Section 10: Planning for Closely Held Business Owners Flashcards
What is code section 2032A?
Special use valuation- as opposed to highest and best use
e.g. farmland w/ expensive land encroaching
What is section code 6166?
Decedent’s estate can elect under certain circumstances to defer payment on estate taxes up to 14 years
e.g. substantial loss if business sold now
What is the option for an uninsurable business owner to fund a buy-sell agreement?
Company can use a sinking fund- use fixed or variable annuities, mutual funds, and other securities- premiums are not deductible but free from basic corporate tax
Who does the 20% pass through deduction apply to?
Pass through entities: sole prop, LLCs, s-corp,partners
-it is not a business deduction- comes out on the personal tax return- “below the below the line deduction” on line 9 (line 7 agi)
Don’t need to itemize
What is IRC section 162 business definition?
-engaged for profit
-regular
-continuous
*rental real estate is biggest question- IRS notice-2019-07 “safe harbor”
Does the business qualify for business?
What tax form does a partnership use?
Partnerships file a 1065
Partners each get a K-1 which flows through to the 1040
How does the sole proprietor report income?
Taxpayer required to file a single form- schedule C (self employment income)
Schedule C losses can be deducted from taxpayer or spouse (joint) other income
How are C-corps taxed?
What is a personal service corporation?
PSC involves the performance of certain fields such as health, law, engineering, architecture, accounting, performing arts, consulting. Also, all the stock must be owned directly by the employees, retired employees, or their estates, or indirectly through partnerships, s-corp etc
If a corporation is deemed to be a “personal service corp”, it will be taxed at 35% flat tax rate so the graduated corporate income tax rates are not available
What is the C-corp accumulated earnings test?
AET: the accumulated earnings tax is a penalty tax imposed on a corp that holds earnings in excess of its normal business needs. The rationale for the penalty is to prevent corps from accumulating earnings that might otherwise distribute as taxable dividends to its shareholders
Corporation must demonstrate the amount it needs to retain to meet reasonable needs of business
$250k credit for c-corp, $150k for personal service corp- tax is 20% times the corp accumulated taxable income
What are the graduated corporate tax rates?
What are the disadvantages of a S-corp?
Rigid rules the must be adhered to throughout its existence
100 max shareholders, one class of stock, only specific types of shareholders (individuals, estates, certain trusts and tax exempt organizations
special allocations are not permitted
Income and deductions must be allocated to shareholders based on % of ownership
What are the limitations on charitable contributions for C-corps?
They are deductible up to 10% of taxable income (with certain adjustments). Generally, charitable deductions in excess of 10% can be carried forward up to five years.
Unlike partnerships and sole props, C-corp is allowed to use a fiscal tax year rather then a calendar year. Depending on the circumstances, there may be a certain advantages using fiscal year.
What entities are not eligible to become a S-corp?
*a financial institution that uses 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
What is the personal holding company tax?
A corporate penalty tax is the PHC- designed to keep shareholders from avoiding the individual income tax on certain types of income generated by property held inside the corporate entity.
The stock ownership test if more then 50% of value of stock is owned directly or indirectly, by no more then 5 shareholders
What is an Intentionally Defective Grantor Trust?
Estate freezing technique-
Effectively for estate planning purposes a gift is made reducing estate
For income tax purposes the gift has not been made so income is taxable
Involves selling assets to a trust using an installment note
What is a Sale-Leasback or Gift-leaseback?
Must be legal transfer of title and sale for FMV of asset
Involves one party selling to another and leasing it back- either by lump sum or installment note
e.g. client has significant assets but poor cashflow, client in high tax bracket and wants to divert income to person in lower tax bracket, owns rapidly appreciating property and wants to shift
What is an intra-family loan?
A loan that can be between non-family members- generally low or no interest charged
Forgone interest is imputed and charged to lender if loan is over $100k subject to the annual federal rate (AFR)
What is a private annuity?
Functions similar to commercial lifetime income single or joint annuity except person to person
e.g. sell business and buyer pays seller income rest of life single or joint
What is a SCIN?
self canceling installment note
Same rules apply as installment sale except at death the note cancels- typically used with family
What is an installment sale?
Payments and tax are spread out over a set # of years, seller must receive payment in following calendar year, then no set terms, must charge market interest rate
This technique affords great flexibility, creates market where one didn’t exist before, allows biz to generate profit to pay, great estate freezing technique- especially valuable to shift growth to next generation
taxes are broken into three parts- return, gain, interest
What is the marketability discount?
Most FLPs have provisions that limit ability to sell- each reduces the value by design and reduces the value/interest to potential buyers
Can be high as 30% discount
What is the minority discount?
Discount due to lack of control routinely applied- reflect the inability for limited partner to control operations or invest assets in a manner that is most advantageous to the limited partner
Typically 20-30%
What is a creditor “charging order” as it relates to assets in a family limited partnership?
Creditor can not: obtain stock or take partnership assets, participate in management of FLP, force liquidation of FLP, attach interest to limited partners
Only thing available is income distributions that the general partner has influence over
Who are the key players in the family limited partnership?
Divided between general partner and limited partnership interests
Can be one or both parents as trustees of family trust, S-corp, or a LLC
GP typically retain very little interest, as little as 1-2%, despite size GP retains control and can control flow of income to family
When is a FLP generally used?
Parents want to shift wealth to their children in a tax efficient way but also maintain control of the assets- children may lack authority or ability to manage assets or family business
What are Parallel payments?
payments are immediately deductible by the payor and taxable as OI to the consultant- can be very efficient tax strategy when structuring the sale of a business
What is the 80-80 test?
Parent company owns at least 80% of shares and 80% of voting rights
What is code section 332?
No gain or loss shall be recognized on the recipient corporation of property distributed in a complete liquidation of another corp if: 80-80 rule is met, corporation must redeem all its shares, transfer must occur in specified statutory time frame- basis of property carry’s over- if there are losses included it can be detrimental to do this
Considerations regarding preparing a business to sell if it is a C-corp
Elect S-corp and wait 5 years to get better tax favor treatment
How does NIIT effect active shareholders?
If active in the business you may not be subject to tax
What is code section 338g?
Net operating losses NOLs can be used to obtain step up in basis through this code section
What are section 751 assets as it relates to the sale of partnership assets?
e.g. “hot assets” inventory, unrealized receivables, recapture , etc
Not 20% cap gain but 37% OI tax on those items- sale price must be allocated accordingly
What is code section 704(c)(1)(b) as it relates to the sale of partnerships?
Especially relate to to FLPs- if you contribute to the partnership and sell- no matter the % of ownership allocations original contributor pays cap gains taxes (so as not to shift gains to fam in lower tax bracket)
What is the valuation calculation?
=earnings/(discount rate minus growth rate)
What is an entity purchase agreement?
buy-sell agreement where the business pays premiums on life insurance for partners and is owner of the contracts
What is mezzanine financing?
Usually used in private placement used by smaller companies involving higher levels of leverage then junk bonds- usually takes the form of unsecured , subordinated debt or preferred stock
When using a redemption agreement funded by life insurance who owns the policies?
business owns life insurance for each owner
What is the schedule of payments for estate taxes if it qualifies as a closely held business?
4 years of interest only and additional max of 10 years of interest and principle
What type of life insurance is used to fund a cross purchase buy-sell agreement?
Joint life insurance
What is Mezzanine financing?
This agreement is set up such that the lender can convert debt to equity should the company default on the loan. A high risk, private placement, often used by smaller companies
What is venture capital funding?
Not always monetary vehicle. T his could include support in terms of leadership or technical advice. Whatever is provided in exchanged for ownership in the company or share of earnings potential
What is leveraged buyout?
Often viewed as hostile, this type of funding can be useful in taking a public company private, to spin-off part of the business, or transfer ownership of a small business
What is restructure debt (or operations)
Can include 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
What is an angel investor?
This investor uses their own money and is less concerned about future profit in lieu of innovation. The investor’s portfolio usually contains less than 10% in this type of investments
What are the rules for a QBI deduction?
IRC Sec. 199A - Taxpayer may qualify to deduct from income taxes an amount equal to up to 20% of qualified business income (QBI) from each pass-through business owned .
Those taxpayers with income exceeding the annual threshold ($326,600 married filing jointly/$163,300 single as of 2020) must meet different qualifications.
Which of the following assets owned inside of a family limited partnership (FLP) is most likely to receive the lowest acceptable valuation discount by the IRS?
business interest
unimproved land
marketable securities
Family Farm
Marketable securities
The following entity is also called an asset holding company and is a method of recapitalization. It is authorized to issue both voting preferred stock and non-voting common stock. The intention is to freeze the interest of the business owner in the operating corporation by subsequent gifts of the non-voting common stock to this entity.
personal holding company
family holding company
family limited partnership
limited liability company
family holding company
A Personal Holding Company exists when more than _____% of a corporation’s outstanding stock is owned by ___ or fewer individuals
60% - five
What type of buy-sell agreement does the business pay the premiums of life insurance on partners and is owner and beneficiary of the contracts?
Entity Purchase Agreement
A sole proprietor responsible to pay ALL unpaid tax liabilities, plus any interest and penalties. This includes the payroll Trust fund taxes and employer share.
True or False
A sole proprietor must pay the entire unpaid tax liabilities, plus any interest and penalties. If incorporated as an LLC or corporation, you would only pay the trust fund taxes.
True
True or False
Partners are not jointly and severally liable for the entire unpaid tax liabilities, plus any interest and penalties.
Partners are jointly and severally liable for the entire unpaid tax liabilities, plus any interest and penalties. In a corporation or LLC, they would only be responsible for trust fund taxes.
False
In a limited liability corporation the shareholder/owner is responsible for only for the payroll trust fund taxes and not the employer’s tax share.
True or False
In a limited liability corporation has a shareholder/owner. They responsible only for the payroll trust fund taxes.
True
Describe a stock redemption plan
n a stock redemption plan the business purchases life insurance on the shareholder’s life. The business is the owner and beneficiary of the policy and pays all of the insurance premiums.
The insurance provides the business with the necessary funds to purchase (redeem) the stock of Client A, at a future time.
Client A’s estate is obligated to sell all of Client A’s stock to the business, guaranteeing a market for the stock in Client A’s estate (at a predetermined price).
Will the surviving business owner receive a step in basis when their partner passes away when using a stock redemption plan?
No
The surviving shareholder does not receive an increase in basis because the business is redeeming only the stock owned by Client A. When the business purchases the stock from deceased partner’s estate, the business will purchase it with a stepped-up basis.
Client A is in business with two co-owners (Owner B and Owner C). Each originally invested $100,000 in the business. The full market value of the business is now $600,000.
Owner B dies and the company buys back the interest under a stock redemption plan, paying B’s estate $200,000. Client A sells their interest when the FMV is still $600,000. What is the impact to Client A’s taxes? 2
Client A recognizes a taxable gain of $200,000
When the corporation buys out the interest of a deceased owner, the surviving owners do not receive an increase in basis for income tax purposes. This means that if Client A sells the interest in the business during Client A’s lifetime, there is a larger capital gain.
Summary of Cross-Purchase Agreement
How does a stock recapitalization work?
To employ this strategy, a business owner recapitalizes stock into voting preferred shares and non-voting common shares. The owner then gifts the non-voting common 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.
What is the effect of stock recapitalizaion?
The value of the gift is the value of the stock reduced by annual exclusions and applicable discounts. Without a qualified payment, the business owner would have a retained interest of zero and the value of the gifted stock would be the FMV of the closely held business.
Recapitalization also freezes the value of the preferred shares at par value no matter how much the business grows, which further reduces the value of the stock in the owner’s gross estate at death.
What is the minimum value rule?
Note that the minimum value rule applies, so the gift tax value of the common stock must be at least 10% of the total value of the business owner’s stock. This technique allows the owner to retain total control of the business, receive income from the preferred shares, freeze the preferred shares at par value, and give family members direct ownership in the business with the benefit of future appreciation on their common shares.
What are the four business valuation methods?
Market Value
Asset Value
Discounted Cash flow
Multiple of earnings
