Section 10: Planning for Closely Held Business Owners

Question 1

What is code section 2032A?

Answer 1

Special use valuation- as opposed to highest and best use

e.g. farmland w/ expensive land encroaching

Question 2

What is section code 6166?

Answer 2

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

Question 3

What is the option for an uninsurable business owner to fund a buy-sell agreement?

Answer 3

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

Question 4

Who does the 20% pass through deduction apply to?

Answer 4

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

Question 5

What is IRC section 162 business definition?

Answer 5

-engaged for profit
-regular
-continuous

*rental real estate is biggest question- IRS notice-2019-07 “safe harbor”
Does the business qualify for business?

Question 6

What tax form does a partnership use?

Answer 6

Partnerships file a 1065

Partners each get a K-1 which flows through to the 1040

Question 7

How does the sole proprietor report income?

Answer 7

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

Question 8

How are C-corps taxed?

Answer 8

Question 9

What is a personal service corporation?

Answer 9

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

Question 10

What is the C-corp accumulated earnings test?

Answer 10

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

Question 11

What are the graduated corporate tax rates?

Answer 11

Question 12

What are the disadvantages of a S-corp?

Answer 12

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

Question 13

What are the limitations on charitable contributions for C-corps?

Answer 13

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.

Question 14

What entities are not eligible to become a S-corp?

Answer 14

*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

Question 15

What is the personal holding company tax?

Answer 15

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

Question 16

What is an Intentionally Defective Grantor Trust?

Answer 16

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

Question 17

What is a Sale-Leasback or Gift-leaseback?

Answer 17

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

Question 18

What is an intra-family loan?

Answer 18

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)

Question 19

What is a private annuity?

Answer 19

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

Question 20

What is a SCIN?

Answer 20

self canceling installment note

Same rules apply as installment sale except at death the note cancels- typically used with family

Question 21

What is an installment sale?

Answer 21

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

Question 22

What is the marketability discount?

Answer 22

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

Question 23

What is the minority discount?

Answer 23

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%

Question 24

What is a creditor “charging order” as it relates to assets in a family limited partnership?

Answer 24

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

Question 25

Who are the key players in the family limited partnership?

Answer 25

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

Question 26

When is a FLP generally used?

Answer 26

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

Question 27

What are Parallel payments?

Answer 27

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

Question 28

What is the 80-80 test?

Answer 28

Parent company owns at least 80% of shares and 80% of voting rights

Question 29

What is code section 332?

Answer 29

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

Question 30

Considerations regarding preparing a business to sell if it is a C-corp

Answer 30

Elect S-corp and wait 5 years to get better tax favor treatment

Question 31

How does NIIT effect active shareholders?

Answer 31

If active in the business you may not be subject to tax

Question 32

What is code section 338g?

Answer 32

Net operating losses NOLs can be used to obtain step up in basis through this code section

Question 33

What are section 751 assets as it relates to the sale of partnership assets?

Answer 33

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

Question 34

What is code section 704(c)(1)(b) as it relates to the sale of partnerships?

Answer 34

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)

Question 35

What is the valuation calculation?

Answer 35

=earnings/(discount rate minus growth rate)

Question 36

What is an entity purchase agreement?

Answer 36

buy-sell agreement where the business pays premiums on life insurance for partners and is owner of the contracts

Question 37

What is mezzanine financing?

Answer 37

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

Question 38

When using a redemption agreement funded by life insurance who owns the policies?

Answer 38

business owns life insurance for each owner

Question 39

What is the schedule of payments for estate taxes if it qualifies as a closely held business?

Answer 39

4 years of interest only and additional max of 10 years of interest and principle

Question 40

What type of life insurance is used to fund a cross purchase buy-sell agreement?

Answer 40

Joint life insurance

Question 41

What is Mezzanine financing?

Answer 41

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

Question 42

What is venture capital funding?

Answer 42

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

Question 43

What is leveraged buyout?

Answer 43

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

Question 44

What is restructure debt (or operations)

Answer 44

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

Question 45

What is an angel investor?

Answer 45

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

Question 46

What are the rules for a QBI deduction?

Answer 46

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.

Question 47

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

Answer 47

Marketable securities

Question 48

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

Answer 48

family holding company

Question 49

A Personal Holding Company exists when more than _____% of a corporation’s outstanding stock is owned by ___ or fewer individuals

Answer 49

60% - five

Question 50

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?

Answer 50

Entity Purchase Agreement

Question 51

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

Answer 51

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

Question 52

True or False

Partners are not jointly and severally liable for the entire unpaid tax liabilities, plus any interest and penalties.

Answer 52

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

Question 53

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

Answer 53

In a limited liability corporation has a shareholder/owner. They responsible only for the payroll trust fund taxes.

True

Question 54

Describe a stock redemption plan

Answer 54

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).

Question 55

Will the surviving business owner receive a step in basis when their partner passes away when using a stock redemption plan?

Answer 55

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.

Question 56

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

Answer 56

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.

Question 57

Summary of Cross-Purchase Agreement

Answer 57

Question 58

How does a stock recapitalization work?

Answer 58

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.

Question 59

What is the effect of stock recapitalizaion?

Answer 59

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.

Question 60

What is the minimum value rule?

Answer 60

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.

Question 61

What are the four business valuation methods?

Answer 61

Market Value
Asset Value
Discounted Cash flow
Multiple of earnings