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Table of Contents
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BASIC CONCEPTS OF BUSINESS PLANNING
SOLE PROPRIETORSHIPS
What is the advantage of operating my business as a sole proprietorship?
What are the disadvantages of a sole proprietorship?
What type of income tax return do I have to file for my sole proprietorship?
Does a sole proprietor have to pay self-employment tax?
GENERAL PARTNERSHIPS
What is a general partnership?
Can one person operate a business as a partnership?
Does my general partnership agreement have to be in writing?
Should a partnership agreement be in writing?
What basic provisions should a properly written partnership agreement contain?
Am I liable for the debts and actions of my partners?
LIMITED PARTNERSHIPS
What is a limited partnership?
What are the main differences between general and limited partners?
Can I limit my liability as a general partner by creating a corporation to be general partner?
What are the duties of the limited partners?
How are a limited partnership's earnings taxed?
Are limited partnerships good estate planning vehicles?
It is easy to make limited partnership gifts?
If I am interested in creditor protection, why should I consider a partnership over a corporation?
How does a charging order work?
Are these limited partnerships the same as the ones I invested in during the 1980s?
Who should be the general partner of a limited partnership?
What about using a limited liability company as a general partner?
What is a management trust? Can it hold my general-partner interest?
REGULAR CORPORATIONS
How does a regular corporation differ from a sole proprietorship or a partnership?
What is the main disadvantage of a corporation?
What are the main advantages of a corporation?
What is the difference between a corporation and a general partnership?
Isn't there a lot of paperwork involved with having a corporation?
Are there any estate planning benefits to incorporating?
S CORPORATIONS
What is the difference between an S corporation and a regular corporation?
What are the requirements for an S corporation?
What advantages does an S corporation have over other business entities?
Do I have to decide whether to be an S corporation before I incorporate?
Can my friend's corporation be a shareholder of my S corporation?
If my living trust owns subchapter S stock after my death, will the S election be disqualified?
LIMITED LIABILITY COMPANIES
What is a limited liability company?
What does it take to form an LLC?
How many people are needed to form an LLC?
Are the LLC laws uniform among the states?
Why are LLCs better than regular corporations?
Why are LLCs better than S corporations?
Why are LLCs better than general or family limited partnerships?
Do you think that LLCs will replace general partnerships?
What asset protection planning is accomplished with an LLC?
Why isn't everyone using an LLC?
PROFESSIONAL CORPORATIONS
What if I am a professional and want to incorporate my practice?
I have a medical practice. Should I form a professional corporation?
Is there a way for me to transfer my professional corporation stock into a living trust?
BUSINESS CONTINUITY PLANNING
What is business continuity planning?
What planning concerns should I have as a business owner?
Is there really a need to continue the business?
How can I make advance plans for the designation of my business successors?
How can I provide for the protection of my spouse with the business assets?
Won't I qualify for the installment payment of estate taxes?
Are there problems with unrelated owners?
Can a fair price be easily established?
LIFE INSURANCE
How can I provide liquidity to pay for my obligations?
Are premiums paid on business life insurance deductible?
Are life insurance death proceeds exempt from income tax?
Are life insurance proceeds payable to a corporation subject to the alternative minimum tax?
I own a business with another person and understand that we should have an agreement providing that if one of us dies, the other will purchase the interest of the deceased owner. Also, I understand that we should probably have life insurance to pay for the buyout. Both of us want to maximize the amount that we receive from our business, and, most importantly, we want to maximize the amount our children actually receive. Should we purchase more insurance than we need to fund the business purchase agreement?
What are the basic types of buy-sell agreements?
What is the advantage of operating my business as a sole proprietorship?
A sole proprietorship requires the least amount of red tape in its formation. Because a sole proprietorship is owned by an individual proprietor, there are no formal filing requirements (there are some very limited exceptions in a few states).
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What are the disadvantages of a sole proprietorship?
A sole proprietorship is not generally conducive to tax planning, liability planning, or business succession planning.
Unlike a corporation, a limited partnership, or a limited liability company, a sole proprietorship offers no liability protection. A sole proprietor's exposure to outside creditors and business losses is not limited to the sole proprietor's investment in the business. A sole proprietor is personally responsible for business losses and claims of business creditors to the full extent of his or her net worth.
A sole proprietorship cannot survive the death of its owner. A sole proprietor may leave his or her business assets by will or trust to relatives or employees, but there is not assurance that the business will survive the proprietor's death.
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What type of income tax return do I have to file for my sole proprietorship?
A person doing business as a sole proprietor reports income and expenses on Schedule C of his or her federal income tax Form 1040.
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Does a sole proprietor have to pay self-employment tax?
If there is net income from the sole proprietorship in excess of $400, the proprietor is responsible for self-employment tax. The purpose of the self-employment tax is to provide Social Security benefits for the sole proprietor. An individual is allowed a deduction equal to 50 percent of the self-employment tax assessed in arriving at his or her adjusted gross income.
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Am I required to apply for an employer identification number if I operate my business as a sole proprietorship?
Your sole proprietorship is not required to apply for a federal employer identification number unless the business is going to pay wages to employees who are subject to federal withholding taxes. If the business has employees, it is required to apply for an employer identification number on a federal income tax form SS-4.
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What is a general partnership?
A general partnership is a business entity in which two or more persons or entities agree to capitalize a business venture for profit.
In a general partnership, the liability of the general partners is joint and several: they have unlimited personal liability for the debts and obligations ot the partnership, and each partner is authorized by law to bind the partnership in business transactions. This is true even if an individual partner does not have the actual authority to do so.
A general partnership is a flow-through entity. Profit or loss of the partnership will typically flow through to the partners according to their respective interests in the partnership on a percentage basis.
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Can one person operate a business as a partnership?
There must be at least two persons involved in the formation of a partnership.
Under the Uniform Partnership Act, person is defined as a natural person, partnership, corporation, limited liability company, or association. Partnerships of various business entities are a common occurrence in American enterprise.
In the absence of an agreement which states to the contrary, all of the partners have equal rights in the management of the partnership.
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Does my general partnership agreement have to be in writing?
If two or more individuals--by spoken or written words--consent to form a partnership, a partnership exists. A partnership contract can be created orally or in writing. Some states add statutory refinements to basic partnership rules.
For example, in New York, a partnership can be created by oral agreement, but if the partnership's terms are not capable of performance within a year, the partnership agreement must be in writing.
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Should a partnership agreement be in writing?
If you do not have a written partnership agreement, your state's laws have created one for you. If you know what your agreement is, but do not know the provisions of your state partnership law, it is advisable that you reduce your particular agreement to writing.
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What basic provisions should a properly written partnership agreement contain?
A partnership agreement should spell out the specifics of the relationship between the partners, including partner compensation, management responsibility, required contributions, and how profits and losses are to be shared.
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Am I liable for the debts and actions of my partners?
If their debts are partnership debts and their acts are partnership acts, you are 100 percent liable for them, just as you are 100 percent liable for your own.
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What is a limited partnership?
A limited partnership is a partnership that has both general and limited partners.
General partners control all of the business operations of the partnership and have full responsibility for its debts, liabilities, and obligations. They have unlimited liability with respect to partnership creditors.
Limited partners do not have control of the business operations of the partnership and have very limited or no voting rights. They are not responsible for the debts, liabilities, and obligations of the partnership. Their losses are limited to the amount of their investment in the partnership.
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What are the main differences between general and limited partners?
General partners have unlimited joint and several liability; limited partners are liable only up the their capital investment in the partnership.
General partners have total responsibility and control of the partnership business; limited partners have no responsibility or control
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Can I limit my liability as a general partner by creating a corporation to be general partner?
Professionals often suggest that a corporation serve as the general partner of a limited partnership. Because a corporation affords its shareholders limited liability, a corporate general partner further insulates the entrepreneur from the general partner's liability. The corporation, however, must have some assets other than its interest in the partnership.
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What are the duties of the limited partners?
Limited partners do not have duties. They contribute capital, and do not participate in the business of the partnership.
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How are a limited partnership's earnings taxed?
A limited partnership is a flow-through entity; its profits and losses flow through to the general and limited partners in accordance with their proportionate ownership percentages.
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Are limited partnerships good estate planning vehicles?
Limited partnerships are an excellent business form to use in transferring assets to family members at discounted values for purposes of federal estate and gift taxes.
This is so for a number of very important reasons. Parents and grandparents can:
- Transfer significant percentages of their ownership interests to other family members and, as general partners; still maintain control of the partnership's affairs.
- As general partners, make all management decisions, receive compensation for making those decisions, and do so with as little as 1 percent or less of the partnership's ownership.
- Give limited-partner interest to succeeding generations at discounted values often averaging 30 to 50 percent of fair market valuations.
- Protect family members from the claims of partnership creditors.
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Do gifts of limited-partner interest qualify for the annual exclusion, lifetime exemption, marital deduction, and minority discounts?
Gifts of limited-partner interests can qualify for all of these tax benefits.
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It is easy to make limited partnership gifts?
Gifts of limited-partner interests are easy to make because fractional interests can be given. For example, a gift of 1/100 of a real estate section can be easily computed and made by deeding that fraction of the real estate to a family member as a 1 percent limited-partner interest.
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If I am interested in creditor protection, why should I consider a partnership over a corporation?
Because the Revised Uniform Limited Partnership Act (RULPA) provides that the assets of a partnership can be seized only through a charging order, many people favor it over corporations when they are trying to attain creditor protection.
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How does a charging order work?
RULPA provides that a charging order may be obtained by the judgment creditor of a partner against that partner's distributive share of the partnership. A charging order will attach to whatever distributions the partner receives from the partnership. If he or she does not receive a distribution, it will not attach to anything.
Under federal income tax law the holder of the charging order is deemed to be in constructive receipt of the partnership's income, and the creditor will be taxed on that income proportionate to the interest attached by the debtor partner. If the debtor is deemed to own 40 percent of the partnership, the creditor will be charged with receiving 40 percent of the partnership's income even though that income is not distributed. As a result, the creditor will receive phantom income--income that is not received--upon which taxes will have to be paid for as long as the charging order stays in existence.
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Are these limited partnerships the same as the ones I invested in during the 1980s?
No, they are not. The limited partnerships that were so popular in the 1980s where used primarily for purposes of raising capital with the promise of tax write-offs that were often much greater than the amount of the investment behind them. They most often resulted in the loss of their investors' capital and were driven by tax greed rather than basic investment economics.
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Who should be the general partner of a limited partnership?
There is no one right answer to this question. The general partner could be an individual, a revocable or irrevocable management trust, a limited liability company, or a corporation. Each of the proposed entities has the advantages or disadvantages associated with that entity's use in business planning in general.
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What about using a limited liability company as a general partner?
Many tax planners would agree that--state law permitting--a limited liability company provides the best balance of creditor protection and tax planning without undue red tape and complications.
Thus, if permitted by state law, limited liability companies make excellent general partners. They give protection from creditors just as corporations do, but they allow all income to pass through to their members just like a partnership's income flows to its partners.
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My attorney and CPA suggested that I create a regular C corporation to be the general partner of my limited partnership. Were they wrong?
Many of the wonderful fringe benefits afforded to shareholder managers of closely held regular corporations have been legislated out of existence. Today's corporation is no longer the ultimate tax shelter it was advertised to be in the 1970s. Professional advisors seem to prefer the limited liability company as a more effective general partner for additional liability protection.
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What is a management trust? Can it hold my general-partner interest?
A management trust is a trust which is created solely to avoid the problems that can occur when a general partner dies or becomes mentally incapacitated. It provides continuance of the partnership for liquidation or court proceedings.
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How does a regular corporation differ from a sole proprietorship or a partnership?
The owners of the corporation own stock in the corporation and are referred to as stockholders or shareholders. Since the corporation is a separate legal entity, it is also a separate taxpaying entity.
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What is the main disadvantage of a corporation?
Because a regular corporation is a separate taxpaying entity, it is possible that the earnings of the corporation are subject to double taxation: the corporation pays taxes on any income it earns, and when the earnings are distributed to individual shareholders, the earnings are taxed again at the shareholders' regular personal income tax rates. The combination of corporate taxation and individual taxation is a major weakness in corporate planning.
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What are the main advantages of a corporation?
Corporations have traditionally offered three primary advantages, but over the years the situation ha been changing:
For may years corporations provided fringe benefits to executives that they could not obtain anywhere else. Because of several punishing tax acts over the past 30 years, many of these fringe benefits have been limited or eliminated.
The ability to shield or protect individual shareholders from various creditors or business losses used to be exclusive to corporatins. With the advent and popularity of limited liability companies and limited partnerships, this is no longer the case. Limited liability companies and family limited partnerships can provide the same creditor protection as corporations without the attendant tax disadvantages.
Many corporations were created purely for their business succession attributes since they can exist perpetually. Once again, however, family limited partnerships and limited liability companies can provide like benefits without the administrative headaches that so often result from doing business as a corporation.
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How are corporations created?
Corporations are created by filing a Certificate of Incorporation or Articles of Incorporation with the Secretary of State in the state in which the corporation wishes to be located. The state laws in whichever state the corporation operates determine what statutory powers the corporation has as a business entity.
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What is the difference between a corporation and a general partnership?
A corporation is a fictitious entity which, for legal purposes, is considered separate and apart from its shareholders. One person can form a corporation and be its sole shareholder, or a corporation can have hundreds of thousands of shareholders, like IMB does. One reason for forming a corporation is to enable the individual shareholders to avoid personal liability. The corporation is controlled and managed by the board of directors, who are elected by the shareholders.
A partnership, on the other hand, is an association of two or more persons who combine their money, labor, or skill for a lawful business purpose. Partners divide the profits and losses according to certain proportions. Unless otherwise agreed, each partner, regardless of his or her capital contribution and regardless of his or her stake in the profits or losses, has an equal say in the management of the partnership.
Generally, a corporation will give it shareholders limited liability, whereas a general partnership does not afford its partners this same protection. In a general partnership, each partner is jointly and severally liable for the torts of the partnership and jointly liable for the contracts of the partnership. This means that each partner's personal assets are subject to any third-party claims against the partnership. The unlimited liability of partners versus the limited liability of corporate shareholders is a key difference between a general partnership and a regular corporation.
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Isn't there a lot of paperwork involved with having a corporation?
While it is true that there is more paperwork and red tape in forming and maintaining a corporation, the promise of limited liability often overrides the administrative inconvenience and professional costs of forming and keeping a corporation current.
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Are there any estate planning benefits to incorporating?
Incorporating affords creditor protection through limited liability and ensures the perpetual existence of a corporation, both of which are pluses to an estate plan. Corporate shares of stock are easily given to others, and corporate management structures are complementary to succeeding generations who may own, but not be active in, the corporate business.
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What is the difference between an S corporation and a regular corporation?
An S corporation is formed like a regular corporation. The major difference between an S corporation and a regular corporation is that the Internal Revenue Code provides that "a small-business corporation" may elect not to be taxed at the corporate level but, rather, to have the corporation's income and losses pass through to the shareholders and be taxed to them.
S corporation income is passed through to the shareholders proportionate to their ownership of the corporation's shares. Thus, an S corporation is a tax pass-through business entity for federal income tax purposes, much like a sole proprietorship or partnership.
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How do I make an S election?
The election to be taxed as an S corporation is made on Form 2553 of the Internal Revenue Service. Form 2553 must be completed and filed with the Internal Revenue Service at any time before the sixteenth day of the third month of the tax year; if filed during the tax year the election is to take effect, or at any time during the preceding tax year. Thus, if the corporation determines to elect subchapter S taxation and has adopted July 1 to June 30 as its taxable year, the election may be made at any time during the preceding fiscal year or by September 15 for the present year.
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What are the requirements for an S corporation?
In order to elect to be an S corporation:
- There must be no more than thirty-five shareholders.
- Shareholders must be natural persons, an estate of a natural person, or certain trusts.
- There must be only one class of stock.
- A nonresident alien cannot be a shareholder.
- The S corporation may not own 80 percent or more of the stock of any other active corporation and retain its S status.
- It cannot own a whole owned subsidiary.
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What advantages does an S corporation have over other business entities?
S corporations do not pay double tax because their income and losses flow through directly to their shareholders. They can be owned and created by a single individual, and they have a vast body of federal law behind them which is recognized in every state.
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Do I have to decide whether to be an S corporation before I incorporate?
You do not need to tell the Secretary of State whether the corporation is to be a regular C corporation or an S corporation. The election to be taxed as an S corporation is relevant only for income tax purposes.
Corporations are automatically taxed as regular corporations under subchapter C unless the corporation elects to be taxed under subchapter S. A corporation which is originally taxed under subchapter C can later elect to be taxed under subchapter S, and vice versa, by filing the appropriate election with the Internal Revenue Service.
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Can my friend's corporation be a shareholder of my S corporation?
A corporation cannot be a shareholder of a subchapter S corporation. Only individuals can hold S corporation stock.
In your particular case, you should consider a limited liability company as a viable organizational alternative. Limited liability company statutes allow corporations to be members (owners) and also allow income and loss to be allocated among the members pro rata to their contributions.
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If my living trust owns subchapter S stock after my death, will the S election be disqualified?
A revocable living trust which is owned by an individual who is a citizen or a resident of the United States qualifies to own S corporation stock because it is a grantor trust.
Another type of trust, called a qualified subchapter S trust (QSST) can also hold S corporation stock. The QSST must provide that all of its income will be distributed to a beneficiary, and under a recent private letter ruling, it may provide that a beneficiary can elect to have the trustees retain all or part of its net income.
A QSST may not allow payment of principal to anyone other than an income beneficiary, even if the trust first disposes of the S stock. If a QSST is created, notice must be given to the Internal Revenue Service, and the notice must contain the following:
- Name, address, and taxpayer identification number of the current income beneficiary, the trust, and the corporation.
- Identification of the election under the Internal Revenue Code.
- Specification of the date on which the election is to become effective.
- All information necessary to show that the current income beneficiary is entitled to make the election.
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What is a limited liability company?
A limited liability company (LLC) is a hybrid business entity that possesses certain attributes associated with corporations and certain attributes associated with partnerships.
Instead of partners or shareholders, the LLC has members. Members enjoy limited liability regardless of whether they participate in the day-to-day affairs of the business. This means that LLC members can participate in the management and control of the business without risking their personal
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What does it take to form an LLC?
Because LLCs are so new and because the laws differ so dramatically from state to state, you will need to check with an attorney in your state to determine the rules and regulations for establishing an LLC.
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How many people are needed to form an LLC?
While under some state statutes only one member is needed to create an LLC, it is recommended that you always begin the formation of an LLC with two or more members.
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Who can be an LLC member?
Unlike the S corporation, an LLC has no restrictions as to the type or character of its members. This means that any person or entity can be a member of an LLC. An LLC can have corporate wholly owned operating subsidiaries and can create different classes of ownership interests and different priorities within or among different classes of owners.
Unlike the partners in a limited partnership, LLC members can participate in the management and control of the LLC's activities without risking limitation on their personal liability. This allows LLC members to materially participate in the LLC's activities and currently deduct LLC losses and deductions that otherwise might be suspended in a limited partnership.
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Are the LLC laws uniform among the states?
The laws regarding LLCs are not uniform among the states. One of the major areas of difference involves whether or not the entity will be classified for federal income tax purposes as a corporation or a partnership. The Internal Revenue Service has looked at the limited liability company statutes of several of the states and has classified the statutes as partnership statutes or as flexible statutes. For example, under Colorado's limited liability company statute, an LLC can be taxed only as a partnership. In this regard the statute is deemed to be a "bulletproof:" partnership tax statute. On the other hand, the Kansas limited liability company statute is referred to as a flexible statute: the drafter of the LLC can organize the company in such a way that it can be taxed either as a regular C corporation or as a partnership.
The test that the IRS applies to determine whether the LLC will be taxed as a corporation or as a partnership includes an analysis of the following:
- Limited liability
- Continuity of life
- Centralized management
- Free transferability of interests
If an entity lacks two or more of these characteristics, it will be taxed as a partnership.
Obviously, limited liability companies have limited liability as the essence of their existence. The drafter of the entity can then choose from among the other characteristics the two that he or she does not want the entity to have.
It is relatively easy not to have free transferability of interests by putting restrictions on the trading of shares. It is also easy to provide in the LLC agreement that any interest in the LLC must first be offered back to the LLC or that the transfer has to be approved by the unanimous vote of all company members.
Continuity of life is another test that is relatively easy to accommodate. Any provision that the company will end upon the death of a member closely resembles a partnership characteristic. It is also possible under some states' statutes to provide that if all of the remaining members vote to continue the entity, it will be continued and does not have to be reconstituted as is required with a partnership. Such a provision does not give the entity the characteristic of a corporation.
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Why are LLCs so popular?
They are popular because they have the best attributes of each of the other business entities currently in existence.
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Why are LLCs better than regular corporations?
An LLC is free from the double-taxation burden of regular corporations. It avoids unreasonable compensation issues and unreasonable accumulation earnings tax issues. It also avoids many of the corporate formalities.
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Why are LLCs better than S corporations?
LLCs are not limited in the number or type of owners. Moreover, an LLC can elect a pro rata step-up of inside basis upon the death of an LLC member. This means that if a member dies and his or her LLC interest receives a step-up in basis, the LLC can elect to allocate the step-up among the LLC's assets. After initial formation, LLCs can receive encumbered property and include their debt or liability in the bases to the LLC without recognizing a gain, compared to an 80 percent ownership requirement for subchapter S shareholders.
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Why are LLCs better than general or family limited partnerships?
An LLC's members can limit their liability to the extend of their investment even if they participate in the management of the company. General partners always remain liable to creditors or for partnership debts.
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Do you think that LLCs will replace general partnerships?
The limited liability company and it counterpart, the limited liability partnership, should replace most existing general partnerships. There is very little advantage to having a partnership in which all of the partners are liable for all the debts of the partnership and all of the acts of each of the other partners.
In addition, the limited liability company has the advantage of being managed like a partnership. Each of the members may have management authority if the state statutes allow such a management style and if it is in fact chosen by the members.
Also, by delegating management to one individual who would be classified as active and materially participating in management, other members may be determined not to be materially participating in management. Under the proposed regulations for limited liability companies, anyone not actively participating in management would not be deemed to have earned income or self-employment income from the LLC. This has a positive tax effect for those members who are seeking to avoid self-employment taxes or to avoid being disqualified for their Social Security retirement benefits.
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What asset protection planning is accomplished with an LLC?
An LLC can be structured for tax purposes much like a general partnership but can retain liability protection for the members. As with a corporation, the assets of the limited liability company would be subject to judicial process by any creditor of the company. The assets of the individual members would be protected from liability of the LLC, and the assets of the LLC would be protected from the liability of the debts of its members.
An LLC is an excellent candidate for general partner in a family limited partnership in that it has strong control characteristics and no adverse income tax consequences.
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Why isn't everyone using an LLC?
The lack of development of case law in this area has caused some practitioners to she away from recommending the LLC until it becomes better known and is tested in the courts.
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If my business associates and I desire to allocate business income and loss among us on a basis that may differ from our cash investment, what type of entity would you recommend?
You should consider either a limited partnership, general partnership, or limited liability company. You could consider a C corporation if you know just how you desire to allocate and are willing to create multiple classes of shares.
An S corporation would not be an alternative because all allocations of income and loss are pro rate by law, based upon the shareholders' interest. The IRS allows such entities to distribute items of income and deductions in ways other than on a pro rata basis. However, there are specific rules on how and under what circumstances this can be achieved.
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What if I am a professional and want to incorporate my practice?
Professional corporations are creations of state statutes that permit certain professionals--such as doctors, dentists, lawyers, architects, and engineers--to run their practices as corporations. Whether or not a professional corporation is a C or S corporation is purely a tax decision.
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I have a medical practice. Should I form a professional corporation?
If you practice with one or more other physicians, it is very important for you to form a professional corporation or limited liability company in order to protect your liability. In partnership law, the liability is "joint and several", so if you do not incorporate, each partner is liable for the malpractice of any of the other partners. All of your personal assets will be subject to a malpractice claim against any one or more of your partners, even if you were not involved in the patient's case.
However, if you all form a professional corporation and become its shareholders and employees, or form a partnership of professional corporations, or form a limited liability company, you will protect your liability. In the case of a malpractice claim against one doctor, the physicians who are not involved in the matter will not be liable and their personal assets will be protected from a lawsuit predicated upon the practice mistakes of a colleague.
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Is there a way for me to transfer my professional corporation stock into a living trust?
If the trustee who holds the license to practice is sole trustee during his or her lifetime, there is a strong argument that this satisfies any state statute.
In addition, your living trust can provide that if you become disabled, the successor trustees can immediately appoint a special professional trustee--who holds the required license--to take title to your stock.
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What is business continuity planning?
It is planning that is calculated to keep closely held businesses going upon the death or disability of their founders and/or leaders.
Closely held businesses face many problems when principals die, become disabled, or resign. These problems can arise when the business is entirely held by family members and also when the business is held among unrelated individuals. The problems are often so severe that only about 30 percent of closely held businesses survive the death of their founders.
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What planning concerns should I have as a business owner?
The primary planning concerns for all business owners, particularly those who are nonrelated owners of the same business, are:
- Ensuring a market to purchase their stock or other business interest at retirement, death, and substantial disability.
- Providing funds for the purchase of the business interests of all of the principals
- Keeping "unwanted partners" such as competitors or nonessential family members from becoming business partners.
In addition to dealing with the above concerns, family businesses must make plans to effectively continue the operations of the business, designate business successors, provide surviving spouses and children with sufficient assets, and provide sufficient liquidity for the payment of estate tax obligations so that the business will not have to be liquidated to pay those taxes.
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Is there really a need to continue the business?
In most family businesses, the business is built upon the personality, marketing, and operational talents of the principals. The absence of a principal creates a major void. While the grief-stricken family seeks to fill that void, customers will have concerns and may go elsewhere.
Post-death or disability problems are often complicated by internal family rivalry and disputes as tot the ownership, control, and operation of the business.
In many states, unless specific authorization is provided to operate a business, the executor (or agent under a power of attorney) can only wind down the business.
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How can I make advance plans for the designation of my business successors?
Ideally, families want children to share equally in the family wealth. However, all children might not have the same interest in participating in the family business or might not be in circumstances that enable them to do so. If one particular child remains in the family business, advance planning is necessary to provide that child with the control and/or ownership needed to successfully operate the business. If one child is active and the others are passive in matters of the family business, the situation is a likely breeding ground for family dissension.
Advance planning should include leaving other or replacement assets, including the benefits of life insurance trusts, to create equality among the children. Additionally, in drafting the estate planning documents, care should be taken to avoid placing a disproportionate estate tax burden upon the children who do not receive the business.
If more than one child will be involved in the family business, the issue of roles and control should be resolved by the family prior to losing the services of the leader parent. Dissension among children could destroy the business and might also adversely affect the family unit. Advance decisions could mitigate or avoid these problems.
Advance planning should also include providing necessary legal authority to continue the business; determining how business decisions will be made and who will make them; instituting early involvement of family members in customer public relations; and providing for funds such as "key person" insurance to provide needed capital during the business hiatus.
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How can I provide for the protection of my spouse with the business assets?
The small-business owner frequently invests profits back into the business, and over time this causes the business to become the major asset in the decedent's estate. If the business owner desires to pass his or her business to children, arrangements must be made to provide sufficient replacement resources for the benefit of the surviving spouse. Advance planning for the purchase of life insurance, as well as preparation of installment sale notes, private annuities, and self-cancelling notes, is essential.
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Are taxes a problem?
Federal estate taxes are a major problem in conjunction with business continuity planning. Often, the family business is a major asset of the estate, and estate taxes are due, in cash, 9 months after the date of death or can be deferred in a few ways. If the business is typical, it will most probably be difficult to value and buyers will not easily be found even at a reasonable asking price. Without business continuity planning, there is every likelihood that the business might have to be sold at a fire-sale price.
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Won't I qualify for the installment payment of estate taxes?
Any business that is 35 percent or more of an estate will qualify for the installment payment of estate taxes. This exception applies only to the first $1 million of business value, and the tax must nevertheless be paid over a 14-year-period with interest. However, only interest is paid, at the rate of 4 percent, for the first 4 years. Thereafter, principal is reduced each year, and interest is paid at the current statutory rate.
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Are there problems with unrelated owners?
There can also be problems with unrelated owners. When an owner dies, his or her heirs often do not want the deceased owner's family in the business. Most generally, the remaining principals do not have the liquidity necessary to buy the deceased owner's shares, and the respective sides have widely divergent views as to the value of the interest in question.
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Can a fair price be easily established?
Even if cash were available, how will a fair price for the deceased owner's shares be determined? Bitter disputes and hurt feelings can result if the terms of a buyout have not been negotiated in advance. In addition, an S election can be ruined if transfers of stock are not controlled and proper provisions for its repurchase are not in place.
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How can I provide liquidity to pay for my obligations?
If your spouse is to continue your business, its value will be included in his or her estate. If liquidity is not otherwise provided, the business may have to be sold or heavily leveraged in debt to cover the resulting federal estate tax obligation. Life insurance planning needs to be discussed early in such a situation.
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Can I purchase life insurance in an irrevocable trust and then let my family liquidate the family business?
This is a meaningful but often overlooked alternative. If you do not have partners who you wish to have the business upon your death, the combination of life insurance and liquidation could be your best alternative. You can make gifts to an irrevocable life insurance trust that purchases life insurance on your life equal to the value of your closely held business interest. Upon your death, the proceeds will be available for your spouse and children and will pass tax-free to your children upon your spouse's subsequent death.
With this approach, your family members can liquidate your business interest and add the proceeds to the insurance benefits they have already received. The tax on the liquidated value of your business interests will be directly proportionate to their liquidated value and might very well play your estate into significantly lower brackets.
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Are premiums paid on business life insurance deductible?
The Internal Revenue Code provides that no deduction is allowed for premiums on life insurance/
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Are life insurance death proceeds exempt from income tax?
The entire benefit paid to the beneficiary is exempt from the beneficiary's income taxes. However, if an existing policy is sold or otherwise "transferred for value", the proceeds may not be exempt from federal income tax.
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Are life insurance proceeds payable to a corporation subject to the alternative minimum tax?
If the corporation is an S corporation, the proceeds received are not subject to the AMT calculation. If it is a regular corporation, however, the proceeds are subject to the AMT calculation.
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I own a business with another person and understand that we should have an agreement providing that if one of us dies, the other will purchase the interest of the deceased owner. Also, I understand that we should probably have life insurance to pay for the buyout. Both of us want to maximize the amount that we receive from our business, and, most importantly, we want to maximize the amount our children actually receive. Should we purchase more insurance than we need to fund the business purchase agreement?
All of these are basically good ideas. However, you must be aware that the value of your interest in the business will be included in your estate for federal estate tax and other death tax purposes. Thus, the higher the value placed upon the business interest, the more the taxation. If you and the other owner artificially inflate the value of your respective business interests, up to 55 percent of that value could pass directly to the government due to federal estate tax.
Assuming that the other owner of the business is not a family member, one recommendation would be to put the lowest possible value on the business interest, especially if the buyout is to be funded by life insurance.
Assume that your interest in the business is worth between $750,00 and $1 million. If the other owner agrees to buy your interest at your death for $1 million, he or she will have an equal funding need when purchasing life insurance on your life. Your business interest will be included in your gross estate at a value of $1 million. At potential federal estate tax rates of 55 percent, your family members may end up getting as little as $450,000.
If, however, you value your interest at $750,000, the federal estate tax savings will be $138,000. The money saved by funding the buyout with $750,000 of life insurance rather than $1 million of life insurance could be used to purchase a second insurance policy on your life in the amount of $250,000. This second life insurance policy would be for the benefit of your family, and it would be owned by an irrevocable trust referred to as on ILIT or wealth replacement trust. The ILIT will be the beneficiary, and the benefits will not be subject to estate taxation. Thus, your family will receive all $250,000 of the proceeds from the second life insurance policy.
In the end, by valuing your business interest at $750,000 instead of $1 million, and by utilizing an ILIT, your family will receive $587,500 ($337,500 from the buyout plus $250,000 from the ILIT) rather than $450,000--an additional benefit of $137,500 without a dime of additional cost.
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What are the basic types of buy-sell agreements?
The three basic types of buy-sell agreements are stock redemption agreements (entity purchase agreements in the case of a partnership or LLC), cross-purchase agreements, and hybrid purchase agreements.
A stock redemption agreement is made between the individual shareholders and the corporation. The individual shareholders agree that upon the occurrence of a triggering event such as the death of a shareholder, they are obligated to offer their respective stock ownership for sale to the corporation. The corporation is likewise obligated to "redeem", or purchase, the stock. The agreement is usually funded by insurance owned by the corporation on the life of each shareholder.
A partnership can buy back a partner's interest through a similar method often referred to as an entity purchase agreement. With this type of agreement, the partnership often purchases life insurance on the lives of the partners and is the beneficiary of that insurance. On a partner's death, the partnership purchases the interest of that partner with the funding provided by the insurance. The result is that the partnership is owned by the remaining partners and the deceased partner's family has cash based upon a predetermined value of the partner's interest. Members of limited liability companies would follow this identical planning pattern.
A cross-purchase agreement is made between the individual shareholders, partners, or members rather than between them and their business entity. With a cross-purchase agreeme4nt, upon the death, disability, or retirement of a principal, the remaining principals are personally obligated to purchase the business interest on a pro rata basis. In cross-purchase agreements, each shareholder usually owns a life insurance policy on the lives of the other business principals. Cross-purchase agreements step up the basis of the purchasing partners to the cost of their purchase.
A hybrid purchase agreement combines both redemption and cross-purchase features. It is referred to as a wait-and-see agreement, as it enables the remaining shareholders to determine whether the corporation has sufficient funds to make the purchase or whether the purchase should be made by the shareholders. With this agreement, life insurance is generally owned by the shareholders and the selling shareholder is required to first offer the stock to the corporation. If the corporation declines to make the purchase, the shareholders are obligated to make the purchase.
By selection hybrid agreements, either the business or the business principals can own life insurance purchased as a funding vehicle.
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Which is preferable, a stock redemption (or entity purchase) agreement or a cross-purchase agreement?
There are several tax and practical factors affecting this decision, but the primary tax issue is for the purchaser to be able to qualify for capital gain taxation rather than ordinary-income treatment on the subsequent sale of his or her business interest. For example:
In starting a business, Able & Baker each contribute $10,000 for 5,000 shares of stock. At the time Able dies, the fair market value of the stock has doubled. If the corporation redeems the stock from Able at his death, Baker will control a $40,000 business but have only a tax basis of $10,000. If a cross-purchase is involved, Baker will purchase the stock at $20,000 and have a $30,000 basis (Baker's $10,000 plus Able's $20,000), which will reduce the gain when the stock is subsequently sold.
Frequently, the controlling practical consideration pertains to funding the buy-sell agreement. Buy-sell agreements are primarily funded with life insurance on the lives of the shareholders or partners. If there are only two shareholders or partners, a cross-purchase agreement can be used, with each owning a life insurance policy on the other. If there are multiple shareholders or partners, it may be simpler for the corporation or other business entity to own the policies. Life insurance owned buy a C corporation is subject to the alternative minimum tax, wile life insurance owned buy individual shareholders is not subject to AMT.
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Copyright © 2007 [ESTATE & BUSINESS LAW GROUP, P.C. All
rights reserved.
Revised:
03/19/12.
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Libertyville, IL 60048
Phone (847)367-4460
FAX (847)367-0090
©2011 Estate & Business Law Group, P.C.