Business Entities Using Corporations, Partnerships, Limited-Liabilities Companies in Estate Planning

Business Entities

• Generally: Many people have existing businesses, and business succession is an important planning objective. For assets not held in an existing business entity, sometimes the formation of a corporation, partnership, or limited liability company can help accomplish estate-planning objectives, including asset management, asset preservation, and even estate reduction. Business entities require that certain legal formalities be observed and that separate accounting records be meticulously maintained. Creating a business entity is relatively inexpensive, but maintaining it can be expensive. It can be even more expensive if it is not done right.

• Corporations: Corporations are frequently used to shelter personal assets from the liabilities of a business. Gifting stock in a family corporation is a relatively simple way to make gifts. Gifts of minority interests and nonvoting stock are not only entitled to valuation discounts, but they entitle the recipient to retain control of the corporation and its assets. Corporations are separate taxpayers ("C corporations") unless their shareholders elect to be taxed individually on their pro rata share of corporate profits ("S corporations").

• Limited Partnerships: Limited partnerships can be formed to allow you to make gifts of partnership interests to family members while maintaining control over the underlying assets. Partnerships do not pay taxes and do not have to make special elections in order to be taxed individually on partnership profits. Partnership interests are usually subject to transfer restrictions that can justify even more significant valuation discounts for gift-tax purposes.

• Limited-Liability Companies: Limited-liability companies ("LLC's") are relatively new, and combine the best characteristics of corporations (limited liability of all members) and partnerships (pass-through of tax benefits). For most purposes, planning with LLC's is very similar to planning with limited partnerships.

• Giving: Gifts of interests in a family business are usually entitled to valuation discounts because of lack of voting control and the lack of marketability. By making lifetime gifts, it is often possible to reduce a person's interest to a minority share (especially for married couples owning equal interest), entitling the estate to a valuation discount for estate-tax purposes.

  • Gifts of business interests are attractive because the value of such interests for gift-tax purposes is less than the pro-rata value. In other words, a 5% business interest has a fair-market value of less than 5% of the business' assets because of certain valuation "discounts" that apply, including a discount for lack of voting control and a discount for lack of marketability.

  • A qualified business appraiser is required to determine the extent of the discount applicable in each situation.

  • This is more fully discussed in an article entitled "Gift Giving Using Limited Partnerships and Limited-Liability Companies", which is in Adobe Acrobat's "portable document format" and requires the Adobe Acrobat Reader program to view.

Buy-Sell Agreements

• Generally: Buy-sell agreements can alleviate disputes that can arise between or among other business owners and can provide for payments to the deceased owner's family without disrupting the ongoing business.

• Binding on the IRS: If the buy-sell agreement is properly structured, the agreement can determine the value of the business interest for estate-tax purposes. In order to be binding on the IRS for estate-tax purposes, the agreement must be a fair agreement that has an enforceable buyout price that is fixed or determined in a way that is reasonably calculated to produce a fair-market price. In other words, a buy-sell agreement cannot be used to create an artificially depressed price just to save estate taxes. An "agreed-upon price" is rarely sufficient for estate tax purposes, so the agreement will usually provide for a price determined by a formula or by formal appraisal.

• "Funding" a Buy-Sell Agreement: A well-designed buy-sell agreement will be "funded" with life and/or disability insurance to the greatest extent possible, but it will also address the payment of the purchase price to the extent not funded by insurance.

Business Succession Planning

One of the most difficult planning decisions relations to the transfer of an operating closely-held business at death. Sometimes it is necessary to sell a family business in order to pay the federal estate tax. A buy-sell agreement (discussed above) can be a useful tool to provide liquidity at death, but it is not the only tool.

• Estate Freezing. The use of installment sales, private annuities, and death-terminating promissory notes are discussed briefly in the article entitled "Estate Freezing Techniques".

• Charitable Trusts. Some times charitable trusts can be used to carry out a sale of a business with reduced tax consequences. Read the example in the "Charitable Trusts" article as though a business were involved. As mentioned in that article, life insurance is required to replace the value that passes to charity upon the settlor's death. This technique will not work unless the deal can be arranged so that the charitable trust does not receive "unrelated business taxable income" and so that there is no prohibited "self-dealing" between the charitable trust and its settlor (or persons and entities related to the settlor).

• Gift Combined with a Sale to a Grantor Trust. For clients who want to transfer a business to their children or other beneficiaries, it is possible to transfer part as a gift and part as a sale. This works best with a business that is organized as a "pass-through" entity for federal income tax purposes, such as an S corporation, a partnership, or a limited-liability company.

  • Step One: Create nonvoting interests. The company should be reorganized with a nonvoting class of ownership. For limited partnerships and limited-liability companies, this step may be unnecessary because state law provides that transferees are not substitute partners or members, and they automatically have no vote.

  • Step Two: Create a "grantor trust". Establish a trust that is considered a "grantor trust" for federal income tax purposes but that will not be included in the settlor's estate for federal estate tax purposes. A "grantor trust" is a trust over which the settlor (grantor) has some powers that cause the trust to be ignored for income tax purposes. The settlor pays all income taxes on the income of the trust, even if the trust is either accumulated in the trust or distributed to other beneficiaries. [NOTE: Some commentators call this an "intentionally defective grantor trust", but I dislike that term because there is nothing "defective" about it. It is simply a grantor trust that was intentionally designed to be so.]

  • Step Three: Give cash or business interests to the trust. The trust should be funded with cash or other assets so that he has some of its own assets. A rule of thumb is to contribute 10% of the value of the business that is going to be purchased. So, if your business has a net worth of $1 million, make a gift of $100,000 to the trust. If the gift involves business interests, because to have a business appraiser establish a fair market value of the gift using a valuation discount based on lack of voting control and lack of marketability.

  • Step Four: Sell the nonvoting business interest to the trust. To establish the purchase price, be sure to use a qualified business appraiser establish a fair market value of the interest being sold based on a valuation discount based on lack of voting control and lack of marketability. The trust will provide a promissory note to the settlor, and the trustee will make payments on the note until the note is paid off. [The note should not be forgiven or ignored. The IRS will ignore the note and treat the entire sale as a gift unless the note is paid under reasonable terms.]

  • For businesses with a cash flow that is sufficient to pay its operating expenses and to pay income to the owner (the trust), this technique will allow the next generation (or whoever the beneficiaries are) to receive part of the business at a discounted gift-tax valuation and to purchase the balance of the gift at the same discounted price.

These materials continue in the article entitled "Estate Freezing Techniques".

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