In our last post, we indicated that the business owner’s guiding principles in evaluating any transaction in which he or she may engage with the business should be the following:

–          Would an unrelated third party have entered the transaction on comparable terms?

–           Is the taxpayer’s behavior consistent with what one would expect from a third-party?

However, one area in which these principles may not be as strictly applied, at least in some circumstances, involves the provision of services by the business.

In a recent decision, the Tax Court considered whether the sole shareholder of a corporation received a constructive dividend when the corporation provided services to the shareholder at cost; i.e., without charging the shareholder an amount equal to the corporation’s customary profit margin.

The corporation was a construction company specializing in housing projects. The taxpayer, who was its president and sole shareholder, constructed his own home. To keep track of the construction costs, the taxpayer caused the corporation to open a “cost plus” job account on its books, though the taxpayer acted as his own general contractor. During the construction, the corporation paid the taxpayer’s subcontractors and vendors directly, and its own crew framed the home. The taxpayer reimbursed the corporation for all amounts paid to the subcontractors, and also reimbursed it for its labor and overhead costs. However, the corporation did not charge the taxpayer its customary profit margin of 6% to 7%.

The IRS argued that this “forgone profit” represented a dividend payment by the corporation to the taxpayer-shareholder.

According to the Code, a dividend is any distribution of property that a corporation makes to its shareholders out of its accumulated or current earnings and profits. “Property” includes money and other property; under some circumstances, the courts have held that it also includes the provision of services by a corporation to its shareholders.

A “constructive” dividend arises where “a corporation confers an economic benefit on a shareholder without the expectation of repayment, . . . even though neither the corporation nor the shareholder intended a dividend.” The key factor in finding that there is a constructive dividend is that “the corporation has conferred a benefit on the shareholder in order to distribute available earnings and profits without expectation of repayment.” However, not every corporate expenditure that “incidentally confers economic benefit on a shareholder is a constructive dividend.”

According to the Court, where a corporation constructively distributes property to a shareholder, the constructive dividend received by the shareholder is ordinarily measured by the fair market value of the benefit conferred. Where the fair market value cannot be reliably ascertained, or where there is evidence that fair market value is an inappropriate measurement, the constructive dividend can be measured by the cost to the corporation of the benefit conferred.

The IRS asserted that the proper measure of a “service-based” constructive dividend was equal to the cost of the services provided to the shareholder by a corporation plus the corporation’s customary profit margin.

The Court disagreed, pointing out that, while it had previously held that the amount expended by a corporation for its shareholders constituted a constructive dividend, it had never held that the dividend included an amount corresponding to the foregone profit. It went on to state that in order to find a dividend, one must first find that there has been a distribution of property to the shareholder that reduces the corporation’s current or accumulated earnings and profits; there must be a finding, it said, that “corporate assets are diverted to or for the benefit of a shareholder” in order to distribute available earnings and profits without expectation of repayment.

The Court contrasted the provision of services to a shareholder at cost with the bargain sale of property to a shareholder. The former scenario, the Court said, does not result in the “diversion of corporate assets or the distribution of its earnings and profits,” while in the latter scenario, the shareholder receives a benefit equal to the excess of the fair market value of the property over the sale price because the property being sold is an asset of the corporation and its sale for less than fair market value diverts to the shareholder actual value otherwise available to the corporation. Similarly, the Court went on, where a corporation provides a shareholder with the use of corporate property and the shareholder does not fully and reasonably reimburse the corporation for its use, the shareholder has received a constructive dividend equal to the fair market value of the use of the property. (The Court did not discuss corporation-to-shareholder loans, but the same reasoning applies; in fact, the Code specifically addresses this scenario in the imputed interest rules of Sec. 7872.) However, the Court noted, the incidental or insignificant use of corporate property may not justify a finding of a constructive dividend.

In the present case, the Court found that the corporation maintained its corporate infrastructure and workforce for business purposes. It concluded that the shareholder’s “use” of the corporation during the construction of his home was at most incidental to those purposes.

The Court also found that the taxpayer had used the corporation as a conduit in paying subcontractors and vendors and that he obtained some “limited services” from corporate employees. He fully reimbursed the corporation for all costs associated with those services, and the corporation did not divert actual value otherwise available to it by failing to apply its usual profit margin. Accordingly, it held that the taxpayer did not receive a constructive dividend.

How much comfort can one derive from the above decision? It seems clear that, if the taxpayer had not reimbursed the corporation for its costs (both direct and overhead), a constructive dividend would have been found. The decision also suggests that, if  properly structured, a shareholder’s use of corporate services may not lead to a constructive dividend. The key to the Court’s decision was that no transfer of corporate property was deemed to occur, and this conclusion seems to have been based, in no small part, on its finding that the taxpayer’s use of the corporation’s services was “incidental or insignificant” and that the services provided were “limited” – none of these terms provides a bright-line standard. Thus, before a shareholder decides to use the services of its own corporation, it would behoove him or her to first consider the nature, extent and cost of the services to be rendered, and then to structure the arrangement appropriately.

With this post, we continue to examine transactions between the closely-held business and its owners.  As we saw last week, special scrutiny is given in situations where a business is controlled by the individual with whom it engages in a transaction because there is a lack of arm’s-length bargaining.  That is certainly the case where a close corporation pays compensation to its controlling shareholder-employee for which it claims a deduction.

The Code allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including salaries or other compensation,  if the payments were reasonable in amount and are, in fact, payments for services.  Whether the compensation paid to a shareholder-employee was reasonable is a question of fact.  In determining the reasonableness of compensation, courts have considered various factors, including:

– The employee’s qualifications;

-The nature and extent of the employee’s work;

-The size and complexity of the business;

-The employee’s compensation as a percentage of gross and net income;

-The employee-shareholder’s compensation compared with distributions to shareholders;

-The employee-shareholder’s compensation compared to that paid to non‑shareholder-employees; and

-The prevailing rate of compensation for comparable positions in comparable businesses.

 All In The Family

In K&K Veterinary Supply Inc. v. Comr., the corporation’s sole shareholder was also its president, co‑CEO and co‑COO; his wife was vice‑president, secretary and assistant CFO; his brother was senior vice‑president, co‑CEO and co‑COO; and his daughter was CFO.

During each of the years at issue, the corporation paid a dividend to the sole shareholder.  It also paid compensation to each of its officers. In addition, the corporation entered into a lease for real property owned by an LLC whose only members were the sole shareholder and his wife.

The IRS disallowed a portion of the deductions claimed for the compensation paid to the employee-shareholder and the related officers. It also disallowed a portion of the deduction claimed for the rent paid to the related LLC.

After considering the various factors described above, including the expert testimony of compensation consulting firms as to the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry, the Tax Court made a significant downward adjustment to the corporation’s compensation deduction, noting, among other things, that the aggregate amount of compensation paid and deducted by the corporation as to the officers was more than 100% of the corporation’s net income before taxes. As to one officer, the Court commented that her hours were “incongruous with her position titles in companies in which family relationships do not exist.”

The Court then considered the rent deduction, stating that in connection with a lease between related parties, the inquiry “requires a careful examination of the circumstances surrounding the rental of the property to determine the intentions of the parties in agreeing upon…the lease and in fixing the terms thereof.”  Relying upon the report of the IRS’s expert, the Court disallowed a portion of the rental deduction.

The taxpayer then claimed that the disallowed portions of the compensation and rent should be treated as dividends paid by the corporation to is shareholder and, so, taxable at a lower rate than the ordinary income rate applicable to compensation and rent.

Again the Court disagreed with the taxpayer, finding that there was “no identity of interest” between the corporation and its sole shareholder and his family members.  The corporation and the shareholder are separate entities, it said, and there is no necessary correlation between the corporation’s right to a deduction for a payment and the taxability of the payment to the shareholder-employee.  According to the Court, the separate treatment of a payment’s deductibility and recognition as income obtains even where the payor and payee are a corporation and its sole shareholder.

 Conclusion

Many a business owner will treat his or her business as their alter ego. While this may seem reasonable on some visceral level, it is not advisable from a tax perspective (not to mention the perspective of one who is seeking to defend against a “piercing” argument by a creditor). Rather, the owner’s guiding principles in evaluating any transaction with the business should be the following: would an unrelated third party have entered the transaction on comparable terms, and is the taxpayer’s behavior consistent with what one would expect from a third-party?  To the extent these questions are answered in the negative, can the taxpayer distinguish or otherwise account for the difference on reasonable business-related grounds? If not, then the taxpayer has to be prepared to have the transactions re-characterized by the IRS and to accept the tax consequences, including penalties, that may follow.

 

[The next blog post will conclude this series on transactions between a business and its owners. Rest assured, there are bound to be many more judicial decisions involving such transactions that will be covered on this blog.]

 

 

Transactions between a closely held business and its owners will generally be subject to heightened scrutiny by a taxing authority, and the labels attached to such transactions by the parties have limited significance unless they are supported by objective evidence. Thus, arrangements that purport to provide for the payment of compensation, dividends, rent, interest, etc., will be examined, and possibly re-characterized, by a taxing authority so as to comport with what would be required in an arm’s-length setting.

 Notwithstanding the many instances in which the IRS and the courts have successfully treated a transaction between a close business and its owners as something other than what was reported on their respective tax returns, we continue to see examples of taxpayers who either have been ill-advised or are just plain careless in their dealings with one another.

A recent Tax Court decision involved an S corporation with a single shareholder, who also served as the president of the corporation. This individual was responsible for all operational and financial decisions of the corporation, and performed nearly all of the work necessary to run the business. He worked full-time for the business, which had no other employees.

During the years at issue, the business experienced some financial difficulties. The shareholder transferred cash to the corporation; no promissory note was issued to reflect the transfer, and no collateral was given.

On the S corporation tax returns for these years, the corporation did not report paying the shareholder any salary or wages. It did, however, distribute money to him as cash was available. It also reported the repayment of loans from the shareholder.

The IRS determined that the shareholder should have been classified as an employee of the corporation and that the distributions should be characterized as wages. The Court agreed, stating that the evidence supported the IRS’s findings: “An employer cannot avoid Federal employment taxes by characterizing payments to its sole employee, officer, and shareholder as dividends, rather than wages, where such payments represent remuneration for services rendered.”

The Court also rejected the taxpayer’s argument that certain distributions represented repayments of loans between the corporation and the shareholder and, as such, should not be treated as wages. The Court considered a number of factors, including the name given to the transaction by the parties, the absence of a fixed maturity date, the likely source of repayment, the charging of interest for the use of the funds, the right to enforce payments, subordination of the purported loan to other creditors, the intent of the parties, and the capitalization of the corporation.  Ultimately, it found that it must determine “whether the transfer, analyzed in terms of economic reality, constitutes risk capital . . . subject to the fortunes of the [business] or a strict debtor-creditor relationship.” Applying the above factors, the Court concluded that the transfers were capital contributions and not bona fide loans. “Where the expectation of repayment depends solely on the success of the borrower’s business, rather than on the unconditional obligation to repay, the transaction has the appearance of a capital contribution.”

Finally, the Court addressed the taxpayer’s argument that the characterization of all distributions to the shareholder as wages would constitute unreasonable compensation to him and, so, some portion thereof should continue to be treated as distributions in respect of his shares in the corporation. The Court responded that there was no evidence to support a finding that the compensation was unreasonable for the services provided.

The foregoing illustrates only one of the many possible outcomes of an IRS audit involving an owner’s transactions with his or her closely held business. Each situation is different and the results will ultimately depend upon the particular facts and circumstances. Thus, in the “right” situation, a payment of compensation may be re-characterized as a nondeductible dividend, a non-pro rata distribution may be treated as a gift, a payment of rent may be re-characterized as compensation, the use of company property may be treated as a dividend, and so forth.

It is important to recognize that the proper characterization (or, from the perspective of the IRS, the “re-characterization”) of a transaction can have significant tax consequences.  The bottom line: decide early on what is intended, then act accordingly. It may require more consideration initially, but it will provide certainty and it may avoid an expensive tax result down the road.

 In the next few blog posts, we will consider other recent situations involving transactions between owners and their closely held businesses.

 

Many of us have encountered variations of the following scenario:  a parent owns and operates a business; his kids are employed in the business; as the kids mature and become more comfortable and established in the business, some of them may want to assume greater managerial responsibility and to have a greater voice in the strategic planning; inevitably, the kids also are anxious to realize a greater share of the economic benefits resulting from their efforts.

It is not always the case that the parent and the kids will see eye-to-eye.  The parent, for example, may want to emphasize a traditional line of business, while his children seek to expand the business, either by product lines, services, or geographically.  Alternatively, the children may want to take the business in an entirely different direction.

Sometimes, however, the parent will feel that the kids are quite capable of growing the business, and that the appreciation in the value of the business resulting from their efforts should inure to their benefit, instead of becoming a part of the parent’s gross estate.   These situations may present difficult estate and succession planning considerations for the family and the business. They also present income tax issues.  In some cases, a tax-free “spin-off” from the parent’s company may be possible and advisable.    However, where this structure is not available, the parties must proceed with caution.

One means by which some folks have sought to accomplish a transition to their kids is by “allowing” the kids to go off on their own and to start their own business.  The existing customers from the parent’s business may “transition” over to the new company, while the parent phases out the old company.  Any “new” business is directed to the new company.

While this process may seem innocuous enough, it raises a number of tax-related issues; for example, has the parent liquidated a portion of the old business and made a gift thereof to the kids?  This “liquidation-reincorporation” risk is not all that far-fetched. Indeed, it was the subject of a recent Tax Court decision, Bross Trucking v. Comr., T.C. Memo 2014-107.

 Bross:  The Kids Get Into the Business; The IRS Takes a Closer Look

In Bross, the parent had been involved in the trucking business for thirty years.  He founded the business, managed it, and was its sole shareholder. Its principal customers were owned by individuals with whom the parent had close personal relationships, and the parent’s corporation did not have formal written agreements with these customers.  In the late 1990’s, the business came under scrutiny by state transportation regulators for various safety concerns.  The business suffered and the parent decided to wind it down.

In 2003, the kids started their own trucking company.  They had not previously been involved in the trucking business, but they sought to service the principal customers of the old business.  They also decided to provide additional services not previously provided by the parent’s business.  The kids owned over 98% of the new company, and an unrelated third party owned the balance.  The parent was not involved in the new company. While the latter did not assume any contracts, insurance or licenses from the parent’s business, it did eventually hire one-half of its workforce from the parent’s company. It also leased many vehicles that had previously been leased by the parent’s company and that displayed that company’s logo, but they placed signs over the logo.  The parent’s company remained in existence and continued to collect its receivables and contend with its liabilities.

The IRS asserted that the parent’s company had distributed its “operations” to the parent, which the parent then gifted to his kids (the alleged value of which would have required the payment of gift taxes), who then organized the new company.  In addition, the IRS asserted that the alleged distribution of the operations (specifically, “goodwill,” which the IRS claimed subsumed several other “attributes” of the business, such as workforce and customer base) to the parent as the sole shareholder of the company should be treated as a sale of such assets, in accordance with IRC Sec. 311(b), the gain from which should be taxed to the parent’s company.  The parent would be taxed upon the gain realized on his receipt of such assets.

The Court considered the issue of whether the parent’s company had, in effect, made a taxable distribution of goodwill.  What it found was that the company did not own any goodwill.  First, it found that any goodwill that the company may have owned was lost when state regulators investigated its safety record and found it wanting. Second, the remaining “attributes” of goodwill were personal to the parent.  Any established revenue stream or developed customer base was a direct result of the parent’s personal efforts.  He developed crucial relationships with the customers and they chose to patronize the company solely because of those personal relationships.  It was his personal ability and reputation that the customers sought.  These relationships were owned by the parent personally, and never were transferred to his company through an employment agreement or non-compete agreement.  He was free to leave the company at any time and to take his personal assets with him.

Moreover, the kids did not contribute any goodwill to their new company because they were never employed by the parent’s company.  The fact that one-half of their workforce had worked for the parent’s company did not convince the Court that there was a transfer of an established workforce-in-place.  This was demonstrated, the court said, by the fact that the new company offered services not previously offered by the parent’s company.  The fact that the old company’s customers had a choice of trucking options, and chose to switch to the new company, further supported the conclusion that no customer base had been transferred.

Thus, the Court concluded, there was no distribution by the parent’s company to the parent, and no gift by the parent to the kids.

From the taxpayer’s perspective, the facts in Bross were fortuitous.  There were a number of items that greatly weakened the IRS’s argument that corporate goodwill had been transferred. In most other settings, the parent’s company will not have been the object of a public regulatory investigation, and the kids would have been involved in the parent’s business, and would have developed their own relationships, before “breaking away” to start their own, similar business.

The takeaway here is that the IRS could have triumphed on better facts.  Thus, the liquidation-gift-reincorporation risk must be considered in any situation where the kids are planning to separate from the parent’s company, to go off on their own.  In any such situation, it is imperative that the parent, the kids, the company and their advisors consider the various alternatives by which the new business may be established, identify the tax risks associated with each, then plan accordingly.  It is not acceptable to simply move ahead and hope for the best.

         Over nearly three decades, I have reviewed the income tax returns of many closely held corporations and partnerships.  Quite often, on Schedule L (the Balance Sheet), I will see an entry for “loan from” shareholder or partner, as the case may be.  I sometimes pause before asking the next series of questions:  did the board of directors or managers approve the loan; how has the loan been documented; is there a note with repayment terms; does the loan provide for interest and, if so, at what rate; has interest been paid; does the business tax return reflect interest expense; has interest income been imputed to the owner-lender?

             The proper characterization of a transfer of funds to a business entity from an owner of that entity may determine a number of potential tax consequences arising from the transfer, including, for example, the following:  the imputation of interest income to the owner-lender; the ability of the lender to claim a bad debt deduction; the making of an indirect taxable gift, in the case of a family-owned business, where the “loan” is really a capital contribution. The proper characterization of the transfer is also important if the owner/lender intends to have priority in the repayment thereof over other owners.

  If a transfer of funds to a closely held business is, in fact, intended to be treated as a loan, then there are a number of factors that are indicative of bona fide debt of which both the lender and the borrower should be aware:

–          Evidence of indebtedness (such as a promissory note);

–          Adequate security for the indebtedness;

–          A repayment schedule, a fixed repayment date, or a provision for demanding repayment;

–          Business records (including tax returns) reflecting the transaction as a loan;

–          Actual payments in accordance with the terms of the loan;

–          Adequate interest charges (at least the applicable federal rate); and

–          Enforcement of the loan terms.

The big question is “was there a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?”  (Cite).  The transaction will come under special scrutiny where the borrowing entity is controlled by the lender and/or members of his or her family.  In that case, especially, can it be shown that there was a realistic expectation of repayment?  Would a third party lender have made the loan on similar terms?  Was there an actual transfer of funds in conjunction with any notes, or did the issuance of notes seek to “recharacterize” the nature of the cumulative funds previously transferred to the entity by the purported lender?

         A recent Tax Court decision involved a family-owned business that had encountered financial difficulties.  The company needed capital and the taxpayer-family member (who also served as the company’s CFO) agreed to commit to a revolving line of credit.  A note was executed, but the stated interest was not payable currently and the credit was unsecured.  No interest or principal was ever paid on the note.  Though the company’s situation continued to deteriorate, and there were insufficient funds to pay all creditors, the taxpayer nevertheless continued to transfer funds to the company until the latter finally failed.

 

The Tax Court Considers the  “Loan”

The taxpayer claimed a worthless debt deduction for the funds transferred to the company.  When challenged by the IRS, however, the taxpayer was unable to produce any records regarding the company’s net worth; she was unable to show that the company recognized COD income; it was unclear whether the taxpayer made a demand for payment; she never commenced legal action to secure repayment, nor did she obtain a valuation that the note was worthless – rather, she drew an independent conclusion as the company’s CFO.

The Court began by noting that whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case.  Advances made by an investor to a closely held or controlled corporation, the Court stated, may properly be characterized, not as a bona fide loan, but as a capital contribution or as a gift.  In order to constitute a bona fide loan, the purported activity must expect that the amount advanced will be repaid.  “Economic reality provides the touchstone,” the Court said.  If an outside lender would not have loaned funds to the corporation on the same term as did the insider, the inference arises that the advance is not a true loan.

Under the facts presented, there was no evidence that a third party lender would have extended credit on comparable terms.  The taxpayer’s behavior as the company’s condition deteriorated was likewise inconsistent with what one would expect from a third-party lender.  The court, therefore, concluded that the advances were not loans and could not generate a worthless debt deduction.

The foregoing is an example of only one situation in which the proper characterization (or, from the perspective of the IRS, the “recharacterization”) of a transfer of funds can have significant tax consequences. Others include intra-family loans (which may be treated as gifts), intercompany loans (which may be treated as distributions to the owners of the lender, then as capital contributions by them to an affiliated entity), and loans to shareholder-employees, which may be treated as distributions or compensation. The bottom line: decide early on what is intended, then act accordingly.

I, for one, hate surprises.

Many successful business people are also community-minded.  They have done well for themselves and their business and, at some point, they seek to share some of their success with the communities they serve and in which they operate, and with the communities in which their employees live and work.  This charitable inclination reflects, more often than not, the philosophy of the owner and chief executive of the business, and he or she often wishes to pass this philosophy along to those members of his or her family who will succeed the owner in the business.

Businesses approach charitable giving and community service in many different ways.  Some donate cash and/or products, others organize a “day of service” by their employees, or encourage their key employees to serve on charity boards or committees.

Some business will establish programs under which they “match” an employee’s charitable contribution, up to a certain amount, provided it satisfies certain criteria; for example, the recipient must be a public charity (verified by the business), the match does not satisfy a legal obligation of the employee, the employee must not receive anything in return, and the employee’s gift is made in cash (not in kind).

A recent IRS ruling considered a variant on one such matching program.  The company, which already had a matching program, proposed to establish its own tax-exempt charitable organization.  The company would be the charity’s sole contributor, the charity would be treated as a private foundation for tax purposes, and the company and charity would share the same officers and directors.

 

It was proposed that the charity assume the company’s role of matching employee gifts.  This “assumption” would be prospective only; the charity would not take on any existing obligation of the company or release the company of any financial burden.  In conjunction therewith, and in addition to the criteria set forth above, the charity represented that it would not match contributions to any organization which the charity or any “disqualified person” controlled.  In general, disqualified persons as to the charity would include (among others) a substantial contributor like the company, the officers and directors of the company, and the owners of the company.

The IRS ruling focused primarily on the issue of self-dealing; specifically, the question of whether the charity’s assets were to be used by or for the benefit of a disqualified person; specifically, the company.  If a disqualified person is found to have engaged in an act of self-dealing with a private foundation, the IRS will impose a penalty tax upon the disqualified person, as well as on certain foundation managers.

The ruling notes that the public recognition that a person may receive, arising from the charitable activities of a private foundation to which such person is a substantial contributor, does not in itself result in an act of self-dealing since, generally, the benefit to such person is “incidental and tenuous.”  For example, the naming of a “public” facility (the construction of which was funded by the foundation) after the substantial contributor of a foundation will not be an act of self-dealing – the benefit to the disqualified person is deemed to be only incidental.

Thus, the IRS ruled, the benefit derived by the company from the payments made by the charity – in the form of goodwill in the community, and increased loyalty and morale among the employees – was incidental and tenuous, and did not constitute self-dealing.

A company-sponsored foundation is only one way by which a closely held business may support charitable activities within its community.  Such a foundation, however, may, also serve as a vehicle through which the owners may instill the family’s values in its younger members, familiarize these family members with the company’s workforce and customers, and train them in the management of a “business” endeavor before getting them directly involved in the company’s actual business.

One of the most frequently encountered scenarios in the context of a closely held business is the following:  individuals X and Y are shareholders of a corporation, X is the majority shareholder (60%) and president of the corporation, and X and Y do not have a shareholders’ agreement.  Over time, the interests of X and Y diverge, and X and Y begin to argue over the direction of the business.  Eventually, X attempts to shut Y out of the management and operation of the business.

The U.S. Tax Court recently considered this very situation, but with the following additional facts:  the corporation is an S corp.; it made no distributions to its shareholders during the period at issue; it issued a Schedule K-1 to each of X and Y, allocating corporate income based upon their relative stock ownership (60-40); and, although the corporation paid a salary to X, no wages were paid to Y.  Kramer v. Comr, T.C. Memo 2013-184.

In response to X’s having shut Y out of the corporation’s operation and management, Y filed a complaint in state court against X and the corporation seeking, among other things, the inspection of corporate records and the dissolution of the corporation.

The lawsuit eventually settled, with the settlement agreement providing that Y’s shares would be redeemed by the corporation, and that each of X and Y would be responsible for his respective tax liability.

On his individual income tax return, Y failed to include his share of the corporation’s income reported on the Schedule K-1 issued to him.  Y argued that he was not liable for the tax on such income because he was not the beneficial owner of shares in the corporation, notwithstanding his record ownership.  Y based his position on the fact that he was improperly excluded from the benefits of ownership.

The Tax Court rejected Y’s position, noting that it had previously held that when one shareholder merely interferes with another shareholder’s participation in the corporation, such interference does not amount to a deprivation of the economic benefit of the shares. In the absence of any agreement giving X any rights to Y’s shares during the period at issue, the Court said, X’s interference did not deprive Y of the economic benefit of his shares for tax purposes.  Thus, the Court held, Y was not relieved from reporting his share of the S corporation’s income on his tax return.

It appears that Y may not have argued that the corporation had more than one class of stock and, therefore, did not qualify as an S corporation.  However, this may be an argument that he should have considered.  In general, a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.  Nevertheless, an “arrangement” may be treated as a second class of stock if it constitutes equity under general tax law principles and a principal purpose of the arrangement is to circumvent the rights to distribution or liquidation proceeds conferred by the outstanding shares of stock. Query whether Y could have carried this burden.

The foregoing illustrates one of the many reasons why a minority interest in an S corporation, a partnership or an LLC, commands a valuation discount.  A minority owner in any of these pass-through entities must report his or her share of the entity’s net income regardless of whether or not he or she receives a distribution from the entity.  In the absence of a shareholder, partnership or operating agreement (as the case may be) that provides for annual distributions to the owners in an amount sufficient to enable the owners to pay federal, state and local income taxes on their share of the organization’s net income, an owner must look to his or her other assets to provide the cash necessary to satisfy those tax liabilities.  This can turn into an expensive proposition for a minority owner, especially for one who is not employed by (or otherwise engaged in) the business.

In most cases, a shareholders’ agreement will benefit primarily the principal (not necessarily majority) shareholder; for example, it may restrict transfers of shares, it may provide for drag-along rights by which the principal shareholder may compel the other shareholders to join him or her in disposing of their shares, it may require the minority shareholders to join in making an election under IRC Sec. 338(h)(10) to treat a stock sale as an asset sale, and it may provide for supermajority voting so as to give the principal shareholder veto power over certain corporate decisions.

However, anyone who is considering an equity investment in a closely held business that is a pass-through for tax purposes – especially someone who is not related to the other owners – should be careful of doing so without the protection that may be afforded by a shareholders’ agreement that provides for at least annual (perhaps quarterly) distributions for the purpose of enabling the shareholders to satisfy their income tax liabilities.  Although a potential investor must recognize a minority investment for what it is – with all its limitations – an investment in a pass-through entity should not turn into a net cash outflow beyond the amount invested solely because of income taxes attributable to the investment.

“Call it what you want, incentives are what get people to work harder.”  — Nikita Kruschev

 

Most of our clients are closely held, often family-owned businesses.  The current owners may be the founders of the business, or they may be a generation or two removed.  Sometimes, the owners have children who are active in the business and who may have manifested an ability to take over the business.  In those cases, our goal is to provide for the smooth transition and succession of management and ownership of the business to those children.

 No Heir?  Or Not Sure Yet?

Quite often, however, the children may have no interest in the business, may not be capable of operating it effectively, or they have not yet exemplified the ability or inclination to do so.

This could put the owners in a quandary, with the only feasible option being a sale of the business at some point down the road.  Of course, the owners’ first priority in this instance will be to maximize the return on their investment, both for themselves and for their family.  Depending upon the business, this may require the retention and cooperation of some key executive employees.

The question, then, is how to incentivize and reward these key employees; how to align their interests with those of the owners; how to entice them to stay with the business, to keep growing the business, to help prepare the business for a likely sale?

There are several options to consider.

 

 Incentive Compensation Choice 1: Equity (or Something Like it)

On the one hand is “equity-based” compensation, which may take two forms.

  1.  Employee becomes an owner.

Under the first form, the employee may become an owner through grants of stock in the employer, bargain sales of employer stock, and non-qualified options to acquire such stock.  In any of these scenarios, the stock may be voting or nonvoting, it may be vested immediately or it may vest over time, and the right to exercise the option may or may not be immediately vested.

  1. Employee Feels Like an Owner

The second form does not involve the actual issuance of employer stock but, rather, seeks to mimic, to some extent, the “economics” of stock ownership.  This includes phantom stock plans (on which there are many variations) and stock appreciation rights. Each of these is basically just a form of non-qualified deferred compensation, the amount of which is tied either to the value of the “shares” credited to the employee’s account or to the appreciation in the value of such shares. (Where the employer is a partnership or LLC, a so-called “profits interest” may be issued, which entitles the employee to a share of future profits and future appreciation.)

The ultimate decision as to which equity-based plan is best suited for a particular business depends upon a number of factors, including the existing owner’s tolerance for minority-interest shareholders, as well as the relative bargaining/negotiating positions of the employer and the key employee.

In my experience, the preference of most business owners is to avoid the actual issuance of equity (even as to family members, at least not until they have proven themselves in the business).  Even with a tightly-drafted shareholders agreement, the rights afforded to a minority shareholder under state common law, and the potential for litigation – especially with an employee with whom there is no familial relationship –  can make issuing equity a risky choice.  Additionally, employees often do not want the obligations that often come along with ownership, e.g., personal guarantees of business loans and leases, restrictions on transfer, etc. (We will cover the issuance of stock options in a future post.  See our post on restricted stock here.)

 

Incentive Compensation Choice 2: Non-Equity Compensation

Alternatively, the incentive may take the form of a deferred compensation arrangement where the amount of the compensation is not tied by some formula to the value of the equity or to the ultimate sale price for the business.  It should be noted, however, that the actual payment of the deferred compensation may be contingent upon the sale of the business.  Indeed, many employers are naturally inclined to defer, and even condition, the payment of the compensation until the occurrence of a major liquidity event. Of course, because the timing of a sale cannot be predicted, such a contingent arrangement may have to account for many factors :

–          Should the executive be immediately vested?

–          Should he or she vest over a number of years, or only upon a sale of the business?

–          Should payments be allowed upon certain events prior to a sale, including at the death or disability of the employee, or for some hardship?

–          Should the deferred compensation be “secured” in some fashion?

Regardless of how these questions are answered, it is important to note that the many ways of structuring a deferred compensation agreement for the key employee of a business all share two critical elements: (A) in order to successfully defer the employee’s tax liability, the arrangement must comply with certain tax principles that have been developed by the IRS and the courts over several decades, and that were modified by § 409A of the Code in 2004; and (B) this compliance must be ensured at the inception of the deferred compensation arrangement – otherwise, the tax and economic results that the parties envisioned will not be attained and someone will be very unhappy.

 

     Nonqualified Plan Basics

It should be noted that, for the most part, these executive compensation arrangements, so-called “nonqualified plans,” are generally not creatures of statute.  Rather, they  are contractual agreements between the employer and the employee, and are very flexible.  They may be structured in whatever form achieves the goals of the parties and vary greatly in design as a result.

Deferred compensation occurs when the payment of compensation is deferred for more than a short period after the compensation is earned (i.e., the time when the services giving rise to the compensation are performed).  Payment is generally deferred until some specified event, such as the individual’s retirement, death, disability, or other termination of service, or until a specified time in the future (e.g., ten years from the inception of the arrangement, or upon the earlier sale of the business).

There are a number of reasons for deferring compensation.  Employers often use deferred compensation arrangements to induce or reward certain behavior; e.g., to retain the services of an employee or to incentivize the employee to attain certain goals (either personal performance goals or operational benchmarks for the business or for the employee’s division).  In the latter situation, the attainment of those goals would trigger either the vesting or payment of the compensation.

Such an arrangement may provide for deferral of base compensation (salary) or incentive compensation (bonuses), or it may provide supplemental compensation (above qualified plan limits).  It may permit the employee to elect whether to defer compensation or to receive it currently.  Alternatively, it may provide for compensation that is only payable on the occurrence of future events. It may be structured as an account for the employee (to which amounts are credited; the benefits payable are based on the amounts in the account, which may even include an actual or “deemed” investment return), or it may provide for fixed benefits to be paid to the employee at some point, or upon some event, in the future.

     The Key Question

The answer to the question of whether or not amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of the employee depends on the facts and circumstances of the arrangement.  A variety of tax principles and Code provisions may be relevant in making this determination, including the doctrine of constructive receipt, the economic benefit doctrine, the provisions of Section 83 of the Code (relating to transfers of property in connection with the performance of services), and the provisions of the Section 409A.  Some general rules regarding the taxation of nonqualified deferred compensation result from these provisions.  Usually, the time for inclusion of nonqualified deferred compensation depends on whether the arrangement is unfunded or funded.  If the arrangement is unfunded, as is typically the case, then the compensation is generally includable in the employee’s income when it is actually or constructively received, or when the plan fails to satisfy the requirements of § 409A of the Code.  An arrangement is unfunded if the compensation is payable from general corporate funds that are subject to the claims of the employer’s general creditors,  It is an unfunded and unsecure promise to pay money in the future—the employee has the status of a general unsecured creditor, and his or her rights may not be assigned or encumbered.

     Section 409A

Under Section 409A, all amounts deferred under a nonqualified plan (for all taxable years) are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture” (i.e., the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings), unless certain requirements relating to the timing of the distributions are satisfied.

Additionally, almost all incentive compensation arrangements impose certain restrictions upon the employee’s right to distributions.  For example, the plan may include “substantial forfeiture” provisions that impose “a significant limitation or duty which will require a meaningful effort on the part of the employee to fulfill.” Note that whether such a forfeiture provision is effective or not in deferring the employees’ income tax liability depends upon the facts and circumstances of the particular case.  Thus, a provision that is tied to the performance of “consulting services” by a non-employee family member will not be given effect if it is not substantial.

     Rabbi Trust

In order to provide an employee with a sense of security with respect to his or her nonqualified deferred compensation, while still allowing deferral of income inclusion (and tax), a so-called “rabbi trust” may be established by the employer to hold assets from which the nonqualified deferred compensation will be paid.  The trust is generally irrevocable and does not permit the employer to use the assets for purposes other than to provide the deferred compensation, except that the terms of the trust must provide that its assets are subject to the claims of the employer’s creditor in the case of the employer’s insolvency or bankruptcy.  The creation of the trust does not cause the related deferred compensation to be includible in the employee’s income because the trust’s assets remain subject to the claims of the employer’s creditors.  As a result, income inclusion as to the employee occurs as payments are made from the trust, provided these comply with Section 409A.

Thus, an employee will not recognize income under a nonqualified plan until is it paid to him or her (or made available for his or her benefit) in cash or property.  The employer, in turn, is not allowed a deduction for a benefit, contribution or payment until the compensation is taxed to the employee.

Final Thoughts

The foregoing discussion highlighted the basic concepts underlying nonqualified deferred compensation and the basic features of such arrangements. As was noted several times, a family member who is also a key employee of the family-owned business is as likely a candidate for such an arrangement as may be an unrelated employee. The question to be considered is whether it makes sense from a business perspective to reward and retain such an individual. Given the flexibility of such an arrangement, it may be possible to tailor its terms in a way that accounts for the particular circumstances of a family member (e.g., for creditor protection). In the case of a family member-employee, of course, there is also the added benefit of shifting some value to the individual on an income-tax-deductible basis.

What’s Next on the Blog?

This blog post concludes our series on transferring the family business or the value its represents.  Please look for further posts of interest to the closely-held business including, among others, stock options, the sale of the business, buy-sell arrangements, split-dollar life insurance, and others.

If there is a particular topic that you would like to see covered, please let us know.

Our last post covered certain gifting techniques. Today, we will look at some non-gift approaches to transferring a parent’s interest in the family business to his or her children.

 Sale

The most common means for transferring  a business interest to someone is through a sale of the interest.  Thus, it not unusual for a parent to sell a business interest to a child. Indeed, a sale may comport with a parent’s philosophy that a child should “earn” the interest. In addition, for a parent who needs a flow of funds in respect of the business interest, a sale presents an attractive option.

A sale is also an attractive option where the parent wants to shift the future appreciation in the value of the business interest out of his or her estate, but the parent’s remaining gift tax exclusion amount is insufficient to cover the transfer.   If a parent sells a business interest to his or her child, for consideration in an amount equal to the value of such interest at the time of the sale, no gift occurs. Moreover, the sale allows the parent to effectively “freeze” the value represented by the interest at its sale price – by exchanging the interest for non-appreciating cash and/or a promissory note – and to shift any future appreciation in the interest (above the sale price) to the child.

The sale could be for the full value of the business interest, or for a bargain price– i.e., an amount that is below the fair market value (“FMV”) of the interest at the time of its sale.  In the case of a bargain sale, or, in an instance in which the IRS successfully challenges the “full sale price” as too low, the excess of the FMV over the amount paid would likely be treated as a gift.  In both instances, however, the increased gift tax exclusion amount (for tax years beginning after 2010) may provide a greater cushion for sales that are partially characterized as gifts.

The Cost of a Sale

Although a sale can be an effective tool for transferring a business interest to one’s children, it will likely come with a cost: income tax. Where the interest sold was a capital asset (as is typically the case), the sale of which generates long-term capital gain, the lower 20% federal capital gains rate would apply to the amount recognized; the 3.8% surtax on net investment income may also apply.

In addition, once an interest is sold to a child, the child would then own the business interest outright, though his or her exercise of many “incidents of ownership” may be contractually restricted somewhat through the use of shareholder and operating agreements.   Alternatively, the interest may be sold to an irrevocable trust of which the child is a only beneficiary – more on this later.

 Installment Sales

A sale may also be structured as an installment sale; i.e., in exchange for the child’s promissory note.  An installment sale may be appropriate where the parent wants to defer the gain recognition on the sale, or where the child is unable to make a lump sum payment for the business interest.

In order to avoid gift characterization of any portion of the sale transfer, the child’s installment obligation should bear a statutorily prescribed minimum rate of interest, the installment obligation should be memorialized in writing (with a note and sale agreement), preferably secured (at least by the transferred property), the term of the note should not exceed the seller’s life expectancy, and payments (both the amount and timing thereof) should be made as required by the terms of the sale and note agreements.  Additionally, as always, the value of the business interest should be established with an appraisal.  Principal may be payable currently or in a balloon at maturity; preferably, interest would be payable currently. Ideally, each of the parent and child should have separate counsel.

Of course, the sale is taxable to the taxpayer for income tax purposes, though gain in respect of the installment obligation is only recognized as principal payments are made; interest (actual or imputed) is taxable as ordinary income.  If the parent should die before the note is satisfied, the value of the note as of the date of death will be included in his or her estate for estate tax purposes. Thus, the FMV of the note at that time (usually the unpaid principal if adequate interest was provided), plus the accrued but unpaid interest,  may be subject to estate tax. Moreover, because it represents an item of “income in respect of a decedent,” the note will not receive a basis step-up (unlike most items of property that are included in a decedent’s gross estate), thus preserving the tax gain inherent in the note.

 SCIN

How does one address the inclusion of the note in the parent-seller’s estate if the parent dies before the note has been satisfied?

In some cases, the parent will receive a “self-cancelling installment note” (SCIN) in exchange for the business interest being sold. In the case of a SCIN, the remaining note principal is cancelled if the parent dies before the end of the note term.  Of course, this benefits the child-buyer, and it also avoids inclusion of the note in the parent’s estate.  This technique works best where the parent is not expected to survive for his or her life expectancy, but is not terminally ill.  

Sale to Grantor Trust

While an installment sale may “freeze” the value of the parent-seller’s business interest for estate tax purposes, there are some disadvantages to consider: the interest and principal that must be paid are taxable; if the seller disposes of the note (or if the child disposes of the purchased property within two years after its purchase), the gain on the sale is accelerated; a special interest charge may apply if the principal of the note exceeds $5 million, which defeats the deferral benefit of installment reporting (though an inter-spousal gift of a portion of the interest to be sold may alleviate this problem); and the sale of an LLC or partnership interest may result in immediate gain recognition (if the entity has any indebtedness).

Thus, there is another option that should be considered: a sale of the business interest to a grantor trust.  In order to use this technique, an irrevocable trust must be created and funded. The trust is structured as a grantor trust so that the parent is treated as the owner of the trust for income tax purposes. In general, the funding requires a seed gift equal to at least 10% of the FMV of the business interest to be sold to the trust.  Again, the increased gift tax exclusion amount allows a greater seed gift to be made on a tax-free basis, which allows more property to be purchased by the trust.  The parent then sells business interests to the trust in exchange for a note with a face amount equal to the value of such assets, bearing a minimum rate of interest and secured by the property acquired. The interest may be payable annually, with a balloon payment at the end of the note term. The sale to the grantor trust is not subject to capital gains tax (since the parent-taxpayer is dealing with him- or herself), and the issuance of the note prevents any gift tax (since there is adequate consideration).  (If the IRS does challenge the adequacy of the consideration, the shortfall will be treated as a gift, which the increased exclusion may protect.)  The value of the business interest sold to the trust is frozen in the parent’s hands in the form of the note, the cash flow from the interest and/or the appreciation in the value of the interest should cover the loan, and the remaining, excess value of the interest passes to the beneficiaries of the trust.

Price Adjustments

In the case of a sale, whether to a child or to a trust (grantor trust or otherwise), of closely-held business interests, the IRS may challenge the transfer as a bargain sale; i.e., the sales price is below the FMV of the property being sold.

In order to address this possibility, taxpayers have sometimes included a valuation adjustment clause in the sale agreement. In general, the IRS has refused to recognize such clauses, claiming that they violate public policy.

More recently, taxpayers have employed “formula clauses” that express the amount of the property being sold as a formula; e.g., “that number of shares having a value of $X as determined for gift tax purposes.”  To the extent that the value of the shares sold, as finally determined, exceeds the stated purchase price, the “excess” shares have usually been directed to a spousal trust or to a charity (but not back to the seller).  However, one court has approved a defined value clause where the excess business interest was “returned” to the donor-taxpayer; the court held that what the taxpayer had transferred was units in a business having a specific dollar value, and not a specific number of units. Thus, the taxpayer was able to avoid a taxable gift in excess of the gift tax exclusion amount.

In the case of a parent who has completely exhausted his or her gift tax exclusion amount, but who still wants to transfer business interests to a child by way of a sale, the parent may want to consider a defined value clause to try to ensure that the amount sold to the child does not exceed the consideration received for the sale.

Family Limited Partnerships

The final transfer vehicle to consider is the family limited partnership, or FLP.  A number of advisers tout FLPs as a great way to generate valuation discounts and, in fact, a properly structured FLP may generate significant transfer tax savings.

Notwithstanding the valuation benefit, the parent’s adviser should not focus the parent-client primarily on the discounts.  There must be legitimate and significant non-tax reasons for forming and funding the FLP.  The discounts that are applied to value transfers of FLP interests should be ancillary benefits to achieving the non-tax goals.  Even when there is a legitimate business reason for using an FLP, the IRS will audit the arrangement for gift and estate tax purposes, and there will be significant costs associated with this.

In many cases, it may not be readily apparent how a FLP would serve a strong non-tax purpose where the asset at issue is an equity interest in an operating business, such as a closely-held corporation or an LLC, especially where the entity has a shareholder or operating agreement in place.  In any case, where the entity is an S corporation the FLP cannot hold its stock at all without voiding the S election.  However, in other cases, as where different family groups own different blocks of equity in a “C” corporation, it may be that there are valid business reasons to hold one group’s shares through a FLP rather than to leave them in the hands of individual members.

Possible reasons for holding the stock of a C Corporation in a FLP might be to maintain block voting, to keep shares within the family, creditor protection, and to handle management succession.  Bear in mind, however, that it still may be difficult to make the argument for a legitimate business purpose.  Indeed, the IRS may find that there was no management of the shares contributed, no attempt to diversify or invest, just a mere “recycling” of value to generate discounts.

That being said, if a parent is in a position to utilize a FLP in connection with the transfer of business interests, consider these guidelines:

–          Document the business reasons

–          Observe “corporate” formalities (documents, meetings, minutes, etc.)

–          Do not contribute personal assets or co-mingle funds

–          Pool assets of various members (have the children contribute capital)

–          Credit capital accounts properly

–          Share economics (e.g., distributions) pro rata

–          Use contemporaneous appraisals

–          Have separate counsel

–          Do not make gifts of FLP interests right away

–          Manage, invest, etc. (do something)

–          No deathbed planning.

Redemption 

Another means by which a parent may “shift” value to children-shareholders (without actually transferring anything to them), or position his or her estate for a better estate tax valuation result, is by way of a stock redemption. A redemption can reduce the parent’s percentage interest in the redeeming business entity and increase that of the children-shareholders.

If the redemption is effected for FMV, there is no gift to the other shareholders, even though their relative interests increase.  The removal of some of the parent’s interests in the business freezes the value thereof by replacing it with cash that may be spent; the reduction in his or her percentage interest of the total equity may also put the parent in a less-than-controlling position, allowing for a minority discount at the time of his or her death.

In the case of a corporation, the redemption is generally an income-taxable event to the parent, though the specific consequences depend upon a number of factors, the primary ones being the status of the corporation as a C corporation, the presence of E&P from C corporation tax years, the taxpayer’s stock basis, and the degree of reduction experienced by the parent (taking into account certain attribution rules). If the reduction is significant enough, the redemption may be treated as a sale of the stock redeemed, allowing recovery of stock basis before any capital gain is recognized and taxed.  If not, then the amount distributed in the redemption is treated and taxed as a dividend distribution to the extent of E&P.  Under the Code, both dividends and capital gains are taxed at the same 20% rate, the primary difference being the recovery of basis. Thus, where stock basis is low, as is often the case with closely-held corporations, the tax consequences may be almost the same.  In addition, the 3.8% surtax on net investment income must be considered.  In any case, the income tax hit must be weighed against the potential transfer tax savings.

In the case of an LLC or partnership, the distribution of cash in partial or complete liquidation of the parent’s interest will be taxable if the amount distributed exceeds the parent’s adjusted basis in the interest. Any gain realized will generally be capital, though the presence of “hot assets” in the entity may change that result to some extent.

Conclusion

The last few posts have assumed that it was in the best interest of the family business that the parent transfer interests in the business to his or her children. In many cases, at least one of the children is capable of managing the business. In some cases, none of them is. In the latter situation (and sometimes even in the former), it may be imperative to the success and continued well-being of the business – and to the financial security of the family – that one or more key employees (including family members) remain with the business after the parent’s retirement or passing. This will be the subject of our next post.

“Blood may be thicker than water,” begins an advertisement in a recent edition of the NY Times Magazine, “but can it hold a business together?”   The advertisement continues, “It’s a little-known fact that nearly 90% of U.S. businesses are family firms. All over America, people pour their heart and soul into building family companies. Unfortunately, few put that same passion into preparing for the next generation to take over, although most say that’s their wish.” It concludes, “ And sadly, due largely to that lack of succession planning, by the third generation a paltry 12% of family businesses remain family controlled.”

In the first blog post of this series, we considered some of the issues that a parent faces in determining the disposition of his or her business among family members. In the second post, we assumed that the parent has decided that the business should be kept in the family, and we considered the conceptual groundwork for the parent’s transfer of interests in the family business to his or her children. Now we turn to the various means by which these transfers may be effected.

Transfer Vehicles

Assuming that the estate tax benefits of gifting outweigh the economic and income tax benefits of retaining the business interests, the following describes some of the vehicles that may be utilized.

Straight Gift

The simplest form of gift is a straight transfer of property that is made without consideration. Such a transfer may be made either outright to a child, or in trust for the benefit of the child (and/or the child’s family). The amount of the gift is the FMV of the business interest (either a voting or nonvoting interest) on the date of the transfer.  (Note: an outright transfer of a business interest should be preceded by the parent’s adoption of a shareholder’s or operating agreement, and the admission of the child as an owner should be contingent upon the child’s agreement to be bound by the terms thereof.) If the transfer is made in trust for the benefit of the child and the child’s family (including the grantor’s grandchildren), some of the grantor’s GST exemption amount may be allocated to the trust so as to protect future trust distributions from GST tax.

To start with some gifting basics, a parent can make annual gift transfers totaling up to $14,000  ($28,000 with the consent of the parent’s spouse) to each of his or her children (or to a trust for the child’s benefit), without such transfers being treated as taxable gifts. In other words, so long as the total value of property transferred by gift (including a business interest) to a child in a single tax year does not exceed $14,000, the parent will not exhaust any of his or her gift tax exclusion amount.  This form of gifting remains the simplest way of transferring business interests to a family member free of gift tax.

Instead of making yearly gifts limited to the annual exclusion amount, the parent may decide to make an outright gift of a larger value that represents a greater percentage of the equity in the business. There are any number of reasons why this may be sensible from a tax perspective.

Closely-held entities are difficult to value, and the IRS will often challenge the reported value for such an entity as well as the size of the discount for the transferred interest (even where both are well reasoned and supported by a professional appraisal – which should always be the case), depending upon a number of factors.  The result is often a compromise or settlement somewhere between the value reported by the parent-taxpayer and that asserted by the IRS.

With the increased exclusion amount, however, any adjustment by the IRS may be less likely to impact the ability of many taxpayers to make such gifts free of gift tax; this, in turn, should give taxpayers more freedom to make annual gifts, or gifts of greater amounts, with respect to hard-to-value business interests.

Grantor Trust

Transfers in trust may also provide an opportunity for leveraging the gift made by the parent-taxpayer and for further reducing the parent’s taxable estate, depending upon the terms of the trust.

A trust is, generally speaking, a taxable entity.  In the case of a so-called grantor trust, however, the parent-grantor who has made a completed gift into the trust continues to be treated as the owner of the trust assets for income tax purposes; thus, the trust’s income and gain are both taxable to the parent notwithstanding the fact that he or she does not have a beneficial interest in the trust.  (For a discussion of trusts as shareholders of an S corporation, see our earlier post here.)

Consequently, the trust property is allowed to appreciate without being reduced by any income taxes. Moreover, there is an added benefit of the parent-grantor’s estate being further reduced by his or her payment of the income taxes attributable to the trust property.  Additionally, this payment of taxes is not treated as a taxable gift by the grantor to the trust.

Of course, there are risks associated with grantor trusts in that the income tax liability generated to the parent-grantor can be relatively substantial, especially with the increased federal rates for ordinary income (39.6%) and capital gains (20%), plus the new surtax (3.8%) on net investment income.

In addition, it is imperative that the parent be careful in structuring the grantor trust so that he or she has not retained any interests, rights or powers with respect to the trust property (the transferred business interest) such that the trust would be included in the parent’s gross estate (for example, a right to income or to control beneficial enjoyment).

GRAT

A parent who wants to receive some revenue stream from the business interest may want to consider a form of transfer which provides some “consideration,” rather than an outright gift.

There is a statutorily-approved means of transferring property to one’s beneficiaries, while retaining an interest in the property, and also reducing the amount of the gift: the GRAT (or grantor retained annuity trust).  GRATs allow the transfer of future appreciation in contributed property, generally without any estate or gift tax charged on the growth of that property.

They are irrevocable trusts to which a parent may contribute property (such as a business interest which is expected to appreciate in value), while retaining the right to receive an annuity (a fixed amount, typically based upon a percentage of the FMV of the business interest initially contributed) from the trust for a term of years.  At the end of the term, the business interest passes to his or her family, or the trust continues for their benefit (possibly as a grantor trust).

The term of the trust (specifically of the parent’s annuity interest) should be such that the parent will survive the term; if he or she dies during such term, the retained annuity interest will cause at least part of the trust to be included in the parent’s gross estate for estate tax purposes.

The annuity is paid out of income, and then corpus, and it may be paid in kind, including from the contributed property. Thus, some portion of the contributed business interest may be returned to the parent; however, if the interest has appreciated during the GRAT term, that appreciation passes to (or for the benefit of) the children.

It should be noted that, in order to make the required payments to the parent-grantor, ideally the GRAT should receive distributions from the business in which it owns an interest. For this reason, S corporation shares or membership interests in LLCs/partnerships are good candidates for GRATs; in general, these entities are not subject to an entity-level income tax, and cash distributions to their owners are generally not taxable. (Absent such distributions, the GRAT will have to make an in-kind transfer to the parent-grantor.)

For transfer tax purposes, the retained annuity interest represents consideration for the contribution into the trust and, so, reduces the amount of the gift. Specifically, the amount of the gift is equal to the FMV of the business interest contributed to the GRAT by the parent over the actuarially-determined present value of the parent’s retained annuity interest.

The receipt of the annuity interest, however, does not cause the transfer of property to the trust to be taxable to the parent, as a sale of the business interest for income tax purposes, because a GRAT is structured as a grantor trust– that is to say, its assets are deemed to be owned by the parent-grantor.  (See our earlier post about legislative proposals aimed at GRATs here.)

If properly structured, the amount of the gift can be minimal; in other words, the present value of the annuity may be nearly equal to the value of the interest contributed to the trust. This allows the parent’s exclusion amount to remain largely intact and available for other gifting, or to protect transfers at death.

In addition, with a short enough annuity term, the parent-grantor is likely to survive the term of the annuity and, so, the trust property, and the appreciation thereon, are likely to avoid being included in the parent’s estate.  At the end of the annuity term, any property remaining in the trust (that has, hopefully, appreciated) passes to the family free of gift tax and estate tax.

All of these benefits are compounded by the fact that the GRAT may be treated as a grantor trust during the term of the parent’s retained annuity interest for purposes of the income tax; thus, its income is taxable to the parent-grantor, allowing the trust to grow further while simultaneously reducing the parent’s estate.   The trust can even continue after the annuity term expires, further leveraging the grantor trust status (by causing the parent to continue to be taxed on the trust income), reducing the parent’s estate, and maybe providing other benefits (like asset protection) for the family.

One day, all of this shall be yours.

For purposes of the above discussion, we have assumed that the parent’s transfer of an interest in the business made sense from both a tax and a business perspective. Implicit in this assumption is the further assumption that the parent’s successor, from within the family, has been chosen. That may not always be the case. What if two of the children are involved in the business, neither one of which has ultimately emerged as the natural successor?  Unfortunately, under those circumstances, there may not be an easy solution, and there are many options to be considered (whether in the framework of a trust, shareholders’ agreement, or otherwise). The bottom line: the parent should not shy away from addressing the tough issue – kicking the can down the road should not be an option. It will ultimately benefit the business and the family if the parent discusses the issue with his or her advisors now.

 Conclusion

The foregoing reflects some of the gift-related methods by which interests in the family business may be transferred to children.  Some are more basic than others, and each may be tailored to address a specific requirement or concern to the parent.  The point is that it behooves the parent to discuss the options thoroughly with his or her advisors before directing that a particular gift transfer be made.

Keep an eye out for our next blog post, where we’ll consider various “non-gift” techniques for transferring interests in the family business.