Planning During Economic Turmoil The Book
Portions of this course outline were excerpted from the new book, Estate & Related Planning During Economic Turmoil, available for purchase from the American Institute of CPAs (AICPA). The complete book analyzes, in addition to planning for closely held businesses, a myriad of related planning issues: financial planning, estate planning, charitable planning, matrimonial planning, and more. The e-book also is accompanied by an array of practical planning checklists for business owners and professionals. It also includes marketing materials for professional advisers. These include a power point which professional advisers can use in making presentation to clients and prospects.
Estate and Related Planning During Economic Turmoil
In handy download format, this new book focuses on the timeliest of topics: estate planning in the current market. Complete coverage of estate planning topics includes sample checklists and a marketing PowerPoint presentation to help you promote your firm’s services in this area. Now available from the AICPA—Estate and Related Planning During Economic Turmoil takes a look at how to assess and modify your estate planning firm offerings in a volatile market. Critical planning topics including estate, trust, charitable, probate, closely held business, financial, and matrimonial planning. This e-book offers you the timeliest resources for estate planning. Make sure that you are covering all of the strategies for your estate planning during these times with Estate and Related Planning During Economic Turmoil. See www.cpa2biz.com. $48.75.
Closely Held Business Planning During Economic Turmoil
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.
For a free 3 hour audio presentation on this topic see www.laweasy.com “Seminar Materials” Section.Introduction
The markets are in turmoil. Tax, business, economic, investment matters are increasingly uncertain. The impact on closely held businesses makes planning for them more important, and more difficult. Lines of credit and other sources of financing may not be available, changes in value have had a profound impact on buy sell agreements, and so forth. Planning needs to be revisited. Documents need to be updated. Insurance, financing, and other arrangements need to be reviewed. When undertaking or reviewing estate planning, business and employment issues could be of paramount importance.Change and More Change – Income and Other Business Tax Changes Abound
To foster employment growth and investment by closely held businesses a host of special tax provisions have recently been enacted and more are likely to come. The following are a mere sampling of a few of these changes to demonstrate the magnitude and scope of change including some of the tax changes that affected business in 2008 and the beginning of 2009 (e.g., the American Recovery and Reinvestment Act of 2009, ARRA, P.L. 111-5, 2/17/2009). The following is a summary of some of the many changes:
Business owners have a planning window of opportunity. An obvious cornerstone of gift and estate planning is to gift/transfer assets out of your estate when values are low. Economic downturns, especially significant ones, are an ideal time to transfer assets. Whether the market bottom has occurred, or remains to be seen, if the time period is long enough, gifting/transferring now, is optimal. These transfers can run the gamut of planning:
Discounts are a critical factor in valuations in jurisdictions which permit discounts in matrimonial valuations. A discount is simply illustrated as follows: 30% of a $100 business is worth less than $30 because the minority interest is hard to market. Recent economic turmoil may legitimately increase the discounts on certain asset valuations. Credit risks may be far greater than they have been in years. Unique factors certainly exist in the current market. Higher discounts might be justified, especially for businesses that are viewed as more risky or for which minority interests would be even less saleable/valuable in the current economy. Asset values may be depressed as a result of the greater discounts. Remember that the law governing discounts in the matrimonial area, including the definition of “fair value” differs from the law governing discounts for estate planning purposes.
Discounts have been a cornerstone of many estate planning leveraging techniques.
Example: A discount is simply illustrated as follows: 30% of a $100,000 business is worth less than $30,000 because the non-controlling minority interests are hard to market and has no control. Different discounts may be identified for lack of control, lack of marketability, absorption discount, and other factors.
Has recent market turmoil legitimately increased the discounts on certain transactions? A number of appraisers have published articles suggesting that the increased volatility in the markets, measurable by various indices, corroborate increase risk and hence discounts, on assets.
Another perspective to understand the concept of enhanced discounts can be gleaned from an approach used of building up a capitalization rate for valuing business assets in today’s environment: [Corporate bond rate + Premium for lower liquidity of target asset as compared to bonds generally + Premium for greater management difficulty of real estate or close business + Premium for unique difficulties of assets in question (location, difficulty to liquidate) + Premium for additional management burdens, and credit risks + Premium to reflect unique factors in 2009 = Total Capitalization Rate.] Credit risks may be far greater than they have been in years. Unique factors certainly exist in the current market.
For taxpayers who have not yet consummated significant leveraged gift transactions (e.g., a sale of assets to a grantor dynasty trust for a note, after having made a taxable gift to that trust), now may be an opportune time while higher discounts might be justified, asset values may be depressed, and interest rates remain low. The possibility of more restrictive estate and gift tax rules under the Obama administration may provide further encouragement for you to proceed and not delay planning. Future legislation could add a family attribution rule (similar to the concepts advocated by the IRS years ago), eliminate discounts for passive investment assets, or take other forms that restrict or even eliminate discounts. For example, Representative Pomeroy introduced estate tax legislation with the snappy title “Certain Estate Tax Relief Act of 2009” (H. R. 436). If this proposal, or a similar proposal now or in the future is enacted, then discounts, will no longer apply to transfers of nonbusiness assets. This change will have a huge impact on planning. The value of any nonbusiness assets held by the entity (e.g. cash and securities held in the family widget manufacturing corporation) will be determined as if the transferor had transferred such assets directly to the transferee with no discounts (i.e., rather than having transferred an interest in say an FLP that would be discounted, it will be viewed as if you transferred the building and stocks held by the FLP). If you transfer an interest in an entity, no discount will be allowed as a result of your not having control over the entity if you and your family (as defined in IRC Sec. 2032A(e)(2)) control of the entity. This might mean that if people unrelated to you control the entity, discounts will still be allowed. Does that mean you and two sorority sisters can set up a securities FLP and still get discounts? This also might mean that discounts for other purposes, such as for absorption of a large parcel of land, will still be permitted? Jane Z. Astleford, 95 TCM 1497. The bottom line is simple, if discounts will enhance the leverage of your estate planning, act while before the window of opportunity is completely shut.Grantor Retained Interest Trusts (“GRATs”); Note Sale to Defective Grantor Trust (“IDIT”) Transactions
These techniques have commonly been used to remove interests in closely held businesses from a senior family member’s estate (see discussions in the earlier chapter on estate planning). Economic conditions may have radically altered the GRAT or IDITs ability to make the required annuity or note payments. Review the ability of the trust to make forthcoming distributions. If cash flow will be insufficient, then distributions of equity in the business held in the GRAT/IDIT back to the seller/grantor will be necessary. This will require a new appraisal for the interest being distributed back. Consider the issue of discount whipsaw discussed above. The appraisal and legal documentation to retransfer equity interests will require advance planning to so that the distribution can be made on as timely basis. Stock certificates or other legal documentation will also be required.
Caution: If a senior family member decides to boost business cash flow to facilitate the continued payment of GRAT annuity payments, or IDIT note payments, might this salary reduction be tantamount to an inappropriate additional contribution to a GRAT or a gift to the IDIT?
Example: Mom gave 40% of the family widget company to a twelve year GRAT. Mom’s salary had been $1 million/year for a number of years, and over many years her salary has grown at about a pace of 5% per year. Cash distributions from the family business will decline in the current year because of economic stress. Since the GRAT receives 40% of these distributions, the cash flow to the GRAT, which it uses to pay annuity payments, will decline. The GRAT will be forced to make annuity payments to Mom in-kind, i.e., with distribution of equity interests back to Mom. Mom is aware that to do so will require that considerable costs be incurred. The business will have to be appraised. Counsel for the business will have to prepare new governing documents, etc. Instead, Mom cuts her salary from $1 million to $100,000/year so that an additional $360,000 can flow to the GRAT [$900,000 savings x 40%]. While this might solve the GRAT payment issue, has Mom made an additional contribution to the GRAT thereby disqualifying the GRAT?Are Rolling or Cascading GRATs Still Estate Planning Nirvana for Business Owners?
A common GRAT technique has been the use of short term “rolling” or “cascading” GRATs. Consider:
Sales to grantor trust remain a hot mechanism for transferring interest in closely held businesses. The combination of low interest rates and low values make this a tremendous technique. It is not clear how long this window will remain open.
First let’s illustrate this technique in simple terms for the uninitiated. You set up a trust. The trust is structured to be a “grantor trust” that is taxed to you for income tax purposes. However, the powers in the trust that create grantor trust status, and other powers and provisions, are tailored so that transfers to the trusts are completed gifts and so that the trust is not included in your estate when you die. This is the tax equivalent of “having your cake and eating it too.” When this specialized trust is established, depending on the crystal ball your tax adviser uses some amount of initial money or assets are given to the trust as a taxable gift (although your lifetime gift exclusion will often prevent any current tax liability being incurred). Once the trust is established and possibly has initial funding, the trust then buys assets from you. The trust will issue a note back to you for the assets purchased. With interest rates at all time lows, the assets will hopefully have a more assured possibility of growing at a rate substantially faster than the interest rate charged (the hurdle rate for tax purposes).
Sales to Intentionally Defective Irrevocable Trusts (“IDITs”) can take various forms. These trusts are also referred to as Intentionally Defective Irrevocable Grantor Trusts (“IDIGITs”).
Each of these factors raises issues that may require careful consideration in light of recent economic developments.
Selling real estate or business interests to an IDIT or gifting them to GRATs has been a common estate planning technique. Several of the implications of recent economic and market developments to these transactions were discussed above (and others in the discussion below of planning for closely held businesses). But when close business or real estate assets were the subject of the sale, additional issues may have been created from the recent economic turmoil. The key for many of these transactions achieving their intended goals was that the real estate or business interests would generate sufficient cash flow for the trust to pay the note, or the GRAT to make its periodic annuity payment. If economic developments have cast doubt on the trust being able to make payments out of cash flow, steps must be taken to address payments from other than cash flow. Since audits have focused more attention on compliance with the formalities of maintaining the transaction meeting payment requirements should be given considerable care. If the result is that the GRAT or IDIT will have to distribute back part of the equity of the underlying real estate or business interests an appraisal will be required as noted above. Given current market conditions three negative results could impact the GRAT/IDIT:
Generation skipping transfer (“GST”) tax exemption must be allocated to a trust to assure that the trust principal is exempt from GST tax. If the allocation of exemption was not sufficient to result in a zero inclusion ratio when intended, the decline in asset values presents an opportunity to clean up these trusts. The amount of GST exemption to be allocated to a trust to correct the inclusion ratio to zero is the trust’s inclusion ratio multiplied by the value of the trust assets at the time of the late allocation.
Example: You gifted $100,000 to a trust for all of your children and grandchildren. While the trust had annual demand (Crummey) powers to qualify the gifts for the annual gift tax exclusion, the trust did not qualify for the GST annual gift exclusion. Further, assume that the rules that automatically allocate GST exemption to certain gifts in trust did not apply to allocate any of your GST exemption to this gift. Although $100,000 of your available GST exemption should have been allocated to that trust on the gift tax return filed for the year of the gift, none was so allocated. If GST exemption had been properly allocated, then no mater how large the value of the business interests in that trust grew in future years the entire balance of the trust will be exempt from GST tax. For a host of reasons the amount of GST exemption allocated can sometimes be done improperly. Since no GST allocation was made distributions from this trust to grandchildren as skip persons for GST purposes will trigger GST tax. The business interests grew to $250,000 by 2008. You would have to allocate $250,000 of GST exemption to the trust at that time to make the trust wholly GST exempt. You were reluctant to do so for a host of reasons, but especially since it was not clear that all distributions would be made to skip persons so that allocating GST exemption would waste some or all of your valuable GST exemption. In 2009 the value of the business interests held by the trust had shrunk by ½ to $125,000. A late allocation of GST exemption at that level would not prove much less favorable then had you properly allocated GST exemption when the trust was initially funded.
Example: In 1998, you gift 5% of a $1 million building to a trust for your grandchildren, and your accountant allocates $50,000 of GST exemption to the trust. Later it is determined that there were errors in the appraisal and the value of the building was $2 million. Since only $50,000 of GST exemption was allocated the GST inclusion ratio for the trust is 50%, ½ the value of the trust will be subject to GST tax. While this issue was more common before the tax laws were amended to mandate the automatic allocation of GST exemption in many cases errors can still occur. The economic downturn may be the optimal time to clean up these GST trust allocation issues. To clean up the problem you need to allocate sufficient additional GST exemption to the trust to make it fully exempt.
Example: Continue the above example. In 2007 the trust value was $200,000. Since only $50,000 of GST exemption was allocated, the GST inclusion ratio for the trust is 50%, you have to allocate 50% x the $200,000 value to the trust, or $100,000 of additional exemption. However, in 2008 the value of the real estate assets declined to $75,000. Now you only have to allocate $37,500 of additional GST exemption to the trust.
Use the decline in values as an opportune time to clean up GST allocation issues. When life hands you economic lemons, make GST lemonade!Estate Tax Deferral
The economic downturn has created a cash squeeze for many businesses and hence estates that own them. Identifying approaches to funding estate tax has become a priority for many personal representatives. Part of this analysis should include identifying ways to defer estate tax. When a recovery eventually takes hold, it may become easier in the future (and less ruinous to a family business) to pay estate taxes then. One common approach to deferral when the estate holds significant closely held business interests is the estate tax deferral under Code Section 6166.
To qualify for estate tax deferral the interests in qualifying closely held businesses must exceed 35 percent of the decedent's adjusted gross estate. The dramatic shift in values can completely change the relative relationship of assets for purposes of qualifying for this requirement. Asset values must be re-tested.
For estate tax purposes the decedent's assets are valued as of the date of death. An election can be made to value the estate’s assets six months after the date of death using the alternate valuation date (“AVD”). If the alternate valuation approach is used, any property distributed to a beneficiary, or sold exchanged, or otherwise disposed of during the period from the date of death to the alternate valuation date is valued at the date of distribution, sale, exchange or other disposition. If beneficiaries fear additional market declines, but nevertheless plan on continuing to hold assets presently held by the estate, it might be advisable not to distribute assets prior to the alternate valuation date so that if there are declines they can be used to reduce the estate tax values. Once an asset is distributed later declines in market value will not lower the estate tax, thus resulting in the vary risk the alternate valuation election was intended to mitigate against. If an executor opts to hold estate assets that could have been distributed prior to the alternate valuation date, care should be taken to document the beneficiaries approval of this, and that the action is in conformity with the provisions of the will and the prudent investor act. Bear in mind when you are serving as a personal representative, that the current economic situation has made many beneficiaries more anxious then ever to receive their distributions, yet those distributions if in kind may have a negative impact from an estate tax valuation perspective.
The alternate valuation election may only be made by the executor if it reduces the value of the gross estate and reduces the taxes due. The election must be made for the estate in aggregate, it cannot be made on an asset-by-asset basis. The recent economic turmoil is likely to result in a significant percentage of estates adopting the alternate valuation date. A special valuation rule applies to certain assets such as patents, life estates, remainders and reversions. These assets are affected by a mere lapse in time are valued as of the date of death, not a later date of disposition or the AVD. Then there is an adjustment to the alternate valuation date to reflect any difference in value that is not due to the mere lapse of time. Treas. Reg. Sec. 20.2032-1(f). If the AVD is used, the value of an asset on the AVD becomes the beneficiary’s basis for that property instead of the fair market value at the date of death. IRC Sec. 1014(a)(2).
The election must be made on an the estate’s Form 706 filed no more than one year after the due date (including extensions). The election is irrevocable. If the valuation of all significant estate assets cannot be appropriately determined, or if the appraiser believes that post alternate valuation data will legitimately be relevant to the alternate valuation date values (or discounts on those values) consideration should be given to extending the estate tax return deadline.
Care has to be exercised to evaluate the inter-play of an AVD election and other estate tax elections and issues. Code Section 303 permits redemption of stock to pay death taxes if the value of the corporate stock exceeds 35% of the gross estate reduced by deductions permitted under Code sections 2053 and 2054. Code Section 2032A requires that 25% or more of the adjusted value of the gross estate must constitute qualifying real property interests. In both these instances, the change in the relative values of estate assets from date of death to the six month alternate valuation date could enable the estate to qualify for these benefits, or prevent qualification.
Example: The ADV election can affect the estate’s qualification for estate tax deferral under Code Section 6166. Assume that the estate is comprised of a family business valued as of the date of death at $7 million, securities valued at $10 million, and a house valued at $4 million. The business, on the date of death, constitutes 1/3rd of the gross estate: $7M/($7M + $10M + $4M) = 33% of the estate. This is insufficient to qualify for estate tax deferral 35% hurdle. Assume that by the date six months post death, the AVD, the business has declined to $6 million, the securities to $4 million, and the house has increased to $5 million in value. The value of the business is now above the Code Section 6166 hurdle: $6M/($6M + $4M +$5M) = 40% of the gross estate, which is sufficient to qualify for estate tax deferral under IRC Sec. 6166. Thus, use of the AVD can have the added benefit of enabling the estate to qualify for additional estate tax benefits, or undermine them, depending on the circumstances.
Another significant issue that affects estates considering electing to use AVD is the potential for varying impact on the estate beneficiaries. These can create tremendous conflicts, and a difficult decision for you as personal representative.
Example: In the preceding example the decedent was survived by three children, each of whom received a separate asset: the family business, securities, and the house. The use of the AVD benefited the children receiving the business and securities, but penalized the child receiving the house. How can you as an executor make the election in such a situation? How can the executor avoid making the election? The overall tax is reduced, but the proportion of tax of the heir receiving the house is increased. Further, income tax basis of each of the beneficiaries is reduced. Depending on their anticipated holding period and expectation about capital gains tax increases, they might have different views on whether an AVD election is advantageous or not.
There is considerably uncertainty as to how the alternate valuation date is to be applied to IRA assets. . It is not clear what happens with property in an IRA on the alternate valuation date. How does 2032 apply to an IRA inherited by a child or other beneficiary? A transfer from the decedent’s IRA to an inherited IRA should not be considered a 2032 distribution or disposition according to most practitioners. Instead, this should be treated as a mere transition of an account, similar to a joint account where the transfer to the surviving joint owner is not deemed to be a disposition under IRC Section 2032. In Rev. Rul. 59-213, 1959 C.B. 244 the IRS stated: “The term “otherwise disposed of” is construed as not applicable to a transfer of jointly owned property which is subject to an unrestricted power of disposition retained therein by the surviving joint tenant, since, in effect, the joint tenant or tenant by the entirety is not relinquishing any authority or power of ownership over the property”. A similar IRA succession issue arises if prior to the September 30 beneficiary determination date in the year following the year of death, the beneficiaries who inherit the IRA split the account into separate IRAs so each designated beneficiary can use their own life expectancy to calculate required minimum distributions (e.g. siblings with significant differences in age). Is the division of an IRA among named beneficiaries a “disposition” that freezes the value for AVD purposes? Finally, is an IRA a single asset or a bundle of separate assets (analogous to a brokerage account)? There seems to be little actual guidance on these potentially significant IRA issues.
Another uncertainty which you must consider as a personal representative is that the Treasury has issued Proposed Regulations. Prop. Reg. Section 20.2032-1(f)(1). The objective of these Regulations is to prevent executors from taking actions that could lower the value of an estate asset and then elect AVD. More specifically, the IRS endeavored to enjoin the consideration of non-market forces. Unfortunately, the application of this seemingly simple objective results in considerable confusion and potential unfairness. The proposed regulations provide that the AVD election permits the property included in the gross estate to be valued as of the AVD to the extent that the change in value during the alternate valuation period is the result of market conditions. The term “market conditions” is defined as events outside of the control of the decedent (or the decedent's executor or trustee). To eliminate changes in value due to “post-death events” other than market conditions, any asset affected by post-death events other than market conditions is included in the decedent's gross estate at its value as of the date of the decedent's death, adjusted for any change in value that is due to market conditions.Graegin Loans
Estate taxes can be devastating to an estate holding a family business (or other non-liquid assets) in “normal” times, but during recession and periods of extreme turmoil, it can be far more problematic. A technique called a “Graegin Loan” might just help you as personal representative address estate tax and other cash flow issues for the estate.
Example. Betty Baker founded Betty Buns, Inc. Like many entrepreneurs, Betty was more focused on her business then on estate planning. Fortunately, Betty’s financial planner, convinced her to set up an insurance trust with a million dollar policy. When Betty died, a substantial estate tax had to be paid. The insurance would be a big help, but not enough to get the family cooking. The financial planner came to the rescue (again). The planner recommended that the Baker family use a Graegin Loan. She recommended that the insurance trust loan the $1 million policy proceeds to Betty’s estate. If the loan is a 10 year loan at 5%, the interest would be $50,000/year. Over the 10-year loan term that’s $500,000. Why would the estate want to pay interest? In most cases the beneficiaries of the insurance trust are similar, or even identical, to the heirs of the estate, so the interest deduction…well they’re kinda just paying themselves. If the loan arrangement from the trust to Wally’s estate is structured in a manner that conforms to the loan used in a court case called Estate of Cecil Graegin, 56 TCM 387 (1988), Wally’s estate will get a deduction, up front, for all of the interest to be paid over the entire 10-year term of the loan! That’s a $500,000 estate tax write-off. So, in addition to the $1 million insurance proceeds becoming available to pay a larger part of the estate tax, the loan of those funds to the estate will generate $500,000 tax deduction further substantially reducing the estate tax!
What’s the Recipe? If Emerald were to cook up a Graegin loan, the main ingredient would have to be an express requirement that, no matter what, the loan cannot be prepaid. Never. Further, if for any reason the estate as borrower defaulted on the loan, it would have to pay not just the interest due until the loan is repaid, but all of the interest due for the entire life of the loan. The loan should be commercially reasonable so that payment is likely. Now that’s a recipe for a weight watchers estate tax cake!
To make sure your tax buns don’t burn, be sure that you verify that state law doesn’t adversely impact the transaction, all the formalities of the loan are adhered to, the interest rate is reasonable, and other formalities are complied with. The IRS will be more likely to view the loan transaction favorably if there is a real family business, real estate or other non-liquid asset that is being safeguarded.Appraisal Issues.
The volatility of the current economic environment makes the appraisal process more difficult. Post valuation date economic developments may make you question whether the appraisal as of the date of death (or the AVD) was correctly done. Every appraisal is based on assumptions as to future economic conditions. What if those assumptions, as with the current economic recession, prove too optimistic. Can the appraiser re-evaluate the assumptions used as of either valuation date to consider post valuation (after the date of death or AVD) factors? What can be done? Can a new appraisal be completed with better assumptions? The answer is not clear-cut. There are conflicting principles involved. The appraisal must be done based on what is known or reasonably knowable on the valuation date. But the tax laws do allow consideration, to some degree, of subsequent information or events in order to provide evidence as to whether the assumptions used in the valuation were reasonable. An expectation that specific future events might occur may influence an assets value and the courts have occasionally permitted the use of hindsight to confirm the appropriateness of these expectations and their impact as of the valuation date. A subsequent sale of an asset can be used as evidence of the asset’s fair market value on the valuation date. The Tax Court ruled that an actual sale made at arm’s length, in the normal course of business, within a reasonable time before or after the valuation date, is the best criterion to value an asset. Estate of Helen M. Noble, et al. v. Commr, TC Memo 2005-2. In Noble, bank stock was sold in an arm’s length transaction more than a year after death and that value was held determinative.
The use of different valuation methodologies may be better at addressing the impact of the economic turmoil. For example, using Monte Carlo Simulation (MCS) instead of mere discounted cash flows (“DCF”), may provide a better approach even if subsequent events are not allowed. The use of a decision tree with assigned probabilities may be a better tool then mere DCF calculations. MCS is likely to do a better job of modeling the downside of an uncertain economic economy than a DCF model or a decision tree. DCF is a static model, frozen in time. MCS is a more sophisticated version of the multi-scenario analysis sometimes used in appraisals. It is a technique wherein we assign probability distributions (worst case, most likely, and best-case scenarios) to different assumptions of the DCF. For example, instead of assuming that sales grows at a specific percentage increase, you could model with MCS that the worst case is that sales will decline 50% in year 1, the most likely is that it will decline 10%, and the best case is that it will increase by 3%. The appraiser may have used a forecast of a sales decline in year 1 of, 7% for example, but this 7% doesn’t capture the terrible possibilities that MCS can capture. The MCS process is to define every one of several assumptions that are really probability distributions and not known, fixed numbers. Examples of other variables could include: the discount rate, fixed costs, variable costs, etc. With MCS the DCF valuation model could be run 50,000 or 100,000 times using random number generators to simulate the probability distribution for each assumption. Each run is its own DCF, but instead of running just one fixed DCF, you run tremendous numbers of them. The software tabulates the results. In MCS, value is no longer just a simple fixed number, but it is a probability distribution. For example, MCS may show that there is a 10% probability that the FMV of the Company is between $1 million and $2 million, a 30% probability that it is between $2M and $3M, etc. While you still arrive at a weighted average FMV, it may be more realistic in the sense that you will show that FMV is really a probability distribution.Business Contractions, Valuation Changes, etc. Impact Estate Planning
With economic problems continuing, you might be inclined to contract your business or professional practice. Unfortunately, there are a myriad of issues and problems with this seemingly simple task. Make sure the pill is not worse then the disease. Changing values of business interests, business contractions, and the repercussions of these can have on estate planning are substantial. The following is only a partial listing of considerations. Also, see the previous discussion of the impact of changing business values on alternate valuation date elections, estate tax deferral, etc.Bequests of Business Interests
Business owners should review their wills, and in particular, revisit distribution provisions especially as they pertain to bequests of family business interests. For example, you may have bequeathed the family mortgage lending business to your daughter who has diligently worked in the business, and “equalized” this bequest by leaving the remaining assets to your son. If the mortgage business is worth a fraction of what it had been when the will was drafted, or perhaps it has been closed, the dispositive scheme needs to be completely re-thought.
Funding taxes on bequests of illiquid business interests needs to be reconsidered. In the past the business may have generated sufficient cash flow to reasonably pay anticipated estate tax deferral obligations to the IRS, this may no longer be likely.S Corporation Stock and Debt Basis; Loans
Paying attention to tax basis is important to maximum tax benefits. For S Corporations, shareholders must track both their stock and debt basis. The amount of a shareholder’s stock and debt basis is very important. Unlike a C corporation, each year the stock and/or debt basis of an S corporation goes up and/or down based upon the S corporation’s operations. The S corporation will issue a shareholder a Schedule K-1.
It is important to understand that the K-1 reflects the S corporation’s income, loss and deductions which are allocated to the shareholder for the year. The K-1 does not state the taxable amount of the distribution. The taxable amount of distribution is contingent on the shareholder’s stock basis. It is not the corporation’s responsibility to track a shareholder’s stock and debt basis rather it is the shareholder’s responsibility. If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder’s stock basis.
Losses and deductions generally flow-through to the S corporation shareholder, but basis limitations may affect the ability to benefit from the loss flow through. If a shareholder is allocated an S corporation loss or deduction flow-through, the shareholder must first have adequate stock and/or debt basis to claim that loss and/or deduction on the shareholder’s personal income tax return. Even if the shareholder has adequate stock and debt basis to claim the S corporation loss or deduction, the shareholder must also consider other tax limitations, such as the at-risk limitations and passive activity loss deduction limitations. These other limitations may prevent the S corporation shareholder from being able to claim the loss and/or deduction.
Computing S corporation stock tax basis is important. In computing stock basis, the shareholder starts with the initial capital contribution to the S corporation or the initial cost of the stock purchased (the same as a C corporation). That amount is then increased and/or decreased based on the flow-through amounts from the S corporation. An income item will increase stock basis while a loss, deduction or distribution will decrease stock basis.
The order in which stock basis is increased or decreased is important. Since both the taxability of a distribution and the deductibility of a loss are dependant on stock basis, there is an ordering rule in computing stock basis. Stock basis is adjusted annually, as of the last day of the S corporation year, in the following order:
When determining the taxability of a non-dividend distribution the shareholder looks solely to his/her stock basis (debt basis is not considered). For losses and deductions which exceed a shareholder’s stock basis, the shareholder is allowed to deduct the excess up to the shareholder’s basis in loans personally made to the S corporation. Debt basis is computed similarly to stock basis but there are some differences. If a shareholder has S corporation losses and deductions in excess of stock basis and those losses and deductions are claimed based on debt basis, the debt basis of the shareholder will be reduced by the claimed losses and deductions. If an S corporation repays reduced basis debt to the shareholder, part or all of the repayment is taxable to the shareholder.
Business owners are more likely to assist family members and/or their businesses during these tough economic times. Prepare written loan documents with an appropriate stated interest rate to avoid the interest imputation rules. If the ultimate use of the funds is to be used to fund a family S corporation, review the S corporation income tax basis rules to optimally structure the loan. S corporation shareholders do not increase that tax basis by their ratable share of corporate indebtedness. Instead, you, as a shareholder, must incur a real economic outlay, and the debt must be owed by the corporation to the shareholder to obtain basis. IRC Sec. 1366(d)(1)(B).
If you are planning to help a child’s (or other donee’s) business, it may be preferable for you to gift or loan your child the funds, and then your child can personally re-loan the funds to the S corporation to increase basis.
Remember if you want a good golf swing, all three segments: the backswing, the downswing and impact, and the follow-through, all have to be right:
You loan funds to your child. That’s the downswing. This loan should be evidenced by a written, dated and signed note. The note should contain reasonable arm’s length terms, and provide for an interest rate that is sufficient to avoid imputed interest or gift issues.
Your child loans money to the S corporation. That’s the backswing. This loan should also be evidenced by a written, dated and signed note. The note should contain reasonable arm’s length terms, and an interest rate that is sufficient. The appropriate corporate actions, if any (e.g., minutes, board approval, etc.) should be taken to approve the loan. If there are governing documents for the corporation (e.g., a shareholders’ agreement) any requirements contained in those documents for a related party loan should be addressed. The payment dates, amounts, interest rate, and other terms and variables in this loan should not mirror the loan you make to your child to avoid an argument by the IRS or claimants of circular loans. Kerzner, TC Memo 2009-76.
Finally, the follow-through needs to be addressed. Interest should actually be paid by your child’s S corporation to your child, and then separately, by your child to you, on time. The formalities of each leg of the transaction should be adhered to so that the transaction is not collapsed under a step transaction theory (as if it were no different than you having simply loaned money to the corporation directly).Business Corporation Distributions, Payment of Personal Expenses and Ignoring Formalities
Those faced with pressing cash needs, and who have experienced dramatic portfolio declines, loss of jobs, or loss of other income, will be inclined to simply take money out of a family entity, or have the entity directly pay personal expenses. Caution should be exercised to protect against adverse tax and legal implications of such distributions. The viability of the entity may be impaired destroying tax and asset protection benefits. If desperate shareholders ignore entity formalities with distributions this will bolster IRS arguments that retained interests exist sufficient to cause any gifted equity interests to be included in a donor/parent’s estate. A couple of simple, but inappropriate distributions to the parent/donor/shareholder, could give the IRS a basis to attack a substantial estate plan.
You may try to cut back on legal fees for annual minutes, needed revisions of shareholders’ agreements and other governing documents. Evaluate the long term appropriateness of these steps and instead follow up to at least the minimum degree required, even if you endeavor to keep the costs to a minimum.Reasonable Compensation
What is “reasonable” to pay as compensation from a closely held business is a thorny issue with the IRS during normal times, but what does it mean during an economic meltdown? What will it mean when the economy and your business recover? If you lower compensation substantially now, when your business recovers will you have a harder time demonstrating a higher reasonable compensation? Have you lowered compensation to an unreasonably low figure in order to withdraw funds as distributions and minimize payroll taxes because of the economic crunch? Since more than two million closely held businesses are organized as S corporations the discussion following will focus in part on S corporations. Some but not all of the concepts will apply in other contexts as well.
Any closely held business, including an S corporation, must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee. The amount of reasonable compensation will never exceed the amount received by the shareholder either directly or indirectly.
Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are more appropriately treated as reasonable compensation for the service rendered to the corporation. Some closely held business owners simply take most of the profits out of their S corporation as distributions, instead of treating them as salary. The difference, distributions are not subject to payroll taxes, wages are. No surprise, the IRS has continued to challenge inappropriate classifications of distributions.
While many items should be evaluated in determining the appropriate calculation of what is “reasonable” compensation, some factors cited by the IRS in these matters of reasonable compensation include:
Several court cases support the authority of the IRS to reclassify other forms of payments to a shareholder-employee as a wage expense and subject to employment taxes. Courts have found shareholder-employees are subject to employment taxes even when shareholders take distributions, dividends or other forms of compensation instead of wages. This means your simply calling something a distribution is not sufficient. You need to have your accountant take the steps and efforts to corroborate that the compensation is reasonable. In light of the dramatic changes in the economy over the past year or two, any analysis of this type needs to be updated. But update cautiously so that you don’t establish precedents that will prove damaging to you when recovery takes hold.
If cash or property, or the right to receive either, was distributed to you as a shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate. Distributing property instead of cash does not change the need for caution and planning.Payroll (Trust Fund) Taxes
Business owners and executives, struggling with economic hardships too often succumb to redirecting payroll tax liabilities to what they view as more important needs, rather than satisfying tax obligations. Heed with caution the many state and federal penalties and consequences from dipping your paws in this cookie jar, including Code Section 6672 and the risk of the 100% penalty against individuals who do not remit taxes (withholding taxes, employee FICA and Medicare taxes). Failing to pay these taxes is a felony punishable by up to five years in prison and fines of up to $10,000. If you’re a “responsible person”, you could face a 100% penalty. Anyone who is required to collect or withhold taxes can be held to be a responsible person. This might include an owner, or even a corporate officer.
While financial difficulties might be argued to waive penalties, it’s a risky gambit. Some courts have held that financial difficulties are not sufficient or reasonable cause to waive penalties. Even if the IRS or the courts are willing to consider that your financial difficulties are reasonable cause it’s a facts and circumstances test, which means no assurance of successEmployee Retirement Funds
If they use funds deducted from employee pay for retirement plan contributions, you will be violating your fiduciary duties under ERISA. ERISA requires that these amounts generally be deposited as soon as they can be segregated from employer assets. The penalties and consequences can be ugly.Buyout Formulas
Any transaction based on valuations should be revisited. If a business uses a stated value purchase price (the equity holders agree on a set price to govern any buyout) that price should be revisited and revised if appropriate. The value of the business may have declined substantially as a result of recent economic developments. If the certificate is not revised there could be an incentive for one partner to resign, or terminate, and exact an unreasonable buyout from the remaining partners. Consider the impact of a provision in a shareholders’, partnership or operating agreement that fixes a value with no adjustment clause for changed economic circumstances or lapse of time.
Sample Provision: The Purchase Price for any Shares of the Shareholders of the Corporation shall be the Stated Value for the Corporation, divided by the number of Shares issued and outstanding, and then multiplied by the number of Shares of the particular Shareholder, or the number of Shares involved in the particular transaction. ny transfer triggered shall be based solely on the Stated Value per Share. The Stated Value of the Shares in aggregate shall be determined as follows. The Parties agree that the Stated Value of all of the issued and outstanding Shares at the execution date of this Agreement is the value set forth in "Exhibit A: Certificate of Stated Value", attached. On or before November 15 of each year hereafter, the Shareholders shall agree upon an updated Stated Value of the Shares, which updated Stated Value shall be set forth in either a certificate or minutes of the Corporation executed by each of the Shareholders, and annexed hereto or maintained in the minute book or other permanent records of the Corporation. Such updated Stated Value shall be deemed to include the value of any goodwill of the Corporation as a going concern. Said Stated Value shall govern until the Shareholders amend the Stated Value by the process contained herein.
Any formula valuation clauses should be revisited. If the fundamental economics of the business have changed, the old formula may simply not be viable. Exercise caution in making these revisions if the buyout formula was executed before October 9, 1990. If the changes constitutes a substantially modification, grandfathering under Code Sec. 2703 may be tainted. Prop Reg § 25.2703-1. For example, the illustrative provision below relies on net book value as its foundation. During “normal” economic times the worry would be that using net book value as a starting point might significantly undervalue interests in the corporation. On the other hand, depending on the impact of the current recession, and the future recovery, it is possible that the formula might overstate the real or fair market value. Each buyout situation needs to be evaluated. Tip: Be certain to review buy out insurance, not only as to amount of coverage, but as to viability of the insurance companies, and other relevant factors.
Sample Provision: The Stated Value shall be the net book value of the Corporation, determined in accordance with the Corporation's regular method of maintaining its books and records, as of the calendar quarter preceding the determination of such Stated Value (e.g., the calendar quarter preceding the death or disability triggering the buy-out hereunder) (“Net Book Value”). The Net Book Value shall be deemed the Stated Value (inclusive of any goodwill, it being the intent of the parties that no further amount be added to such book value on account of goodwill, other than those specific items listed below. The following adjustments/rules shall be applied in Determining Net Book Value: The Net Book Value of the shares of any wholly owned subsidiary, shall be determined in the same manner as the Net Book Value of the Corporation (including the adjustments herein), shall be substituted for the cost of such shares on the books of the Corporation. The fair market value of any security publicly traded (except for the shares of any wholly owned subsidiary) or real estate, including any improvements thereon, shall be substituted for the cost of such securities and/or real estate on the books of the Corporation. The value of real estate shall be determined by a written report of an independent appraiser selected by the Accountant. If the Accountant fails to make such a selection, then by the Board of Directors. If the Board of Directors fail to designate an appraiser, then the President shall. No intangible assets shall be included, except for purchased intangibles or purchased goodwill, as same may be regularly and usually reflected on the books of the Corporation, and there shall be no allowance for goodwill of the Corporation. Accounts receivable, and an estimated cost of fixed assets previously deducted by the Corporation under Code Section 179 elective expense deduction shall be adjusted in the reasonable discretion of the Accountant. If the fair market value of such fixed assets could reasonably exceed Fifty Thousand Dollars ($50,000) then the Accountant shall engage an appraiser and obtain a written report estimating the value of same.
Independent of the valuation issue, the dramatic economic changes could have had varying impact on the ability of each equity holder to fund the required payments. This could give one owner a significant advantage over others to trigger a buyout. This could be used by a financially stronger owner to call a buyout knowing full well another equity owner won’t be able to pony up the capital. This could be done to force a buyout at current depressed prices. Estate planning for the business interests may be obviated by an unexpected buyout by an adversarial partner.Estimated Tax Payments
Estimated tax payments should be reviewed. Declining business profits may have altered the amount of payments required. This could provide a needed boost to cash flow. However, as recovery occurs, estimated tax payments should be monitored.Business Insurance
If you’re having substantial economic troubles, you might be tempted to cut or eliminate property, casualty, liability and other insurance coverage. It may be possible to modify coverage, e.g., increasing deductibles to reduce costs, rather than eliminating coverage entirely. Eliminating coverage could be a sure fire way to financial ruin.FLPs and LLCs Making Personal Distributions
If you are faced with cash needs, experienced dramatic portfolio declines, loss of jobs, etc., it will become increasingly difficult to resist the pressure to simply withdraw funds out of family controlled entities such as a family limited partnership (“FLP”). Carefully consider the dangers of simply paying for personal expenses from entities, or making undocumented distributions. Such transactions can have a myriad of negative tax and legal consequences. Most significantly the integrity of the entity can be compromised which can subvert any asset protection benefits the entity provided, thus exposing remaining personal assets to risk that you likely can ill afford. Distributions from entities for which equity interests have been given to children or other heirs may support an IRS argument that the gifted equity interests should be included in your estate as the donor since the payment of personal expenses, or loans/distributions that mirror personal cash flow needs, demonstrates your significant retained interest.Split a Closely Held Corporation if Business is Bad and Getting Worse?
It can be a challenge holding a closely held business together when times are good. Tough economic times often brings out the worst in people, business owners included. A Code Section 355 tax free division of a business may be an option worth considering. This can be useful not only for family businesses, but especially for closely held businesses owned by unrelated partners, such as two entrepreneurs who joined together to start and develop the business in the “good times”. Another option includes having one owner or group of owners (or descendants if the business has made it to the second generation) buy out the other owner or group of owners. But if all of the owners remain actively involved in the business (and even those that might have said they’d retire may not do so for the foreseeable future as their 401(k) has become the proverbial 201(k). In these situations the 355 corporate division or "split-up" of the business so that each owner or owner group can go their own way may be the best option.
While Code Section 355 has been around for a while, a recent private letter ruling reminds you that it is alive, well and perhaps more flexible than many tax pros realize. This ruling held that a corporation's distribution of stock in a newly formed controlled corporation to several shareholders met the requirements of Code Sections 368(a)(1)(D) and 355 and was therefore a non-taxable event. PLR 200809017.Can you Fire a Partner because Business is Bad and Getting Worse?
When business was humming, marginal partners may have been profitable. Now they may not even be tolerable. Can you fire a partner? While a severe measure, it may become necessary. Since there may be no right under state law to remove a partner, the provisions of the partnership agreement are essential to consider. So start by reviewing all governing documents (employment agreement, shareholders’ agreement, letters of understanding, etc.). What do the agreements provide for? Is there a mechanism to force a buyout or termination? Has the situation eroded to a point where application of a “for cause” provision can be justified? Be mindful that remaining partners owe a fiduciary duty to the targeted partners. What are the demographics of the particular partner you’re seeking to terminate? Evaluate the risk that a terminated partner may claim age discrimination. Terminated partners might also sue on the basis that the remaining partners violated their fiduciary or contractual obligations due the terminated partner (partners have fiduciary obligations to each other). Evaluate all the potential risks, disruption to the practice, and the costs of severance and termination into your analysis. Perhaps creating a contract or non-equity partner status may be a preferable compromise to both parties to reduce the likelihood of suits and costs that offset the hoped-for savings.Defer Making a New Partner
With the economy tough, and even if a recovery is anticipated, it may be advisable to reevaluate a decision to make an associate a partner in your firm for the time being. For example, assume that your medical practice hired a new associate 2 years ago under an employment agreement that gave you an opportunity to “date” until both sides made a decision as to partnership. Your practice focuses on high end elective procedures so that the economic downturn is having an impact on your revenues, and you fear it will worsen. But even if the economy recovers you remained concerned about the potential impact of President Obama’s health care goals. If the associate is a good fit, perhaps you can delay partnership another year to keep the practice profitable for existing senior partners.
Before making this move carefully determine who told what to the new associate. If the managing partner of your practice promised the associate that she’d be a partner “for sure”, she might have a successful claim against you for the deferral. Caution: This doesn’t mean that deferral isn’t a possible course of action, just that you have to be mindful of the risks inherent in the process.Get a Non-Compete Agreement From Any Terminated Employee/Partner
The unemployment statistics confirm that a tremendous number of employees have been terminated. If you’re the employer terminating an employee hire employment counsel to review strategies for a non-compete agreement as part of any severance package and documentation. Will the non-compete clauses in the partnership or employment agreement protect your business? The law governing non-compete agreements is constantly evolving, and varies by state, so caution is always in order. In a recent California case, for example, Edwards v. Arthur Andersen, LLP, S147190 (Cal. Aug. 7 2008), the court upheld a California statute limiting non-compete agreements. In this case the employee signed a non-compete when he began employment as a tax accountant in which he agreed that for 18-months after termination he would not perform similar services for any clients of his employer and that for 12 months after termination he would not solicit any of the employer’s clients. The court found that the noncompetition agreement was invalid because it restricted the employee’s ability to practice his profession in violation of the statute.
Review any restrictions in existing documents (e.g. employment agreement or separate non-compete) before taking any action.
Evaluate what you might be able to obtain as additional protection in a termination or severance agreement.
Consider how a court might view the restrictions especially in light of the current difficult economic times.
If a former employee/partner will be able to compete, especially at a lower cost in hard economic times, is termination the best option?
Be certain all future agreements contain enforceable provisions, include severability clauses that endeavor to save the rest of the agreement (and other restrictions) in the event the non-compete (or any other clause) is deemed too broad to be valid.Get a Release/Termination Agreement from a Terminated Partner/Employee
If you’re terminating an employee or partner, it has become common practice to make a severance payment to obtain a release of claims to hopefully avoid a myriad of potential issues, especially claims for discrimination on any of the many protected characteristics. Caution: Releases are not a guarantee against a lawsuit. Consider the following:
If a you, as an executive, receive a buyout offer from your employer. In all instances, even if the documentation appear simple, review everything with employment or corporate counsel and consider all the legal implications, including the following:
Planning for the closely held business, employment and related matters, like every other aspect of planning, requires consideration of the impact of the economic circumstances.
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