporation’s stock or a partnership’s interest, and
-Qualified payment rights: Fixed-rate cumulative payment (that is, cumulative preferred stock periodic dividend) or payment which the transferor elects to treat as a payment. Qualified payments are fixed in time and amount.

Question 6

Minimum Value Rule

Answer 6

value of the interest gifted to the younger generation of the family business: Value of family business - Value of retained qualified payment = Value of gift

Minimum value that can be assigned to the transfer of junior equity interest is determined by:
10% of the total value of all equity interests in the partnership or corporation + the total indebtedness of the entity to the transferor or applicable family member

Question 7

Transfer Taxation of Distributions

Answer 7

Transfer of applicable retained interest is included in estate and death of transferor is considered taxable event. Late payments can be designated as taxable event.
value of the unpaid distribution is added to the taxable estate or taxable gifts of the transferor along with the value of the retained corporate stock or partnership interest

Amount subject to transfer tax is reduced by any amount (unpaid distributions) subject to transfer tax

Question 8

Value of Retained Frozen Interests for Subsequent Transfers

Answer 8

considered double taxation since an interest valued at zero when retained is subsequently valued at FMV when the transferor dies or transfers the retained interest. To avoid this, there is an adjustment to the decedent’s and possibly the transferor’s spouse’s adjusted taxable gifts: by reducing adjusted taxable gifts to reflect the amount by which the decedent’s taxable gifts were increased due to Sec. 2701 over the increase in the estate or adjusted taxable gifts attributable to the inclusion of the applicable retained interest in the estate.

Question 9

Valuation of a Closely Held Business

Answer 9

-Cross-purchase /redemption plans and partnership liquidation agreements have a substantial impact on the valuation of a business, including restrictive agreements. Lower valuation for the business interest may result from retained interests that do not fully participate in the future growth of the business, such as preferred stock and frozen partnership interests, and long-term installment sales. Valuation discounts are available for transfers made to junior family members, such as minority discounts and lack of marketability discounts, which reduce the value of the gifted shares. Other discounts are available to reduce a person’s gross estate such as key person discounts, blockage discounts, and fractional interest discounts.

Question 10

Valuation Discounts

Answer 10

transfers of closely held business interests and family limited partnership interests to family members. Discounts can be taken for lack of marketability and minority interests that reflect the limited public value of the gifted shares, and the limited partner’s lack of control and influence over the company. Shouldn’t be >35-45%

Question 11

Lock-In Discount

Answer 11

when a limited partner cannot withdraw from a partnership and is therefore “locked-in” to maintain his investment.

Question 12

Other Discounts

Answer 12

reduces the value of a decedent’s estate after 2010:
-A key-person discount is taken upon the death of a key employee in a closely held business to compensate for the loss to the business.
-A blockage discount is permitted if a sizeable amount of a decedent’s publicly traded stock would depress the stock’s market price if sold.

Question 13

Fractional Interest Discount

Answer 13

“co-ownership” discount is available at the owner’s death when the fractional interest owned in the property cannot be readily sold.

Question 14

Avoiding Pitfalls

Answer 14

over-reliance on expert valuations, and having gifted property brought back into the estate tax calculation as adjusted taxable gifts.

Question 15

Controlling Interests

Answer 15

premium is added to each unit of stock transferred to limited partners when the collective value of their shares control the business or partnership.

Question 16

Application of lack of marketability and minority discounts

Answer 16

A lack of marketability discount can be combined with a minority interest discount for valuing limited partnership shares. A lack of marketability discount is available for all interests, whether it is a minority or a majority interest. A minority discount is available since minority ownership cannot influence the business, compel dividends, or liquidate the company. Both discounts apply to shares in closely held businesses, not to publicly traded shares on a stock exchange.

Question 17

Business continuation agreements

Answer 17

• agreement between the business and individual owners, either a corporate stock redemption agreement or partnership liquidation agreement, frequently called an entity plan,
• agreement between the individual owners, a cross-purchase or criss-cross agreement,
• agreement between the individual owners and a key person, family member, or outside individual such as a third-party business buyout agreement, or
• combination of the foregoing.

For corporations: Most common: stock redemption plans/stock retirement plans, and shareholder cross-purchase plans

For partnership: partnership liquidation agreement

Question 18

Use of Business Continuation Agreement

Answer 18

-When guaranteed market must be created for the sale of a business interest in the event of death, disability, or retirement.
-need to peg value of the business for federal and state death tax purposes.
-When a shareholder/partner is unable or unwilling to continue running the business with the family of a deceased co-owner.
-When the business involves a high amount of financial risk for the family of a deceased owner and it is desirable to convert the business interest into cash at the owner’s death.
-When it is necessary/desirable to prevent all or part of the business from falling into the hands of outsiders. This could include a buyout of an owner’s interest in the event of a divorce, disability, or insolvency if there is a danger a business interest would be transferred to a former spouse or creditors.
-Where it is desirable to lend certainty to the disposition of a family closely-held business. Rather than relying on will provisions of a parent to transfer the business interest, a binding buy-sell agreement between parent and child could be used.

Question 19

Stock Redemption Plan is more advantageous in the event of

Answer 19

principal owner’s disability, allowing use of corporate funds for the purchase and are more cost effective from a tax standpoint than using personal funds

Question 20

Cross purchase advantage

Answer 20

give the other owners more control over a successor who can manage the business and can also provide big tax advantages for the new owners.value of the business interest for estate tax purposes is pegged by the agreement and usually the company’s tax advisor is consulted about the matter

Question 21

Tax Implications of Stock Redemption Agreements

Answer 21

Since corporation is the owner and beneficiary of the policies, the insurance value is not includable as insurance proceeds in gross estate for federal estate tax purposes; but the proceeds will be used in valuing decedent’s interest in the business unless there is an agreement fixing the price and proceeds are excluded from purchase price

Buy-sell agreement establishes the value of the business if:
- estate is obligated to sell at death
-prohibits shareholder from disposing interest during lifetime without first offering to corp at no more than contract price
-price was fair/adequate/from arm’s length transaction
-price was fixed by terms of agreement

Question 22

Insurance Premiums and Sinking Fund

Answer 22

• Premiums not deductible and not taxable to shareholders, but death proceeds/disability income received income-tax free.
  -Sinking fund may be established to pay for stock redemption

Question 23

Dividend Distribution

Answer 23

Exception to treatment of redemption as dividend:
-redemption of all of a shareholder’s stock since the other shareholder ceases all control

-“family/trust/corporation” attribution rule,

Question 24

Section 303: Stock Redemption

Answer 24

-allows a corporation to make a distribution in redemption of a portion of the stock of a decedent that will not be taxed as a dividend:

-When there is a desire to keep control of a close or family corporation within the decedent-shareholder’s family after death.
-When the corporation’s stock is a major estate asset and a forced sale or liquidation of the business in order to pay death taxes and other costs is a threat.
-Where a tax-favored withdrawal of funds from the corporation at the death of the stockholder would be useful.

Question 25

Section 303: Stock-Redemption (Requirements)

Answer 25

-redeemed stock must be included in decedent’s gross estate for federal estate tax purposes.
-value for purposes of federal estate tax of all stock of the corporation that is included in determining the value of the decedent’s gross estate must be more than 35% of the excess of the value of the gross estate minus the sum allowable as a deduction under IRC Sec. 2053 that is estate expenses, indebtedness, and taxes, and Sec. 2054 that is losses. Gifts of all property made within 3 years of death are included in the gross estate before the percentage test is applied
-only an amount equal to the total of:
-All estate taxes, inheritance, legacy, and succession taxes including generation-skipping transfer taxes and interest thereon imposed by reason of decedent’s death, and
-Funeral and administration expenses whether or not claimed as a deduction on the federal estate tax return can be redeemed and receive favorable income tax treatment, that is, avoid dividend treatment.
-Any excess will be taxed under the rules of IRC Sec. 302. This means any balance may be taxed as a dividend to the seller, the executor or heir from whom the stock is being redeemed, or the balance may qualify for favorable tax treatment, that is, no realization of taxable gain due to the stepped-up basis of the stock upon the decedent’s death.
-A redemption under Sec. 303 will qualify for favorable tax treatment only to the extent that the interest of a shareholder whose stock is redeemed is reduced either directly or indirectly through a binding obligation to contribute toward the payment of the decedent’s administration expenses and death taxes.

Question 26

Section 303: Stock-Redemption (How Is It Done?)

Answer 26

The redemption is protected under Sec. 303 only if it is from a stockholder who is obligated to pay death taxes, funeral or administration expenses, or whose share of the decedent’s estate is reduced by these expenses.

Question 27

Section 303: Stock-Redemption (Tax Implications)

Answer 27

Amount paid is not treated as a dividend- treated as the exchange price for the stock and generally results in no gain being recognized at all by the estate. Exempt from attribution/constructive ownership problems

Question 28

Which are types of business continuation agreements

Answer 28

• Cross-purchase agreement: between individual owners
• Entity plan: between business and individual owners
• Third party business buyout agreement: between individual owners and key person/family member/outside individual
  -Corporations use stock redemption plans/cross-purchase plans

Question 29

In which of the following situations can you use Sec. 303

Answer 29

to take care of death taxes and other costs which could possibly cause liquidation. The other situations where this can be used are when it would be useful to withdraw funds from the corporation on the death of the stockholder and when redemption is desirable.

Question 30

Installment Note

Answer 30

sell a business or other property to family members who cannot afford to pay a down payment or make payments at regular intervals. This is a secured promise to pay with flexible payments, which removes the business and the business appreciation from the owner’s estate.

Question 31

Self-Cancelling Installment Note (SCIN)

Answer 31

structured as an installment sale with a provision that the note will partially or fully cancel automatically before the note matures or at the business owner’s death.
when the business owner does not want the present value of the outstanding installment payments included in his estate at death/is not expected to live long. advantageous when estate tax benefits from excluding future installment payments>additional income tax seller pays on premium received since estate taxes >personal income tax rates

accelerated unrealized capital gain must be reported on the estate’s income tax return at owner’s death (Form 1041)

Question 32

Private Annuity

Answer 32

sale of property or a business to family members who make unsecured, fixed payments to the owner throughout the remainder of his life, received by the seller as a tax-free return of adjusted basis, capital gains, and interest taxed as ordinary income. If the seller dies sooner than his actuarial life expectancy, the unrealized gain will be included on his estate’s income tax return, even though the remaining payments will not be included in his estate.

Question 33

Gift or Sale Leaseback

Answer 33

business owners who do not have sufficient liquidity from their business to transfer funds to family members. Allows owner to gift or sale business property to children then lease it back, providing children with lease payments and the business owner with lease deductions.

Question 34

Family Limited Partnership

Answer 34

business entity that allows general partners the ability to reduce their estates, use discounts to leverage annual exclusion gifts, and maintain control of the business by gifting limited partnership shares to other family members.
-Pros: only %GP interest is included in estate, creditor protection for LPs
-Cons: Cost for attorney for partnership agreement, appraisal and annual tax prep, and GPs are responsible for all debts

Question 35

Limited Liability Company

Answer 35

business entity that allows voting members to reduce their estates, use discounts to leverage annual exclusion gifts, and maintain control of the business by gifting non-voting units to other family members.

Gifts of non-voting membership interests to family members qualify for annual exclusions if they are deemed present interests. These transfers remove the annual exclusion amounts and future appreciation from the managing members’ estates

Question 36

Intra-family Loan

Answer 36

transfer funds to family members which reduces the lender’s estate and avoids transfer taxes if structured properly.
Most family loans, however, are typically structured as lump-sum payments made directly to family members to help pay for first homes, cars, education expenses or new business start-up costs.

Question 37

Bargain Sale

Answer 37

sale for less than fair market value that is part sale and part gift

Gifted amounts that exceed the annual exclusion will be brought back into the seller’s estate as an adjusted taxable gift.

Question 38

A ________________ is a legal, tax-paying entity established under state law that allows senior family members to transfer property to junior family members at significantly reduced transfer costs, to reduce the value of their estates.

Answer 38

A family limited partnership (FLP) is a legal, tax-paying entity established under state law, which is a partnership consisting entirely of family members. The FLP allows senior family members to transfer property to junior family members at significantly reduced transfer costs, to reduce the value of their estates.

Question 39

The IRS Valuation Manual states that the fractional interest discount is generally based on which of the following factors:

Answer 39

Size of the fractional interest
Number of owners
Size of tract and likelihood of partition
Use of land
Access to financing

Question 40

An item of income in respect of a decedent (IRD) may have which of the following tax liabilities:

Answer 40

estate tax
income tax

Question 41

Each installment note payment received by the seller is comprised of which of the following

Answer 41

a tax-free return of capital based on the seller’s adjusted basis,
capital gains, and,
interest taxed at ordinary income rates.

Question 42

Life insurance and disability income premiums used to fund the purchase of an owner’s interest are ___________ to the corporation.

Answer 42

not deductible to the corporation. On the other hand, the death proceeds and disability income proceeds will be received by the insurance corporation on an income tax-free basis.

Question 43

A ________________ is a legal, tax-paying entity established under state law that allows senior family members to transfer property to junior family members at significantly reduced transfer costs, to reduce the value of their estates.

Answer 43

family limited partnership (FLP)

Question 44

Anne, Gloria, and Hank started a small specialty tech manufacturing firm 5 years ago. Each invested $500,000. The company is growing rapidly, and the owners implemented a cross-purchase buy-sell agreement, based on a valuation of $9,000,000. Within a year, Hank died unexpectedly, and the buy-sell agreement was executed. Following the buy-sell, what is Anne and Gloria’s respective basis in the company?

Answer 44

Anne and Gloria each owned a $1,500,000 policy on Hank, and each purchased $1,500,000 of Hank’s $3,000,000 in the company. The $1,500,000 interest each purchased is added to their original basis of $500,000, resulting in Anne and Gloria each having a $2,000,000 basis in the company following the execution of the buy-sell.