FINAL REVIEW Flashcards
Reasonable Salary & Bonuses
deductible to corp, taxable to employee
Paying unusually large salaries to business owners is NOT considered an appropriate adjustment to earnings (disguised dividends which would NOT be deductible)
Owner/Executive/Key Person Additional Compensation Plans
Cash bonus plans are not subject to nondiscrimination rules generally applicable to other benefits
Equity split dollar life insurance plans generally pay a DB to the ER equal to the lesser of the ER’s premium contributions or the policy’s cash value
Reasonable Accumulated Earnings
Earnings in a corp can be accumulated at reasonable levels for business purposes, meaning taxation to the owners can be deferred
The accumulated earnings tax (beyond minimum credit) does not automatically subject a business to excess earnings if they can prove a valid and acceptable business reason
LLCs Operating Agreement
LLCs (limited liability companies) organized under state law and must have an operating agreement in writing
Avoiding Estate Tax on Section 162 Plan
Estate tax inclusion of an ER provided life insurance sec. 162 plan can be avoided if an irrevocable trust is the applicant, owner, and beneficiary of the policy
Math: Sec. 162 Double Bonus or Zero Tax Calculation
Taxable bonus divided by 1 minus EE tax rate
Partnership Liquidation with NO Buy/Sell Agreement
a deceased partner’s heirs can force the partnership to liquidate
Surviving partner(s) becomes liquidating trustee(s); they may not seek new business from existing customers; MUST account for all partnership profits
Two Partner General Partnership
an equally owned two-partnership GP does not mean that all partnership assets are owned 50% each; but it does mean that at the death of a partner, the other partner becomes a liquidating trustee
Value of Deceased Partner’s Interest for Estate Tax
in establishing the value of a deceased partner’s interest for federal estate tax purposes under a buy/sell agreement w/ unrelated partners, the agreement should contain a first offer option during lifetime to prevent a lifetime sale above the buy/sell price at death
Stock Attribution Rules
Shares of stock in a partnership are considered as being owned proportionately by the owners
Shares of stock owned by an estate are considered being owned by a beneficiary w/ a 100% direct present interest in the estate
S Corporation (Miscellaneous)
S corp shares may be transferred to family members who are not actively involved in the business
A voting trust can be an S corp shareholder
Premiums for life insurance funding in an S corp stock redemption plan are paid out of the taxable income of the S corp
T or F: The estate and the beneficiaries can take advantage of a Sec. 303 stock redemption
True
Section 303 Stock Redemption
Allows corp to purchase stock w/out any adverse income tax effect to cover federal estate taxes, state estate or inheritance taxes, and funeral costs
Does NOT allow stock sales to corp to pay taxes due on the final income tax return of the deceased business owner; and the stock does NOT have to be redeemed before the estate tax return is filed
Family attribution rules do NOT apply to a Sec. 303 redemption
Book Value/Intangible Assets/Goodwill
Book value of a business entity is the excess of business’s total assets over total liabilities
Intangible assets that tend to increase value of a business above its book value include the reputation of the business, quality of the management, and the ownership of a brand name
Goodwill = a business’s earnings in excess of a fair ROR
Selling a Business
When business is sold, selling price need not be a predetermined exact or fixed amount, and the payment for the business need not be in cash
When a business liquidates, accounts receivables are not included at 100% and goodwill is not typically included as a significant part of the business’s value
Selling a Business: Capitalization of Earnings Method
Capitalization of earnings method uses weighted avg of last 5 years business earnings divided by an appropriate ROR
Business Interruption Insurance
Can replace business earnings lost d/t peril involving machinery and equipment; NOT losses d/t adverse business conditions
Miscellaneous
Corporations can and often do have only 1 shareholder
Corporations do not have to be incorporated in every state where they conduct business
Limited Partnerships must have general partners and limited partners
A Sole Proprietor files just one tax return for both business and personal income
T or F: Tax free stock recapitalization of a corp can provide preferred stockholders w/ a steady dividend income
True
Preferred Stock
does not usually share in the growth of the business
Right to income = YES
Priority @ liquidation = YES
Restrictions that affect value = YES
Share in growth = NO
Uses of Preferred Stock
Uses of preferred stock issued as a dividend or issued in a recapitalization:
a. The preferred stock can be used in a Sec. 303 stock redemption
b. The preferred stock can be gifted w/out diluting control of the corp
Issuing Nonvoting Common Stock (NVCS) in a Recapitalization
NVCS is received by existing shareholders w/out current income tax
NVCS can be redeemed by corp via Sec. 303 w/out affecting voting control
Transfers of NVCS can be made to a shareholder’s children w/out reducing the parent’s control of the family corp
NVCS gifted to successors will benefit from future appreciation equally with the voting stock
The voting common stock retained by the parent after a gift of the NVCS will give the parent control
Nonvoting stock is typically discounted as a minority interest
Insured Disability Buy/Sell Agreement
In an insured corporate or partnership disability buy/sell agreement, definition of disability should match definition in the insurance policy and a mandatory period of time of disability should be stated for the sale
Premiums are NOT deductible
If there is a lump sum paid to a disabled shareholder/partner, does NOT qualify for step up basis
Primary Purpose of Closely Held Corporation Buy/Sell
To protect shareholders from an unwanted sale to outside interests if a shareholder wants to sell their stock
Installment Payment Interest Rate
IRS will NOT accept whatever interest rate is chosen to be used in the installment contract on which the seller and buyer agree
There is imputed interest and rates published by the Treasury; the AFR (applicable fed rate) a low rate, may be used depending on the terms of the agreement
Tax-Free Asset vs. Tax-Free Stock
A buyer will prefer a tax-free asset purchase over a tax-free stock purchase because the asset purchase would receive a higher potential basis
Math: Capitalization of Earnings Method for Value of a Key Employee
Determine amount of excess earnings by dividing the tangible assets by expected ROR
Excess earnings divided by expected ROR equals the value of key employee
Key Person Life Insurance
The DB should be selected to reflect the key person’s value to the business
Corp must provide notice to key person and obtain the key person’s consent
Policy can be used to fund a NQ deferred comp plan w/ retirement benefits if the key person lives to retirement
Corp owns the policy, pays the premiums and is the beneficiary
Premiums NOT deductible to corp as a reasonable business expense
Key person’s value to the business cannot be forecasted indefinitely
Documents of Organization and Tax Filing Status
Ccorps/Scorps/LPs required to file documents of organization; GPs are not required to do so
Ccorps/Scorps/partnerships have either a separate tax status or file an informal tax return; SPs do NOT
Corporate Form of Business
Provides continuity of the business, limited liabilities to shareholders, transferability of ownership interests and lower marginal tax rates
NOTE: at complete corporate liquidation, a corporate distribution of property to shareholders generally recognize gain in the property for which they pay income tax
Corporate Directors
Assume no contractual liability for legal contracts formed by corp
Generally not liable to shareholders for errors in judgement even if they used reasonably prudent standards
Qualified Business Income Deduction
Subject to limitations, pass-through entities (SPs/partnerships/Scorps) can take a 20% tax deduction for qualified business income (QBI), this deduction may be positively impacted for high income owners if there are significant W-2 wages or investments in qualified property
Sole Proprietor (SP)
Can create retirement plan for themselves similar to corporate retirement plan
Can deduct losses incurred in business from their AGI from other sources
May not deduct premiums for group term life insurance on their own life
Partnership Dissolution and Termination
Property rights in a partnership property continue after partnership is dissolved
Termination of a partnership is not the same as dissolution in legal terminology
Professional Corporations
Stock Redemption Buy/Sell: Professional corps typically redeem the stock of a deceased SH
Liquidation: at the liquidation of a professional service corp, if the IRS imputes a goodwill value, it will be added to the capital gain to be recognized by SHs
Math: Capitalization of Earnings Method
Average earnings divided by expected ROR
T or F: A corp may acquire its own stock if it serves a business purpose and there will be no financial injury to the corp’s creditors
True
Corporations and Unincorporated Entities Taxed as Corporations
Business organized as corporations under state law will be taxed as corporations; so will “unincorporated” entities such as banks, insurance companies, state and foreign owned entities
Closely-Held Business Owner Income
Income to the owners of a closely-held business can be in the form of compensation for services provided as a director or EE, as well as income in return for capital invested in the business
Executor Liability IF Business Continues
If the executor of a deceased SP gets the consent from all heirs and creditors to continue the business, the executor is liable for acting in a negligent manner and incurring business losses
IRC 6166
Provides for the payment of estate taxes in 10 installments; 1st installment of principal MUST be paid 5 years after the date the federal estate tax return is due; w/ payments being made over the next 9 years and estate kept open until installments are paid
***Section 6166 would not be used if an insured buy/sell agreement is in place
Specific Performance as a Judicial Remedy
“Specific Performance” serves as an effective judicial remedy for surviving partners if there has been a breach of the buy/sell w/ the deceased partner’s estate
Estate as Beneficiary in Cross-Purchase Buy/Sell
The estate of the insured should not be listed as the beneficiary because the estate would hold both the deceased’s business interest and the life insurance policy proceeds,
ALSO,
The deceased’s shareholder’s business interest and the life insurance policy proceeds might be subject to claims against the estate
Family Attribution
Family attribution rules provide a tax burden for a senior family member who wants to transfer their business interest to heirs
Family attribution rules: a SH whose stock has been redeemed by the corp will have stock attributed to them if owned by their spouse, child or grandchild, NOT BY A GRANDPARENT
Family attribution rules can be waived so long as the individual whose stock is redeemed agrees to the following over the 10 year period following redemption:
a. Not serve as an officer of the corp
b. To acquire NO stock in the corp unless inheritance or bequest
c. Notify IRS if a prohibited interest in the corp happens
d. NOTE: the former stockholder may become a creditor to the corp
Grantor Related Annuity Trust (GRAT)
Stock transferred into a GRAT:
Ex. 5 yr trust, annuity payments for 5 yrs
At end of 5 yrs, grantor’s son receives the stock
The transfer IS subject to gift taxation
If grantor dies before trust pays out and is terminated, the principal of the trust is included in the grantor’s estate
Stock Redemption? Cross Purchase?
Closely-held family business, is a stock redemption agreement preferable to a cross purchase agreement? Not necessarily
INC wants to hold purchase price down in their buy/sell and wonders if the life insurance funding will inflate the value of the stock: is a stock redemption agreement preferable to cross purchase agreement? Not necessarily
Option to Purchase Shares in the Event of SH Death
If a SH in a close corp enters into a contract that allows the corp an option to buy their shares in the event of their death:
a. Option is not enforceable
b. Option agreement can provide a price or a price formula
Installments in a Disability Buyout
Installments instead of a lump sum payment/purchase is an advantage because the IRS allows capital gains treatment on the sale as installments are paid
Interest on installment payments is not considered tax-free to the seller
Risk Management
Loss Prevention = risk management technique to reduce the chance of loss
Insurance and risk management is NOT concerned w/ “speculative risk”
Insurable Risk = a risk where losses are definite in regards to amount and time
T or F: Common methods for a business interest to transfer risk include the purchase of insurance and using hold-harmless agreements
True
Tax Treatment of Salary Continuation Plan
For an ER to receive favorable tax treatment for contributions to a salary continuation (disability income) plan, the plan does not need to be funded by DI insurance and the plan does not need to cover all employees
Payments from plan are taxable for EE
ER receives a tax deduction for benefit payments from a plan
Installment Sale of Stock
An installment sale may be designed to remove stock from the seller’s estate but unpaid installment payments before the seller’s death are included in the estate
The IRS will NOT accept just any interest rate used in the installment contract on which the seller and buyer agree
Irrevocable Life Insurance Trust (ILIT)
Very useful estate planning tool for a business owner and it can accomplish a lot of things, but providing retirement income for the owner is NOT one of them
Life Insurance to Fund a NQ Deferred Compensation Plan
No deduction for premiums paid by ER
Benefits are taxed to EE
Miscellaneous 2
Transfer restrictions will decrease the value of preferred stock
Fringe benefits to EEs do not result in a tax credit
IRS does NOT provide a mathematical formula for determining maximum reasonable compensation
Minority Shareholders
The value of a minority stock interest in a closely-held business can be discounted, but this is not the case in a publicly-traded corporation
Cumulative voting may enable minority shareholders to get representation on the corp’s BOD
Economic Effects of Partnership Liquidation
Economic effects of the liquidation of a partnership following the death of a partner:
interfering w/ the surviving partner’s careers
a shrinkage of partnership assets
a delay in the settlement of a deceased partner’s estate
T or F: Business overhead insurance benefits typically include reimbursement for the disabled individual’s lost income or earnings
False
Anti-Estate Freeze Statutes
A business owner may experience difficulty in planning to transfer their ownership to family successors d/t anti-estate freeze statutes that have added uncertainty and transfer tax costs to many traditional transfer techniques
Section 302 Stock Redemption
To be treated as a capital transaction, a Section 302 stock redemption can be substantially disproportionate w/ respect to the shareholder whose stock is redeemed and it can be a complete redemption of all stock the corp owned
To qualify as substantially disproportionate, a redemption must reduce the SH to below both (1) 50% of ownership and (2) 80% of their prior holdings
Deceased Shareholders (Miscellaneous)
If no stock redemption agreement exists, the executor or administrator has the right to vote for then deceased SH
If there is no buy/sell agreement in a close corp, it may be difficult for the heirs of a minority SH to sell the corporate stock following their death
Surviving SHs are favored over a deceased SH’s heirs if an option agreement is in place that sets out a predetermined price
Sole Proprietor Death
If no buy/sell, their personal representative has a duty to complete unfinished obligations that do not require the sole proprietor’s personal performance
SP buy/sell w/ a key employee funded w/ life insurance: key employee should be the life insurance policyowner AND beneficiary
If key employee cannot afford premiums, options can be bonus the amount or set up a split-dollar insurance arrangement
Trustee Used in Insured Buy/Sell
the trustee does not necessarily have to pay the premiums on the policies
T or F: All state require ERs to purchase insurance coverage for workers compensation
False
Life Insurance Proceeds
Death proceeds to fund a stock redemption agreement are not taxable to the corp even if a transfer-for-value occurred when the policy was transferred to corp
Sec. 79 life insurance proceeds are received by a named beneficiary income tax free
Partnership Insured Cross Purchase Buy/Sell Agreement “First-Offer”
If a partnership has an insured binding cross purchase buy/sell agreement, it should include provisions stating the ownership, beneficiary arrangements, and premium payment details for all policies funding the agreement; including the “first offer commitment or restriction” to sell to other partners first
Goodwill in a Partnership Buy/Sell Agreement
In an entity partnership buy/sell agreement, if there is specific language that provides for a definite and reasonable amount of the total price to be for goodwill, it does not affect the taxation to the seller; and the payment is NOT deductible for partnership income tax purposes
Initial Contribution to a Partnership
In forming a partnership, the initial contribution does NOT have to be substantial; it can be property or cash; and the contribution is NOT a taxable event
Cross Purchase Life Insurance Policyowner and Beneficiary
In a cross-purchase partnership buy/sell agreement, the beneficiary of a life insurance policy should be the policyowner
Underfunding a Partnership Buy/Sell Agreement
Even when a partnership buy/sell agreement sets a formula for the price of the business, and even if there is insurance in place, there can still be a problem of underfunding
General and Limited Partner Liability
General partners are liable for the partnership’s losses; liability extends to all assets of the partner
Limited liability partners are not liable for partnership losses but can lose all of their partnership interest if the partnership loses all of its assets in a lawsuit
General Partner Operating Losses Deductible
In a general partnership, current year operating losses can be deducted for federal income tax purposes
Partnership Distributive Share
Partnership’s distributive share: a partner is taxed on entire distributive share and a partner’s basis in the partnership will be increased by the amount of a distributive share that is reinvested in the partnership
Limited Partner Future Income
Limited partners share in the future income of the business; NOT in the capital contributed, the operations, the personal liability for the business’s debts
Extra Expense and Dependent Business Interruption Insurance
Extra expense insurance = designed to indemnify for additional costs of operations necessary as a result of destroyed physical facilities, NOT the costs to rebuild
Dependent business interruption insurance = covers a business owner’s lost profits from a supplier’s premises being destroyed by fire… DEPENDENT…SUPPLIER
Miscellaneous 3
A private annuity can be designed to be excluded from the seller’s estate for tax purposes
A tax-free stock sale (“B” reorganization) involves a sale made solely for the buyer’s voting stock
“Residual disability” benefits provision gives the insured an incentive to go back to work
A disabled SH does NOT lose the right to vote their stock
Entity-Type Partnership Buy/Sell Agreement
Entity approach provides pooling and makes the transaction more affordable for the lower-interest younger partners; entity agreement is probably more practical where partners have unequal ages and relative interests
The entire partnership interest is included in the estate, including the value of its goodwill
The cost basis received by the survivor is greater in a cross-purchase agreement
The partnership should be the designated beneficiary
Proprietorships
The proprietor has unlimited liability for business operations
The business terminates by operation of law at the bankruptcy of the proprietor
Title to specific business property is held by the proprietor
A proprietor cannot be considered an EE for tax purposes
Necessary Items for an Insured Partnership Buy/Sell Agreement Between Unrelated Partners to Peg the Value of the Business Interest for Estate Tax Purposes
The price set represents the fair value of the business at the time of the agreement
The contract to buy and sell is an arm’s-length transaction
The buy/sell agreement contains a first-offer provision
Limited-Liability Companies (LLCs)
An LLC differs from a limited partnership because all owners of an LLC have limited liability
The organizational formalities of an LLC can cause significant legal costs
Insured Cross-Purchase Buy/Sell Agreement for a Closely Held Corporation
Provision should be made for the disposition of the insurance policies held by the decedent’s estate on the lives of the survivors
The buyers get the purchase price included in their basis in the stock
The agreement should contain a first-offer provision to peg the business value for estate tax purposes
The corporation has no obligation under a cross-purchase agreement, and such payments could be taxed as dividends
Tax Treatment of an Insured Stock-Redemption Buy/Sell Agreement
The surviving shareholders get control of the corporation w/out interference from the deceased shareholder’s heirs
Policies used to fund the agreement accumulate cash value tax free
Proceeds are received tax free by the corp on the death of a SH w/out the imposition of the transfer-for-value rule
The estate must include the stock held by the deceased; the estate merely transfers the stock for the insurance proceeds
Corporations Making a Subchapter S Election
The election is terminated if there are more than 100 shareholders in any taxable year
The election is not terminated if any of the stock is held by a voting trust in any taxable year
Each shareholder is taxed on their share of the corp’s income whether or not it is distributed
A Subchapter S election will continue unless a majority of the shareholders vote to terminate the election
Discounted-Future-Earnings (DFE) Method of Business Valuation
Uses earnings projection over future years rather than being based on past years’ figures; however past income data may be significant in making the projection
Section 303 Redemption
An estate must be holding closely held corporate stock valued at more than 35% of the adjusted gross estate to qualify for a Sec. 303 redemption
Family attribution rules do not apply to a Sec. 303 redemption
Uses of a Grantor-Retained Annuity Trust (GRAT) to Transfer a Family Business
A GRAT is normally a grantor trust and income is taxable to the grantor until the trust terminates; even if it is not structured as a grantor trust, the current income taxes are shared by the grantor and the trust
All or a portion of the GRAT’s principal will be included in the grantor’s gross estate for tax purposes of their death occurs before the trust terminates
Stock Redemption Buy/Sell Agreement Calling For Complete Redemption of Shares Owned By Family Members May Involve Adverse Income Tax Consequences Due to Attribution Rules. For Purposes of Determining Whether the Entire Interest is Redeemed, An Estate is Treated As Owning Stock Held By Each of the Following:
The decedent’s brother who is an unpaid beneficiary of the estate
The residuary beneficiary of the estate
The trust established by the decedent during his lifetime that is an unpaid beneficiary of the estate
NOTE: the income tax regulations provide that a person is no longer considered an estate beneficiary after they have been paid in full and there is only a remote possibility that the person will have to return the property to satisfy a claim against the estate; however, stock is attributed from an unpaid beneficiary of the estate to the estate regardless of the relationship; moreover, the residuary beneficiary is considered an unpaid beneficiary until the estate is closed
Factors in Determining a Reasonable Salary Level for a Shareholder Employee
The EE’s specialized skills
Compensation paid to other EEs w/ similar duties in the firm
Compensation paid to EEs of other firms w/ similar duties
NOTE: salary should be based on the EE’s services rather than the ownership interest
Discounts Applicable to the Valuation of a Closely Held Business Interest
Blockage discount
Minority discount
Liquidation discount
Individual Disability Income Insurance
Noncancelable contracts provide guaranteed premium rates
Residual disability benefits are provided as long as income is diminished because of a disability even if the insured returns to work part-time
Characteristics of a Corporation
A corporation cannot exist unless it has been chartered by the government
A corporation usually has the power to acquire its own stock to the extent of its available surplus
A SH is not liable for the debts of a corporation
A SH has no basic right to any allocable share of corporate profits; corporate profits are received by a SH only when the corporation’s BOD declares the distribution of those profits in the form of a dividend
Installment Sale of Corporate Stock
The buyer’s basis for the stock is equal to the total selling price not including the interest paid
At death, for federal estate tax purposes, the gross estate includes the present value of any unpaid installments on an installment note held by the decedent
Insured Buy/Sell Plans for an S Corporation
Stockholders effectively bear the premium burden under both cross-purchase and stock-redemption plans
W/out a buy/sell agreement a SH’s death could result in an involuntary revocation of the subchapter s election
A buy/sell agreement has no impact on the corporation’s exposure to the accumulated-earnings tax
The S corporation is not subject to corporate level tax rates
Sec. 79 Group Term Life Insurance Plans Provided to Employees
A participant incurs taxable income to the extent that the face amount of coverage on their life exceeds $50,000
Key employees will be taxed on the entire amount of their coverage if the plan discriminates in either coverage or benefits
The taxable amount of coverage is subject to tax based on the so-called Table 1 rates contained in Sec. 79 regulations
Groups w/ fewer than 10 members can receive the tax benefits of Sec. 79, but they are subject to more stringent nondiscrimination requirements
Tax-Free Reorganization
A tax-free B (stock) reorganization requires that 80% or more of the stock in the acquired corporation must be exchanged
Substantially all the assets must be sold in a tax-free asset sale
Capitalization Factor
Weighted average annual earnings divided by required ROR
Corporate Salary Continuation Plans
Plans may discriminate
The insured may be the direct beneficiary
Federal Income Tax Consequences of an Insured Corporate Buy/Sell Agreement
When stock is purchased from a deceased SH under a cross-purchase plan, there will be an increase in the purchasing SH’s total basis for their stock in the corporation
The sale of stock at death pursuant to an insured cross-purchase plan results in sale-or-exchange tax treatment
The payment of life insurance premiums is a nondeductible expense in either a cross-purchase or stock-redemption agreement
The proceeds will never be taxable income to the estate of an insured in a buy/sell agreement
Use of Life Insurance to Fund NQ Deferred-Compensation Benefits
The policies must be owned by the corp or subject to claims of general creditors of the corp to avoid adverse income tax results
Benefits received by participants taxable as compensation
Premium payments are not deductible since benefits are deductible when paid to the recipient after the deferral
Death benefits are part of the participant’s estate and they can name the beneficiary
Federal Income Taxation of Partnerships
A partnership pays no income taxes
Although the partnership agreement will generally control the tax consequences, the IRS will disregard any provision whose principal is tax avoidance
Advantages of a Regular C Corp Over an S Corp
Shareholder-employees may be eligible for more tax-favored fringe benefits
More favorable treatment of EE fringe benefits for more-than-2-percent shareholder-employees
Insured Cross-Purchase Corporate Buy/Sell Agreement
The agreement typically requires more policies than a stock-redemption plan
The corporation is not a party to the cross-purchase agreement and has no responsibility for the purchase of a deceased SH’s stock
Adjusted Book Value $500K, Avg Annual Earnings $100K, Expected Return 15%, How Much of the Avg Annual Earnings May Be Attributed to Goodwill?
Expected to have annual earnings $75K; amount earned above $75K can be attributed to goodwill
Workers’ Compensation Coverage
The multi-state ER should secure “other states” coverage to be sure that the coverage is adequate under the laws of every relevant state
Traditional liability requirement of fault is not required
Purpose of Voting Arrangement (Closely Held Corporation Having Bylaws that Provide Cumulative Voting For Directors)
To allow SH holding a minority interest to have the best opportunity to elect at least one director
Corporate Stock Redemption Under Sec. 302 of the Internal Revenue Code
It is given capital gain treatment if the redemption meets the requirements of a substantially disproportionate redemption
Sec. 302 provides rules for determining when a redemption qualifies as “substantially disproportionate”
Sec. 162 Bonus Life Insurance Plans
The participating employee is the owner of the policy covering their life
Permitted to discriminate
The bonuses are taxable current compensation to the participant
ER is able to deduct reasonable bonuses paid to the EE, regardless of how the EE uses the bonus
Family Limited Partnerships (FLP)
The FLP is potentially useful to transfer business or other family investments to the next generation at a discounted transfer tax cost
Most partnership laws would include investment partnerships as a valid partnership
Technique normally involves the transfer of the senior family member’s property through gifts of limited interest to successor generations
The general partnership interest provides control over management, distributions, and liquidations and is NOT a minority interest
Section 79 Group Term Life Insurance Plans
EE is taxed on contributions for coverage in excess of a $50K DB
Sec. 79 has complex nondiscrimination rules
Section 6166 Installment Payment of Estate Tax
A closely held business in excess of 35% of the adjusted gross estate must be included in the gross estate to qualify
The estate must be kept open during the installment period
The estate may use Sec. 303 redemptions to make the installment payments
Only interest needs to be paid for the first 5 years
Compensation Planning for the Regular (C) Corporation
Compensation of shareholder-employees will be treated as a dividend unless it represents a reasonable and ordinary business expense
Reasonable compensation is determined by many factors and is often a subjective and illusory target
The choice of fringe benefits often hinges on the personal needs of the owners and the differing tax benefits available for various fringes
Bonus payments made w/in 2 and a half months after the close of the tax year can be deducted by a corporation in the previous tax year if the obligation was fixed in the prior year
Liability Exposures of a Closely Held Business
Workers’ compensation statutes place strict liability on ERs to respond to certain injuries or illnesses suffered by EEs
Corporate directors are subject to liability claims brought by corporate SHs in behalf of the corporation if directors’ actions injure the corporation
Liability concerns have led many business owners to form LLCs
Partners are both jointly and severally liable
Section 303 Redemption
A corporation may retain earnings in the year of a SH’s death for a 303 redemption w/out an accumulated-earnings tax penalty
The redemption can be made later when tax payments are made
The threshold amount for qualification is 35% for representation of the adjusted gross estate for the estate to qualify
Amounts limited to estate taxes and deductible funeral expenses, NOT charitable contributions
Disadvantages of a Mandatory Buy/Sell Agreement at the Death of a Business Owner
The heirs may wish to stay in the business
The survivors may be unable to finance the sale
*above points are correct disadvantages
**Both situations are inconsistent w/ a mandatory buy/sell agreement
Adjusted-Book-Value Method of Valuing a Business
Assets are valued as close to current fair market value as possible
The addition of an amount for goodwill to assets is usually part of the adjustment
This method is recommended for companies that primarily hold investment products and real estate
Earnings are not considered in book value
Characteristics of a Typical Entity-Type Partnership Buy/Sell Agreement Funded by Life Insurance
Partnership owns the policies
The partnership is beneficiary of the policies
The partnership pays the premiums
Generally the life insurance proceeds are free of federal income tax
Characteristics of a Taxable Sale of All the Assets of a Corporate Business
The buyer’s depreciation basis for the assets is equal to the purchase price
The SHs of the selling corporation have no taxable income from the asset sale itself
SH approval may be necessary
In an asset sale, courts have held buyers personally liable for seller liabilities in some cases
Key Employee Life Insurance
The premium costs are nondeductible
The appropriate insured is an individual w/ unique skills or substantial personal business contacts
The transfer of the policy to the EE at retirement is excepted from the transfer-for-value rules
The insurable interest in life insurance need only exist at the inception of the contract, and the corporation is free to retain the policy
ILIT a Useful Tool for the Owner of a Family Business
The proceeds can assist in reducing the liquidity burden w/out adding to the estate taxes
The proceeds can provide income to the surviving spouse and an inheritance to heirs who will not inherit the business
Principal Purpose of a First-Offer Commitment in a Typical Corporate Buy/Sell Agreement
Helps prevent the transfer of stock to purchasers outside of the closely held SHs
Results Upon Death of a Partner Without a Buy/Sell Agreement in the Termination of a Partnership
Shrinkage in the value of partnership assets
Danger to the surviving partner’s business career
Delay in the administration of the deceased partner’s personal estate
Surviving partner or partners become the liquidating trustee(s), and this role generally is opposed to continuing the business
Transfer of a Family Corporation Through the Provisions of a Parent-Owner’s Will
This method may be impractical if the owner is concerned about providing income to an inactive surviving spouse
Providing income for a surviving spouse generally calls for a different transfer method since it would be difficult for the business to provide indefinitely for an inactive surviving spouse following an owner’s death
Continuance of a Business by the Administrator of a Deceased Proprietor’s Estate
The administrator may have difficulty getting the consent of all interested parties
Administrator can charge reasonable fee for services but does not share in profits
Administrator is acting as a sole proprietor under these circumstances
The heirs have the right to consent to actions when the administrator deals personally w/ the estate
Insured Stock-Redemption Buy/Sell Plan
The redemption amounts should be distributed only if the corporation has sufficient surplus
Life insurance premiums are NOT deductible
Policies are owned as part of regular corporate assets, subject to claims of corporate creditors
Policies are exempt from the accumulated-earnings tax only if they are accumulated for a reasonable business purpose
Limited-Liability Companies
The are formed and operated under auspices of state law
They generally adopt pass-through income tax treatment
Discounted-Future-Earnings (DFE) Method of Valuation
It is appropriate to discount future earnings related to goodwill
Lower credence should be attributed to more distant forecasts
Book Value of a Business
The book value may be more appropriate than other measures to a liquidating business
Book value often inadequately gives the true value of assets
Taxable Stock Sale of a Business
The purchaser acquires the corporation subject to its assets and liabilities
A stock sale is typically simpler since shares of stock rather than physical assets are transferred
The acquiring corporation gets a basis in the assets of the acquired corporation equal to the basis of the assets in the hands of the seller
The buyer need only find enough SHs who will agree to sell their stock
The Ability of a Business Enterprise to Raise Funds
A closely held corporation is often limited by practical circumstances of its ownership structure in the amount of funds it can raise; closely held corporations often provide no advantage in raising funds
General partners must be active
Sole Proprietor may personally borrow funds to be used in the business
The limited partnership is one method of organizing to raise substantial funds
Required for a Valuation Provision Contained in a Buy/Sell Agreement Between Family Members to Fix the Estate Tax Value of the Business Interest at the Purchase Price
The agreement must have a bona fide business purpose
The agreement cannot be a device to transfer to family for less than full consideration
The terms must be comparable to similar arm’s-length agreements
A fixed purchase price is NOT a statutory requirement
The Proprietorship Form of Enterprise
Proprietorships outnumber other forms of business by almost 3 to 1
The proprietor typically has limited ability to raise funds for business expansion
The proprietor can delegate business authority to agents and employees
Proprietors are self employed and are not eligible for tax-favored status under IRC Sec. 79 group term life insurance plans
A Shareholder in a Closely Held Corporation Should Typically Not Leave Stock to Their Heir (In Lieu of a Buy/Sell Agreement) Unless:
The decedent’s estate contains other substantial assets
Transfers Excepted From the Transfer-For-Value Rule
To a closely held corporation in which the insured is a SH
To a partner of a partnership in which the insured is also a partner
To a partnership in which the insured is a partner
If transferred to a SH of a corporation in which the insured is also a SH presents adverse tax consequences
Valuation of a Corporation for an Insured Stock-Redemption Buy/Sell Agreement
It is more equitable to consider the value of the insurance in the ultimate purchase price
The formula price fluctuates and would only coincidentally correspond to the purchase price at the time of death
Events Resulting in the Termination of a Business by Operation of Law
The death of a general partner
Closely held corporation is a separate entity that continues unless actively terminated at the death of a SH
Corporations
Corporate officers are not individually liable for corporate actions
Corporations are empowered and regulated under state law
Sec. 6166 Provisions for the Installment Payment of Estate Tax
A portion of the installment payments will incur a special 2% interest rate
An eligible estate must hold a closely held business interest whose value is greater than 35% of the adjusted gross estate
The sale of the business by the heirs accelerates the remaining installment payments
The installment period is limited to 15 years, but an executor may elect a shorter period
Choice of an Entity-Purchase Versus Cross-Purchase Partnership Buy/Sell Agreement
A cross-purchase agreement should be selected if the surviving partners expect to sell their interests during their lifetimes
An entity agreement may solve the affordability problem if one partner is significantly older than the others
An entity agreement should be selected if there are large number of partners included in the agreement
The transfer of life insurance to a partnership in which the insured is a partner is excepted from the transfer-for-value rule
Objectives for a Small Business Owner to Make the Decision to Incorporate Attractive
Some earnings are to be retained for business expansion
Owner/employees want to benefit from tax-favored group life insurance
Owners desire to be sheltered from the liability risks associated w/ business operations
The dividend treatment given to distributions to passive SHs is unattractive vis-a-vis the partnership pass through taxation concept
Issuance of Preferred Stock in a Recapitalization
The dividends paid by the corporation will be distributed first to the preferred stock
The preferred stock normally will not have voting rights but, at the very least, will not have preferred voting rights
Insured Stock Redemption Buy/Sell Agreement
The corporation owns the life insurance policies, pays the premiums, and is the beneficiary of each policy
The corporation is distributing the redemption proceeds, and the survivors get no basis as a result
S Corporations
S corporations typically avoid corporate-level taxes
Use of a Buy/Sell Agreement to Transfer a Family Corporation From a Parent to Younger Generations
The parent can provide for inactive heirs since the state will receive substantial sale proceeds
The active heirs will be the designated buy/sell purchasers
The parent holds the business interest until death
The family attribution problem will generally be troublesome to the estate if designed as a stock redemption and sale or exchange treatment may be difficult to achieve; a cross-purchase would avoid this problem
An Insured Partnership Entity Buy/Sell Agreement
The payments made by the partnership to the estate are treated as liquidation payments for tax purposes
The insurance funding tends to inflate the partnership value and should be considered in the valuation provision
An Installment Buyout May Be Preferable to a Lump-Sum Purchase in a Disability Buy/Sell Agreement for the Following Reasons:
Installment payments are easier to finance by the buyers
Installment-type payments more closely match disability insurance income payments
The seller is able to spread the taxable gain over the installment period
The form of payment does not have an impact on estate includability
The Taxation of Business Enterprises
The taxation of S Corps has similar aspects to the partnership tax
LLCs can generally choose to be taxed as partnerships
The owners of an unincorporated trade or business may be eligible for a 20% deduction from qualified business income (QBI) w/ certain restrictions
The 20% deduction from QBI is available for an unincorporated service business but may be limited or eliminated once the business owners taxable income reaches certain threshold amounts
Death of a Majority Shareholder in a Closely Held Corporation
The heirs may be willing to accept the decedent’s stock in lieu of specific bequests
Minority SHs cannot force liquidation
The corporation has continuity of its own
The survivors do not have the voting power to control the BOD
Valuation of a Key Employee
The sophisticated methods for determining value will take into account the cost of replacing the key employee
The key employee’s value may be different from their salary
The traditional methods are often incomplete
Goodwill can also be attributed to other factors such as brand loyalty or the favorable location of the business
Corporation With an Established Salary Continuation Plan Funded With Disability Income Insurance. Employer Pays All Premiums, Employee Will Receive Any Benefits at Disability Directly From the Insurance Company
A covered EE need not report the premiums paid by the employer as income
Benefits are taxable as ordinary income because they are compensation
Selling Stock in Annual Installments, How Much of the First Annual Payment is Treated as a Taxable Gain?
First determine profit ratio = gain divided by the contract price
Then multiply the profit ratio times the principal installment payment
Closely Held Corporations Differ From Large Publicly Held Corporations
Most owners of closely held corporations are actively involved in business management
NOTE: closely held corporations must generally follow corporate operating formalities
Benefits of a Stock-Redemption Buy/Sell Agreement
The agreement provides the survivors w/ the freedom to operate w/out unwanted heirs as coshareholders
The survivors receive no cost basis for the amount of the redemption distribution
Key Employee
The key employee may be identified by a specialized skill
The key employee’s value often includes a goodwill element
The key employee may have unique sales skills
The true value of a key employee should consider that the EE will ultimately retire and cease services to the business
Risk Management Techniques
Loss reduction techniques are designed to reduce the financial impact of losses once they occur
Speculative risks are uninsurable
Only pure risks are insurable
Risk avoidance is NOT a transfer of the risk but the elimination of the risk
Limited Partnerships
At least one general partner must exist
Limited partners cannot take an active role
Compensation Planning for Closely Held Businesses
SHs of closely held corporations can be compensated either by salary or dividend payment
Partnerships do NOT have to distribute distributive share amounts
Adjusted-Book-Value Being Most Appropriate
A holding company
One of the most difficult aspects of the ABV method is the valuation of intangible assets such as goodwill; most appropriate for those least likely to have intangible assets
Leave Stock to Son in Will or Enter Into Buy/Sell Agreement With Son; When to Use Buy/Sell Agreement?
Mom has other heirs who need to be provided for
Mom has a marital deduction will w/ a unified-credit bypass share
Mom’s other assets include several illiquid items
Buy/Sell would NOT be used if Mom is substantially rated and likely to become uninsurable
Risk Management Techniques
Risk identification is often a sophisticated process involving the financial statements of the business
Some types of risk transfer involve the contractual shifting of risk to third parties other than insurers
Choice of Organizational Form
Corporations are authorized solely by state law and are required to follow certain operating formalities
Corporate rates are not higher at all levels of income
The general partner must have unlimited liability
Ownership control disputes are possible any time there is more than one owner in partnerships
The Partners of a Typical Commercial General Partnership
The partners have the authority to dissolve the partnership and liquidate partnership assets at the death of one partner
The property is owned in undivided equal interests as tenancy in partnership
The surviving partners become liquidating trustees and are likely to have a technical dissolution
The partners must consent to the sale of business assets
