Overview Of The Estate Planning For Small Business Owners

Sole Proprietorship

Although perhaps the most common form of business ownership, the sole proprietorship affords few, if any, estate planning opportunities. Except in the rare situation where a ready, able and willing buyer is waiting in the wings or a legatee is wiling and able to continue the business, the ultimate disposition is liquidation of the business.

Assuming that the owner does not desire to incorporate or form a family partnership, there are still several vehicles available to provide tax shelter and some measure of estate planning benefits:

• Use of a Keogh plan, under which the owner may set aside $15,000 or 15% of his income, whichever is less, provided all full-time employees with at least three years of experience are included in the plan.

• Use of an Individual Retirement Account (IRA) either to supplement a Keogh plan or substitute in its place if the owner does not wish to include employees. The limits on the IRA are $2,000 for the owner, plus an equal amount for his spouse, if also employed, or a total of $2,250 if the spouse is not employed.

• Use of a Simplified Employee Pension (SEP) plan under IRC §408(k). Although administration is relatively simple, all employees over 25 must be included in the plan.

• Careful selection of an executor who has sufficient knowledge of the business or sophistication in general business matters to properly conduct the business, in accordance with the deceased owner’s desires, until sale.

• Special use valuation under IRC §2032A, which may be available where the adjusted value of the property used in farming or another trade and business equals 50% or more of the adjusted value of the gross estate, and the adjusted value of the qualified real estate equals 25% or more of the adjusted value of the gross estate. Although “material participation” is still required, ERTA has relaxed the rules for qualified use and has shortened the period for continued use by the years from 15 to 10 years.

• If the value of a closely held business exceeds 35% of the decedent’s adjusted gross estate, the estate may, in some circumstances, have up to fourteen years within which to pay that portion of the federal estate tax attributable to the business, in accordance with IRC §6166.

Partnership

The partnership form of business is subject to many of the estate planning limitations of a sole proprietorship. It does, however, boast the advantage of having at least one other person involved in the business who can purchase the business interest upon the death of the partner. Normally, death of one of the partners automatically terminates the partnership unless the partnership agreement provides otherwise. The resulting distribution of partnership assets to the partners or their successors in interest can often result in disastrous losses to all. There are, however, four alternatives available, each involving varying tax consequences: 1) a sale of the deceased partner’s interest to the remaining partners, 2) a sale of the interest to one or more new partners, 3) a distribution to the deceased partner’s estate, or other beneficiary, and liquidation of the interest, or 4) continuation as a partner by the estate or other designated beneficiary.

The determination of the value of a partnership interest for either a buy-sell or buy-out agreement is a matter properly negotiated by the partners. Once determined, however, if the price is binding on all parties and they are not free to dispose of their interest during life, the price set in the agreement is generally accepted as the basis for estate tax valuation. If there is no agreement, the fair market value as of the date of death or alternate valuation date must be determined, a task which can often prove very difficult.

The special use valuation provision of IRC §2032A, as well as the estate tax deferral benefits of IRC §6166 are also available provided the deceased partner owned at least 20% of the capital interest in the partnership or there were not more than 15 partners. In addition, the tax sheltered retirement benefits available to partners are the same as those available to a sole proprietorship — Keoghs, IRAs and SEPs.

Corporation

By far, the corporate form of business provides maximum flexibility for estate planning. But it is not always necessary or appropriate to put the whole enterprise into a single corporation. The possibility of combining the corporate form with individual or partnership ownership should not be overlooked. The use of multiple corporations should also be considered.

Although there are advantages to preorganizational planning, there are still many things that can be done at the postorganizational stage to achieve worthwhile financial and estate planning benefits. The owner of a successful operating company often sees his business increasing in value to the point where continued appreciation will either expose his estate or, if the owner makes use of the unlimited marital deduction, the estate of the surviving spouse, to federal estate tax at high rates. To avoid this, the owner may consider freezing the value of his interest at its present level and making gifts of the potentially appreciable interest to junior members of the family at relatively low gift tax cost.

The primary method by which this objective may be accomplished is by recapitalization, the typical scenario involving the senior family member exchanging his common stock for common and preferred stock in a tax free exchange in accordance with IRC §368(a)(l)(E). The preferred stock will carry the present fair market value of the business and the common stock will carry the appreciation potential. At the owner’s death, the preferred stock will then be included in the gross estate at par value.

However, care must be taken to insure that the capitalization has a bona fide business purpose; the mere saving of taxes is not such a bona fide business purpose according Rev. Rul. 77-321. The principal problem with recapitalization is that a lifetime disposition of the preferred stock may result in ordinary income under IRC §306. Still, if the stock is merely preferred with respect to a fixed dividend and repayment of par value on liquidation, and both the common and preferred stock have equal voting rights and are otherwise entitled to share equally in dividend and liquidation proceedings, it may not suffer the IRC §306 taint.

A holding company may also be a vehicle for effecting a freeze. In its most basic form, senior family members exchange their common stock in the operating company for preferred stock and new common stock in the holding company and then give the common stock to junior family members.

The use of an Employee Stock Ownership Plan (ESOP) is another means of furthering the interest of the principal shareholder of a corporate enterprise, especially in view of the improved leverage and other advantages afforded by ERTA. In particular, an ESOP can be very useful in connection with the disposition of an interest in a closely held corporation. In particular, it may be used to buy out the interest of the deceased shareholder. A sale of stock by an estate to an ESOP provides the same liquidity as an IRC §303 redemption to pay death taxes, funeral and administration expenses, and yet avoids the limitations of a §303 redemption.

The private annuity offers still another method of planning for business interest, particularly with respect to closely held corporations. Typically, under the private annuity arrangement, the parent stockholder sells his stock in the corporation to his children in return for their promise to pay him, and often his spouse, a fixed sum annually or at shorter intervals for life. The principal advantage of the private annuity is that it offers, if properly structured, the ability not only to freeze the value of the transferred stock, but also to remove an asset from the transferor-annuitant’s estate without incurring either gift or estate tax. Theoretically, the value of the transferred stock will equal the value of the annuity contract: hence, no gift tax. And, on the death of the transferorannuitant, the annuity obligation typically ends: hence, no estate tax.

Installment sales, and the favorable tax consequences which a sale structured in this manner may receive, provide yet another method by which one can freeze the value of the business interest. This is accomplished by converting the value of the asset into a fixed maturity debt obligation. As long as the value of the promissory note equals the value of the corporate stock transferred, there will be a transfer for full and adequate consideration and no gift will result. The value of the note as of the date of the noteholder’s death will, however, be an asset includible in the decedent’s gross estate. But under the Installment Sales Revision Act of 1980, the noteholder will have reported the gain from the sale of the property in proportion to the receipts in each year.

Finally, use of a family investment company can provide significant financial estate planning advantages. Properly structured, it can, among other things, shift income from a high bracket family member to those in lower tax brackets, provide an alternative to recapitalization of one or more closely held corporations, effect gift tax savings on a transfer of the interest to junior members, and effect estate and gift tax savings on transfers at death. However, to obtain many of the available benefits, the investment company must not qualify for treatment as a personal holding company. As a practical matter, this means that personal holding company income, as that term is defined by the Internal Revenue Code, must be distributed annually or risk imposition of a penalty tax. Thus, shareholders face double taxation of earnings, once at the corporate level and again at the individual level when earnings are distributed to them. But as a result of the Subchapter S Revision Act of 1982, it may be possible to escape double taxation through a Subchapter Selection.

Conclusion

Regardless of what form of business entity is most desirable from an estate planning point of view, the desires of the client, although often frustrating optimal use of the techniques available, must take precedence. Where possible, the corporate form generally offers the greatest opportunity for estate conservation and tax savings. However, all forms of business ownership offer some opportunity for estate planning, if properly utilized.