15 Intrafamily and Other Business Transfer Techniques

Question 1

Business Succession Planning

Answer 1

Process of planning for the eventual sale or transfer of control of an owner’s interest in a business

1. Identify suitable person(s) to take over the business
2. Determine when transfer will take place (e.g., during lifetime or at death)
3. Identify suitable method of transfer (e.g., sale or gift)
4. Prepare for possible tax consequences (e.g., income tax on sale; gift or estate tax on gratuitous transfer)
5. Ensure that financing is in place if transfer involves a sale

Question 2

Possible Challenges in Business Succession Planning

Answer 2

1. Owner’s ego, idiosyncrasies, and unrealistic expectations
2. Determining value of business
3. Preparing employees for new ownership
4. Possible issues in intrafamily transfers
   
   1. Unequal treatment of children
   2. Children’s lack of motivation or skill to run business
   3. Resentment at working for new owners

Question 3

Family Limited Partnership (FLP)

Answer 3

In general

1. created to transfer assets to younger generations at a reduced gift tax valuation and cost.
2. A major objective is to generate valuation discounts (for estate and gift tax purposes) on the transfer of a limited interest in the partnership. The discounts are available because a limited partner cannot easily sell her partnership interest (lack of marketability discount) and cannot manage the partnership’s operations (minority discount).
3. Typically, a senior family member transfers an asset (such as a closely held business) to a partnership in exchange for a 1% general partnership interest and a 99% limited partnership interest.
4. The senior family member then makes gifts (over time) of the limited partnership interests to junior family members.
5. The transfer of the limited partnership interests constitutes a gift, eligible for the annual exclusion

Question 4

FLP Advantages

Answer 4

1. The senior family member can retain control of the business because the senior family member is the only one with a general partnership interest (limited partners are not allowed to participate in management of the business).
2. Restrictions can be placed on junior family members’ ability to transfer limited partnership interests by methods such as the general partner having first right of refusal for the sale of limited partnership interests.
3. Some protection against creditors may be afforded, especially for limited partners.
4. Transfers can be made at substantial discounts as compared to the value of underlying assets.
5. With proper planning, gifts of limited partnership interests are eligible for the annual exclusion.

Question 5

FLP Disadvantages

Answer 5

1. Attorney’s fees will be incurred when the partnership is established.
2. Appraisal fees may be required to support underlying asset valuation and discounts taken each time partnership interests are gifted.
3. Business should be capital-intensive, such as an operating a business or family farm; it is not appropriate for a personal service entity

Question 6

Recapitalization

Answer 6

A lifetime transfer technique for corporations

1. The senior family member/business owner trades common stock for common nonvoting stock and preferred voting stock.
2. The senior family member retains the preferred voting stock, and gives the common nonvoting stock to the children.
3. Any appreciation that occurs after the recapitalization and gifting of common stock is attributed to the common stock
4. Under Section 2701 of Chapter 14, the preferred stock retained by the senior family member is generally valued at zero, so the common stock becomes the full value of the business and the amount of the taxable gift.
5. Under certain conditions (e.g., preferred stock is cumulative), some value may be assigned to the preferred stock

Question 7

Bargain Sale

Answer 7

Sale of an asset for less than full consideration, usually made to related parties.

Part sale and part gift

Question 8

Tax Ramifications of Bargain Sale

Answer 8

1. Difference between the sales price of the asset and the seller’s basis in the asset will be a taxable gain to the seller for income tax purposes.
2. Difference between the FMV of the asset and the consideration received is considered a gift.
3. Buyer’s tax basis is equal to the greater of the amount paid by the buyer, or the seller/donor’s basis in the property at the time of transfer, and the amount of increase, if any, in basis for any gift tax paid.
4. Gift portion is eligible to qualify for the annual exclusion if it is a completed gift.
5. Property sold will not be included in the seller’s gross estate, but the portion that is considered a taxable gift will be added back to the seller’s taxable estate as an adjusted taxable gift in arriving at the estate tax base.

Question 9

Leasebacks

Answer 9

Leaseback strategies transfer business assets to younger generations.

They allow a family to use business assets to accomplish transfer goals in a tax-efficient manner without disrupting the operation of the family business.

A key to a leaseback arrangement is that the older family member (not the business) owns the property. The business has been leasing the property from the older family member in the past.

• When it is time to transition ownership of the business property, the older family member transfers the ownership of the business assets to the younger generation by a sale or a gift.
• Next, the younger family member leases the asset back to the business at a commercially reasonable rate.
• The business makes the lease payment to the younger family member. This gives the younger family member income to accomplish the goal

Question 10

Gift Leasebacks

Answer 10

Help transfer income to a younger generation without expectation of payments back to the older generation.

The point is to pass income-producing property out of the older generation’s estate to the younger generation.

Question 11

Sale Leasebacks

Answer 11

Sale leasebacks transfer assets and income to the younger generation

As a result, the younger generation can afford to make payments back to the older generation, to help the younger generation buy the business from the older one.

Question 12

Differences between Gift and Sale Leasebacks

Answer 12

1. Sale leasebacks make payments to the older family member. In a gift leaseback, the older family member does not receive a payment.
2. Most sale leasebacks will involve the older family member stopping or slowing work. In a gift leaseback, the older member will probably be in the prime working years and not need income.
3. With a gift leaseback, the younger family often has a financial need outside of the business. A sale leaseback usually involves the younger family member taking a more active role in the business

Question 13

Installment Sales and Self-Canceling Installment Notes (SCINs)

Answer 13

1. Used as planning device to minimize estate taxes
2. Installment note—a note providing that buyer will pay purchase price in installments over time
   
   1. If seller dies before note is paid off, remaining unpaid balance plus any unpaid interest accrued to the seller’s DOD generally is included in gross estate for estate tax purposes
   2. Value of the asset sold is not included in gross estate
   3. SCIN—an installment note that cancels at the seller’s death
      
      1. Value of the notes canceled at the death of the seller is not included in seller’s gross estate
   4. Any remaining unrecognized gain from the sale inherent in the SCIN must be reported on estate’s income tax return (not included in the gross estate)
      
      1. SCINs are usually made to family members

Question 14

Private Annuities

Answer 14

Sale of an Asset (typically to a related party) in exchange for an unfunded promise to pay a lifetime annuity

Question 15

Private Annuity Consequences

Answer 15

1. There will be no gift and, therefore, no gift tax as long as the present value of the annuity to be received equals the value of property transferred.
2. There are no immediate income tax implications, but gain is reported similar to payments received from an installment sale. The gain is recognized using an exclusion-inclusion ratio (similar to an annuity) after recognizing interest income to the extent of market rate.
   
   1. Ordinary income is the interest component.
   2. Return of basis—This is based on an exclusion ratio: (Investment in contract)/ (Total expected return) = exclusion ratio
   3. Capital gain—This is based on an inclusion ratio
3. They may not have security or collateral.
4. If the seller outlives life expectancy, the buyer will have made a bad bargain, and the seller’s gross estate must include all the annuity payments received during life, but not consumed before death. However, the seller could use the annual exclusion and forgive up to $15,000 ($30,000 for split gifts in 2019) of the payment without incurring any gift tax consequences.
5. They are ordinarily used when the seller is not expected to live the full actuarial life expectancy.
6. Interest is not deductible to buyer for income tax purposes.

Question 16

Buy-Sell Agreement Benefits

Answer 16

1. Can establish value of the business for estate tax purposes
2. Provides cash (liquidity) to the decedent’s estate
3. Provides for business continuation
4. Guarantees there will be a buyer for the business at the decedent’s death
5. Increases a business’s access to credit because of continuation plan

Question 17

Buy-Sell Agreement Provisions

Answer 17

1. Parties to and purpose of the agreement
2. Description of the business interest
3. Restrictions on transfers before death
4. Method used to determine purchase price
5. Funding of the purchase price
6. Whether agreement can be modified or terminated

Question 18

Buy-Sell Agreement Types

Answer 18

• Cross purchase
• Entity
• Wait and see

Question 19

Cross-Purchase Agreements

Answer 19

1. It is possible to have a business buy-sell agreement without funding with life insurance if the potential buyers have sufficient liquid assets. However, that is not usually the case
2. A solid buy-sell agreement will have triggering events identified (e.g., death and/or disability), valuation methodology identified either by formula or pro-cess, and a funding mechanism in place. One such funding mechanism is life insurance.
3. Under a cross-purchase agreement funded with life insurance, a partner or shareholder purchases a sufficient amount of life insurance on the lives of each other partner or shareholder to ensure sufficient liquidity to buy out the deceased or disabled partner or shareholder.

Question 20

Problems with Cross-Purchase

Answer 20

• Number of policies: n*(n-1)
• Cost disparity when ages are different

Question 21

Tax Ramifications Cross-Purchase

Answer 21

1. Premiums are not tax deductible and the life insurance proceeds are not includable in taxable income.
2. Because the business interest receives a step-up in basis to FMV at the businessowner’s death, there may be very little capital gain for the selling family.
3. The purchaser(s) in a cross-purchase agreement will have a basis in the purchased interest equal to the price paid for the interest. It allows increased tax basis for surviving owners.

Question 22

Entity Agreement

Answer 22

Alternative to cross-purchase agreement

• Business buys insurance
• When a partner dies, insurance purchases his share
• Number of policies = # partners

Question 23

Stock Redemption Agreement

Answer 23

Entity agreement when entity is a corporation

Question 24

Tax Ramifications of Entity Agreements

Answer 24

• Premiums not tax deductible
• Proceeds not includable
• Entity won’t receive deduction for amount paid to deceased’s estate
• If entity is family-owned corporation, IRS may treat redemption as a divident

Question 25

Wait-and-see Agreement

Answer 25

• Hybrid between entity and cross-purchase agreement
• Ultimate purchaser might be entity itself, other owners, or combination
• Business typically has right of first refusal
• Agreement ensures that SOMEONE will buy the entire interest
• Most flexible

Question 26

Factors for deciding type of buy-sell

Answer 26

• Number of owners/shareholders
  
  • Entity pref. if many
  • Entity easier to obtain/fund
• Flexibility
  
  • Cross-purchase more flexible than Entity because can change pctg. after death
• Funding
  
  • Cross-purchase problems when age disparity
  • Business pays under Entity
• Valuation
  
  • CP: Each owner receives proceeds to buy out decedent
  • Entity: Business rec. proceeds; pays estate

Question 27

Disability Buy-Sell

Answer 27

Same as buy-sell, except on disability of owner

Question 28

Disability Buy-Sell Provisions

Answer 28

• Elimination period
• Definition of disability
  
  • Own occupation
  • Modified occupation
  • Any occupation
• Salary continuation plan
  
  • Disability income insurance available (different from disability buy-out insurance)
• Disposition of policies agreement
  
  • What to do when no longer needed
• Premature Death Clause

Question 29

Types of Disability Buy-Sell Agreements

Answer 29

• Cross-purchase
  
  • Premiums paid are not deductible
  • Proceeds are not taxable
  • When bought out, recipient may recognize significant capital gain
  • Owners have a basis in the insurance equal to basis in business
• Entity
  
  • Same as CP, except business has basis in insurance

Question 30

Factors for Choosing Type Disability Buy-Sell

Answer 30

1. Number of businessowners
2. Flexibility
3. Funding
4. Valuation

Question 31

Valuation Discounts

Answer 31

• The transfer tax value of closely held businesses, real estate, and other assets may be significantly reduced by using various valuation discounts.
• Often used in conjunction with an FLP.

Question 32

Minority Interest Discount

Answer 32

• A reduction in value of a transferred asset is often allowed if the asset represents a minority interest in a business.
• A minority interest is any interest that, in terms of voting, is not a controlling interest
• Minority owners cannot manage the business or compel its sale or liquidation. Therefore, outside buyers would not be willing to pay the same amount for a minority interest as they would for a majority or controlling interest.
• For transfer tax purposes, minority discounts (when available) often range from 15% to 35%

Question 33

Lack of Marketability Discount

Answer 33

• Reduction in value of a transferred asset is often allowed if asset has an inherent lack of marketability.
• Interests in a closely held business and partnership interests are more difficult to sell than interests in other assets such as publicly traded stock. Therefore, a discount is often allowed for the lack of marketability.
• Lack of marketability discounts typically range from 15% to 35%, and can be used for both minority and majority interests.
• A lack of marketability discount can be used in conjunction with a minority discount to produce a larger overall discount.

Question 34

Blockage Discount

Answer 34

Discount attributable to the value of large blocks of corporate stock that are listed on a public exchange.

• A discount may be available because a large block of stock is often less marketable than smaller amounts of stock.
• The theory behind a blockage discount is that a large amount of stock included in the decedent’s gross estate cannot be liquidated at one time without a decrease in the stock’s market price.
• The discount would be based on the decrease in the realizable price below the current market price of the stock

Question 35

Key Person Discount

Answer 35

A discount may be allowed for a business in which a key person has died or becomes disabled.

• The discount is based on the premise that the stock of a closely held business will decline if a key person, such as the founder, dies or becomes disabled.
• The discount may be reduced by the value of key person life insurance proceeds payable to the corporation on the death of the key person