Planning for Closely Held Business Owners

Question 1

Compare and contrast the financing methods used by closely held business owners

Answer 1

• Mezzanine financing - Agreement that is set up so that the lender can convert debt to equity interest should the company default on the loan. A high-risk, private placement, often used by smaller companies
• Venture capital funding - Not always a monetary vehicle, but could include support in terms of leadership or technical advice. Whatever is provided is exchanged for ownership in company or a share of the earning potential
• Leveraged buyout - A method of acquiring a company with money that is nearly all borrowed. Allows investors to make a large acquisition without committing a lot of capital. The acquirers of the target company often attempt to sell or take the target company public after five or ten years in the hopes of making sizable profits. Can be expensive and complex but can provide considerable returns if successful
• Restructured debt - Can include a sale of equity to new investors and hiring of new leadership as a response to financial issues created from the failure of a product or a way to improve the business
• Angel investor - Groups of individuals that provide equity financing to start-up companies. Good for companies that do not qualify for adequate bank financing but still require outside financing. They can set their own terms for the agreement
• Preferred stock recapitalization - A business owner recapitalizes stock into voting preferred shares and non-voting common shares. The owner then gifts the non-voting shares to children. The business owner’s retention of cumulative preferred shares provides a qualified payment because the owner retains the right to receive dividends at a fixed par value

Question 2

Relate the lifecycle stages of the closely held business to opportunities for advisors to add value for the business owner

Answer 2

• Startup - Help with funding
• Growth - Help with business management?
• Maturity - Begin to prepare succession planning
• Transition - Continue to develop and assist with succession planning, help with transition
• Succession - Assist new management, assist previous business owner to deal with influx of cash
  (?)

Question 3

What are the potential business succession/exit strategies?

Answer 3

1) Bankruptcy
2) Transfer to a family member
3) Go public
4) Preparing for Exit
5) Winding down
6) Sale

Question 4

List the range of potential buyers

Answer 4

• Strategic/synergistic Buyer
• Financial
• Family Member
• Non-Family
• Key Employee

Question 5

What is a strategic buyer?

Answer 5

• A strategic buyer is a company that acquires another company in the same industry to capture synergies
• Strategic buyers generally have the expertise necessary to operate the business, and can eliminate the money that is being paid to top level management

Question 6

What is a non-strategic buyer?

Answer 6

A financial buyer may have the means to purchase a company, they do not necessarily have the expertise to run the business

Question 7

What are the implications of a strategic buyer?

Answer 7

• With a strategic buyer, there are intentions to purchase the business for it’s future potential and the intangibles that the business has
• Will look to actually build and grow the business
  (?)

Question 8

What are the implications of a non-strategic buyer?

Answer 8

• With a nonstrategic buyer there are mainly financial intentions in mind
• Look to purchase the business for the assets it holds on its balance sheet
  (?)

Question 9

What are the advantages and disadvantages of business succession within a family?

Answer 9

• Can provide stability to the family business management without any tensions or conflict when passing to the next generation. Flexibility and decreased cost in labor. Long-term outlook for the family company to plan many years ahead
• Lack of structure. Nepotism: lack of competence at a senior level can have a huge impact on a company’s success. It can be difficult to determine objectively who will be the next heir. Negligence of formal training. Clashes for control

Question 10

What are the advantages and disadvantages of business succession with an outside buyer?

Answer 10

• Allows for business continuity where there is little to no worry that the business will survive. Can help avoid potential family succession conflicts
• Lack of funding: there is a potential that a potential outside buyer may not have enough to purchase the business

Question 11

What are potential family conflicts and issues that could result from succession planning or the sale of a closely held business as they relate to family dynamics?

Answer 11

• Feud between family members to take on the highest role
• Conflicts that are non-business related can be brought up and disrupt business operations
• Potential confused expectations of an assigned role
• Misunderstandings of agreed rules (e.g., who works, how much paid, behavioral expectations)

Question 12

What are the features of C-Corps?

Answer 12

• A separate entity from the owners. Have shareholders. Require an articles of incorporation or certificate of formation. May have annual shareholder meetings and ongoing meetings with the board of directors
• Limited liability to owners. Shares in a corporation are easy to gift or transfer to other individuals, so it makes it easy to transfer after death
• More formalities than other entities, makes setup long and complicated

Question 13

What are the features of S-Corps?

Answer 13

• A corporation or an LLC that is similar but not identical to a partnership. Must be domestic.
• Has only one class of stock and each share is equal in distribution and liquidation rights. The shares may have different voting rights
• Shareholder limitation of 100
• Certain trusts can hold shares. Limited liability for shareholders
• There are a few entities not eligible to become an S-Corp: financial institution that uses the reserve method of accounting, insurance company, corporations that elect to have credits for certain income from non-US sources, current or former domestic international sales corporation. C-Corps and nonresident aliens may not be shareholders. There are rules that must remain throughout the S-Corp’s life. Special allocations are not permitted

Question 14

What are the features of LLCs?

Answer 14

• Hybrid business entities; they can be taxed as any other business entity of the owner’s choosing (Sole proprietorship or partnership or corporation), and has limited liability that’s generally associated with corporations
• Reduced liability on the owner for the business and it’s debts/obligations. Owners, whether just one or two or multiple, can operate with limited liability. Personal assets are protected. Fewer required formalities compared to corporations. Flexibility in ownership and management structure
• LLC requirements vary from state to state, so multi-state transactions can be complex. May incur an additional tax depending on the state the LLC is in and if it’s a partnership

Question 15

What are the features of Partnerships?

Answer 15

• Partnerships can be two or more individuals. There are different types of partnerships, the main ones include: general partnership, limited partnership, limited liability partnership, and limited liability limited partnership
• Equal ownership in profits and losses, management rights, and an individual can only become a member if all partners agree to bring them on
• Generally easy to set up and have less regulations than corporations. Multiple sources to raise capital for the business
• Risk is not limited to the general partner’s share. Liable for debts, liabilities, and obligations, even if only one general partner is solvent. If a partner withdraws and proper planning hasn’t been developed, it may complicate the agreement and lead to termination issues

Question 16

What are the features of Sole Proprietorships?

Answer 16

• A sole proprietorship is a one-person business operation. It is tied to the person and is simple to setup (single entity)
• The formalities of setup are easier than other entities. Compared to other entities, they are easy to operate since there is one owner that manages everything
• Because the business and owner are a single entity, there is no liability protection. The liabilities of the business are the liabilities of the owner, and should the business fail, the owner’s personal assets may be used to pay off debts. The business ends at the death of the owner, and the value of the business is difficult to transfer after death

Question 17

What are the tax implications of C-Corps?

Answer 17

• It is a separate taxpayer and files on Form1120 and pays its own tax
• No special tax rate for capital gains, taxed at corporation’s regular tax rates. Flat rate of 21%
• Allowed to use fiscal year for taxes if they want
• Double taxation as a dividend. These distributions aren’t deductible for the corporation, plus the shareholder is taxed on the dividend. The corporation doesn’t receive a tax benefit, and the shareholder also has to pay tax.

Question 18

What are the tax implications of S-Corps?

Answer 18

• Files Form 2553
• Income, deductions, cap gains/losses, etc., are passed through to the shareholders. This must be in proportion to the stock ownership
• Deductibility is limited to the shareholder’s basis in stock. A shareholder’s basis cannot go below 0
• Excess loss can be carried forward for future years

Question 19

What are the tax implications of LLCs?

Answer 19

• Form 8832, can choose how they want the LLC to be taxed. LLCs with two or more people will be taxed as a partnership
• If a single owner and they don’t file Form 8832, they are a “disregarded entity” and will file everything through Schedule C. If they file as sole proprietorship through Form 8832, they will be taxed as a C corporation or an S corporation.
• Tax disadvantages would be the same as the business entity they chose to be taxed as

Question 20

What are the tax implications of Partnerships?

Answer 20

• Each partner files taxes separately and splits the income, expenses, deductions, etc., in proportion to the interest of said partner
• File Form 1065 and specific items are listed on Schedule K-1
  *Special allocations - only if there is substantial economic effect. Can adjust the income and profits among partners so it’s not proportional to the partner’s interests, with rules and exceptions
• Very complicated process to file the taxes
• Business income is treated as self-employment income and will have the SS and Medicare tax

Question 21

What are the tax implications of Sole Proprietorships?

Answer 21

• Even though the owner and the business are considered a single entity, the business activity and records must be kept separate
• The owner will file a Schedule C of 1040 form; will generally file one single return
• Considered self-employment income, which is subject to self-employment tax
• Social Security and Medicare tax. SS tax is 12.4% limited to $168,600 of net earnings. 2.9% Medicare tax on net earnings

Question 22

What are the types of buy-sell agreements?

Answer 22

• Stock Redemption (Redemption Agreement, entity purchase) - The company purchases life insurance on the shareholder’s life. The corporation is the owner and beneficiary of the policy and pays all of the insurance premiums. The insurance will provide the company with the necessary funds to purchase (redeem) the stock of the withdrawing or deceased shareholder, at a future time. The shareholder’s estate is obligated to sell all of the deceased owner’s stock to the corporation, and this arrangement guarantees a market for the stock in the shareholder’s estate, at a predetermined price. The cash received by the shareholder’s estate provides some liquidity for the estate, which the executor can use for any purpose
• Cross-Purchase - An agreement made by individual shareholders,
  not the corporation, to purchase a shareholder’s stock upon the death or disability
  of a fellow shareholder. Life insurance policies are typically used to fund the cross-
  purchase agreement, and each shareholder purchases a policy on the other participants’
  lives. Each shareholder is the beneficiary of the various policies he owns and is also
  responsible for paying the premiums. The death benefit amount of each policy is equal
  to the amount each shareholder needs to purchase a percentage of the stock from a
  deceased shareholder’s estate. The formula for determining the number of policies
  is N × (N − 1) with N being the number of shareholders.
• Hybrid - Also known as “wait and see” agreements,
  postpone the decision of whether to use a cross-purchase agreement or a stock
  redemption agreement until after the shareholder’s death. Similar to a cross-purchase
  agreement, shareholders purchase life insurance on the lives of the other participants.
  The corporation has a first option to purchase any or all of a deceased shareholder’s
  interest, and surviving shareholders have a secondary option to purchase any stock
  remaining. If a stock redemption is chosen, the shareholders could use the proceeds
  of the life insurance to make interest-bearing loans or capital contributions to the
  corporation to effectuate a stock redemption

Question 23

What are the types of funding strategies for death and disability planning?

Answer 23

• Key person life insurance
• Split-dollar life insurance
• Buy-sell agreements
• Selective pension plan
• Stock redemption
• Hybrid plans

Question 24

What are the different exit path approaches?

Answer 24

1. Income Approach
2. Market Approach
3. Asset or Cost Approach

Question 25

What are the different valuation methodologies?

Answer 25

1. Market Capitalization - Simplest method, calculated by multiplying the company’s share price by its total number of shares outstanding
2. Times Revenue Method - A stream of revenues generated over a certain period of time is applied to a multiplier that depends on the industry and economic environment
3. Earnings Multiplier - Used to get a more accurate picture of the real value of the company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. Adjusts current P/E ratio to account for current interest rates
4. Discounted Cash Flow (DCF) Method - Similar to earnings multiplier, this method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period number. The main difference between this and profit multiplier is that it takes inflation into consideration to calculate the present value
5. Book Value - This is the value of the shareholder’s equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets
6. Liquidation Value - Net cash that a business will receive if its assets were liquidated and liabilities were paid off today

Question 26

What are the advantages of the different valuations methodologies?

Answer 26

1. Market Capitalization - Simplest method of calculating value.
2. Times Revenue Method - Can look at companies that are similar and see their valuations
3. Earnings Multiplier - Provides an accurate picture when looking at profits and cash flow
4. Discounted Cash Flow (DCF) - Provides an accurate picture to project future cash flow
5. Book Value - Most useful for business that have a lot of assets in their book
6. Liquidation Value - Simple, establishes a value for all the assets to pay off the liabilities, and then see what is left

Question 27

What are the disadvantages of the different valuations methodologies?

Answer 27

1. Market Capitalization - Not necessarily the most accurate or fully representing methodology
2. Times Revenue Method - The industry multiplier may not be accurate compared to the actual business
3. Earnings Multiplier - Multiples can change over time as investors become more or less eager to own the shares based on market dynamics
4. Discounted Cash Flow (DCF) - Based on value to investor, as beneficiary of future cash flows, is the sum of those future cash flows. Based on estimates. Prone to errors
5. Book Value - Difficult to value if business mostly has intangibles. Does not consider a company’s future earning potential. Challenge in valuing assets that are difficult or expensive to value, when much of the value lies in the way it provides a financial benefit to the company. Not especially useful for complex businesses
6. Liquidation Value - Might be difficult if there are assets that are hard to value in a sale

Question 28

What are the different types of discounts and premiums?

Answer 28

• Valuation Discount
• Minority Discount
• Marketability Discount

Question 29

What is the valuation discount?

Answer 29

The sum of each of the FLP interests combined does not equal the sum of the assets themselves because ownership of LP interest in an FLP does not convey any rights of management or control over underlying assets plus the FLP agreement prohibits the partners from freely transferring their interests to non-family members

Question 30

What is the minority discount?

Answer 30

• A discount for lack of control, is routinely applied to establish the estate and gift tax values of minority limited partner interests
• This discount reflects the inability of a limited partner to control the operations of the FLP and to invest its assets in a manner that is advantageous to the limited partner.
• The minority interest discount principle refers to the fact that the owner of less than a majority interest in an enterprise cannot by himself control day-to-day or long-range managerial decisions, impact future earnings, control efforts for growth, establish executive compensation, or access corporate assets through liquidation
• Because the owner of a minority interest lacks control over the business, an acquiror of a minority interest pays less for that interest, on a pro-rata basis, than if he were acquiring a controlling interest in the business
• In instances where the owner lacks the ability to exercise control over the operations of the enterprise, the owner’s interest can be worth significantly less than its liquidation value
• Typically a 20-30% discount

Question 31

What is the marketability discount?

Answer 31

• Applied to the value of limited partnership interests that do not offer a readily available market for trading
• Such a discount reflects the fact that a partner who contributes assets to an FLP in return for a limited partnership interest generally has difficulty finding a buyer (if one exists)
• Usually around 30% discount or higher

Question 32

Explain the order for applying discounts in the business valuation process

Answer 32

• Typically used for gift and estate tax savings, these discounts will be applied to LLCs, FLPs, closely held businesses where the property is transferring to a family member for the most part
• Establishing the FMV first, then discounting the value of the property by considering the businesses’ lack of control and lack of marketability
• Once discounts are established and applied, can then look to transfer/sell
• First minority discount applied, then lack of marketability discount
  (?)

Question 33

Determine the impact of the type of buyer on the applied valuation method and sale structure

Answer 33

• Third parties - The goal is to receive as much as possible while minimizing the tax/gain consequences of the sale
• Employees - Employees know the existing business intimately, but may not have the money to be able to outright purchase the business from the owner. Financing can come from the seller, an outside financing source, or through an ESOP. Installment sales are an option if the seller helps with the monetary aspect up front, other sale structure options include leveraged buyout and ESOP
• Family members - Opportunity to pass wealth and growth of business to family members that are typically in a lower tax bracket. Utilizing valuation discounts will help with estate and gift tax. Various sales structures like installment sales, bargain sale, intra-family loans, can help provide the buying family member pay for the business over time. This also keeps the wealth in the family, may be useful to look at valuation methods that provide a lower FMV so that there is less of a tax burden on the seller
  (?)

Question 34

Describe the benefits, risks, financial implications, and tax implications of private sales

Answer 34

• Getting cash increases personal liquidity and diversifies one’s assets, which in turn reduces stress and risk. Partial sales additionally reduce personal financial risk by often removing personal guarantees on company debt
• Possible need to finance a portion of the transaction, which can leave some of your assets at risk. If you remain involved with your business after a sale, however, new owners face less risk and may be willing to finance more of the sale price on their own
  (?)

Question 35

Describe the benefits, risks, financial implications, and tax implications of public sales

Answer 35

• To increase liquidity for a company’s stock, which may allow owners and employees to sell stock more easily. To acquire other businesses with the public company’s stock. To attract and compensate employees with public company stock and stock-options. To create publicity, brand awareness, or prestige for a company
• Increased regulatory requirements, loss of privacy and control, and higher costs associated with being a public company
  (?)

Question 36

Describe the benefits, risks, financial implications, and tax implications of SCINs

Answer 36

• A variation of the installment sale and typically used among family members if the property owner has a short life expectancy. The note contains a provision under which the balance of any payments due at the date of death will be automatically canceled. The term of the SCIN must be less than the actual life expectancy of the seller, otherwise it will be taxed as private annuity
• Good for when the seller wants to retain a payment stream that will not continue beyond their death. Good for when the estate tax benefits exceed the income tax cost that results from the premium payment for the cancel-at-death feature
• Taxable gains are prorated over the payment period, can shift most of the profit from a high-income year to other lower tax-bracket years. Installment payments are broken up into return on basis, gain, and interest income. Taxpayer must report parts of the payment that represent gain and interest income. Note is canceled upon holder’s death
• At death, the note is canceled and not included in the gross estate. When an installment note is canceled/unenforceable, it is treated as a taxable disposition on the note and that gain is taxable to the decedent’s estate as IRD. There is no IRD deduction allowed for the estate
• Application of the 7520 rate is important, otherwise any interest rates below this amount are considered partial gifts to the buyer
• Sale price of the property must exceed the actual FMV of the asset to reflect the risk of death. If the seller lives to receive all payments, they will have to report gain in excess of the actual gain that would have been realized had the property been sold at FMV.

Question 37

Describe the benefits, risks, financial implications, and tax implications of recapitalization

Answer 37

• A recapitalization is generally income tax-free. Under IRC §368(a)(1)(E), no gain need be recognized upon a so-called “E reorganization.” In order to be valid, the reorganization must have a legitimate business purpose, such as estate planning, beyond mere tax avoidance
• Gift non-voting shares of common stock to adult children and keeping remaining cumulative preferred shares. Keeping the cumulative preferred shares provides a qualified payment because owner has retained the right to receive dividends at at fixed par value.
• Value of the gift equal the value of the stock reduced by annual exclusion & applicable discounts would be gift tax payable
• Without a qualified payment the owner would have a retained interest of zero & the value of the gifted stock would be FMV of the business. Recapitalization also freezes the value of pref shares at par value no matter how much the business grows which further reduces the value of stock in the owner’s gross estate at death
• Minimum Value Rule: this applies so that the gift tax value of cumulative stock must be at least 10% of the total value of the business owner’s stock. This technique allows the owner to retain control of the business, receive income from the preferred shares and freeze the preferred shares at par value and give members direct ownership in the business with the benefit of future appreciation on the common shares
• Regarding taxes, the owner must retain the right to receive dividends at a fixed par value on the cumulative preferred stock at least annually therefore the gift tax will be applied only on the amount of common stock transferred not to the entire value of the common stock
• Qualified interest: An interest is not considered qualified if the dividends are non-cumulative or if the owner retains extraordinary payment rights such as the right to exercise puts or calls and the right to convert shares or liquidate. An unqualified interest would cause the qualified shares to be taxed at FMV of the business interest not on the partial amount of the stock gifted
• The cumulative preferred shares satisfy the owners income needs while providing them with a qualified payment in the form of fixed dividends. However, any appreciation in value of the business will occur outside the owner’s estate. The non-voting common shares are removed from the owner’s estate which avoids estate taxes
• Noncumulative describes a type of preferred stock that does not pay stockholders any unpaid or omitted dividends. Preferred stock shares are issued with pre-established dividend rates which may either be stated as a dollar amount or as a percentage of par value

Question 38

Describe the benefits, risks, financial implications, and tax implications of seller

Answer 38

• Expedites the sales process as it eliminates the need for third-party lenders, banks, and extensive paperwork. The reduced red tape allows for a smoother transaction, making the property available to the buyer without the typical waiting period, ultimately resulting in faster closings
• Risk of unfavorable loan terms From the Seller. Sellers who are extending their own financing (also called “taking back a mortgage”) often charge a higher interest rate than institutional lenders, because of the increased level of risk that the buyer will default (fail to pay, or otherwise violate the mortgage terms)
• Seller financing can be used to defer capital gains taxes on the sale of a business or property. Deferring your capital gains tax means that you don’t have to pay taxes on the money you make from the sale until a later date. Typically, when a business is sold, the seller will pay taxes on the entire profit

Question 39

Describe the benefits, risks, financial implications, and tax implications of third-party financing

Answer 39

• Typically a leveraged buyout, where shareholders are bought out using mostly borrowed funds. The acquirer group (buyer of business) seeks to issue debt instruments and then use target-generated cash flow (the purchased business) to pay off principal plus interest. The debt instruments can go to third-party lender, target shareholders, or the target itself
• There are a number of anti-abuse provisions which requires structuring the LBO very carefully. A number of code section rules that will lead to tax issues if not followed
• With the borrowed funds, the acquirer is able to purchase the business while retain ownership, but must be cognizant of high interest payments in the early years, and nondeductible principal repayments in the later years. Will typically require a combination of selling company assets to pay down deb and/or increasing income/cash flow from the retained business assets
• Seller will have to realize gain on the sale of the business when sold if done outright. With leveraged buyout and use of debt instruments, may fall under installment sale rules

Question 40

Describe the benefits, risks, financial implications, and tax implications of private annuities

Answer 40

• The seller of the annuity (annuitant) conveys complete ownership of a property to a buyer who is obligated to make periodic payments to the annuitant for a specified period of time. Usually this is the annuitant’s lifetime, but can also be for the life of their spouse or another party
• Payments structured as an annuity. It is a fixed payment that is calculated using IRS valuation tables based on the annuitant’s life expectancy and current interest rates
• Good for when a client wishes to retire and shift control of a business to a family member or key employee. Good for when a client wishes to remove a sizable asset from their estate. Good for when a client owns a large parcel of non-income-producing property and wants to make it income producing. Useful when estate is very large and the major or sole heir is a grandchild or two generations below the client (considered a sale and isn’t subject to GSTT). Good for when the family’s objective is to keep certain property in the family or direct it to specified family members and the current owners do not want it subject to a will contest or statutory rights that might thwart their directive wishes
• Risks are that all payments cease at annuitant’s death, even if only one payment was made. If annuitant outlives their life expectancy, the buyer might pay more than anticipated. If the buyer predeceases the annuitant, the buyer’s estate must continue to make any remaining annuity payments throughout the annuitant’s lifetime
• Each annuity payment to an annuitant is treated partially as a tax-free return of capital, partially as capital gain, and balance as ordinary income. When the annuitant recovers their basis, the entire payment is taxed as ordinary income. Buyer isn’t allowed any deduction for payments
• No gift if the buyer’s annual payments to the annuitant are actuarially equal to the FMV of the property sold. If the value of the promise made to the buyer is less than the value of the property transferred, the difference will be considered a gift by the annuitant
• Not includable in taxable estate. Annuity payments are not included either. If annuity is joint, the payments continue until the second death

Question 41

Three approaches to valuing a closely held business?

Answer 41

1. Market approach - Compares private company to other companies in the public securities markets. Includes adjusting financial statements of the private company, analyzing multiples of the public securities, and making adjustments for the differences between the private company and its publicly traded counterparts. Private transactions of other companies bought and sold in the marketplace can also serve as evidence of the subject company value. Information is difficult to find and sometimes not reliable
2. Income approach - Involves measuring some level of income or cash flow and capitalizing these amounts into value. The value of a company to any investor is always the present value of its future income or cash flow. Analysis of the private company’s past performance is the best indication of its future performance. Sometimes forecast of future cash flows is determined to be a more reliable expectation of the company’s future performance
3. Adjusted balance sheet approach - Used in situations such as real estate and other types of holding companies. Involves adjusting the assets of a company to their FMV and deducting all outstanding liabilities. Situations for this approach arise when application of the market or income approach yields a value below the company’s book value, or when those approaches are eliminated from consideration altogether. In those cases, adjusted balance sheet approach is used to establish a valuation floor, since every company is worth at least the FMV of its assets less its liabilities

Question 42

What is an installment sale?

Answer 42

• A device for spreading out the taxable gain on the sale of an asset and deferring income tax on the gain from the sale of the property. Instead of the owner receiving payment outright for selling property, they receive payments spread over a set term of years
• Good for selling property to individuals/family members that may not have enough capital to purchase property outright. Good for when an individual in a high income-tax bracket holds substantially appreciated real estate, and can be an effective estate freezing device when the sale is between family members and the business is rapidly appreciating
• Taxable gains are prorated over the payment period, can shift most of the profit from a high-income year to other lower tax-bracket years. Installment payments are broken up into return on basis, gain, and interest income. Taxpayer must report parts of the payment that represent gain and interest income
• The installment note holder can choose to forgive all or a portion of payments made by the buyer if they want to apply the gift tax exclusion or exemption to the payments
• At death, any remaining installment payments due at the seller’s death is included in the gross estate. The entire unrealized gain on the balance of the note is accelerated and must be recognized. The right to receive payments on the installment obligation is treated as IRD and the payments are taxable income to the new recipient. No step-up in basis at death

Question 43

What are intra-family loans?

Answer 43

• An interest-free or below-market-rate loan. Money is lent at either below-market interest rates or with no interest. They must be actual loan agreements and should be put in writing. The loan terms, including interest rate, should be clearly stated. Typically employed in loans between family members
• Not many tax advantages, but may be useful to allow the individual borrowing the funds achieve a certain goal
• Loans less than $10,000 or $20,000 from a married couple are exempt from gift and income tax rules (with exceptions). Both income and gift tax consequences otherwise.
• When a lender makes an interest-free loan, they may have to pay income tax on the imputed interest that they should’ve received. The forgone interest is deemed a gift and will also be subject to income tax by the lender. The amount subject to gift and income taxation is the difference between the applicable federal rate and the interest actually payable under the agreement between the parties.

Question 44

What is a bargain sale?

Answer 44

• A transaction in which a donor sells property at a price below the FMV.
• Typically occur between family members or to charity.
• The difference between the FMV and the actual sales price is considered a taxable gift, which can be offset by the donor’s annual exclusion. Donor will realize income and pay capital gains tax to the extent that the sale price exceeds their basis in the asset. For a bargain sale to charity, the donor receives an income tax deduction for the gifted portion, not for the portion sold to charity

Question 45

What is a sale/gift leaseback?

Answer 45

• A sale-leaseback involves one party selling property to another party and then leasing back the same property. A gift-leaseback, a gift of property to an individual or to a trust is subsequently leased back. Must be a legal transfer of property for the full FMV of it. The amount of lease payments must be reasonable and at FMV
• Good for removing property from an owner’s estate and provide income to family members in the form of lease payments. Good for when a client has significant assets but poor cash flow. Good for when a client is in a high income tax bracket and wants to divert highly taxed income to a member of their family in a lower tax bracket. Good for when a client owns rapidly appreciating property and would like to shift that future wealth to a family member and save estate taxes on that appreciation
• For sale-leaseback, the seller must pay tax on any gain realized just as for any other sale. For gift-leaseback, the donor has made a taxable gift to the beneficiary or trust and may have to use a portion of the unified credit to offset the tax. Future growth is removed from the client’s estate

Question 46

Describe the use of an IDGT as a business transfer technique

Answer 46

• It’s an irrevocable trust designed to preserve family wealth by transferring appreciating property and income to family members, which reduces the value of the grantor’s estate
• Good for a business owner who wants to transfer business to a trust for the benefit of their family at a low gift-tax cost and receive an income stream that can be used to supplement or fund their retirement
• Transfers to IDGTs are completed gifts for gift tax purposes; defective for income tax purposes. The assets are not included in the grantor’s estate, but the income is taxed to the grantor, who is treated as the “owner” of the trust for income tax purposes
• Grantor can sell or transfer assets to an irrevocable trust. Since the grantor pays the income tax generated by the trust, the trust essentially grows tax free. Having the grantor pay the income tax also reduces the amount of tax owed. Trust income is taxed at 37% at a lower income threshold than an individual

Question 47

Describe family limited partnerships

Answer 47

• Limited liability entity created under state law. Ownership of partnership interests typically limited to family members of the same family. Partnership tax rules apply
• Good for when parents want to transfer wealth to their children in a tax-efficient manner but also want to retain control of their assets and continue to manage their property
• At formation, family members contribute property in return for ownership interest in the capital and profits. Divided between general and limited partnership interests. General partners typically retain a small interest while maintaining complete management and control. They assume personal liability for debts in the FLP. Limited partners receive partnership interests with potential for appreciation on their interests
• Important to make sure that assets transferred to the FLP has legitimate family business purpose and that the FLP runs as a business entity
• Gift tax and estate tax valuation benefits are also associated with FLPS. As a general rule, the value of an FLP interest is worth less than direct ownership of a percentage of the assets