Business owners have unique concerns in addition to the usual estate and retirement planning issues. Business owners fear their heirs might sell or dismantle the business or the wrong people might run it. Those results can be avoided, but the owner must plan carefully and implement the plan.
Small business succession can be divided into two major issues. The first issue is the personal aspect of succession. Who will manage the business or have a say in its operations? The second major issue is the financial aspects of transition: estate taxes, cash flow, and the like. I will focus on this second issue in this posting.
The financial aspects can be divided in two parts. The first part is ensuring that the estate has enough cash flow to pay the taxes and other estate expenses. The second part, which can help with the second part, is to reduce the estate taxes related to the business.
While most people focus on estate taxes in their planning, the plan also must ensure the estate will have the cash to pay those taxes and other expenses without selling the business or taking other drastic action. Often, the solution is to get cash from the business to the estate, and the owner must ensure that the business has enough cash to meet the estate’s needs.
Let’s look first at a few tax strategies to improve the estate’s cash flow.
One seemingly-attractive tool is the deferral of estate taxes under Section 6166 of the tax code. This section allows the estate taxes to be deferred over 14 years. Only interest is paid for the first four years; then principal and interest are paid for the next 10 years. The interest rate charged is low.
While enticing, many small business owners should not rely on this tool. First, you cannot be sure that Congress won't change or repeal the section when it is too late for you to do additional planning. Second, many small businesses won't qualify for the extension. The business must meet the section’s definition of “closely held,” and its value must be at least 35% of the owner's estate. The owner also must own a minimum percentage of voting power, and the business must be an “active trade or business,” which can exclude real estate and other significant operations. Another complication is that the IRS can put a lien against the business until the tax bill is paid, even when the election is made properly.
Another strategy to consider is tax code section 303, which is an efficient way to get cash from a business to an estate. Stock can be redeemed from the estate. The estate pays the long-term capital gains rate if the amount of stock redeemed equals the cost of estate taxes, funeral expenses and estate administration. But this provision also has limits. For one, it applies only to regular corporations. S corporations and LLCs cannot use it. Like Section 6166, it would be risky for most estate owners to rely on it.
Another way to get cash from the business to the estate is known as a Graegin note, after the Tax Court case that approved it. The estate can borrow from the business to pay estate taxes, and it can deduct the interest as an estate administration expense. The case generally is interpreted as allowing a lump sum deduction against the value of the estate of the interest to be paid, though the interest is paid over time. This deduction can reduce estate taxes significantly.
The IRS is looking closely at Graegin note transactions. The estate must show that the interest expense is reasonable and necessary. That generally means showing that the estate needs the cash and that it is not feasible to sell assets to pay the taxes. Some estate planners recommend borrowing from a third party instead of directly from the business. The business can guarantee the note.
Cash flow also can be established with non-tax strategies, such as life insurance, loans, and cash management by the estate owner.
Now, let’s look at estate tax reduction strategies unique to business owners.
In recent years, two key estate planning strategies for business owners have come under attack from the IRS: private annuities and family limited partnerships. Private annuities are in limbo because of recent IRS rulings and regulations in the works. FLPs still are viable for those who follow the guidelines set in court cases, and we have covered them in past issues of Retirement Watch.
Fortunately, there are a host of other viable strategies for the business owner to consider without the risk of locking horns with the IRS.
An installment sale, and its variation known as a self-canceling installment note (SCIN), allows the owner to sell the business to one or more family members (or to employees). The owner controls the tax bill, defers taxes, and establishes a manageable payment plan for the buyers.
Taxes from the sale are deferred, because they are recognized only as payments are received. Taxes can be accelerated if the seller cancels the note, transfers the note, or sells the business to a related party who sells it to someone else within two years. The future appreciation of the business is out of the seller's estate. At the seller's death, only the present value of the note is included in the estate.
With a SCIN, the note is canceled on the seller's death; no value is included in the seller's estate. But the term of the note should be no longer than the seller's life expectancy on the date of the sale, and the buyer will have to pay a premium above the business's value to justify the cancellation feature. The SCIN needs to be carefully structured with an experienced estate planner to avoid gift taxes and other potential pitfalls.
If done properly, either a SCIN or straightforward installment sale removes future appreciation from the estate and reduces estate taxes. Each also allows heirs or other buyers to use future business cash flow to buy the business. In either version, the owner is selling the business now, not at some point in the future.
A little-used tool for business owners is the gift (or sale) and leaseback. Suppose the owner wants to remove assets from the estate but wants to continue running the business. If there are assets used by the business that the owner holds outside the business, the owner can give assets to the children and have the business lease them back. The owner must possess the assets individually for this to work. Or the business can sell the assets to the children and lease them back.
The arrangements can provide both cash flow and tax benefits to the children, in addition to the estate planning benefits. The IRS scrutinizes closely these types of transactions between related parties, so they need to be planned and executed carefully.
An effective tool that can be difficult to explain is the intentionally defective grantor trust (IDIT). This allows the seller to remove a property from the estate and still retain control. The strategy’s success depends on the different definitions of ownership under the estate and gift tax on the one hand and the income tax on the other hand.
The owner creates a trust and sells appreciating assets such as a business or key property to it in return for an installment note. The seller retains enough control of the trust to treat him as owner under the income tax rules but not enough control to include the trust assets in his estate. An experienced estate planner needs to draft the trust to meet this requirement.
The assets and their appreciation are out of the seller's estate, though the installment note's present value might be in the estate. The seller also is taxed on the income of the trust, which is a way of making a gift to the trust beneficiaries without paying estate and gift taxes. If the owner pays the income taxes, the trust assets are able to compound without the burden of income taxes.
For the business owner with enough cash flow to pay the income taxes, the IDIT is worth a look.
A strategy that probably is not used enough is the employee stock ownership plan (ESOP). The tax law provides a number of incentives to use an ESOP.
In a typical ESOP, a small business owner creates the ESOP and a related trust. The company borrows money from a bank and in turn lends that money to the trust. The owner sells some or all of his stock to the trust. Over time, the company makes annual contributions to the trust, which are deductible. The trust uses the money to repay the loan from the company, which the company uses to repay the loan from the bank.
Special tax breaks allow the company to deduct both the interest and principal it pays on the loan. It also deducts contributions made to the trust as well as dividends paid on stock owned by the trust.
The owner also receives individual tax breaks. Gains from the sale of the stock are deferred if within a year the owner uses the proceeds to purchase securities issued by domestic companies and meet other restrictions. Taxes are due only as the owner sells those investments. The owner can sell whatever percentage of his stock he wants. In many ESOPs, the owner still retains a majority share of the company.
An ESOP is best for an owner whose children do not plan to run the company and do not want to own it. The ESOP gives a share to each employee and must meet nondiscrimination rules; the owner cannot pick and choose which employees get greater shares in the ownership distribution. When an employee leaves the company, he receives cash equal to the value of his ESOP account. Employees generally are allowed to vote on major corporate changes, such as mergers and acquisitions.
When done right, the estate plan of a business owner enhances the value of both the business and the owner's estate. It also provides more for the heirs and avoids potential problems involving taxes, cash flow, and the survival of the business.
08-28-2008 2:44 PM
Filed under: Estate Planning, estates, Estate tax, Carlson, Bob Carlson, income taxes, estate taxes, real estate, retirement plan, retirement, retirement plans, business sales, selling a business, small business