Business and Estate Planning 2010 Columbia Bank Seminar

Business and Estate Planning 2010 Columbia Bank Seminar

Estate Planning Overview for 2010 Planning for the Closely Held Business

By: Martin M. Shenkman, CPA, MBA, JD

IRS Circular 230 Legend:  Any advice contained herein was not intended or written to be used and cannot be used, for the purpose of avoiding U.S. Federal, State, or Local tax penalties.  Unless otherwise specifically indicated herein, you should assume that any statement in this communication relating to any U.S. Federal, State, or Local tax matter was not written to support the promotion, marketing, or recommendation by any parties of the transaction(s) or material(s) addressed in this communication.  Anyone to whom this communication is not expressly addressed should seek advice based on their particular circumstances from their tax advisor.

Formal Attire:
  • You want your business documents to be dressed for success.
  • Annual meeting and minutes.
  • Governing agreements.
  • Corporate kit and permanent file checklist.
  • Proper signature (capacity, title, entity) on all documents.
Obama Medicare Tax and its Impact on Closely Held Businesses:
  • At present, only wages and earnings from self-employment are subject to the Medicare tax.
  • However, starting in 2013, a 3.8% Medicare tax will be applied to the greater of the following: your client’s net investment income or the excess of your client’s modified adjusted gross income (MAGI), over a threshold amount. The threshold amounts are $200,000 for a single taxpayer and $250,000 for a taxpayer filing a joint tax return.
  • These amounts are not supposed to be indexed, so inflation will erode these thresholds over time. Failure to adjust these amounts is a significant departure from many prior tax law changes.
  • Over time these caps and the tax raise will shift from applying to the wealthiest sliver of taxpayers to a broader range of taxpayers. This could be an ugly repeat of the expansion of the nefarious alternative minimum tax.
  • Investment income derived as part of a trade or business is not subject to the new Medicare tax on investment income. Does that mean that if you retain liquid assets and the income they generate inside your business that the tax will be avoided? Likely not, unless the business can justify a business purpose for this.
  • Although there are no rules or guidance yet, creating minutes documenting the business purpose of retaining investment assets in the business might be one of the steps to take to support this type of action.
  • However, one downside for this type of planning will be exposing liquid assets to business creditors and claimants.
  • Tax rates of the business, the ability to justify retained earnings, creditor issues, virtually the full gamut of planning considerations, can all be relevant to planning. But will the Medicare tax rate warrant such efforts?
  • Passive real estate, as defined under the existing passive loss rules of Code Section 469, could be adversely impacted. There might be some incentive for real estate owners to re-evaluate their status under the passive loss rules even if they don’t have passive losses.
GRATs are G-R-E-A-T!
  • Grantor Retained Annuity Trusts.
  • How they work.
  • What might proposed legislation do?
  • Moral of this tale – get them while you can.
Annual Gifts of Stock or Membership Interests:
  • Verify S corporation rules and shareholder qualification.
  • Appraisal.
  • Gift letter.
  • Minutes.
  • Cancel old stock certificates and issue new.
  • Execute an Amended and Restated Shareholders’ Agreement reflecting new owners.
Shareholders’ Agreement and Operating Agreement – some sample provisions you might want to consider:
  • Trusts as shareholders.
  • Confirm compensation versus distributions for payroll tax purposes.
  • Limit donor/senior generation’s control and assure that they have a fiduciary responsibility for any actions.
  • S corporation provisions to be included in all shareholder’s wills and trusts.
  • Mandate S corporation distributions to pay tax or, alternatively, do not mandate distributions.
  • Why did you give 5% of the stock to a former key employee? Consider phantom stock arrangements.
  • Power of attorney to act on behalf of certain shareholders for certain administrative matters.
  • Buy sell that goes well beyond death buyout.
Dividing your Business to Protect Against Liability and Prevent a Domino Effect:
  • Code Section 355 divisions.
  • LLC for real estate and intellectual property rights.
  • Consider passive loss implications.
Intercompany Documents – some examples and why you need them:
  • Loans are the biggie so often ignored.
  • Consulting agreements. GRAT example if not paid from entity in GRAT.
  • Treat as if they are independent entities, even if family controls all.
  • Encyclopedia Brown and the case of the missing lease renewal option.
LLC Succession Plan in a Simple Operating Agreement:
  • Who needs a single member operating agreement? You do.
  • Name a manager and create all manager roles and titles in a limited manner.
  • In the event of disability, the successor manager can step in.
Split-Dollar Life Insurance and the Closely Held Business:


  • Mother and Father own the stock in a family business organized as an S corporation and both are employees (if not, the arrangement illustrated will have a different result).
  • They have utilized their lifetime $1 million gift exclusion. Assume further, that the annual premium for a $12 million survivorship policy is $94,000/year.
  • There would be a substantial gift tax cost incurred for them to make cash gifts to an irrevocable life insurance trust (“ILIT”) to pay for the premiums. Instead the ILIT and Corporation enter into a non-equity split-dollar arrangement.
  • Pursuant to this arrangement, on termination, Corporation will receive the greater of the aggregate premiums paid or the policy cash surrender value.
  • Although Corporation does not own the policy, this arrangement is taxed under the economic benefit paradigm of the 2003 Regulations.
  • The payment of the insurance policy premiums in this example consists of two components:

    1. Corporation pays for the value of a joint and survivor term insurance policy under Table 2001 that is about $850.00. This amount is treated as taxable income to Mother and Father, perhaps as a dividend distribution from Corporation. Then this amount would be a deemed gift by Mother and Father to the ILIT.

    2.Corporation pays the balance of the premium $93,250, to the ILIT directly as an investment in the policy. Because the corporation is entitled to receive back the premiums paid or cash value in the policy, there is no indirect gift to the ILIT by the Mother or Father as a result of this payment.

  • A roll out strategy is needed - consider GRATs.
Your Will Could be Really Wrong:
  • If your will leaves an amount to a trust or children based on the amount that doesn’t create a federal estate tax (a common way to write will language because of the many changes the law has taken over the years) what happens if there is no estate tax?
  • Your dispositive scheme may just go haywire! You need to revise your will to contemplate a world without an estate tax. Tax advisers never had this scenario on their radar screen.
  • In some instances the manner in which assets are owned or a will or trust is structured it might be feasible to correct the problem after death through post-mortem planning. For example, it might be feasible for a surviving spouse or children to disclaim assets they receive, even in trust, and have those assets then pass to the beneficiary who was really intended to receive them.
  • A will or revocable trust may establish a trust for many beneficiaries (called a “sprinkle” or “pot” trust). If some assets pass to persons that were not intended, but sufficient assets remain in a pot trust, it might be feasible with appropriately directed distributions from that trust to equalize or offset unintended consequences created by the repeal of the estate tax.
  • Unfortunately, in many situations, the consequences of estate tax repeal, possibly even if the estate tax is reinstated retroactively, litigation may ensue. Many courts may adopt a construction that would minimize taxes, which has historically been significant, but if this impacts the actual beneficiaries inheriting, will they take this approach?
  • Word formulas that leave a specified calculated amount based on tax law to a particular beneficiary or trust may no longer be effective, or worse, may completely contradict the testator’s intent.
  • Word formulas have been used to fund bypass trusts, state bypass trusts, to divide bequests as between bypass and QTIP, funding the marital or bypass, funding trusts for grandchildren or other exempt persons, etc.
  • The elimination of the estate and GST tax can result in all or nothing passing to one of the intended recipients of a formula clause.
  • Example of Bypass Funding.  Your will was written when the estate tax exclusion was $600,000 and you bequeathed the largest amount that would not trigger a federal estate tax to your children from a prior marriage.  The balance, which was the bulk of your estate, was to pass to your new spouse.
  • Sample Pre-2010 Will Clause Funding Federal Bypass.  “I give, devise and bequeath the pecuniary sum which is the largest dollar amount which will not create a federal estate tax on my death, to the Trustee of my Applicable Exclusion Trust, in trust, (“Applicable Exclusion Trust”) to be disposed of in accordance with the provision below "Application of Applicable Exclusion Trust.”
  • This common scenario raises a myriad of issues, by way of example:
    • How will the language in your will “the largest amount that will not trigger federal estate tax” be interpreted if there is no estate tax? Will the simplistic literal interpretation apply? If there is no federal estate tax than an infinite amount can pass free of estate tax.
    • Does the application of the literal interpretation of the provision result in your entire estate passing to your children and nothing to your surviving spouse? Does it matter if that was clearly not the intent of the testator?
    • Will courts recognize the intent at the time the will was drafted to pass a portion of the estate to the spouse and only a portion, not all, to the children? This would be a strained interpretation if the will had been in place for many years.
    • As the federal estate tax exclusion has increased from $600,000 to $3.5 million everyone has had plenty of time and notice to revise their documents to readjust the amount passing to the children under a will similar to that above. So why on this final step of repeal would the courts recognize something different? At which point of the spectrum from $600,000 to $3.5 million to the entire estate was the testator’s “intent?”
    • The counter argument is that if no change was made to the will language as the exclusion increased, that perhaps that was the intent.
    • What if there were projections prepared by the estate or financial planner or CPA that reflected what would occur under the formula and those projections clearly illustrated that a limited dollar figure would pass to the children? If the presumption of the testator when the will was signed was that there would be an estate tax, how should that presumption be factored into the analysis?
    • If Congress retroactively reinstates the estate tax to January 1, 2010, but you die before the reinstatement is passed, what happens? Will a retroactive estate tax change survive a constitutional challenge?
    • It is pretty likely that someone with substantial wealth will die between January 1, 2010 and the date Congress eventually reinstates the estate tax (if Congress in fact does so) whose heirs will have a tremendous incentive to challenge any reinstatement. But even if such a challenge was successful as to the federal estate tax, how will it affect the state estate tax and property law?
    • There is now talk of giving tax payers the option to choose estate tax or carry over basis from January 1, 2010 to enactment.
Carry Over Basis and the Closely Held Business:
  • Consider the possibility of designating an independent person as a “special” executor to make certain tax determinations. That person, if a fiduciary and “executor,” would have to obtain letters testamentary or administration. 
  • It is not clear whether instead such a person could not be an executor, and in some other fiduciary or quasi-fiduciary capacity be granted the limited powers to make specified tax decisions.
  • A significant issue is that these “limited” tax decisions, considering the combination of income, gift, estate and GST taxes, affect a substantial portion of the value of many estates.
  • How can the decisions made be coordinated with that of the surviving spouse and how far can the role of some type of protector be carried? What would state law say in regards to such a new and novel “executor” type function?
  • Wills should also have express language authorizing the executor to allocate the $1.3 million general basis adjustment and the additional $3 million spousal basis adjustment.
  • This allocation power, perhaps, should be exercised by an independent person, not a beneficiary who would benefit. This is far from a simple matter to address as the possibilities are endless. For example:
    • What is the expected holding period for the property? If property, such as a family cottage, is intended to remain for generations in the family it is less in need of an allocation to increase basis than are other assets which are more likely to be sold.
    • Are other avenues to avoid, defer or minimize the potential future capital gains tax available, and how does their availability compare to other assets in the estate if the maximum basis adjustment has to be rationed to the various assets?
      1.CRT Example: If the estate holds raw land that is likely to be donated to the local church for an expansion project, the basis adjustment is less important as compared to other assets if a charitable remainder trust could be used.
      2.1031 Exchange Example: If the estate owns a shopping center and, rather than sell it, a tax deferred Code Section 1031 exchange is a likely possibility, then the allocation of basis to the shopping center may be less advantageous than an allocation to other assets.
      3.Exchange Funds: If highly appreciated securities could be contributed to an exchange fund to diversify without incurring capital gains then these assets would be less in need of an allocation.
      4.Principal Residence: If the decedent’s principal residence can be sold and exclude gain under the home sale exclusion rules, then, to the extent that that exclusion will avoid taxable gain, basis adjustment should not favor the residence.
    • What will the capital gains tax rates be?
    • What are the tax bracket and status of the beneficiaries receiving the property?
    • The myriad of factors and competing interests of different beneficiaries will also make it difficult for advisers to evaluate and weigh the many options.
    • How will counsel to the executor advise on the allocations? If there are no directives in the will (and how should those be drafted?) as to how the basis adjustment should be allocated, what framework can be used to make a determination?
    • Clients might consider carving out specific assets that should, or should not, receive an allocation. This might include a direction not to favor a family business in the basis adjustment allocation because the testator wants the business held forever.

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