By Kenneth P. Brier
This article first appeared in the Fall 2016 issue of Massachusetts Family Business magazine.
Estate planning is never more challenging than when it’s for the owner of a family business. Such planning is fundamentally different from planning for other individuals, so the one-size-fits-all standard estate plan is virtually certain to fail the owner’s needs.
Why the Standard Plan Will Fail
Worst is the unplanned estate. Everyone has an estate plan, whether you realize that are not. If not planned by you, the government has a standard plan for you.
Only slightly better is a “standard” lawyer-draft estate plan. Though it may be sophisticated in a generic sense, it may well fail to address the critical issues of business owners. For example, passing S corporation stock on to trusts of the kind commonly provided in the “standard” estate plan will blow the corporation’s S election.
Finally, even a well-executed estate plan, sensitive to special business issues, can fail if it is out of date. Personal and financial circumstances often change. And applicable state and federal laws have been in a continual state of flux.
Four Precepts for Planning for the Business Owner
I boil the special attributes of estate planning for the business owner down to four precepts: one, think globally; two, face succession or face extinction; three, deal with liquidity issues; and four, divide, discount and conquer.
Thinking globally: There is never a clear dividing line between planning for the business owner and planning for the business. If a business owner does not like the currently available choices, he or she often has the ability to change the menu. For example, an owner, unlike a rank-and-file employee, can amend an existing retirement plan to obtain further options or terminate it and adopt a whole new plan. To avoid making a taxable gift, I have sometimes suggested that an owner transfer business opportunities to the children, rather than the whole business. The owner can set the children up in a new company, primed with contacts and know-how and poised to grow at the expense of the old one.
Facing succession issues: Every business owner needs to pay attention to succession issues, addressing the orderly transfer of ownership, responsibility and control of the enterprise upon eventual retirement, disability or death.
Lifetime transfers, often made in conjunction with the founder’s winding down or retirement, can promote an orderly transition. Ownership, responsibility and control need not be vested in same person. Those attributes can be separated by, for example, issuing non-voting stock or hiring professional managers. The owner needs to determine whether the stock will be gifted or sold, and if the latter, whether within the family or to an outside party. A common issue is how to deal with several children, only one of whom works in the business. Does that child get all of the shares? If an unequal distribution, should the other children’s inheritances be evened off with other property? The owner needs to exercise special care in the choice of personal representatives and trustees. Who will have the ability to run the business until an orderly disposition can be made? A buy-sell agreement can address many of these issues.
Dealing with liquidity issues: The government still extracts a sizeable estate tax from any large estate, and it wants payment in cash, not stock, within nine months from the date of death.
Often neither the business owner’s estate nor the business has enough cash of its own to pay the tax bill. Borrowing is only a temporary expedient. But cash that is otherwise unavailable can be generated through life insurance. Though it is not free, it does provide a tax-advantaged way to pre-fund the cash needs and make cash available exactly when it is needed. Whether or not there is insurance, either the estate or the business commonly will have to sell assets to a third party, often a life insurance trust.
A buy-sell agreement can come into play as a liquidity vehicle, prescribing in advance the arrangement whereby the estate will sell its shares to the party with the cash, usually derived from an insurance policy. If the sale is made to the company, it is a redemption agreement. If the sale is to the other owners, it is a cross-purchase agreement.
Divide, discount and conquer: Transferring interests in closely-held businesses at the least tax cost commonly has involved various strategies to suppress value. This is done by carving the business up into various minority interests, or more generally, restricting the individual owners’ rights in the business interests. The premise is that the sum of the parts then does not equal the whole. These techniques are often labeled as creating discounts, though the term “discount” in many respects is a misnomer, because you really do need to affect the current value of the individual owner’s interest. There are two kinds of basic discounts that may apply, namely discounts for lack of marketability (illiquidity) and minority interest (lack of control).
Strategies to divide and discount got a substantial boost in 1993 through the IRS’s issuance of a revenue ruling retreating from its position of aggregating family interests for valuation purposes. Neither Mom’s stock nor Daughter’s stock was now to be considered in determining whether or not Dad had a controlling interest. In fact, even if Dad did have a controlling interest, he might carve off a smaller piece and give it away as a minority interest.
The IRS since then has since waged a rear-guard campaign to combat such discount planning, especially as it extended to non-operating family limited partnerships and LLCs. This counteroffensive has recently culminated in new proposed regulations on valuation discounts for intrafamily transfers of business interests, seeking to breathe new life into 1990 tax legislation providing for the taxation of certain lapsing rights and the disregarding for valuation purposes of certain restrictions on liquidation. It remains to be seen whether these controversial proposed regulations will be finalized in something like their present form and what effect they might have on an operating businesses.
Kenneth P. Brier is a partner of Needham-based Brier & Ganz LLP, a boutique law firm focusing on tax, business, estate-planning and wealth preservation matters.