Business Estate Planning

Abstract

This article focuses on business estate planning. It will provide a general overview of the business estate planning process for both family owned businesses and closely held businesses. Topics of discussion include business estate planners and advisers, business estate planning goals and objectives, the connection between Internal Revenue Code and business estate planning, and succession planning. The issues associated with post-mortem business estate planning will be addressed.

Keywords Business Estate Planning; Family Owned Business; Internal Revenue Code; Loosely Held Business; Post-Mortem Business Estate Planning; Succession Planning

Insurance & Risk Management > Business Estate Planning

Overview

In the United States, small businesses, which characterize the majority of closely held businesses (CHB) and family owned businesses (FOB), drive the economy. According to a 2014 report by the Small Business Administration, 99.7 percent of U.S. employer firms were classified as small businesses with fewer than 500 employees in the first decade of the twenty-first century, and of the 27 million small business in 2011, about 75 percent were nonemployer firms (sole proprietorships, partnerships, and incorporated businesses). Despite the strength and power of small closely held businesses and family owned businesses, numerous small businesses do not survive the transition from first- to second-generation ownership and management. When a business owner dies or retires, the business may be liquidated, continued, or sold to family, employees, or outside party. Small businesses, both closely held businesses and family owned businesses require successful business estate planning to survive the transition from first- to second-generation ownership (Grassi, 2007).

Businesses, including closely held business and family owned business, require estate planning to control the direction and future of the firm at the time of an owner's death or retirement. Business estate planning refers to the minimization of estate or transfer tax as well as active succession planning undertaken when transferring a family owned business or closely held business to the next generation. Small businesses are all at risk for failure when the business owner dies or retires. For example, the lack of a clear business successor and estate taxes as high as 40 percent can ruin businesses. Business estate plans are intended to minimize business disruption during the transition phase between business owners or managers (Hess & Havlik, 2005).

Effective business estate planning involves the following steps and stages: educating business owners and heirs about the estate planning processes and issues; coordinating and sharing plans with all significant shareholders; addressing the next generation's estate plans; soliciting multiple opinions from estate planners; sharing the business owner's intentions and plans fully with the board of directors; and reviewing the estate plans regularly with business estate advisers. Business estate planning requires that business owners and heirs address potentially uncomfortable issues such as mortality, aging, privacy, power, business operations and goals, resources, family dynamics, and leadership. Common issues associated with the choice to delay or forgo business estate planning include making irrevocable decisions, fearing disclosure, and clinging to privacy. Business owners that fear and delay business estate planning due to the potential complications, loss of privacy, and the risk of heirs losing their companies to estate taxes, family fighting, and lack of clear leadership (Ward & Aronoff, 1993).

The following section provides a general overview of business estate planning processes for both family owned businesses and closely held businesses. Topics of discussion include business estate planners and advisers, business estate planning goals and objectives, the connection between the Internal Revenue Code and business estate planning, and succession planning. This section serves as a foundation for later discussion of the issues associated with post-mortem business estate planning.

Applications

Preparing a Business Estate Plan

Ideally, business estate planning should begin at the very start of a business venture. To maximize the advantages available from effective business estate planning, business owners should choose their business entity or type with their estate plans in mind. The business type will limit or expand the options and financial tools available to the business upon the business owner's retirement or death (Grassi, 2007). The following sections describe the key elements of the business estate planning process.

Business Estate Planners & Advisers

Business estate planning, which generally includes business succession decisions, requires the input of multiple parties including business owners, family business counselors, estate planning advisers, accountants, lawyers, managers, and human resources personnel. The lawyer involved in the business estate planning process will review the following documents: articles of incorporation, articles of organization, bylaws, operating agreements, partnership agreements, other governance documents, loan agreements, and any other relevant documents and contracts. In some business estate planning processes, multiple lawyers will be required to review and prepare documents. For example, a business lawyer prepares the buy-sell agreement, a labor lawyer prepares the employment agreement, a tax lawyer prepares the retirement and deferred compensation plan, and an estate planning attorney prepares the wills and trusts (Grassi, 2007).

Business Estate Planning Objectives & Goals

Business owners develop estate plans for multiple financial and personal reasons. Business owners generally make their estate planning goals and objectives explicit as part of the estate planning process. Common estate planning objectives and goals include the following: treat all heirs fairly; provide heirs who are active in the business with an opportunity to progress in the business; minimize transfer estate and gift taxes; avoid a forced liquidation of the business in the event of the business owner's death; retire and receive a monthly pension from the business; receive an income from business for perpetuity; provide for the surviving spouse and any minor or dependent children; design a succession plan for the business that provides stability for the business and its owners as well as certainty as to the transfer of ownership and control of the business; engineer a smooth transition of the business without the loss of revenue or consumer confidence; and design a business estate plan that coordinates with and facilitates the business succession plan (Grassi, 2007).

Internal Revenue Code & Business Estate Planning

The Internal Revenue Code (IRC), particularly IRS Revenue Ruling 59-60, and numerous other laws, such as the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Pension Protection Act of 2006, control and regulate business estate planning. Federal estate taxes, as described in the Internal Revenue Code, rely on accurate business valuations. IRS Revenue Ruling 59-60, passed in 1959, accomplished the following: provides a framework for the best way to value shares of capital stock of closely held corporations for estate and gift tax purposes and defines fair market value as the general standard of value for federal estate and gift tax purposes (Maccarrone & Warshavsky, 2003).

The Internal Revenue Code permits the following techniques and strategies to be used for business estate management and execution: installment sale, private annuity, gift or sale leaseback, intentionally defective irrevocable trusts (IDIT), special-use valuation, and buy-sell agreements (Rattiner, 2004).

  • Installment sale: Refers to the sale of a business to a family member through a manageable payment schedule. This strategy spreads the business estate tax burden over the life of the transaction.
  • Private annuity: Refers to arrangements in which the buyer of a business receives an asset, such as real estate, from the seller in return for a promise to pay an annuity for life to the seller. Internal Revenue Code section 72 governs the taxation of private annuities. In most cases, the exchange in a private annuity transaction is viewed as even and goes untaxed.
  • Gift or sale leaseback: Refers to arrangements in which the parent company disposes of an asset to reduce the size of the estate but leases the asset back for company use. The Internal Revenue Service, to prevent fraud, reviews and oversees all gift or sale leaseback agreements to ensure that the company does not retain total control of the leased asset and that appropriate rent is paid for the use of the asset.
  • Buy-sell agreements: Refer to agreements between business owners to sell the interests of a deceased owner to the other remaining partners at a price determined beforehand. Buy-sell agreements often use business insurance to fund the purchase of the deceased owner’s interest in the company. There are two main forms of buy-sell agreements: cross-purchase and stock redemption.
  • Stock redemptions: The Internal Revenue Code allows businesses to control and minimize business estate taxes through stock redemptions. Section 303 of the Internal Revenue Code gives each business estate the opportunity to remove cash from the business without a tax penalty through a partial redemption of company stock.

Succession Planning

Business estate planning must include decisions about how, when, and to whom to transfer control of the business. Business owners tend to focus attention on choosing the best successor, while estate planners tend to focus on strategies and techniques for minimizing estate taxes. Succession planning must explicitly describe the channels of ownership succession and management succession. The following tools are useful for succession planning: “Shareholder agreements, stock recapitalizations, voting trusts, voting agreements or irrevocable proxies, and trust arrangements” (Hess, 2005, p.56).

  • Shareholder agreements: "Shareholder agreements" refer to an explicit agreement between a company’s shareholders that outlines the way the company should be managed as well as shareholders’ rights and responsibilities. The shareholder agreements, which include information on the regulation of shareholder relationships and the management of the company, expedite the transfer of control from one business owner to his or her heir through limits on share transfers by shareholders who are not active in the family business as well as purchase obligations for the company or the heir. In addition, a shareholder agreement may explicitly state that when the owner dies or retires, control of the business passes to a designated successor. Lastly, shareholder agreements clarify succession issues by identifying officers, selecting the size of a company’s board of directors and the procedure for selection of board members, and explicitly providing guidelines on the restrictions for issuing additional shares.
  • Stock recapitalizations: Stock recapitalization is a technique used by business owners who choose not to specify a business successor in the shareholder agreement. "Stock recapitalization" refers to the process of trading in a single class of company stock in favor of two separate classes: voting and non-voting. The U.S. Supreme Court defined "recapitalization" as a capital structure reorganization within the existing framework of an established corporation. A business must satisfy three requirements to prove that its stock recapitalization is valid: First, the stock recapitalization must be part of an overall plan of reorganization. Second, the stock recapitalization must include exchanges of stock or securities of the corporation for other similar stock or securities. Third, the stock recapitalization must have a valid business purpose. Stock recapitalization, which may legally be structured as a tax-free transaction, provides large potential tax benefits to the business and shareholders.
  • Voting trusts: Voting trusts are a common tool for transferring control from one party or generation to another. A "voting trust" refers to an agreement in which shareholders transfer stock and voting rights, but not economic rights, to a small group of individuals for a specified time period. The voting trust transfers voting power but not wealth; therefore, the voting trust does not change the economic ownership of the business. In fact, despite the transfer of voting rights, no financial change is reported for income tax purposes after the transfer of stock to a voting trust. Voting trusts occur when company shareholders establish a voting trust agreement and switch their company stock shares over to the voting trustees. The process involves the issuance of voting trust certificates to the shareholders that match the number of shares transferred. The voting trustees become the legal owners of the stock and exercise all rights to vote.
  • Voting agreements and irrevocable proxies: Voting agreements are informal arrangements that control voting of the company shares without officially altering company ownership. Voting agreements differ from voting trusts due to the absence of legal transfer of share title. In addition to the voting agreement, business owners generally augment the arrangement by granting an irrevocable voting proxy to his or her specified successor to vote the shares of stock of the company.
  • Trust arrangements: Business owners who plan to transfer business control to a chosen successor without including shareholders often create trust arrangements. Trust arrangements grant business control to the chosen successor without altering ownership or getting shareholder approval.
  • Ultimately, successful business estate planning will include tax planning, estate planning, and succession planning. Despite the importance of succession planning, and business estate planning in general, to the passage of wealth, resources, and power between generations, approximately 80 percent of all family businesses operate without a succession plan, according to a 2007 white paper by the Family Business Institute. They report that as a result, only 30 percent of family businesses are successfully transferred from one generation to the next.

Issues

Post-Mortem Business Estate Tax Planning

Advanced or lifetime business estate planning has the potential to eliminate some or all business estate taxes and create a clear successor to the business owner and business manager. While business estate planning is most effectively undertaken prior to a business owner's death, there are post-mortem business estate planning strategies and techniques available to heirs to reduce or eliminate federal estate taxes.

The techniques available for post-mortem business estate tax planning are similar to the lifetime business estate planning techniques. The following techniques are available to the heirs of business owners who did no estate planning during his or her life or who engaged in inadequate or inaccurate business estate planning (Oliver & Granstaf, 1998).

  • Alternate valuation: In the event of the death of an owner of a family owned or closely held business, business heirs or estate executors may petition for alternate valuation to lessen the burden of estate tax. Business estates that decline in value after the death of the business owner are eligible for alternate valuation. Alternate valuation, which values and taxes business property on the date of distribution, sale, exchange, or other disposition within six months of the death, is governed and controlled by Internal Revenue Code section 2032.
  • Special-use valuation: In the event of the death of an owner of a family owned or closely held business, business heirs or estate executors may petition for special-use valuation to lessen the burden of estate taxes by up to $500,000. The special-use valuation, which determines a business’ value by looking at its usefulness in the activity for which it is mainly employed instead of looking at its ideal use, is governed and controlled by section 2032a of the Internal Revenue Code. Eligibility requirements for the special-use valuation include the following: The deceased business owner or member of the deceased family must have both owned and used the property in the business for a minimum of five of the last eight years; and the deceased business owner must have actively and physically participated in the business.
  • Disclaimer and qualified terminable interest property (QTIP) election: In the event of the death of an owner of a closely held corporation, business heirs or estate executors may use a disclaimer or qualified terminable interest property (QTIP) election to make it easier to use the deceased's unified tax credit or marital deduction. A disclaimer or qualified terminable interest property election legally allows the use of a deceased business owner's unified tax credit applicable to certain amount of property tax-free. Disclaimers are governed and controlled by Internal Revenue Code section 2518, qualified terminable interest property elections under Internal Revenue code section 2056.
  • Delaying payment of business estate taxes: In the event of the death of an owner of a closely held corporation, business heirs or estate executors may be able to delay the payment of business estate taxes. Delayed business estate taxes are subject to interest charges.
  • Post-mortem stock redemption: In the event of the death of an owner of a closely held corporation, post-mortem stock redemption can be used to cover expenses related to death taxes, funeral costs, and administration expenses. Post-mortem stock redemption is governed and controlled by the Internal Revenue Code section 303. The Internal Revenue Code section 303 states that stock redemption may be used if the stock of a closely held corporation exceeds 35 percent of an individual's adjusted gross estate. Post-mortem stock redemption is not usually subject to income tax.

Ultimately, a business owner's death poses a real threat to the health of his or her business, creates the very real possibility of significant business interruption, and often results in a cash shortage. Federal business estate tax rates may reach 40 percent of the value of the business. Post-mortem business estate planning, while inferior to lifetime business estate planning, may help keep the business operational and profitable.

Conclusion

In the final analysis, business estate planning is a vital activity for all family owned businesses and closely held businesses. Business estate planning is a collaborative effort and process involving valuing the company, determining succession, establishing transfer or sale of business control, assets, and property, and planning for and minimize estate and gift taxes. Factors and variables that influence the business estate planning process and the business estate value include the following: "Lifetime gifting and gift tax computation; the transfer tax basis; business stability and continuity; generation-skipping taxes; estate taxes; business interest valuation; special use valuation; alternate valuation date; the family owned business deduction; and estate liquidity" (Maccarrone & Warshavsky, 2003). Ultimately, business estate planning is most effective when undertaken prior to a business owner's death or retirement.

Terms & Concepts

Business Estate Planning: The minimization of estate or transfer tax as well as active succession planning undertaken when transferring a family owned business or closely held business to the next generation.

Buy-Sell Agreements: Buy-sell agreements refer to agreements between business owners to sell the interests of a deceased owner to the other remaining partners at a price determined beforehand.

Closely Held Business: A business in which most of the stock is held by a few shareholders who have no plans to sell.

Fair Market Value: The price that a buyer would be willing to pay and a seller would be willing to accept when neither party has any obligation to buy or to sell.

Family Owned Business: A business mainly controlled by members of a single family. Two or more family members must be actively involved in the business for it to be designated a family owned business..

Installment Sale: The sale of a business to a family member through a manageable payment schedule.

Private Annuity: Arrangements in which the buyer of a business receives an asset, such as real estate, from the seller in return for a promise to pay an annuity for life to the seller.

Shareholder Agreements: An explicit agreement between a company’s shareholders that outlines the way the company should be managed as well as shareholders’ rights and responsibilities.

Stock Recapitalization: The process of trading in one class of company stock in favor of two different classes: Voting and non-voting.

Succession: The process of handing over the control of an organization from a current to a new leader.

Voting Trust: An agreement in which shareholders transfer stock and voting rights but not financial rights to a small group of individuals for a specified time period.

Bibliography

Blackman, I.L. (2013). Estate plan secrets they don't reveal in law school. Modern Machine Shop, 86, 40-42. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89016073&site=ehost-live

Blesy, D. (1993). Estate planning for business owners: A case study. Journal of Financial Planning, 6, 179-187. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5558571&site=ehost-live

Grassi, S. (2007). Estate planning for the closely held business after the pension protection act of 2006. Gifts and Trusts Journal, 32, 87-131.

Hess, D & Havlik, K. (2005). Attitude adjustment. Trusts & Estates, 144, 56-62.

Kess, S., & Mendlowitz, E. (2015). Helping business owners with succession planning. CPA Journal, 85(8), 76-77. Retrieved December 9, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=109144476&site=bsi-live

Maccarrone, E., & Warshavsky, M. (2003). Estate planning for business owners. CPA Journal, 73, 34-38. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10826455&site=ehost-live

McAlister, J.R. (2010). Test your planning with a 'fire drill.' Family Business, 21, 18-20. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=47715301&site=ehost-live

Nelton, S. (1994). What I've learned — part two. Nation's Business, 82, 74. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9405201327&site=ehost-live

Oliver, J. (1998). Postmortem estate planning for small business owners. Journal of Accountancy, 186, 31-35.

Prince, R. & Schutz, A. (1989). Marketing estate planning to small business owners. Trusts & Estates, 128, 47-55.

Rattiner, J. (2004). Small estates. Financial Planning, 34, 133-137. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14659509&site=ehost-live

Rivers, W. (2012). Classic family business estate planning mistakes: A case study. Family Business Advisor, 1-2. Retrieved November 15, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87654580&site=ehost-live

Scroggin, J. (2000). Two realities for a business owner. Advisor Today, 95, 50. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3099070&site=ehost-live

Solomon, M. (2000). Estate planning for the business owner. Ohio CPA Journal, 59, 51. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3454597&site=ehost-live

Ward, J. The fears of estate planning. (1992). Nation's Business, 80, 57-59.

Suggested Reading

Garman, A., & Glawe, J. (2004). Succession planning. Consulting Psychology Journal: Practice & Research, 56, 119-128. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13758128&site=ehost-live

Hisrchfeld, C. (2002). ESOPs as an estate planning vehicle for business owners. Journal of Financial Planning, 15, 92-97. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=7866193&site=ehost-live

Lansberg, I., & Gersick, K. (2015). Educating family business owners: The fundamental intervention. Academy of Management Learning & Education, 14(3), 400–413. Retrieved December 9, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=109928673&site=bsi-live

Lurz, B. (2003). End games. Professional Builder, 68, 54. Retrieved July 24, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10288342&site=ehost-live

Essay by Simone I. Flynn, Ph.D.

Dr. Simone I. Flynn earned her Doctorate in cultural anthropology from Yale University, where she wrote a dissertation on Internet communities. She is a writer, researcher, and teacher in Amherst, Massachusetts.