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Family-business owners, like others,
must plan for the future. Death is
inevitable, retirement is likely, and
disability is possible. Some owners want
to pass the business to the next
generation, while others may want to
sell the business outright. To protect a
business and the hard work and
investment it represents, owners must
carefully consider the financial, tax, and
management decisions that need to be
made to ensure the smooth transition of
the business to the new owners.
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Estate taxes for the family business
Estate taxes can be an extremely burdensome expense to the heirs of the owner of even a small business. In 2000-2001, a decedent can pass the first $675,000 of his estate (notwithstanding the unlimited marital deduction) without any estate tax being due. Often, the value of the small business alone exceeds this $675,000 figure. Estates above $675,000 can be taxed at rates as high as 55 percent of the decedent's estate and typically these taxes are due within nine months of the decedent's death. Although payment of estate tax in installments is an option, in instances where the bulk of the estate is the family-owned business, the heirs may face a dilemma: Must we sell the business just to pay the taxes for inheriting it?
Congress has recognized the burden placed upon families faced with the dilemma of whether to sell the business to pay taxes. In 1998, Congress passed the latest legislation to reduce the estate taxes for family-owned businesses. As part of the IRS Restructuring and Reform Act, IRS Code §2057 allows certain heirs of a person who died owning a qualified family business interest to exclude up to $1,300,000 from estate taxes that would otherwise be attributable to the value of the business. This provision is known as the Qualified Family-Owned Business Interest deduction (QFOBI).
There are three key elements that must be satisfied to get the deduction, and, they are very technical and apply only to limited situations. First, the business must meet the definition of a "qualified family-owned business." Second, the "adjusted value" of the business must exceed 50 percent of the decedent's "adjusted gross estate." Third, the decedent's "qualified heirs" must operate the business for a sufficient period after the decedent's death.
Qualified family-owned business
A qualified family-owned business can take various forms, such as a sole proprietorship, corporation, partnership, or limited liability company. For businesses other than sole proprietorships, the decedent and his or her family members must own any of the following: (1) at least 50 percent of the entity; (2) at least 30 percent of an entity in which members of two families own 70 percent; or (3) at least 30 percent of an entity in which members of three families own 90 percent. IRC §2057(e).
Some businesses are specifically excluded from the definition of a qualified business. Among those are a business whose principal place of business is outside the United States and a business whose stock was readily tradable on an established securities market or secondary market within three years of the decedent's death. The Code also excludes the portion of a trade or business that is attributable to cash or marketable securities that exceed the expected day-to-day needs of the business. If the business is a personal holding company where, for example, more than 35 percent of the adjusted ordinary gross income for the year of death consists of passive income, then the business would be specifically excluded. Passive income is income from sources such as interest, dividends, and certain kinds of royalties and rental income.
Calculating the adjusted gross estate and the adjusted value of the business
For estate tax purposes, a decedent's gross estate consists of all interests in property, real and personal, tangible and intangible, owned by the decedent at the time of death. IRC §2031. Very simply, the "adjusted gross estate" is the fair market value of the assets that decedent owned (gross estate) minus the debts owed by the decedent. This figure is calculated as of the date of the decedent's death.
To get the QFOBI deduction, the "adjusted value of the business" must exceed 50 percent of the deceased business owner's adjusted gross estate. The adjusted value of the business consists of the aggregate of all qualified family-owned business interests that are included in the gross estate and pass to a qualified heir, plus any lifetime transfers of such interests by the decedent to members of the decedent's family (other than the decedent's spouse) if those interests have been held continuously by members of the family and were not otherwise includible in the gross estate. This ability to transfer interests of the family-owned business to family members without sacrificing the opportunity to meet this 50 percent test presents useful estate planning options.
The QFOBI deduction requires that a qualified heir inherit a qualified family-owned business. A qualified heir can be a spouse, children, siblings, parents, and the spouses of children. The definition also is expanded to include anyone who was actively employed in the business for at least ten years preceding the date of the decedent's death.
Having a qualified heir is not enough to receive the QFOBI deduction. Congress also required that those qualified heirs operate the business for certain periods of time following the decedent's death. During the ten-year period following the business owner's death, a qualified heir or a member of the qualified heir's family must operate the business for more than three years in any eight-year period. If the QFOBI deduction is used but then the continued operation requirements are not met, the qualified heir who inherited the business would be obligated to repay the estate taxes plus interest that were saved by the QFOBI deduction.
Consider buy sell agreements and form of business ownership
Buy-sell agreements are useful in any family business situation. The form of the buy-sell agreement will depend on the form of business ownership (sole proprietorship, corporation, partnership, etc.). The buy-sell agreement has two basic purposes. First, it establishes rules for the operation of the business, if the business has more than one owner. Those rules can help prevent, or in any case resolve, disputes that may arise. Secondly, the buy-sell agreement typically provide payments to the deceased owner's family without disrupting the ongoing business. Typically, the price for the deceased owner's business interest is determined through an accounting formula or by formal appraisal, or by annual agreement among the business owners. Buy-sell agreements are often funded with life insurance or disability insurance to the greatest extent possible.
Many family businesses are operated as sole proprietorships, where the family business owner owns the business directly without setting up any separate organization such as a corporation or limited liability company. This is simpler, and it can have good income tax results depending upon the situation. However, a sole proprietorship is by far the most dangerous way to own a business. The business owner is directly liable for any debts, claims or lawsuits that may come from the business. If the business owner is sued, all of his personal assets are at risk if there is not sufficient insurance coverage in place. Moreover a sole proprietorship is not a separate "company," it is just the ownership of the business' assets. Since there is no actual "company," transferring the sole proprietorship business at death or selling it can be more difficult. Accordingly, every business owner who hopes to eventually sell or transfer his or her business, or who is concerned about potential liabilities, should consider placing his or her business into a separate entity such as a corporation or limited liability company as discussed below.
A corporation is another common form of business ownership. A corporation is established under the laws of the state, and it is a separate legal entity. Very often a tax election is made to have the corporation taxed as an "S corporation," to reduce the double taxation of income that can result when corporations pay dividends to their owners. There are limits as to the types and number of shareholders for S corporations, so not all corporations are eligible for that special tax treatment.
The ownership of a corporation is determined by who owns the corporation's shares of capital stock. A transfer of stock could be by sale or gift, or transfer by will. For estate tax planning, sometimes it makes sense for the controlling shareholder to reduce the size of his or her taxable estate by transferring stock by a gift or at a reduced sale price. For sales of stock at prices below market value, the seller could also be subject to gift tax to the extent that the value of the stock exceeds the selling price. For example, gifting stock to your heirs will lead to a corresponding decrease in your gross estate. Note that gifts exceeding $10,000 are subject to gift tax and that the donee acquires the donor's basis in the stock. If the stock has appreciated a great deal, the donee could owe considerable tax.
Limited liability companies and family limited partnerships
A limited liability company (LLC) is a relatively new form of business organization. LLCs are a hybrid of partnerships and corporations, offering the limited liability of corporations with the benefits of single level taxation found in partnerships. Owners of the LLC are called "members," and the trend is for states to allow one-member LLCs, including North Carolina.
The LLC and also the family limited partnership (FLP) are frequently used to reduce the value of a business owner's gross estate. By transferring the business to the LLC or FLP, and then transferring some part of the ownership of the LLC or FLP to other family members, the business owner's remaining ownership interest receives a "valuation discount" for purposes of determining the gross estate. In other words, if a business owner has a taxable estate for estate tax purposes that either exceeds the QFOBI or is not eligible for the QFOBI, the business owner might consider transferring the business to an LLC or FLP to help reduce the estate taxes. After the LLC or FLP owns the business, some relatively small portion of the ownership interests could be gifted to children, while the majority control remains in the parent-business owner. The remaining ownership interests would be valued at less than a proportional value of the business.
To apply numbers to this situation, assume that the entire LLC was worth $2,000,000 at the business owner's death, but 10 percent of the ownership interest had passed to the children prior to death, so that the parent-business owner still owned 90 percent of the LLC. The value of the LLC for estate taxes would be discounted below 90 percent times the total value, so that instead of the parent's LLC being valued at $1,800,000, it could be discounted by 25 percent or more. The tax value would be $1,350,000 or even less if a larger discount would be justified. This one step alone could save $100,000 of estate taxes, depending upon other assets in the estate. In this way the business owner could retain effective control of his business but reduce the estate tax cost by proper use of the FLP or LLC to obtain valuation discounts. This is a sophisticated estate planning technique, and requires the advice of experienced legal counsel.
An FLP must have at least two partners, a general partner and a limited partner. The general partner may have complete control over the partnership's affairs (subject to the limited partner's fiduciary responsibility), while the limited partner may only be an investor with no control over the daily operations. If properly structured, only the general partner is liable for the obligations of the limited partnership.
Commonly, most of the partners in a FLP are in the same family. A common scenario is for parents to create a FLP and name themselves as both general and limited partners. Usually, the general partnership interests are small (1 percent for example) and the parents hold the remaining interests as limited partners. The parents then transfer assets to the FLP, and subsequently transfer some or all of the limited partnership interests to their children. Retention of the general partnership interests ensures control of the business remains with the parents, but the transfer of limited partnership interests reduces the gross estate.
For most business owners, their company represents years of hard work. Business owners need to have a succession plan in place to protect themselves, their family, and their business. Taking advantage of the QFOBI deduction and the other techniques described in this article requires advance planning and expert advice. This article serves only as an overview of the kinds of options available. If you or a family member owns or may own a family business in the future, you should consult with an attorney experienced in these matters.
Prepared by Dennis J. Toman and Steve Clark,
Booth Harrington Johns & Toman, LLP in Greensboro, North Carolina.This publication is provided as a public service and is designed to acquaint you with certain legal issues and concerns. It is not designed as a substitute for legal advice, nor does it tell you everything you may need to know about this subject. Future changes in the law cannot be predicted, and statements in this publication are based solely on the laws in force on the date of publication.
Date: May 2001
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