An ideal estate plan for a closely-held business owner should have two major components: (1) an estate plan and (2) a management succession plan. The estate plan addresses issues involving succession to beneficial ownership of property, minimizing transfer taxes and providing for adequate liquidity. The management succession plan centers around the control of the property, establishing a successor(s), management of the business operations and other unique family considerations.
Typically, the estate plan will center around three major objectives: (1) reducing the taxable estate; (2) freezing future appreciation; and (3) providing for liquidity needs.
Reducing the Taxable Estate
In order to reduce the taxable estate, the business owner may wish to create fractional ownership interests as part of an annual gifting program and in order to take advantage of potential valuation discounts. Family Limited Partnerships (FLPs) and/or Limited Liability Companies (LLCs) are often used to achieve these goals.
Freezing Future Appreciation
Freeze techniques are designed to accomplish the objective of transferring the appreciation in value of assets in the client’s estate to the succeeding generations, so that this appreciation will escape estate and gift taxation. An effective freeze uses assets with high appreciation potential. As a result, closely-held business interests are often attractive assets for a freeze. However, freeze techniques have potential income tax consequences. Triggering events for income tax and capital gain tax should be assessed prior to implementing a freeze technique or relinquishing assets. The tax code also has special valuation rules under Chapter 14 which must be taken into consideration. GRATs, installment sales, private annuities and taxable gifts are among the various strategies which can be employed to facilitate an estate freeze.
Providing for Liquidity Needs
Liquidity is of special concern when the primary asset is an interest in a closely-held business. The last thing a successful entrepreneur would want to have happen is for a lifetime of work to be disposed of in a “fire sale” in order to pay estate taxes.
A complete liquidity analysis or reviewing operating capital (or “A complete liquidity analysis and assessment of working capital requirements”) should identify liquidity requirements needed for the support of survivors, payment of estate taxes, post-mortem debt service, administration expenses and funding bequests. Major sources of liquidity include cash, marketable securities, expected proceeds from life insurance and sales under a buy-sell agreement. Techniques available for using liquidity held inside a closely-held business should be considered. A buy-sell agreement or a corporate redemption under I.R.C. Section 303 can provide a mechanism for making funds held inside a company available to an owner-decedent’s estate. Special valuation rules under Section 2032A may be available to reduce the estate tax burden on the family-owned business by reducing the value of the real property utilized by the business for estate tax purposes, and thereby reducing the tax liability. Long-term payment of the estate taxes associated with closely-held business interests, as provided under Section 6166, can extend the term for tax payment and reduce the estate’s need for immediate liquidity to pay estate taxes.
Management Succession Plan
Planning for a transition requires providing for the succession of management control as well as the transfer of asset ownership. Management succession planning requires the identification of qualified successors who are members of the family or possibly the identification of non-family members who have management potential. To facilitate an orderly transition of management authority or establishing successors, the owner should select the next generation of management (whether or not it is family members) and begin the transition process well before the time at which the owner intends to retire. An orderly process of management transition serves to groom the successor manager(s) and allows time for the nonmanagement family members to accept the new management structure.
These agreements provide many benefits. For the decedent, it ensures a ready purchaser for an otherwise difficult asset to sell, creating liquidity in the decedent’s estate. In addition, it may also fix the value of the decedent’s shares in the corporation for estate tax purposes. A Buy-Sell Agreement benefits the surviving shareholders by eliminating the possibility that third parties will become shareholders in the corporation and by reducing the potential for friction among the surviving shareholders and the decedent’s surviving spouse or heirs.
Buy-Sell Agreements commonly occur in two formats: (1) the corporate purchase and (2) the cross purchase. In a corporate purchase agreement, the corporation purchases the stock of the deceased shareholder. In a cross-purchase agreement, each surviving shareholder purchases a pro rata share of the decedent’s stock. To determine which form of agreement is best, you must consider the complexity of funding the agreement and the structure of the client’s business.
For example, if the survivors plan to use the proceeds of a life insurance policy to purchase the deceased shareholder’s stock, remember that those proceeds will first be subject to the policy owner’s creditors. Therefore, the relative financial stability of the corporation and the shareholders should be considered and the policy should be owned by whichever is more financially sound. (However, in a cross-purchase, the survivor will get “credit” on his or her basis for the purchase price paid to the decedent’s estate. In the corporate purchase, that additional basis is lost. Therefore, a cross-purchase is usually the best alternative, all other factors being equal.)
Funding is a significant consideration when entering a Buy-Sell Agreement. It often comes from the proceeds of a life insurance policy. The advantage of life insurance is that it provides ready cash and also ensures that no operating capital will be needed to purchase the decedent’s interest. In a corporate purchase agreement, the corporation owns a life insurance policy on each participating shareholder. In a cross-purchase agreement, each shareholder owns life insurance policies on the other shareholders. When there are several shareholders, the sheer number of policies involved may make a corporate purchase agreement the better choice, simply because it would be less complicated. When there are only two shareholders, a “first to die” policy is an option. It is especially advantageous when the cost of insuring one shareholder is significantly more than the cost of insuring the other. (For example, when one is much older than the other.) It avoids the inequity of one owner’s having to pay more to insure his or her co-owner.
Enterprise Bank & Trust does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal, and accounting advisers before engaging in any transaction.