Estate Tax Issues for The Family Owned Business©

By Gregory L. Foster
Verrill & Dana, LLP
One Portland Square
Portland, ME 04112-0586

July 5, 2002

Planning for the death of a business owner has been, and continues to be, one of the greatest challenges facing a business owner and his or her advisors. This is often considered as part of the overall theme of “succession planning”, intending to cover the whole array of means by which a family business may continue past the time of leadership by either the family member or the current family owner, or current controlling interest. Succession planning involves not only providing for taxes, but more importantly, how to continue the operation of the business by grooming a successor; the alternative is a sale upon death. While succession planning itself covers a very wide variety of subjects, this paper will in rather brief terms touch upon a number of financial techniques and tools which are currently available.

1. Transfer Taxes - The New Law.

The estate tax is repealed for decedents dying after December 31, 2009; unfortunately, it comes back again, essentially in its present form for deaths after December 31, 2010. It was styled in this fashion for revenue counting and budget planning purposes, but Senator Collins explained shortly after the passage of the tax act just before Memorial Day that for Congress, “nine years is an eternity”. In other words, don’t gamble or bet that it will stay in its present form until the full repeal nor its reemergence. You can plan for the next two or three years, but after that don’t be surprised with additional changes, and don’t necessarily plan for the repeal of the repeal.

a. Gift Taxes: For almost twenty years the estate and gift taxes have been unified, meaning that the same tax rates and lifetime exemptions applied whether property was given away during lifetime or retained until death. Beginning in 2002 they are “delinked”, and the gift tax will remain after estate tax is repealed.

(1.) Annual gift exclusions remain at $11,000 per year per donee per donor (plus inflation adjustments); it was $10,000 for many years.

(2.) Lifetime exemption of $675,000 for 2001 increased to $1,000,000 in 2002 and thereafter. It does not increase above $1,000,000.

(3.) Rates will vary from 37% to highest rate charged for estate tax, which will decrease from the old 55% to 45% over time.

(4.) A married couple may elect to treat a gift as if one-half was made by each.

(5.) Spouses can still give each other unlimited amounts, recognizing, however, that a gift to a spouse simply defers the time when a tax is to be paid depending, of course, upon which spouse dies first. This is an important tool which may be used to ensure a family can benefit from two lifetime exemption amounts.

(6.) The gift tax is imposed upon the value of the property which was given away, as opposed to the estate tax which values the property which is retained.

(7.) The payment of a gift tax on large lifetime gifts is
excluded from the estate if the donor lives three years.

(8.) Example: If Sally’s estate is currently worth
$3,000,000, and she gives $2,000,000 to her children and pays a $1,000,000 gift tax (assuming a 50% rate and she had already used up her lifetime exemption), and lives three years, there is no estate left to be taxed and the children end up with $2,000,000. If she died leaving $3,000,000 equally to children, they would share in the after tax value of the property, which would be $3,000,000 minus $1,500,000 for taxes (assuming a 50% rate) leaving them $1,500,000. Thus, there is a $500,000 difference in the net amount ultimately passing to the children if the property is transferred by gift as opposed to the estate. This must obviously be balanced with the financial needs of the donor after the gift is to be made. Also, the donees of a gift have a lower income tax basis than heirs of an estate.

(9.) But with the lifetime exemption increasing and with the possibility of estate tax repeal, does it make sense to pay a gift tax today? Depending on health considerations, probably not.

b. Estate Tax: The Estate Tax is scheduled to be eliminated for 2010, subject of course to further change. It then reappears in 2011 and thereafter.

(1.) Lifetime exemption changes are as follows:

(a.) $1,000,000 - 2002 and 2003
(b.) $1,500,000 - 2004 and 2005
(c.) $2,000,000 - 2006, 2007, 2008
(d.) $3,500,000 - 2009

(2.) Rates decrease from the current maximum 50% (was 55%) down to 45%, however, the present credit for taxes paid to the State is eliminated so the overall reduction will not be as great as may be expected, since the States may themselves be expected to inact inheritance or estate taxes of their own to replace this revenue.

(3.) Currently when a person dies, the value of his or her property included in the estate becomes the new tax basis for the recipients of the property upon a subsequent sale. (For gifts, the donee’s income tax basis is the same as the donor’s (with some possible adjustments)). Under the new law, in 2010 the step-up in basis will only be on the first $1,300,000 of property, increased by an additional $3,000,000 for qualified spousal property, which amounts may be allocated among property owned at the time of death.

(4.) The value of the decedent’s property at death is valued at the fair market value of the interest actually owned, or over which he or she retained too much control. After deductions for the unlimited marital deduction, if there is one, and other expenses and debts, the balance is taxed under the then current rate schedule; the heirs are then distributed the balance either outright, in trust, or otherwise.

(5.) The tax is usually deducted from what the residual beneficiaries receive. If large amounts are paid outside of the estate through, for example, life insurance or retirement plan distribution, unless the will provides otherwise, the total tax on all this property is deducted from the residue of the estate.

(6.) For example, assume John died in 1999 and then Sally dies in 2002 leaving a $2,000,000 estate comprised of $1,600,000 IRA payable to the two children, and a $400,000 residence. Assuming the estate tax is $500,000, from where is the estate tax to be paid? The residence must be sold and $100,000 must come from the IRA, but income tax must be paid on that distribution!

c. Generation Skipping Tax : There is also a 50% generation skipping tax (was 55%) which applies to property transferred to someone not of the next generation, but of a second lower generation, (i.e. grandchildren). Currently there is a $1,060,000 exemption which increases at the same amount as the estate tax exemption until eliminated along with the estate tax. Except for the repeal itself, this may indeed be one of the greatest single, and yet underused, estate tax planning tools for families, particularly if there are liquid assets available and if the assets are not really needed by the older generation.

2. Ways to Minimize Estate and Gift Taxes

One goal of estate planning is to delay the time when the tax must be paid and to minimize the amount which must eventually be paid.

a. Marital Deduction. The most common technique to delay the payment of estate taxes is to fully utilize the marital deduction, if it is available, for estates in excess of the lifetime exemptions remaining. A traditional plan might provide for what is termed a “credit shelter/family trust” equal to the amount of lifetime exemption available, with the balance paid outright to the surviving spouse, or to be held in trust for the spouse’s benefit during lifetime and remainder over to the credit shelter trust for ultimate disposition.

(1.) To qualify for marital deduction, the spouse must be paid all income from the property during lifetime and the use of the property cannot end before the death of the surviving spouse.

(2.) Thus if a person died in 2002 and the lifetime exemption is $1,000,000 and if the total estate was $1,500,000, then $500,000 would be paid in the form of a marital bequest, with the tax on this marital bequest being due only at the death of the surviving spouse.

b. Installment Payments. Another method of deferring the payment of the tax is to attempt to qualify under the provisions of §6166, which permits a deferral of tax for up to ten years at a favorable interest rate. This provision applies only in the event that a substantial percentage of property held within an estate is a family business or real estate used in a family business. The restrictions, and continuing “negative covenants” which apply, make this a difficult choice for most businesses.

c. Gifts. Lifetime gifts are a way to eliminate value from an estate. Subsequent increases in value of property are truly eliminated from the estate, as is the annual exclusion with respect to such gift, however, because a portion of the lifetime exemption amount may be utilized, the value of the initial gift is not really eliminated entirely. There may also be a lower income tax basis.

d. Valuation Adjustments. Give property in small, fractional, amounts so that there may be available valuation adjustments because it will not be readily salable and for lack of control. A 60% interest in a business is worth more than twice that of a 30% interest because it carries with it control. Query, how marketable is it?

e. Example. By way of further example, assume a husband owns a business in which his wife also works. Assume too that there are two children. Assume also that the business is worth $2,000,000. If a child were to be given a two percentage point interest, 2% of $2,000,000 would be $40,000. However, since this is a minority interest, and it is also not particularly marketable since it is a closely held business, an appraiser might discount the value of this property by 20% to 40%. If each of the children were given the two percentage point interest, then the remaining interest held by the father would be 96%. He might then also gave half of the remainder to his wife, but there is no tax because of the marital deduction, (or a trust for her benefit which would qualify for the marital deduction). He would have remaining a 48% interest. He therefore has a non-controlling, minority interest which also is not marketable by itself. Thus, by making several small gifts, plus utilizing the marital deduction, the founding family member will have put himself into the position of having a minority, with all that entails (i.e. keep an eye on the votes), but at the same time have the ability to now plan for the value of the business at a substantially reduced amount. The bottom line - the value of the business has effectively been reduced by $400,000 - $800,000.

f. Under the present scheme of the law, the ultimate way to save taxes would be to die 2010 (but not in 2011). What an awful result!

3. Tax Free Life Insurance: Is it possible for life insurance on a person’s life not to be included in that person’s estate. In other words, is it possible to have $1,000,000 worth of life insurance on John, and yet not have any of those proceeds taxable in his estate?

a. Wife Buys. One answer is to simply have John’s wife buy the policy on her husband and pay for the premiums out of her own resources. The husband does not then have any incidence of ownership with respect to the policy. It is owned by his wife and she is presumably the beneficiary of the policy, which she has purchased. It is therefore, much like an investment to her with the proceeds paid to her upon his death. Of course, the insurance proceeds would be includable in her estate, but there is certainly the anticipated deferral element and the means to provide her liquidity while John’s estate might own low income producing assets in the form of family real estate.

b. Children Buy. An alternative is to structure an arrangement under which the children own the policy and pay for the premiums themselves. These premiums might be paid out of the proceeds of gifts which the older generation may make, however, obviously one wants to ensure that there is not a direct tie-in by having the insured actually pay the premiums directly. This is clearly an area where dotting the i’s and crossing the t’s is helpful to ensure exclusion from the estate.

c. Simple Trust. If there are several children, perhaps the policy could be owned in a simple trust with the proceeds paid to the trust with directions to pay the proceeds to the children.

d. Partnership. A partnership or LLC might be the owner of the policy and indeed may be an ideal owner with the partners or members contributing funds to pay the premium. In the eyes of the IRS, however, there should be some other income producing assets, such as shares of stock in a company or rental real estate, to give a “business purpose” to the structure which the IRS says is necessary to have a partnership.

e. ILIT. Perhaps the most common way of owning insurance, for the purpose of excluding it from an estate, is to use an irrevocable life insurance trust (“ILIT”). Under this arrangement, John establishes a trust of which a friend or bank acts as the trustee. The trustee then applies for insurance on John’s life and the trust owns the policy and pays the premium.

(1.) The donor might make an annual contribution (gift) to the trust, with the trustees using the gift to pay the premium to the insurance company.

(2.) Typically there are one or two beneficiaries under the trust who are given the right to withdraw a certain portion of contributions to the trust each year. This is often referred to as a so-called “Crummey Provision”. This is treated as a completed gift to those who have the right to make the withdrawal, but traditionally they do not act upon the written notice they are given.

(3.) Under such an arrangement, the surviving spouse is oftentimes the income beneficiary of the trust with the remainder over to the children. Sometimes the trust might be divided into two segments, one of which would be an amount equal to the generation skipping exemption amount, with the balance being held as a separate share which would pay the proceeds somewhat sooner, such as at the death of one of the children.

(4.) A variation of number three above might be to give income producing assets to the trust so that the income (after income taxes) is used to fund the amount of the insurance premiums. There is then no need for annual gifts to be made to the trust and it’s ensuing paperwork, but a trust income tax return would be necessary.

(5.) The life insurance might also be used as a way to generate estate liquidity, with the trust then using the insurance proceeds to buy property from estate of the deceased. For example, the purchase of an interest in the family business or residence may permit for the payment of estate taxes. Another use of this particular technique might be to have the insurance proceeds payable in an amount sufficient to “cover” the increased income tax which will be attached to and associated with property passing through an estate but which does not get a step up in tax basis.

(6.) With full use of the marital deduction, estate taxes, if any, will be due only at the death of the surviving spouse. Therefore, oftentimes a second to die policy is purchased. Proceeds are payable only upon the death of the second spouse.

4. Funding Buy/Sell Arrangements: Family business arrangements often provide that upon the death of a member, some portion of his or her stock, or other interest, will be repurchased by the company or other owners to provide liquidity for purposes of paying estate taxes, and to buy out the equity interest of the deceased. Sometimes a formula price is used, however, if the buyer(s) under the Buy/Sell arrangement are members of the deceased’s family, the IRS will disregard the formula price unless it is equal to the fair market value of the property. While the question of the determination of the price is always problematic, one does not want to lose sight of the question, “How is the promise to buy back the stock to be honored?” In other words, how do you pay for the stock at the death of the shareholder?

a. Life Insurance. The most obvious answer is to purchase life insurance.

(1.) If the business is to purchase the interest and there are two insured shareholders, there would need to be two separate policies; if there were three shareholders then there would need to be three separate policies; and so forth. That works reasonably well if the policies are owned by the business which receives the proceeds upon death, and then uses the proceeds to purchase the deceased shareholders stock. But life insurance payable to a corporation, however, can give rise to income tax through the alternative minimum tax, so this too must be considered.

(2.) Purchase by shareholders may be preferable, with funding by life insurance products. If there are three shareholders, however, then each person would need a separate policy on the other two and vice versa. It is obvious that this becomes rather unwieldy and more expensive particularly if there are more than two or three shareholders.

(3.) A trust or partnership might own the policy with the proceeds used to purchase the deceased’s stock. The amount of insurance should, of course, increase as the value of the company (hopefully) increases.

(4.) This might be funded with Universal Life Insurance which can be structured in many different ways. The cost of such a policy is often lower in many instances, because of the use of what is called term and whole life insurance within each contract.

b. Installment Redemption. An alternative is to plan for the company to repurchase the shares with internally generated cash accumulated over the years. This raises issues at some point with what is called accumulated earnings, since the IRS by direction of Congress, wants to subject corporate distributions to dividend tax treatment. This may sometimes be avoided by the S election, although receipt of insurance proceeds creates its own problems for an S Corporation and its shareholders.

(1.) The company might repurchase the stock over time which, while it may not give immediate liquidity, at least provides a market for the stock and a continuing stream of income for the survivors.

(2.) Seek a bank loan for purchase of shares upon the death of a shareholder. The financial institution may, however, feel somewhat less secure if a founding father dies than if someone who is relatively new to the company. Therefore, one wants to approach this alternative rather carefully and have some rather candid discussions with the bank and clearly have succession plans in place which will permit the bank to be comfortable that it will be repaid the borrowed funds.

c. Restrictive Ownership. Often not considered but still a way of assisting the funding of a buy/sell is to have minority interests involved, so that substantial discounts may be applied to the shares which are being repurchased, and which also would be applied for estate tax calculation purposes. Obviously, having a minority interest is not necessarily welcomed by a family member, as he or she might then be “outvoted” by others who own relatively small numbers of shares. Trusts may be used for holding ownership of stock.

5. Probate Process. Some people believe the probate process is a concern. While this can be troublesome in some areas, such as New York and Massachusetts, Maine has a rather simple and informal process for probating estates, and therefore privacy would be the primary reason for avoiding probate. A Living Trust may assist in simplifying the probate process and provide lifetime benefits as well. To briefly review:

a. A will passes property owned by the deceased.

b. Certain property does not pass under the will, such as that which pass by operation of law, such as jointly held property, and property passing outside the system under contract, such as life insurance and retirement plan designations.

c. The balance of the property would then be paid as described in the will, dealing with tangible personal property and real estate, with the residue being paid over to a trust which can be established under the will, or to an inter vivos or living trust.

d. A living trust is a trust simply which is established by and nominally funded by the decedent as part of his estate planning documents. It is this trust which contains the primary dispositive provisions, much like a will, so that privacy may be maintained. For example, if there are significant monetary bequests to individuals and institutions, the amount will be not be disclosed to others if paid out of an inter vivos trust, as opposed to a trust which is established pursuant to the will itself and which is open to public inspection because it is part of the probate process.

e. A living trust can also be useful for the holding of property as aging progresses, with the Trustee able to quickly step in to help with financial affairs.

Conclusion. Many tax issues must be considered by a business owner in addition to actual plans for management succession. Proper planning can provide for payment of the taxes, if any, so the focus can be on continuation of the business.

Email Greg Foster at glf@verdan.com.

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