Estate Planning Advisor Keeping the Family Business in the Family - - PDF document

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miller nash llp | Spring 2014

Estate Planning Advisor

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2 Personal-Property Dona- tions: Achieving the Tax Deduction You Expect 3 An Essential Business Agreement: The Buy-Sell 4 Keeping Separate Property Separate: Trusts for Benefi- ciaries Most family businesses do not sur- vive ownership by the next generation. When the members of the founding generation are ready to retire, they can,

• f course, sell the family business to

an outside buyer or an employee. They can also liquidate it. But many owners dream of passing on the business to the next generation. What are the best ways to accomplish this? What issues must be overcome? Do the Children Have the “Right Stuff”? An initial issue that must be very carefully considered is whether the next generation has what it takes to carry on the family business and whether it makes sense to do so. A hardheaded analysis needs to be made to determine whether at least one of the founder’s children has the work ethics and business smarts to make the busi- ness prosper. The same analysis needs to be made as to whether the business should be kept at all. If the business specializes in products or services that are becoming obsolete in the market- place, it might not make sense to invest the time and energy to transfer it to the next generation. What if There Is More Than One Child? If more than one child could potentially be involved in the family business, another hardheaded analysis has to be made as to whether the busi- ness should pass to one or more chil-

• dren. Although there are exceptions,

siblings often have difficulties working together as equals in managing a family business. We have seen many siblings fighting with one another to work out issues relating to managing a family business—almost always to the detriment of the business and their

• wn interests.

Treating the No-Control Child

• Fairly. Even though a child (the “No-

Control Child”) is not given control of the business while another child (the “Control Child”) is given control, the No-Control Child can receive his or her proportionate share of the founder’s

• estate. A few of the more popular solu-

tions that should be considered are set forth below (all examples assume two children):

• Nonvoting Interest. Transfer a 50

percent nonvoting business to the No- Control Child and a 50 percent voting interest to the Control Child.

• Other Equally Valued Assets. An-
• ther approach is to give the No-Control

Child other assets equal to the value of the family business. Life insurance can be used to fund such a gift.

• Promissory Note or Preferred
• Interest. A very popular approach is

to transfer to the No-Control Child a preferred interest in the company. So if the company was worth $10 million, the No-Control Child could be given a note from the business for $5 million, leaving the Control Child with a busi- ness with a net value of $5 million. Alternatively, the No-Control Child can be transferred a preferred interest in the company, such as $5 million in pre- ferred stock that pays a fixed dividend. Gift the Family Business During Life or at Death? Should the family business be transferred by gift or sale during life or at death? If at death, the

Keeping the Family Business in the Family

by Ronald A. Shellan

ronald.shellan@millernash.com 503.205.2541

2 | miller nash llp | Estate Planning Advisor

Personal-Property Donations: Achieving the Tax Deduction You Expect

Thinking of donating the bottle of Chateau Lafite that’s been aging in your cellar to your favorite charity’s next auc- tion? Or, better yet, the dust-catching sculpture inherited from your grand- mother? Navigating the minefield of personal-property-donation deductions can be tricky, but success is likely if technical requirements are taken into

• account. Here are a few of

the IRS rules governing the income tax deductibility of certain personal-property donations: 1. The Related-Use Rule: Income tax deductions for donations of artwork, col- lectibles, wine collections, watercraft, and similar tangible personal property are limited to your cost basis unless the donated personal property is related to the charity’s tax-exempt purpos-

• es. If so related, a deduction

can be claimed equal to the fair market value of the donation. Thus, deductions for donations of property to charity auc- tions will always be limited to your cost

• basis. On the other hand, your donation
• f the sculpture to a museum that uses

it for display or educational purposes will be deductible at fair market value. But if the sculpture is valued at $5,000

• r more and the museum disposes of

it within the year of the donation, your deduction will be limited to your tax basis (in most cases, the value of the sculpture at your grandmother’s date of death).

• 2. The Appraisal Requirement:

If you donate artwork and claim a total deduction exceeding $20,000, you are required to attach a qualified appraisal to your return. You may request an IRS statement of value for donations

• f artwork claimed to exceed $50,000

in value (the IRS will require a $2,500 user fee). Works valued at this level are automatically reviewed by the IRS Art Advisory panel. You may request an IRS statement of value for these. 3. The Three-Year Reporting Requirement: A charity that sells or

• therwise disposes of donated personal

property within three years of the dona- tion is required to file an information return with the IRS. A discrepancy between the amount that the charity re- ports it received and the value that you may have claimed earlier as a deduction could cause the IRS to question the amount you deducted. 4. Your Own Creations: The Internal Revenue Code limits your deduction for donations of works of art

• r similar property created by you to the

cost of materials used in the project. 5. Business-Inventory Donations: Deductions for businesses donating items of inventory to a charity are gen- erally limited to the lesser of fair market value or the cost of the goods donated. To ensure against double deductions, a business must remove the donated items and the related costs from its opening inventory for the year of the donation. There are two special excep- tions to the deductibility limit for business-inventory donations by C corpora- tions: First, when donating inventory for the care of the ill, the needy, or infants, a corporation can deduct the lesser of its cost basis plus 50 percent of the difference between the cost basis and the list price or 200 percent

• f the cost basis. Second,

this expanded limitation also applies to donations

• f

“qualified research property” to institutions of higher learning or scientific research bodies that certify that the property will be used for research purposes. 6. Donations to Goodwill, Etc.: Donations of used clothing or household items in good condition to Goodwill Industries or rummage sales are valued at less than your cost in most cases, so their present value is fully deductible.

by Jack B. Schwartz

jack.schwartz@millernash.com 503.205.2560

“If you donate artwork and claim a total deduction exceeding $20,000, you are required to attach a qualified appraisal to your return.”

Estate Planning Advisor | miller nash llp | 3

An Essential Business Agreement: The Buy-Sell

(continued on page 5) by William S. Manne

bill.manne@millernash.com 503.205.2584

The buy-sell agreement can be one

• f the single most important docu-

ments that a co-owner of a closely held business will sign. The following Acme In-Law hypothetical case study illus- trates the importance of a well-crafted buy-sell and how it can be instrumental to effecting a smooth transition to a co-owner (including family members

• r key employees).

George Acme appreciated his son- in-law, Tom Gardner. Tom had been with the company for

• ver 20 years, had gradu-

ally assumed operational management, and was the acting CEO. He had purchased 25 percent of the ownership from George

• ver the years—mostly at

a low value in recognition

• f his valuable services.

Everyone knew that Tom would eventually own the company and carry on the fine traditions of

• Acme. But that was before George

died and Tom’s sister-in-law be- came the executor of the estate. She was happy to sell the balance of the company—but at full fair market value and in cash, or she would sell the business to the highest bidder. Only later would she realize that without Tom’s cooperation, the business was unlikely to sell—no buyer would want a disgruntled minority co-owner, especially the current CEO. Both owners had issues with value, control, and successor ownership—issues best discussed and resolved before a transfer event such as a death or a sale opportunity arises. Had Tom and George acted on a timely basis and created a buy-sell agreement, the business would have transferred at a fair price to the benefit of all

• concerned. Now, it likely wouldn’t

continue at all. The buy-sell agreement (also called a shareholder agreement or, in the case

• f partnerships or limited liability com-

panies, embedded in the partnership or

• perating agreement terms) is designed

to control the transfer of ownership in a business when certain events occur. Typically, these events include the death

• f an owner and a sale and transfer of
• wnership from one owner to another
• r to an outside party. In addition to

controlling these events, the agreement will often also include transfers to take effect upon an owner’s permanent and total disability, termination of employment, retirement, bankruptcy,

• r divorce, or in the event of a business

dispute among the owners. At each of these events, the buy-sell agreement might require the business

• r the remaining owners to purchase

the departing owner’s interest, or might give an option to the business or the remaining owners to buy that own- ership interest. Finally, it might provide the departing owner with the option to require the company to buy his or her

• wnership interest.

The well-crafted agreement will also establish the value of the purchase, set the terms and conditions of the buy-

• ut, and give additional protection to

all owners. In short, the buy-sell agree- ment, in addition to other protections, tells owners to whom they can sell, at what price and terms, and under what restrictions.

Advantages of a Buy-Sell Agreement

A thoughtful buy-sell agreement can be a valuable document if it is well drafted and kept up to date regarding changes in ownership, value, and other circumstances. Let us take a look at some of the principal fea- tures that owners should expect from a well-crafted buy-sell agreement: 1. Ownership in the business can be transferred

• nly in accordance with

the agreement. This benefits both the

• wner wishing to transfer ownership

and the other owner or owners want- ing to acquire it. In the first instance, the buy-sell agreement can assure a selling owner, or his or her estate, of a purchaser for fair value and upon terms and conditions that are mutually accept-

• able. For the remaining owners (such

as Tom), the agreement means that any transfers of ownership must be made,

• r at least offered, to them. This elimi-

nates the threat that an outside party

• r a co-owner’s spouse or children will

become owners of the business, thereby diminishing management, control, and value.

“The well-crafted agreement will also establish the value of the purchase, set the terms and conditions of the buyout, and give additional protection to all

• wners.”

Estate Planning Advisor | miller nash llp | 4 In our previous edition, we dis- cussed the fundamentals of community property, including the rights affected by characterization of property as “com- munity” or “separate,” and some com- mon misconceptions about community and separate property. As we saw, even in community- property states, certain property is characterized as “separate” property by default—this includes property owned by one spouse before marriage, gifts and inheritances (even if they are received by a spouse during marriage), and the income earned from separate property. We also saw that separate property may become community property if it is not titled properly and kept separate from community property. Those of us living in community- property states, and those of us with heirs who live in community-property states, should carefully consider the possibility that although lifetime gifts, bequests, and inheritances are all “separate” property by default, they can easily be converted into community property. One way to convert separate prop- erty into community property is by a signed agreement; we will discuss the intentional conversion of property from separate to community in a subsequent

• article. The more common way that

property is converted is by uninten- tional commingling of assets. This kind of unintentional com- mingling happens all the time. For example, a daughter receives a gift of $14,000 from her father in 2014, and deposits that money into a joint savings account that she shares with her hus-

• band. By the year 2024, it will be nearly

impossible to determine what part (if any) of that $14,000 gift remains. Even though the $14,000 would have been characterized as the daughter’s separate property at the time of the gift, no court would carve out $14,000 of separate property for the daughter ten years later. A fairly simple way to protect against unintentional commingling of assets is to create a trust for the benefit

• f the recipient. In the example above,

if the father gives his daughter $14,000 in trust in 2014, there will be no uncer- tainty whether that money belongs to her as her separate property or whether it is part of her marital community. In 2024 (as long as the money is still in trust), it will still be just as easy to determine what funds constitute the gift made to the daughter, as well as any interest or apprecia- tion, and all those funds will be the daughter’s separate property. Often, couples who enter into marriage with each spouse possessing his or her own separate property are interested in either protecting that separate property

• r

converting it into com- munity property. Later articles will discuss how to accomplish either of these goals.

Keeping Separate Property Separate: Trusts for Beneficiaries

by A. Paul Firuz

paul.firuz@millernash.com 206.777.7443

by Adrienne P. Jeffrey

adrienne.jeffrey@millernash.com 206.777.7512

Estate Planning Advisor | miller nash llp | 5 5 2. Valuation is set not only for purposes of a sale, but also for estate tax valuation purposes. Privately owned businesses are notoriously difficult to value. Your idea of your business’s value at your death might be much lower than the IRS’s valuation. If you have not created a binding process for valuing the business, the IRS is free to impose its own value determination. Take the initiative by designing a valu- ation in your buy-sell agreement that will help support a similar valuation for estate tax purposes. 3. The terms and conditions of any transfer, including the interest rate imposed on delayed payments, and the length of buyout period and security, can be fixed. In addition, when appro- priate, funding for the transfer can be established ahead of the event. This provides a clear picture to a departing

• wner of how much money he or she

will receive and how often. Likewise, the remaining owners know in advance the extent and duration of their buyout

• bligations. This allows all the owners

to plan their respective futures with more certainty. Had Tom and George created an agreement providing for terms such as these, their valuable business would have been transferred to the benefit of all owners, as well as the employees, customers, and others having an inter- est in seeing Acme survive. In summary, there can be many advantages to a thoughtful and well- crafted buy-sell agreement. An Essential Business Agreement: The Buy-Sell | Continued from page 3

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Keeping the Family Business in the Family | Continued from page 1 business will have received a step-up in basis to its fair market value at the decedent’s date of death, thus reducing income taxes in the form of depreciation deductions and, if the business is ever sold, capital gains. But will the business thrive when the founding owner is get- ting up in years even if managed by his

• r her children? There is often a strong

desire for a child to take control and move on and not wait to reach his or her 60s—a typical age when the founder will pass on. Further, for larger estates (over $10.68 million for a married couple), there can be significant estate tax savings from gifting the property during life. Further, many states (in- cluding Oregon and Washington) have no gift tax, but do have an estate tax, so significant state estate taxes can be saved by making a gift during life. Sell the Family Business During Life With an Installment Sale? During retirement, the founder generation might want a source of income from the

• business. In that case, an installment

sale or a part installment sale and part gift might be the best approach. One downside of a sale is that it will gener- ate income taxes. But income taxes on a sale can be avoided through the use of a grantor trust. It is certainly a dream of most entre- preneurs that they can develop a family business and someday pass it on to the next generation. With careful planning, that dream can come true.