The Family Business—Planning Techniques & Considerations

In considering potential planning options for family business owners, determining the client(s)' specific goals must be the first priority. This is always important in estate planning, but when a business is involved it is nearly impossible to consider any steps before discussing attitudes, the current business structure, family members' roles in the business, and relationships between family members involved in the business and those not involved. Major issues which are imperative for the planner to assess include:

• Is immediate transfer of management or control desired, or is the concern solely in regard to the effect on the business and the family if a death or incapacity occurs? What is the experience level of beneficiaries involved with the business? Have they been involved for long enough to be reasonably certain that they want to make the business their lifelong career? Are they responsible enough to base Mom & Dad's retirement on their ability to produce and their understanding that income to their parents cannot be a discretionary expense on their part?
• Will the overall plan of distribution in the estate plan enable beneficiaries involved with the business to continue operations? Will the plan carry out intended results even if asset values change? Will the plan be perceived as fair by all family members, or will it increase chances for a contest or family discord?
• Is capital gains tax an issue?
• Is estate tax a concern, even after planning is complete? Do estate tax planning techniques utilized leave enough flexibility so issues don't arise upon the first spouse's death? Is the effect of future growth considered?

Let's discuss planning options and the impact of the issues listed above on planning techniques.

Is Immediate Transfer of Control Desired, or is the Issue Limited to Planning if Death or Disability occur?

Most family businesses, regardless of size, have survived and thrived because of diligence, hard work, and risk taking on the part of the owner(s). Giving up ownership and/or control is a major step which should not be utilized unless there are very good reasons to do so and without significant thought and discussion. Disadvantages, as well as advantages, should be discussed very thoroughly before taking steps. Even if we create significant tax savings, if the client loses control or ends up with substantially increased paperwork, we will have a very unhappy client unless these disadvantages are discussed in detail before the decision is made to implement steps which will change the current owner's management authority.

Prior to relinquishing control to other family members, it is essential that the transferee(s) have had sufficient experience to be sure that they are ready to make a long term commitment, and to make the transfer of responsibility reasonable. Parents should not be put in a position which would never be considered if a family business was not involved. In other than family business situations, would any of us invest our entire life savings in a business under new ownership, often with little or no down payment made? If a sale is completed and children cannot make the payments, parents' options are not good. Do they foreclose on their children, or take the business back and then attempt to resell it?

Considerations Regarding Plan of Distribution in Estate Planning with a Family Business Involved

Estate planning documents are sometimes drafted to provide for distribution of the family business to certain family members, with all other assets distributed to other beneficiaries. This plan can be very dangerous for many reasons. First, asset values may change substantially, especially when a business is involved. If business values increase and other assets are used for health care or other expenses, non-business beneficiaries may not receive intended amounts. If business values decline and other assets increase in value, beneficiaries receiving business assets may not be treated fairly. Secondly, unless specifically provided otherwise, all debt and expenses will be paid from the residue (or net proceeds of a trust). This can result in debt being paid from assets intended for non-business beneficiaries. Third, unless a specific provision is included to distribute personal property among all beneficiaries, beneficiaries receiving the business may inadvertently be left out of personal property such as family pictures and heirlooms.

Although each situation must be analyzed and drafted based on the individual client's needs, granting an option to purchase business assets to beneficiaries involved in the business, with residue (or net proceeds) distributed among all beneficiaries is a beneficial alternative in many cases. If desired, discounts and/or financing may be provided to optionees. Purchase price may be locked in if the desire is to 'freeze' the price, so future growth does not increase the price paid by optionees. If clients are insurable, an established price also makes it easy for optionees to put life insurance in place to provide funds with which to exercise the option. If fluctuations in value should affect the option price, then the option may be based on fair market value when the option is exercised, or any other formula for determining value.

Using an option rather than outright distribution of business assets to beneficiaries involved in the business is easier for other beneficiaries to conceptualize. Most family members understand that those working in the business deserve to have the opportunity to purchase it. Discounted option prices are understandable, since optionees often help to build business values. Unequal distributions or outright distribution of business assets tend to create greater potential for resentment from other beneficiaries.

Capital Gains Considerations

Frequently, in order to eliminate triggering of capital gains tax, sale of business assets is postponed until the death of one or both spouses. This is especially worth considering if parent-owners have had health problems or are in advanced years. If it is the parent(s)' desire to transfer management and control to the next generation but capital gains is an issue, then lease agreements may be utilized in order to transfer control, while retaining ownership in the senior generation. Although lease payments will be fully taxable to the senior generation, tax will only be due on lease payments received. If business assets are retained by the senior generation, upon the parent(s)' death, step up in basis is achieved, and payments on sale of the business are free of capital gains tax. If the estate plan is structured so the lessee receives all or part of the business as an inheritance, the lessee will benefit from the stepped up basis. If the sale occurred pre-death, that benefit would be lost.

The lease agreement may provide that expenses which would typically be the responsibility of the owner are assumed by the lessee. This simplifies life for the senior generation, while providing a true taste of business ownership for the junior generation. An option may be included as part of the lease agreement to provide a discounted option price to provide benefit to the optionee for lease payments made. HOWEVER, if a lease is very similar to the effect of a sale, with lease payments equivalent to payments which would be made if the property was sold on installment contract, and with the option price similar to the principal balance on an amortization schedule, you risk classification of the transaction as a sale by the Internal Revenue Service.

If the option is provided only in the trust agreement, since it is revocable on the part of the grantor, the risk of the lease with option being construed as a sale is avoided. Additionally, if the option is provided only in the estate plan, the optionee should receive full stepped up basis, even though a discounted option price is paid. Since the option in the estate plan is an inheritance of values over and above the option price paid, the beneficiary receives the stepped up basis. If the option is provided in the lease agreement, stepped up basis is not achieved since no gift or inheritance occurred. Upon entering into the option contract, the owner no longer has the right to increase the purchase price, so no gift or inheritance occurs when the option is exercised.

The obvious disadvantage to including the option only in the estate plan and not in the lease agreement is that no protection is given to the lessee if lessors later change their minds about the option provisions or revoke the option entirely. Additionally, if nursing home or other expenses deplete assets, the lessee could be in a position of having made lease payments over a long period of time, but with no equity and no guarantee that (s)he will be able to purchase assets. A long term lease is also problematic if the lessee wants to make substantial improvements to the property.

Estate Tax Planning and Probate Avoidance

The 'easy' first step in planning is to be certain that both estate tax credits are utilized (in the case of a married couple), and that probate is avoided on both estates (provided that creditor issues don't make the probate statute of limitations period advantageous). This is particularly important when business values can create substantial tax liability and probate expense, but where liquidity is limited. These goals can be achieved by implementing one joint or two individual revocable grantor trusts.

In long term marriages, where both spouses have built the business together, or where the couples' desire would be for all assets to go outright to the spouse if estate tax was not an issue, to provide maximum flexibility to the surviving spouse, an 'all to spouse with right of disclaimer' may be a beneficial alternative. This leaves the spouse with alternatives if values change, or if fully funding the credit shelter trust will create cash flow, creditor, or other issues. For example, if substantially all assets are used as collateral for lines of credit for the business, (or for business expansion plans) challenges may arise if mandatory funding formulas in the estate plan mandate funding of the credit shelter trust at the time of the first spouse's death. Particularly if one spouse died prematurely, the surviving spouse may decide to retain all assets, and then use an irrevocable life insurance trust or other methods to provide funds with which to pay the future tax.

If one spouse would prefer not to continue involvement in the business if the other spouse did not survive, a sale to family member(s) upon the death of one spouse may be advantageous to everyone. Let's assume that, if one spouse passed away, the surviving spouse would prefer to transfer control to children who are involved in the business. Upon the first death, if the child(ren) working in the business purchase it, the surviving spouse now has either cash or an account receivable, rather than the concerns of an ongoing business. If capital gains issues prevent owners from transferring the business during their joint lifetimes, upon the death of one spouse, due to step-up in basis occurring upon the first spouse's death, all or part of the business (depending on state of residence and titling and classification of assets), may be sold without negative capital gains ramifications.

The credit shelter trust can more easily hold cash or an account receivable than the business interest. If ownership of the business interest is split between the surviving spouse (or his/her revocable trust) and the credit shelter trust, income tax planning, business financing, and day to day operations can be significantly complicated. Sub S elections may be jeopardized, and accounting to prevent commingling of assets can be time consuming and cumbersome. By triggering the sale of business interests upon the first estate, funding of the credit shelter is simplified. However, if a disclaimer is used, beware of taking steps for sale of the business by the surviving spouse prior to executing the disclaimer, since sale of the business would be an acceptance of benefits which would jeopardize the disclaimer. If the estate plan includes an option to purchase to specific beneficiaries, the disclaimer is not jeopardized by the sale, since the sale is not discretionary on the part of the surviving spouse. Providing the option allows the business interest to be sold, with proceeds available for funding of the credit shelter trust. Additionally, including option provisions within the estate plan prevents potential fiduciary duty issues which arise for the trustee of the credit shelter trust if business interests are sold from the credit shelter trust, where flexibility on price and terms could be severely limited.

Use of Irrevocable Life Insurance Trust When Family Business Exists

Life insurance owned by business owners can create significant amounts of estate tax liability. Typically, insurance was originally purchased to cover outstanding debt and to provide working capital in the event of an owner's death. If debt has now been reduced, clients may wonder whether they should reduce insurance coverage. Our recommendation in many cases is to retain insurance, and to consider converting the portion of the insurance not needed to satisfy debt to a joint and survivorship policy. The lower cost of the joint and survivorship policy would allow clients to increase insurance coverage without additional cost, or to retain current coverage with reduced expense. Insurance currently needed to cover remaining debt may be retained by clients if it is important to them that the proceeds are easily accessible to satisfy debt, or this insurance could be transferred to an irrevocable life insurance trust. If the clients' taxable estate exceeds their combined credit equivalents, they may choose to transfer all insurance values to the life insurance trust. With proper planning, liquidity may still be made accessible with which to pay debt. The insurance trust may not provide for direct payment of the client's debt, estate tax liability, or other benefits without being pulled back into their taxable estate(s). However, insurance proceeds held by the life insurance trust may be used to purchase assets from decedent's trust or estate, or loans may be made from the irrevocable life insurance trust to the decedent's trust or estate, provided fair market interest and terms are used.

Retaining insurance in a life insurance trust will provide proceeds with which to pay estate tax liability created by retaining all business values in the clients' control. Many clients prefer incurring the cost of life insurance premiums in exchange for retaining control of their own businesses. If it's not practical to eliminate tax, providing funding with which to pay the tax is the next best thing, particularly when, if funding is not available, business interests may be jeopardized due to lack of liquidity. In cases where, if the owners didn't survive, the business would be sold, this may not be a major issue. When the goal is to preserve the business for family members, providing liquidity so the business is protected becomes extremely important.

Variations in Planning if Business Entity is a Corporation, Limited Liability Company, or Family Limited Partnership

If the business entity facilitates transfer of shares without transferring control, (such as corporate stock, LLC shares, or FLP interests), gifting to transfer current values and future growth is an easier task. Additionally, for gift tax purposes, minority discounts may be used, allowing for removal of values from the parent's taxable estates while transferring more shares than would be possible if full value was used. These techniques are excellent methods of minimizing estate tax without relinquishing control. However, beware of being too creative with these methods if estate tax planning is not an issue after credits are utilized. Remember that transfer of assets during lifetime gives up the benefit of stepped up basis upon the parent(s)' death which is beneficial even when step up applies to stock or LLC shares rather than to individual assets. Federal estate tax rates are higher than capital gains rates, so if both tax issues exist, minimizing estate tax takes precedence. However, if estate tax is eliminated with other planning techniques, then protecting the stepped up basis is very important.

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