Business Succession Planning

<div class="Section1"><br /> <br /> Potential adverse estate tax consequences may result if a life insurance policy used to fund a buy-sell agreement is actually owned by the corporation itself, but the policy beneficiary is someone other than the corporation. If, at the time of death, the insured owns more than 50 percent of the corporation’s voting stock, the entire value of the death benefit paid out under the policy may be included in the insured’s estate.<a href="#_ftn1" name="_ftnref1">¹</a> This is because, as a majority shareholder in the corporation that owns the actual policy, the insured will be deemed to have retained incidents of ownership in the policy that are sufficient to warrant inclusion of the death benefit in his or her estate.<br /> <br /> These adverse tax consequences only exist if three circumstances are present: (1) the corporation is the named owner of the policy, (2) the insured owns more than a 50 percent interest at death and (3) the policy beneficiary is <em>not</em> the corporation.<br /> <br /> Any proceeds payable to a third party for a valid business purpose (for example, satisfaction of the corporation’s business debt), so that the corporation’s net worth is increased by the amount of the proceeds, will be deemed to be payable to the corporation and so will not be attributed to the decedent.<br /> <br /> In order to avoid the inclusion of the death benefit in the insured’s estate, the corporation could name itself as policy beneficiary or could take steps to ensure that the insured owns less than 50 percent of the corporation’s voting stock upon his or her death.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  Treas. Reg. § 20.2042-1(c)(6).<br /> <br /> </div>

<div class="Section1"><br /> <br /> IRC Section 303 was enacted expressly to help solve the liquidity problems frequently faced by estates that are comprised largely of stock in a closely-held corporation, and to protect small businesses from forced liquidations or mergers due to the impact of estate taxes. Within the limits of IRC Section 303, surplus can be withdrawn from the corporation income tax-free.<br /> <br /> In certain instances, stock of a public corporation also may be redeemed under IRC Section 303.<br /> <br /> Any payments by a corporation to a shareholder generally are treated as dividends (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8999">8999</a>). Despite this, under certain circumstances IRC Section 303 allows a corporation to redeem part of a deceased stockholder&rsquo;s shares without the redemption being treated as a dividend. Instead, the redemption price will be treated as payment in exchange for the stock in a capital transaction.<br /> <br /> An IRC Section 303 redemption can safely be used in connection with the stock of a family-owned corporation because the constructive ownership rules (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9000">9000</a>) are not applied in an IRC Section 303 redemption.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> The following conditions must be met if a stock redemption is to qualify under IRC Section 303 for non-dividend treatment:<br /> <p style="padding-left: 40px;">(1)&nbsp; The stock that is to be redeemed must be includable in the decedent&rsquo;s gross estate for federal estate tax purposes.</p><br /> <p style="padding-left: 40px;">(2)&nbsp; The value for federal estate tax purposes of all stock of a redeeming corporation that is includable in a decedent&rsquo;s gross estate must comprise more than 35 percent of the value of the decedent&rsquo;s adjusted gross estate.<a href="#_ftn2" name="_ftnref2">²</a> The &ldquo;adjusted gross estate&rdquo; for this purpose is the gross estate less deductions for estate expenses, indebtedness and taxes<a href="#_ftn3" name="_ftnref3">³</a> and for unreimbursed casualty and theft losses.<a href="#_ftn4" name="_ftnref4">⁴</a> The total value of all classes of stock includable in a gross estate is taken into account to determine whether this 35 percent test is met, regardless of which class of stock is to be redeemed.<a href="#_ftn5" name="_ftnref5">⁵</a></p><br /> <p style="padding-left: 40px;">IRC Section 303(b) provides that a corporate distribution in redemption of stock will qualify as an IRC Section 303 redemption if all the stock of the corporation that is included in determining the value of a gross estate exceeds 35 percent of the adjusted gross estate. Although most gifts made by a donor within three years of death are not brought back into the donor&rsquo;s gross estate under IRC Section 2035, certain kinds of gifts are brought back. These are the &ldquo;first kind of exception&rdquo; gifts. Gifts of corporate stock that fall within this classification are part of a gross estate for purposes of computing the 35 percent requirement (or the 20 percent requirement discussed below) and a corporation&rsquo;s redemption of this stock will qualify as a sale or exchange if all other requirements of IRC Section 303 are satisfied. IRC Section 2035(c)(1)(A) states generally that the three-year rule will apply for the purposes of IRC Section 303(b). This is generally interpreted as follows: If a decedent makes a gift of any kind of property within three years of his or her death, the value of the property given will be included in the decedent&rsquo;s gross estate for purposes of determining whether the value of the corporate stock in question exceeds 35 percent of the value of the gross estate, but a distribution in redemption of that stock will not qualify as an IRC Section 303 redemption unless the stock redeemed actually is a part of the decedent&rsquo;s gross estate.<a href="#_ftn6" name="_ftnref6">⁶</a></p><br /> <p style="padding-left: 40px;">The stock of two or more corporations will be treated as that of a single corporation, provided that 20 percent or more of the value of all of the outstanding stock of each corporation is includable in a decedent&rsquo;s gross estate.<a href="#_ftn7" name="_ftnref7">⁷</a> Only stock directly owned is taken into account in determining whether the 20 percent test has been met; constructive ownership rules do not apply even when they would benefit a taxpayer.<a href="#_ftn8" name="_ftnref8">⁸</a> Stock that, at a decedent&rsquo;s death, represents the surviving spouse&rsquo;s interest in property held by the decedent and the surviving spouse as community property or as joint tenants, tenants by the entirety, or tenants in common is considered to be includable in a decedent&rsquo;s gross estate for the purpose of meeting the 20 percent requirement.<a href="#_ftn9" name="_ftnref9">⁹</a> The 20 percent test is not an elective provision, meaning that if a distribution in redemption of stock qualifies under IRC Section 303 only by reason of the application of the 20 percent test and also qualifies for sale treatment under another section of the IRC, the executor may not elect to have only the latter section of the IRC apply and thus retain the undiminished IRC Section 303 limits for later use. All distributions that qualify under IRC Section 303 are treated as IRC Section 303 redemptions in the order they are made.<a href="#_ftn10" name="_ftnref10">¹⁰</a></p><br /> <p style="padding-left: 40px;">(3)&nbsp; The dollar amount that can be paid out by a corporation under protection of IRC Section 303 is limited to an amount equal to the sum of (x) all estate taxes, including the generation-skipping transfer tax imposed by reason of the decedent&rsquo;s death, and federal and state inheritance taxes attributable to a decedent&rsquo;s death, plus interest, if any, collected on these taxes, and (y) funeral and administration expenses allowable as estate deductions under IRC Section 2053.<a href="#_ftn11" name="_ftnref11">¹¹</a></p><br /> <p style="padding-left: 40px;">(4)&nbsp; The stock must be redeemed not later than (x) three years and 90 days after the estate tax return is filed (the return must be filed within nine months after a decedent&rsquo;s death), (y) 60 days after a Tax Court decision on an estate tax deficiency becomes final, or (z) if an extension of time for payment of tax is elected under IRC Section 6166, the time determined under the applicable section for payment of the installments. For any redemption made more than four years after a decedent&rsquo;s death, however, capital gains treatment is available only for a distribution in an amount that is the lesser of the amount of the qualifying death taxes and funeral and administration expenses that are unpaid immediately before the distribution, or the aggregate of these amounts that are paid within one year after the distribution.<a href="#_ftn12" name="_ftnref12">¹²</a></p><br /> <p style="padding-left: 40px;">(5)&nbsp; The shareholder from whom stock is redeemed must be one whose interest is reduced directly, or through a binding obligation to contribute, by payment of qualifying death taxes and funeral and administration expenses, and the redemption will qualify for capital gains treatment only to the extent of that reduction.<a href="#_ftn13" name="_ftnref13">¹³</a> That is, &ldquo;the party whose shares are redeemed [must actually have] a liability for estate taxes, state death taxes, or funeral and administration expenses in an amount at least equal to the amount of the redemption.&rdquo;<a href="#_ftn14" name="_ftnref14">¹⁴</a></p><br /> The stock of any corporation, including an S corporation, may qualify for IRC Section 303 redemption. Moreover, any class of stock may be redeemed under IRC Section 303. Thus, a nonvoting stock, common or preferred, issued as a stock dividend or issued in a lifetime or post-death recapitalization can qualify for the redemption.<a href="#_ftn15" name="_ftnref15">¹⁵</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC Secs. 318(a)-(b).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect; 303(b)(2)(A).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&sect; 2053.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&sect; 2054.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.303-2(c)(1).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; Rev. Rul. 84-76, 1984-1 CB 91.<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&sect; 303(b)(2)(B).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; <em>Est. of Byrd v. Comm.</em>, 21 AFTR 2d 313 (5th Cir. 1967).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.&nbsp; IRC &sect;&sect; 303(b)(2)(B).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.303-2(g); Rev. Rul. 79-401, 1979-2 CB 128.<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.&nbsp; IRC Secs. 303(a), 303(d).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.&nbsp; IRC Secs. 303(b)(1), 303(b)(4).<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.&nbsp; IRC &sect;&sect; 303(b)(3).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.&nbsp; H.R. Rep. No. 94-1380 at 35 (Estate and Gift Tax Reform Act of 1976), <em>reprinted in</em> 1976-3 CB (Vol. 3) 735 at 769.<br /> <br /> <a href="#_ftnref15" name="_ftn15">15</a>.&nbsp; Treas. Reg. &sect;&nbsp;1.303-2(d).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> One of the exceptions to dividend treatment (discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8999">8999</a>) is contained in IRC Section 302(b)(3). IRC Section 302(b)(3) provides that if a corporation redeems all of a shareholder&rsquo;s remaining shares so that a shareholder&rsquo;s interest in the corporation is terminated, the amount paid by the corporation will be treated as a payment in exchange for the stock, not as a dividend. In other words, the redemption will be treated as a capital transaction (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8604">8604</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8634">8634</a>).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> There will be no taxable dividend, then, if a corporation redeems all of its stock owned by an estate. In determining what stock is owned by an estate, the constructive ownership or attribution-of-ownership rules contained in IRC Section 318 must be applied.<br /> <br /> Consequently, to achieve non-dividend treatment under IRC Section 302(b)(3), a corporation must redeem not only all of its shares actually owned by an estate, but also all of its shares constructively owned by the estate.<br /> <br /> One of these constructive ownership rules provides that shares owned by a beneficiary of an estate are considered owned by the estate. For example, assume that a decedent owned 250 shares of Corporation X&rsquo;s stock, so that the decedent&rsquo;s estate now actually owns 250 shares. Assume further that a beneficiary of the decedent&rsquo;s estate owns 50 shares. Because the estate constructively owns the beneficiary&rsquo;s 50 shares, the estate is deemed to own a total of 300 shares. Redemption of the 250 shares actually owned, therefore, will not affect a redemption of all the stock owned by the estate.<br /> <br /> Further, stock owned by a close family member of a beneficiary of an estate may be attributed to an estate beneficiary, because of the family constructive ownership rules, and through the estate beneficiary to the estate. An estate beneficiary would be considered to own, by way of family attribution rules, shares owned by the decedent&rsquo;s spouse, children, grandchildren, and parents.<a href="#_ftn2" name="_ftnref2">²</a> There are two ways in which the family attribution rules can be addressed.<br /> <br /> First, the First Circuit has held that where, because of hostility among family members, a redeeming shareholder is prevented from exercising control over stock that the individual would be deemed to own constructively under attribution rules, the attribution rules will not be applied to the individual.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> On the other hand, the IRS has indicated it will not follow this decision and has ruled that the existence of family hostility will not affect its application of attribution rules.<br /> <br /> If certain conditions are met, however, the IRS will not apply the ruling to taxpayers who have acted in reliance on the IRS&rsquo; previously announced position on this issue.<a href="#_ftn4" name="_ftnref4">⁴</a> The Fifth Circuit also has taken the position that the existence of family hostility does not prevent application of attribution rules, thus creating disagreement between the two circuit courts that have ruled on the question.<a href="#_ftn5" name="_ftnref5">⁵</a> The Tax Court consistently has held that hostility within a family does not affect application of attribution rules.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> The second way in which the family attribution rules can be addressed is if the sale of the departing owner&rsquo;s interest qualifies as a complete termination of the shareholder&rsquo;s interest.<a href="#_ftn7" name="_ftnref7">⁷</a> A family member, as well as entities such as estates and trusts, can accomplish a complete termination by waiving the family attribution rules if (1) the departing owner has no interest in the corporation immediately after the sale, (2) the owner does not acquire any such interest within 10 years from the date of the sale (other than stock acquired by gift or inheritance), and (3) the owner agrees in writing to notify the IRS of any acquisition described in (2).<a href="#_ftn8" name="_ftnref8">⁸</a><br /> <br /> Constructive ownership rules are complicated and their application requires expert legal advice. It generally may be said that a danger of dividend tax treatment exists in every case involving a family-owned corporation engaging in a stock redemption. There are, however, means available in some cases to avoid the harsh operation of the rule. A partial redemption may be able to escape dividend tax treatment even in a family-owned corporation.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Rev. Rul. 77-455, 1977-2 CB 93.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&sect; 318(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; <em>Robin Haft Trust v. Comm.</em>, 75-1 USTC &para;&nbsp;9209 (1st Cir. 1975).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Rev. Rul. 80-26, 1980-1 CB 66; IRC &sect;&sect; 7805(b).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em>David Metzger Trust v. Comm.</em>, 82-2 USTC &para;&nbsp;9718 (5th Cir. 1982), <em>cert. den</em>., 463 U.S. 1207 (1983).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em><em>See</em> Cerone v. Comm.</em>, 87 TC 1 (1986).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&sect; 302(b)(3); <em><em>see</em></em> IRC &sect;&sect; 302(c)(2) for situations in which constructive ownership rules of IRC &sect;&sect; 318(a)(1) will not apply.<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.&nbsp; IRC Section 302(c)(2).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A showdown clause, also known as &ldquo;shoot out,&rdquo; &ldquo;slice-of-the-pie,&rdquo; &ldquo;Russian roulette&rdquo; or &ldquo;Chinese wall&rdquo; clauses, essentially allows one party to name a price upon the occurrence of a triggering event under a buy-sell agreement. Upon occurrence of the triggering event, one party specifies a price at which the party would buy (or sell) the business interests at issue, and the others decide whether to buy the interests (or sell their interests) to the naming party.<br /> <br /> When a business owner invokes a showdown clause, this is essentially expressing a decision to exit the business. This provision works best if both sides are in an equal financial position because, if the parties are on unequal footing, the clause may provide a route for one owner to unjustifiably &ldquo;chase out&rdquo; a co-owner from the business. A showdown clause is frequently invoked in a situation where a deadlock in management or another similar issue exists among the various business owners that cannot be resolved through other methods.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> In <em>Wilcox v. Styles</em>,<a href="#_ftn2" name="_ftnref2">²</a> a showdown clause was enforced by the courts, leading to an eventual dissolution of the business due to a deadlock over management issues that occurred between the two business owners of a closely-held corporation. The court upheld both the agreement containing the showdown clause and the pricing specified under the agreement, which was supported in part by an independent expert appraisal. The court in this case emphasized the importance of the written agreement&mdash;a mere oral agreement would be insufficient.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Generally, offers made pursuant to a showdown clause cannot be used to establish the value of the business interest for estate tax purposes. By their nature, showdown clauses involve voluntary lifetime transfers of property, and do not prevent the interests from being sold at a higher price than that specified in the buy-sell agreement (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9002">9002</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; <em>RS &amp; P/WC Fields Ltd. Partnership v. BOSP Invs</em>., 829 F. Supp. 928 (1993).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; 127 Or. App. 671 (1994).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; <em>Bruce v. Cole</em>, 854 So. 2d 47 (2003).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> A right of first refusal requires that a selling business owner give his or her co-owners or the business entity itself the opportunity to purchase certain business interests at the same price that he or she is able to obtain from a third party investor.<a href="#_ftn1" name="_ftnref1">¹</a> The co-owners will be given the option of matching the terms of the competing offer before the selling owner is able to sell his or her interests to a third party. Though the agreed upon price may not fix the value of the interest for estate and gift tax purposes,<a href="#_ftn2" name="_ftnref2">²</a> it can be considered as one of the factors that could determine its value. Likewise, the depressive effect of a restrictive agreement such as a right of first refusal is one of the factors that should be considered in valuing a gift of stock.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> While a right of first refusal may provide comfort to all business owners in that they know they will have a right to purchase a departing business owner’s shares before third parties are given the right, business owners must remember that in the context of a closely-held business, there is often a very limited market for the shares. Even if a business owner is able to find a third party buyer, the remaining business owners will then be forced to come up with a matching purchase offer, which may prove difficult in the small business context when funds are more limited.<br /> <br /> Further, a right of first refusal often gives a departing business owner the power to find a willing buyer that the remaining business owners may be forced to accept in the event that they are unable to match the purchase price. As the departing business owner will no longer be involved in the business’ operations, he or she may not be the person best suited to choose a replacement owner.<br /> <br /> In the context of a buy-sell agreement, if the triggering event is the withdrawal of one business owner, only the remaining owners or entity itself have the right to purchase the departing owner’s interests. The price or method for determining the price will be fixed by the agreement, and the agreement has often been pre-funded with insurance or accumulated earnings in order to ensure that the remaining owners are able to make the purchase. Therefore, the buy-sell agreement is often the more advantageous method for planning a departing business owner’s transition.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  See <em>True v. Comm.,</em> 390 F.3d 1210 (2004); <em>Oldcastle Materials, Inc. v. Rohlin</em>, 343 F. Supp. 2d 762 (2004).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  <em>Fry Est. v. Comm.</em>, 9 TC 503 (1947).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  <em>James v. United States,</em> 148 F.2d 236 (1945).<br /> <br /> </div>

<div class="Section1"><br /> <br /> Any disposition of property where at least one payment will be received after the close of the tax year of disposition may be treated as an installment sale.<a href="#_ftn1" name="_ftnref1">¹</a> Generally, however, the installment method of taxation (<em><em>see</em></em> below) is not available for sales between certain related parties unless they can clearly establish that the transaction was not intended to avoid tax.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Gain on an installment sale is required to be reported under the installment method unless the taxpayer &ldquo;elects out&rdquo; of using the method by the due date for filing a return (including extensions) for the year of the sale. Taxpayers may elect out by reporting all the gain as income in the year of the sale on Form 4797 (<em>Sales of Business Property</em>), or on Form 1040, Schedule D (<em>Capital Gains and Losses</em>), and Form 8949 (<em>Sales and Other Dispositions of Capital Assets</em>).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Installment sales are often used in the context of a buy-sell agreement where the business owners have not planned in advance to fund the purchase through the use of insurance or otherwise (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8994">8994</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8995">8995</a>). Though installment sales may be used to purchase the interests of a departing business owner, they do not provide the immediate liquidity to the retiring owner or deceased owner&rsquo;s estate that can be realized through a life insurance strategy or by using accumulated earnings to purchase the interest outright.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Practically, an installment sale may be the only means of purchasing a departing business owner&rsquo;s interests if the buy-sell agreement was not funded in another manner.<br /> <br /> <hr><br /> <br /> Essentially, an installment sale requires the corporation (or shareholders if the buy-sell agreement is structured as a cross-purchase agreement, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8999">8999</a>) to purchase the interests of the departing business owner using a note, under which it will pay for the interests over time. The departing business owner (or that owner&rsquo;s estate) reports gain on the sale using the &ldquo;installment method,&rdquo; which means that the gain for any given year equals the part of the gain that is actually received (or considered to have been received) during that tax year. The departing business owner must also report as income the amount of the payments received in the year that are deemed to represent interest income. The portion that is deemed to be a return of the owner&rsquo;s adjusted basis in the interests is excluded as in any other sale.<a href="#_ftn4" name="_ftnref4">⁴</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8609">8609</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8936">8936</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8959">8959</a> for a discussion of determining basis in various contexts.<br /> <br /> The departing owner can elect out of the installment sale method and report the entire amount of gain in the year of sale, even though he or she has not yet received all of the proceeds.<br /> <br /> The installment method cannot be used if the business interests at issue are securities that are publicly traded on an established market.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 453(b)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 453(g)(2). If the buyer disposes of the asset within 2 years of the purchase, there are additional restrictions in IRC &sect; 453(e), also called the anti-Rushing Rule, see <em>Rushing v Comm.</em>, 441 F.2d 593 (5th Cir. 1971).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRS Tax Topics 705 (May 28, 2015).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRS Pub. 537.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRS Pub. 537.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Trust entities can be useful in business succession planning, whether the trusts are revocable or irrevocable. The two forms of trust are not mutually exclusive, and in many instances, a succession plan may contain more than one trust entity. The decision to have one or both depends on the business owner&rsquo;s goals, how much control the senior generation wants, when the assets will be transferred to the heirs and other restraints that are imposed.<br /> <br /> A grantor retained annuity trust (GRAT) is an irrevocable trust to which the business owner transfers shares in his business while retaining the right to a fixed annual annuity payout for a stated term of years.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> In response to a comment on the IRS&rsquo;s proposed GRAT regulations, the final regulations include and use interchangeably both the term &ldquo;GRAT&rdquo; (which does not appear in the statutes or the regulations) and its Treasury Regulation citation, &sect;&nbsp;25.2702-3(b).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> At the end of the term, the property remaining in the GRAT (the appreciation and income in excess of the annuity amount that is to be paid to the business owner) will pass to the trust beneficiaries (often the owner&rsquo;s children or grandchildren). Only the value of the remainder interest is subject to gift tax.<br /> <br /> The amount of the taxable gift to the beneficiaries can be reduced by structuring the trust with a larger annuity payout or a longer stated term. Further, the value is dependent on the IRS Section 7520 interest rate in effect at the time the trust is established&mdash;a lower interest rate can also reduce the value of the taxable gift.<br /> <br /> A GRAT may be structured so that there is little or no gift tax payable on the value of the remainder interest that passes to the trust beneficiaries. For gift tax purposes, this is known as a &ldquo;zeroed-out&rdquo; GRAT. If the zeroed-out GRAT produces a return in excess of the annuity amount payable to the business owner, the GRAT will succeed in passing on the reminder interest (the trust&rsquo;s excess income and appreciation) to the trust beneficiaries at little or no gift tax cost to the business owner. If the zeroed-out GRAT fails to produce a return in excess of the annuity amount and the remainder beneficiaries receive nothing, there is minimal downside risk since there was little or no gift tax cost to the business owner upon establishing the zeroed-out GRAT. The primary risk of using a GRAT (especially a short term GRAT) to transfer business interests is that if the business owner fails to survive the stated term, the GRAT may be included in his estate and subject to estate taxes.<br /> <br /> The Ninth Circuit confirmed this result. In a case where the GRAT creator died before the GRAT terminated, the court held that there was no actual transfer of the trust property.&nbsp;She had created the GRAT structure to transfer interests in a family business to her daughters, receiving a $302,529 annuity payment annually for 15 years. The business generated enough income so that the value of the partnership interest was not decreased by the monthly annuity payments. Under IRC Section 2036(a), because the decedent was still enjoying the economic benefit of the property at death, the entire GRAT value was included in her gross estate. The court rejected the argument that the value should be excluded because the statute does not specifically list &ldquo;annuities&rdquo; as property that may be pulled into the estate.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9012">9012</a> for a discussion of the use of intentionally defective grantor trusts in family business succession planning.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; TD 9414, 2008-35 IRB.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; <em>Badgley v. U.S.</em>, Case No. 18-16053 (9th Cir. 2020).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> IRC Section 1371 provides that an S corporation is subject to the same rules that apply in the context of a C corporation unless there is a specific rule that has been developed for S corporations. Despite this, one of the primary differences between an S corporation and a C&nbsp;corporation is their basic tax treatment, which has an important impact upon the issues that the entity will face during liquidation. Because S corporations are taxed at a single level, taxation of a sale or other liquidation of the business will usually occur only at the individual level, unlike in the context of the C corporation, where the corporation itself will be required to pay taxes on any gain before passing the profits through to shareholders, who will also be taxed on the amounts they receive.<br /> <br /> Many S corporation shareholders will have a higher stock basis than that of a C corporation shareholder. This is because the basis of an S corporation shareholder&rsquo;s stock is increased by any earnings of the S corporation that are passed through for tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a> Depending upon how long the corporation had existed as an S corporation, and the level of earnings that were passed through to shareholders, S corporation shareholders may have substantially higher tax bases upon sale. Because tax basis decreases the amount of gain that the shareholders are required to recognize upon sale, the S corporation shareholder&rsquo;s total tax liability will often be lower than the C corporation shareholder&rsquo;s upon liquidation of the company.<br /> <br /> If the S corporation was ever a C corporation, however, the S corporation will be required to account for any built-in gains, which are taxed at the highest rate applicable to C corporations (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8955">8955</a>).<a href="#_ftn2" name="_ftnref2">²</a> The tax on built-in gains is designed to preserve a part of the double tax structure for certain S corporations that were formerly C corporations. The built-in gains tax applies if the S corporation sells an asset within a five year period (formerly 10 years) following its S corporation election.<a href="#_ftn3" name="_ftnref3">³</a> The tax on built-in gains is imposed at the S corporation level, in addition to any taxes that are paid by the S corporation&rsquo;s shareholders. This tax will only apply in situations where the S corporation was formerly a C corporation and liquidates within 10 years of making its S election.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect; 1367(a), 1366(a)(1)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 1374(b)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect; 1374(d)(7), as amended by PATH.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Under a self-cancelling installment note (SCIN), the selling business owner agrees to sell property to a buyer (often, the owner&rsquo;s children or other beneficiaries) in exchange for an installment note that expires either when the seller receives the maximum price for the property or upon the occurrence of a cancellation event, such as the seller&rsquo;s death. This is a form of installment sale transaction (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9007">9007</a>). It allows the seller to secure the purchase for the business interest, while still retaining the ability to defer part of the gain.<a href="#_ftn1" name="_ftnref1">¹</a> In turn, the buyer can claim an interest deduction with respect to the payments made.<a href="#_ftn2" name="_ftnref2">²</a> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8027">8027</a> for a discussion of the new rules governing the deduction for business interest under the 2017 tax reform legislation.<br /> <br /> Under a SCIN, if the cancelling event is the selling business owner&rsquo;s death, all remaining payments under the note are canceled upon the seller&rsquo;s death, similar to a private annuity. Typically, the purchaser pays a premium for this cancellation feature in the form of either a higher interest rate or a larger purchase price. Gain under a SCIN is recognized by the selling business owner as payments are received. However, when the seller dies, any unrecognized (i.e., cancelled) gain at the seller&rsquo;s death under the SCIN is reportable either on the seller&rsquo;s final IRS Form 1040 or on the seller&rsquo;s estate&rsquo;s IRS Form 1041.<br /> <br /> In order for the IRS to recognize the SCIN, the term of the note must be shorter than the seller&rsquo;s life expectancy at the time of the sale, based on IRS mortality tables.<a href="#_ftn3" name="_ftnref3">³</a> The advantage of using a SCIN, as opposed to other installment sale methods or an intentionally defective grantor trust (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9012">9012</a>), is that the unpaid balance is not included in the seller&rsquo;s estate.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> However, if no payments are made under the SCIN before the death of the seller, the IRS may argue that the value of the SCIN is zero and should only reduce the value of the note.<a href="#_ftn5" name="_ftnref5">⁵</a> A SCIN signed by a family member is presumed to be a gift rather than a bona fide transaction.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> SCINs are particularly useful if the seller has a relatively short remaining life expectancy because if the selling owner outlives the term of the note, the estate tax benefit will have been lost and the owner may actually have incurred additional expenses in the form of higher income taxes or gift tax liability.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 453(f)(3).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 163(d)(5); Treas. Reg. &sect; 1.163-8T(b)(3) (investment expenditure).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; GCM 39503.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; <em><em>See</em> Frane vs. Comm.,</em> 998 F.2d 567 (8th Cir. 1993); <em>Moss v. Comm.</em>, 74 TC 1239 (1980).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; <em><em>See</em> Estate of Costanza v. Comm.,</em> 320 F.3d 595 (6th Cir. 2003); <em>Robert Dallas</em>, TC Memo 2006-212.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; <em>Estate of Costanza v. Comm.,</em> 320 F.3d 595 (6th Cir. 2003); <em>Estate of Labombarde v. Comm.</em>, 58 TC 745 (1972).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The preferred solution to the problem of transferring family partnership interests at death depends upon the particular type of&nbsp;family&nbsp;partnership&nbsp;and the circumstances surrounding it. A&nbsp;family partnership&nbsp;may be between two spouses, a parent and his or her adult child or children, the entire family, or the parent and a trustee or trustees, the latter acting for minor children. In some instances, disposition of the&nbsp;partnership&nbsp;interests by will may be a satisfactory solution. In most instances, a buy-sell agreement will be the preferred solution. Except in the case of two spouses, the income tax savings that result from the&nbsp;family&nbsp;partnership, by reason of spreading the business income, will more than pay the premiums on the life insurance used to finance the agreement.<br /> <br /> When a&nbsp;family&nbsp;partnership&nbsp;has been formed by two spouses, it is sometimes assumed that there is no need for a buy-sell agreement to take effect at death. The spouse-partners may take the position that a buy-sell agreement is unnecessary because the survivor (assuming there are no children or other heirs) will take the interest in the business from the first-to-die under the intestacy laws of the state in the absence of a will. Moreover, in most states, each has a statutory right to one-third of the property owned at death by the other, and this right cannot be eliminated even by a will to the contrary.<br /> <br /> Notwithstanding the circumstances that exist so far as inheritance is concerned between the spouses, a buy-sell agreement is practical and in some instances may be necessary in order to avoid serious problems upon the death of the first-to-die. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9016">9016</a> for a detailed discussion of the use of buy-sell agreements in the context of a family partnership.<br /> <br /> Where two spouses are partners in a&nbsp;partnership&nbsp;business, they may execute wills leaving their interests in the business to each other. This procedure will sometimes eliminate any liquidation problems at death because the surviving spouse will own the entire business by virtue of the duly executed will, and it eliminates any doubts or problems so far as the surviving spouse&rsquo;s rights are concerned.<br /> <br /> There are several major problems, however, that require serious consideration, even though the spouses have executed wills leaving their business interests to each other. The decedent may have personal creditors pressing claims against the estate. Such claims must be satisfied before the surviving spouse can take over the decedent&rsquo;s business interest.<br /> <br /> Aside from personal creditors of the decedent, the business itself may be faced with substantial liabilities. Any such claims, if pressed for settlement, will need to be satisfied by the surviving spouse.<br /> <br /> There is always the chance that the decedent&rsquo;s will may be contested by other potential heirs, and if set aside will leave the surviving spouse in the same position as if no will had ever been executed. Consequently, if the will is set aside for one reason or another, the surviving spouse will then take under the intestacy laws of the particular state involved, which may give a large portion of the decedent&rsquo;s business interest to heirs other than the surviving spouse. And if any of these heirs are minors, liquidation of the business could become necessary.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; <em>Spivak v. Bronstein</em>, 79 A. 2d 205 (Pa. 1951).<br /> <br /> </div></div><br />