Estate Planning for the Closely-Held Business. Presented By: Thomas J. Collura, Esq. and Joseph T. La Ferlita, Esq.

Transcription

1 Estate Planning for the Closely-Held Business Presented By: Thomas J. Collura, Esq. and Joseph T. La Ferlita, Esq.

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3 NEW YORK STATE BAR ASSOCIATION Trusts and Estates Law Section Fall Meeting September 14, 2017 ESTATE PLANNING FOR THE CLOSELY-HELD BUSINESS Thomas J. Collura, Esq. Hodgson Russ LLP Albany, New York Saratoga Springs, New York Palm Beach, Florida (518)

4 TABLE OF CONTENTS I. OVERVIEW... 1 II. ESTATE PLANNING CONSIDERATIONS Introduction Choice of Entity... 2 A. Forms of Business... 3 B. Business Considerations... 3 C. Financial Considerations... 6 D. Tax Considerations General... 6 E. Fringe Benefits and Deferred Compensation... 9 F. Debt Financing Distinctions Between S Corporations & LLCs G. Entity Classification; Check-the-Box Regulations H. Termination of a Business Entity Business Succession A. Dispositions of Business Interests upon Death B. Transfers to Family Members C. Transfers to Non-Family Disability Planning III. ESTATE ADMINISTRATION Dispositions of Business Interests at Death Taxation A. Estate Tax B. GST Tax C. Income Tax - Generally D. Fiduciary Income Tax and Accounting Concepts Appendix A 31 Appendix B 33 i

5 ESTATE PLANNING FOR THE CLOSELY-HELD BUSINESS I. OVERVIEW Estate planning and administration for a closely held business presents many unique challenges and opportunities for owners and their advisors. The challenges are unique since business owners are faced with the difficulty of planning for the financial and personal impact of death or disability upon their family, as well as the impact such events have upon co-owners, employees, the business and its customers or clients. For most closely held business owners, the decision-making process is not governed by purely financial, business and tax considerations. Instead, the process is often complicated by many competing personal and family issues, particularly where the business was founded by the owner or inherited from other family members. As a result, the business is often thought of as a living entity that many business owners want to survive both for the benefit of their employees, clients, customers, etc. and also as a testament to their life s work. There are many difficult questions to be answered by business owners and their advisors, including: What is the best form of entity for the business? Who should be transferred equity and/or control of the business? When should any transfer occur? How should any transfer be structured? How do you value a business interest? What are the legal requirements and restrictions on such transfer? What are the tax consequences upon any transfer during life or at death? Will there be sufficient liquid assets to fund any payment due the owner or for taxes? The answer to these questions will vary based upon a multitude of personal and business factors including the age, health and personal desires of the business owner, the nature of the business, the legal structure of the business, the existence of any agreements among co-owners or others, and the proposed business succession plan, i.e. the plan to transfer the business to family, management or others. Given the complexity of these issues, proper planning and administration of estates of business owners requires legal knowledge and experience in a multitude of disciplines, primarily business, tax and trusts and estates. This often will require the coordination of several attorneys with expertise in each of these areas of practice, as well as consultation with accountants, business valuation experts and other financial advisors. 1

6 The purpose of this outline is to identify some of the business, tax and estate issues that should be addressed during both the estate planning and administration process and provide a broad overview of the many business, tax and estate considerations necessary to properly advise the owner of a closely held business. These materials focus upon owners of operating businesses but are also applicable to owners of real estate and real estate entities. Additional planning considerations for professionals, e.g., physicians, dentists, attorneys, accountants and other licensed professionals, is not addressed. Moreover, most of the issues relate to owners who have majority control of the business, but they may also apply to minority owners who provide significant services or resources to businesses. Section II provides a big-picture overview of estate planning considerations (and, as such does not cover all the details of more sophisticated transfer tax planning concepts and techniques). Likewise, Section III provides a big-picture overview of estate administration issues (again, without covering in detail all of the fiduciary and tax considerations related to an estate with closely held business interests). Each business owner s situation is different and requires more detailed and sophisticated analysis and planning. II. ESTATE PLANNING CONSIDERATIONS 1. Introduction Estate planning for the owner of a closely held business encompasses all of the usual estate planning considerations, including: Federal and state income, gift, estate and generation-skipping transfer ( GST ) tax planning; Life insurance planning; Review of forms of ownership and beneficiary designations; and Preparation of wills, trusts, powers of attorney ( POAs ), and health care proxies ( HCPs ). Since these general planning considerations are the topic of many general estate planning courses and materials, they are covered in these materials only to the extent they relate to planning for the disposition of an interest in a closely held business. The critical difference in planning for the business owner is that planning is needed concerning the ownership, management, operation and succession of the business. These business planning consideration are examined below. 2. Choice of Entity Perhaps the most important decision for a business owner is the choice of entity to operate the business. There are many factors that must be weighed, examined and reevaluated to accomplish the business owner s current and future concerns regarding ownership, management, operation and succession of the business. The following is a summary of various choices of entity and the business, financial, tax and other factors to consider in choosing the business form. 2

7 A. Forms of Business 1. Sole Proprietorship A business conducted in an individual owner s capacity; not a separate business entity for federal tax purposes Partnership (General or Limited) An association of two or more persons carrying on a business for profit; a separate entity for federal tax purposes S Corporation A type of corporation where shareholders elect to have corporate level income treated as directly received by shareholders C Corporation A type of corporation created under state law that is separate and distinct from its owners; may be subject to double taxation Limited Liability Company ( LLC ) A hybrid entity created under state law that generally combines the liability protection of a corporation with the federal tax benefits of a partnership. 5 B. Business Considerations 1. Limited Liability Available with a corporation, a limited liability company, and for limited partners in a limited partnership, but not for general partners. Note, however, a general partner admitted into a pre-existing partnership is only personally liable for obligations incurred after his or her admission. 6 Corporation: A shareholder is not personally liable beyond the amount of his or her investment. LLC: A member has limited personal liability, even if a member is designated as a manager. 7 Limited Partnership: A limited partner is only liable to the extent he or she contributed capital. 8 1 See Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945) (this case established the rule that a proprietorship is not a separate taxable entity). 2 See Uniform Partnership Act 6(1) (1914). 3 See The Internal Revenue Code of 1986, as amended ( I.R.C. ) See I.R.C. 1361(a)(2). 5 See New York Limited Liability Company Law ( N.Y.L.L.C. ) 102(m); see also Limited Liability Companies FAQs, available at 6 See Revised Uniform Partnership Act 306(b) (1997). 7 See Uniform Limited Liability Company Act 303 (1996). 8 See Revised Uniform Limited Partnership Act 303 (2001). 3

8 For liability considerations, determine: Is adequate insurance available? At a reasonable cost? If not, consider using a corporation or LLC. Limited liability of corporate shareholders and LLC members may not exist for certain liabilities or certain shareholders (or members of an LLC), especially where they are responsible officers of the corporation. See, e.g., I.R.C. section 6672 and N.Y. Tax Law sections 1131(1) and 1133(a), which impose personal liability for certain withholding taxes. See also N.Y. Business Corporation Law ( B.C.L. ) section 630, which imposes personal liability for certain wages. In addition, a manager of an LLC may be personally liable to LLC members if he or she fails to act in good faith or meet the conduct for governing outlined in the articles of organization. See N.Y.L.L.C. sections 409, Centralized Management Management can be concentrated in a board of directors of a corporation or in the general partners of a limited partnership. If a limited partner participates in the management or control of a partnership, he or she may risk the loss of limited liability status. 9 In a general partnership, centralization may be more difficult but may be possible, to an extent, through designation of a managing partner or through other devices. An LLC will normally appoint managers and thus achieve centralization of management. In New York, unless the operating agreement provides otherwise, LLCs are considered to be member-managed LLCs, meaning each LLC member is deemed to participate equally in the management process. See N.Y.L.L.C. section Investors Requirements of investors may influence the choice of entity. Will the group of investors be large or small? Will they be active in the operation of the business? Some may want votes while others may want a preferred return on investment. Some may want full participation plus limited liability. Although classes of partnership and LLC interests can be used to accomplish certain objectives, if the number of investors is large or the objectives are varied, classes of corporate stock may be more desirable. Stock can be voting or nonvoting, preferred as to dividends, liquidating distributions or redemptions, cumulative or noncumulative as to dividends, convertible into other classes of debt or equity, etc.. 4. Transferability Generally, investors prefer transferable or marketable interests. Shares of a corporation are usually more readily transferable than partnership interests or LLC membership interests, although transferability may be reduced, as a practical matter, because of buy-sell agreements or the closely held nature of a business. Generally, the shares of a corporation are freely transferable by sale or gift. In contrast, when a general or limited partner sells his or her right in a partnership, the transferee usually obtains only economic rights (e.g., rights to a share of partnership profits). The transferee does not gain management control within the partnership unless admitted by a partnership vote. 10 Under most circumstances, transfer of an LLC membership interest is subject to the same restrictions as a transfer of a partnership interest. 11 In New York, for example, an LLC 9 See id. 10 See Revised Uniform Partnership Act 502, 503 (1997). 11 See Uniform Limited Liability Company Act

9 member may assign his or her membership interest, but the assignee does not become an LLC member unless he or she gains approval through written consent or by a majority vote. See N.Y.L.L.C. sections Continuity The death of a partner or member may terminate a partnership or LLC, but the death of a shareholder does not affect a corporation s legal status. A corporation exists in perpetuity unless the corporation s articles of incorporation specify otherwise. 12 But note that a corporation may lose its franchise due to unexpected problems such as failure to pay its state franchise taxes for two consecutive years (N.Y. Tax Law section 217), exceeding its legal authority (N.Y.B.C.L. section 101(a)(2)), a deadlock of directors or shareholders (N.Y.B.C.L. section 1104), oppressive action by those in control directed against complaining shareholders (N.Y.B.C.L. section 1104 a), etc. A partnership continues for the term identified in its partnership agreement. 13 Likewise, an LLC continues for the term identified in its articles of organization. 14 Similar to a corporation, aggrieved LLC members may petition for judicial dissolution of an LLC. See N.Y.L.L.C. section 702 (portions of the N.Y.B.C.L. may be considered in determining dissolution by operation of law. See N.Y.B.C.L. section 1104) Nature of the Business Partnerships are often used for small businesses, tax preferred investments and professional services businesses (e.g., doctors, lawyers). LLCs are also versatile entities that have become more commonplace. In New York, for example, an LLC can be formed for any lawful business purpose, and that purpose does not need to be disclosed in the articles of organization. See N.Y.L.L.C. section 401. Corporations are frequently used in high risk businesses such as construction companies and in larger or more complicated businesses where passive investors wish to delegate control to officers and directors. Certain businesses subject to state licensing requirements may find that they cannot use a normal business corporation; a Professional Service Corporation must be used instead. See generally Part 15 of N.Y.B.C.L. and more specifically N.Y.B.C.L. section 1503(a) regarding engineering, architecture and other professions. Incorporation of certain businesses may require prior approval by regulatory bodies. See, e.g., N.Y.B.C.L. section 201(d) (day care center for children requires social services approval); section 201(e) (hospital requires public health council approval). In addition, limited liability partnerships in New York allow the formation of a partnership to provide professional services. See Article 8- b of N.Y. Partnership Law. 7. Pass-through Taxation If a pass-through entity (an entity that is not, itself, subject to tax) is desired, an LLC deserves serious consideration. It affords its members protection from the organization s tort and 12 See Model Business Corporation Act 3.02 (1999). 13 See Revised Uniform Partnership Act 801 (1994). 14 See Uniform Limited Liability Company Act 203(a)(5). 15 See also Schindler v. Niche Media Holdings, LLC, 1 Misc. 3d 713, 772 N.Y.S. 2d 781 (Sup. Ct. 2003). 5

10 contract liabilities, like an S corporation. An LLC is also more flexible than an S corporation in that the types and number of members are not restricted, distributions need not be ratable, etc.. 8. State Taxation State tax issues may also have a bearing on the decision. Are the owners all in New York State? Will the entity do business in states other than New York? Not every state follows the federal treatment of S corporations and LLCs. C. Financial Considerations 1. Compare the added costs of incorporating and maintaining the corporation with the advantages to be derived. Do the advantages justify the added costs? 2. Costs include: filing and organizational fees, legal fees, annual franchise taxes ($25 minimum in New York State 16 ), qualifying to do business in other states, additional or more complex tax returns, payroll taxes and returns, maintaining bank accounts, carrying various types of insurance (e.g., liability, property, workers compensation, bonding, and unemployment insurance), obtaining a taxpayer I.D. number and/or sales tax I.D. number obtaining an unemployment insurance I.D. number, obtaining permission to pay wages by check, permits, licenses, approvals, cost of letterhead and contracts in corporate name, and addressing problems in assigning leases, contracts (e.g., manufacturers rep or auto dealership) or other rights or obligations the corporation, etc. There may be annual filing fees for other entities (i.e., LLC s) as well. In addition, New York imposes a tax on LLC s based on the number of LLC members. 17 See Appendix A for a chart comparing New York State filing fees for different New York entities. 3. Banks, bonding companies or others may prefer a corporation because of the continuity, different interest ceilings for individuals and corporations, the ability to accumulate assets in the corporation, etc. If an individual owns several businesses and each is subject to separate risks (e.g. three restaurants each subject to food poisoning risks) three corporations may be preferred because the limited liability provided by each corporation may insulate the assets of the other two corporations and help to assure the long term viability of the overall business. D. Tax Considerations General 1. Generally, income from a sole proprietorship is reported on the individual owner s federal income tax return and is subject to the income tax rates applied to individual taxpayers. See I.R.C Typically, partnerships are not taxable entities. Income, losses and credits flow through and are utilized by each partner. See I.R.C. section 701; N.Y. Tax Law section 601(f). For 2016, the highest federal individual rate (on ordinary income reported on a joint return) is 39.6% for taxable income over $466,950. A partnership must file an information return, which includes the 16 See Definitions for Article 9-A Corporations, the NYS Dept. of Taxation and Finance, available at bus/ct/def_art9a.htm#min tax. 17 See also Limited Liability Companies FAQs, available at 6

11 name of the partners and the amount of income, deductions, gains, or losses attributed to each partner. See I.R.S. Form Generally, for capital assets held by an individual longer than 12 months, the gain recognized on the sale will be taxed at a maximum rate of 20%. This lower rate may also apply to dividend income. 4. There is no separate federal or New York State tax regime for LLCs. Under most circumstances, LLCs are treated as partnerships for federal tax purposes, although a taxpayer may elect to treat an LLC as a corporation (see Section 6). For New York State tax purposes, the State s tax treatment of an LLC will conform to its federal classification C corporations are taxable on their incomes at graduated rates that may or may not be lower than individual rates. See I.R.C. section 11. Federal rates for 2016 are as follows: Taxable Income Rate $50,000 15% $50,000-75,000 25% $75, ,000 34% $100,000-$335,000 39% $335,000-10M 34% $10M-15M 35% $15M M 38% $18.333M+ 35% 6. Consider, the important impact of New York State franchise taxes, which are the higher of $25 (minimum), 6.5% of allocated entire net income (for 2016) or.125% of allocated business and investment capital. 19 See N.Y. Tax Law section 210(1)(a). 7. Consider also FICA (Federal Insurance Contributions Act) taxes of corporation shareholder employees versus the self-employment taxes of general partners and many LLC members. For 2016, the employer and employee each pay FICA taxes at a rate of 7.65% (15.3% total). This 7.65% breaks down to 6.2% for Social Security and 1.45% for Medicare hospital insurance. The 6.2% (but not the 1.45%) tax only applies to a certain portion of the taxpayer s 18 See New York State Dept. of Taxation and Finance, Publication 16, available at pdf/publications/multi/pub16.pdf. 19 Source for 2016 rates: see min tax. 7

12 wages (the first $118,500 in 2016). For self-employed persons, rates are 12.4% for Social Security (subject to the same ceiling) and 2.9% for Medicare hospital insurance. 20 An additional Medicare tax (commonly referred to as the Obama Tax ) went into effect in 2013 and applies to wages, railroad retirement compensation, and self-employment income over certain thresholds (e.g., threshold for married filing jointly is $250,000). The additional Medicare tax rate is 0.9%. 21 Note: Employment tax distinctions between S corporations and LLCs: A managing member of an LLC is not considered an employee and is therefore required to pay the 15.3% self-employment tax on net earnings over $400. Generally, the amount subject to this tax is 92.35% of a member s net earnings from self-employment. 22 This self-employment tax rate is two times higher than the tax rate of a shareholderemployee in an S corporation. An S corporation shareholder is considered a corporate employee if he or she provides employee services to the S corporation. As discussed above, an S corporation is subject to FICA taxes. The S corporation shareholder-employee pays one-half the employment tax of a managing LLC member (at a rate of 7.65%) for wages paid by the S corporation. The S corporation, itself, pays the other half of the employment tax for its shareholder-employees. The net income of an S corporation (not attributable to wages) passes through to the shareholders without being subject to employment tax. 23 As a result, choice of entity can create significantly different tax consequences for employment tax purposes. 8. Special status corporations, such as Subchapter S corporations, may be appropriate in certain situations. The income of Subchapter S corporations is usually taxed at the shareholder level rather than at the corporate level. See generally, I.R.C. section 1373(a). Losses and credits also pass through on a pro-rata basis for each shareholder. To qualify for this treatment, an election must be made and certain tests must be met (e.g., fewer than 100 shareholders, only one class of stock outstanding, shareholders must be individuals). See I.R.S. Form If most of the activities will be passive investment activities, such as the collection of rents, royalties, interest, dividends, etc., a corporation may not be desirable because of the personal holding company rules. See I.R.C. section 541 et. seq.. These rules impose a corporate level penalty tax under certain circumstances. 20 Source for 2016 rates: see 21 See Internal Revenue Service, Questions and Answers for the Additional Medicare Tax, available at Additional-Medicare-Tax. 22 See Internal Revenue Service, Topic 554: Self-Employment Tax, available at taxtopics/tc554.html. 23 See Internal Revenue Service Publication 15, Employer Tax Guide, available at 8

13 10. If the business will generate large amounts of accumulated earnings and business reasons for retaining the accumulations do not exist, a corporation may be undesirable because of the accumulated earnings tax. See I.R.C. section 531 et. seq In the situations described in (9) and (10) above or where the owners wish to withdraw more cash from the business than they can justify as reasonable compensation, a partnership or LLC may be preferable because withdrawals from a C corporation could be subject to double taxation (first as corporate earnings and second as dividends). A business is allowed to deduct a reasonable allowance for salaries and compensation. I.R.C. section 162(a)(1). If the IRS disallows a compensation deduction for a C corporation, the C corporation s taxable income increases and the IRS may treat the excess compensation as a taxable dividend. See Treas. Reg. section (b)(1). In determining whether the level of compensation is reasonable, the business must consider several factors, including: a. Size and complexity of business; b. Qualifications of the salary earner; c. Work performed; d. Value to corporation of the employee; e. Relative success of business; f. Comparable salaries in comparable companies; g. Ratio of salary to income; h. Past compensation (undercompensated?); i. Fixed or contingent payments; j. When were rates fixed (before corporate earnings determined?); k. Relationship to company (shareholder?); l. Dividend history; m. Relationship between percentage of stock and level of compensation; and n. Inflation and other economic conditions. It is impossible to establish a rule of thumb regarding a safe or unreasonable level of compensation. (Compare Helen L. Foos, 41 TCM 863, in which compensation of $1.6 million each was reasonable for mother and son, with Maryland Pikesville Distillery, 3 TCM 542, in which $300 was reasonable for father and $600 was reasonable for son because the corporation, a personal holding company, had minimal activities.) E. Fringe Benefits and Deferred Compensation Fringe benefits may give employees tax free or tax reduced benefits. Certain fringe benefits for shareholder employees will not produce similar deductions for partner employees. In other instances, larger tax free and tax reduced benefits are available for shareholder employees than for 9

14 partner employees. This is also true in the deferred compensation area. Where a business has the financial capability and the desire to maximize its use of fringe benefits and deferred compensation, a corporation may be more desirable than a partnership or LLC. F. Debt Financing Distinctions Between S Corporations & LLCs Generally, basis is a monetary value assigned to property (usually the cost of such property) used to determine a taxpayer s investment and corresponding gain or loss on the property for tax purposes. The basis figure will be modified over time to accommodate changes to the property, such as additional contributions, and deductions, such as depreciation. See I.R.C. sections Whether debt used to purchase property is reflected in a business owner s stock or membership basis depends on the type of entity. S corporation shareholders only receive basis for personal loans made directly to the corporation. See I.R.C. section 465. In contrast, members of an LLC may increase the basis in their membership interest by their share of entity-level, recourse or nonrecourse debt. See I.R.C. section 752. This distinction is especially important for an entity considering the purchase of real estate in a highly leveraged transaction. For members of an LLC, basis generally includes the value of the recourse and nonrecourse loan, which permits for a significantly greater allowance of depreciation deductions. G. Entity Classification; Check-the-Box Regulations 1. Check-the-Box regulations provide an entity classification system that allows certain eligible business entities, after considering the factors discussed above, to elect a federal tax classification. A business entity with two or more members may elect to be treated as (i) an association (taxed as a corporation) or (ii) a partnership. A single member entity may elect to be taxed as (i) an association (taxed as a corporation) or (ii) to be disregarded as an entity separate from its owner (in essence, a tax nothing ). 2. By default, an entity with two or more members will be classified as a partnership and an entity with a single member will be disregarded as an entity separate from its owner. In order to elect a classification other than the default, the taxpayer must submit IRS Form 8832 and check the box. Generally, entities that do not qualify for the Check-the-Box election include corporations formed under state or federal law, trusts, insurance companies, and certain governmental entities formed exclusively under state or local law. See Treas. Regs. sections through H. Termination of a Business Entity Termination of an entire business can occur through (i) sale to a third party of all ownership interests or (ii) a pro-rata distribution to the owners of all the assets held by the business during liquidation. Corporation: During a complete corporate liquidation, a shareholder may receive cash and/or property. The shareholder is deemed to have exchanged his or her stock for the total amount received in the liquidation (property is valued at its fair market value). See I.R.C. section 331(a). Liquidation ordinarily results in capital gain or loss to a shareholder because the shareholder is treated as having sold the corporation back his or her own shares in exchange for the liquidating distribution. See I.R.C. sections 1001, Typically, liquidation has no income tax impact at the corporate level, unless the corporation must sell assets to generate cash for distribution. Then the 10

15 corporation must recognize gain or loss on the sale of assets. See I.R.C. section 1366(a)(1) for impact of asset sale on S corporation shareholders. Partnership: In complete liquidation of a partnership, all the partnership assets are collected and reduced to cash. During the winding up process, cash is paid out in the following order to settle outstanding debts: (1) to creditors, other than partners; (2) to partners, other than for capital contributions and profits; and (3) to partners for capital contributions. The remaining cash, if any, is distributed to partners for profit. 24 Generally, a partner may recognize gain through liquidation to the extent the partner s liquidation proceeds are greater than the adjusted basis of the partner s interest immediately before liquidation. See I.R.C. section 731(a)(1). Similarly, a partner may recognize gain if he or she sells his or her partnership interest to a third party. See I.R.C. section 741. In either event a liquidation or the sale of a partnership interest gains may be characterized as capital and/or ordinary, depending upon the character of assets previously held by the partnership (e.g., accounts receivable, which are treated as ordinary income assets, versus real estate, which is treated as a capital asset) Business Succession The value of most closely held business interests is not readily ascertainable because their value derives primarily from owners unique experience, knowledge, personality and relationships. Thus, a closely held business interest is oftentimes an illiquid asset. As a result, decisions need to be made how an owner can transfer or liquidate the value of such interest upon disability, death, retirement or other termination of his ownership interest. Typical planning options include the sale and/or gift of some or all of the business during life or death to family, sale of some or all of the business during life or death to management or third parties, or possibly the dissolution and liquidation of the business. A. Dispositions of Business Interests upon Death In the absence of an agreement among the owners, state law will determine whether or not the interest is transferrable upon death and the effect of an owner s death upon the business, as follows: 1. General Partnership. New York Partnership Law provides that absent a partnership agreement to the contrary, the death of one partner results in dissolution of the partnership. 26 A partnership is a contractual relation dependent upon the personality of its members. The admission or withdrawal of a member so radically changes the contractual rights inter se as to produce essentially a new relation even though the parties contemplate no actual dissolution of the firm and 24 See Revised Uniform Partnership Act 802, 807 (1994). 25 Gain or loss is generally considered capital, except to the extent sale proceeds are attributable to hot assets. See I.R.C Hot assets include unrealized receivables, inventory, and depreciation recapture subject to ordinary income. See I.R.C. 751(a)(2). 26 N.Y. Partnership Law

16 continue to carry on business under the same name, under the original articles and with the same account books. 27 The law is clear that upon the death of a partner, the deceased partner s representative has only an equitable interest in the distribution of any surplus remaining after the payment of firm debts; the representative has no legal interest in the assets. 28 When no definite agreement covers the valuation of the deceased partner s interest, the legal representative of a deceased partner is entitled to receive the value of the deceased partner s partnership interest as of the date of dissolution, together with interest or, in lieu of interest, the profits attributable to the use of the partner's right in the property of the dissolved partnership. 29 Once the partnership has been dissolved, the remaining partners can create a new partnership. They cannot, however, continue or revive the previous entity unless the partnership agreement so provides. 30 Continuation of the partnership after its dissolution creates a new partnership at will Limited Partnership. New York Partnership Law provides that the death of a limited partner does not dissolve a limited partnership. 32 If a limited partner dies, the partner s executor or administrator may exercise all of the partner s rights for the purpose of settling his estate or administering his property, including any power under the partnership agreement of an assignee to become a limited partner. 33 However, the assignee of a limited partnership interest is only entitled to the economic interest in the partnership. The assignee may become a limited partner if: (1) the assignor gives the assignee that right in accordance with the partnership agreement; (2) all partners consent to the admission of the assignee as a limited partner; or (3) the partnership agreement so provides. 34 The death of a general partner is treated as a withdrawal. 35 Upon the withdrawal of a general partner, the partnership will dissolve unless: (1) the partnership agreement allows for the continuation of the partnership with a different general partner; or (2) the remaining partners vote to continue the partners with a new general partner Ruzicka s v. Rager, 277 A.D. 359, 360 (1st Dept. 1950). 28 N.Y. Partnership Law N.Y. Partnership Law Bitetto v. F. Chau & Assoc., LLP, 10 Misc. 3d 595, 601 (N.Y. Sup. Ct. 2005). 31 Peirez v. Queens P.E.P. Assoc. Corp., 148 A.D.2d 596, 597 (2d. Dept. 1989). 32 N.Y. Partnership Law This is a statutory default. The Partnership Agreement can modify this and call for the dissolution of the partnership upon the transfer of any partnership interest. 33 N.Y. Partnership Law N.Y. Partnership Law , N.Y. Partnership Law (f). 36 N.Y. Partnership Law

17 The death of a general partner is treated similarly to that of a limited partner. The executor of the general partner s estate can assign the general partner s interest. 37 The assignee will inherit the economic interest associated with the partnership interest. 38 The assignee can become a limited partner, but not a general partner, if: (1) the assignor gives the assignee that right in accordance with the partnership agreement; (2) all partners consent to the admission of the assignee as a limited partner; or (3) the partnership agreement so provides Limited Liability Company. Unless otherwise provided in the Operating Agreement, the death of a member does not dissolve a New York LLC formed after October 24, 1994, unless within 180 days thereafter, a majority of remaining members agree to dissolve the LLC. 40 When a member of a New York LLC dies, the legal representative of the deceased may exercise the deceased s rights as a member of the LLC to settle the member s estate or administer the member s property. 41 Except as provided in an operating agreement, a membership interest is assignable in whole or in part. Assignment of an interest does not dissolve the LLC. The assignee does not become a member and is not entitled to anything other than the right to allocations and distributions. 42 An assignee does not become a member of the LLC unless a majority of the members in interest consent. This provision may be varied by the operating agreement. Once a member, the assignee has all of the rights, powers, preferences and limitations of a member, to the extent they were assigned and the assignee is liable for the contribution obligations of the assignor. The assignee is not liable for the obligations a member incurs from withdrawing in violation of the operating agreement or receiving an unlawful distribution. The assignee is not liable for contribution obligations about which he or she did not know at the time of the assignment and that the assignee could not determine from the operating agreement. The assignee is also not liable for any accrued liabilities of the assignor unless he or she specifically assumes them Corporation. Corporations have perpetual life and are not affected by the death of a shareholder. Similarly, there is no prohibition under the New York Business Corporation Law ( N.Y.B.C.L. ) restricting the assignment or transfer of shares of stock. In fact, New York Courts will invalidate any provision prohibiting the transfer of stock but will uphold a right of first refusal option as a valid restriction on transfer. 44 Any restrictions that effectively prohibit share transfers is unenforceable. 45 A restraint on the transferability of stock will be upheld if it is reasonable, in 37 N.Y. Partnership Law N.Y. Partnership Law N.Y. Partnership Law N.Y. LLC Law 701(b). Note: NY LLC s formed before October 24, 1994 are governed by the previous version of this section. 41 N.Y. LLC Law N.Y. LLC Law N.Y. LLC Law Allen v. Biltmore Tissue Corp., 2 N.Y.2d 534, 542 (1957). 45 Wildenstein & Co. v. Wallis, 79 N.Y.2d 641 (1992). 13

18 accordance with public policy and effectuates a lawful purpose. 46 Factors in assessing reasonableness of the restriction include price, duration and purpose. 47 In Lam v. Li, a court held that an option to buy 50% of shares of a corporation for ten dollars, without time limit, which was binding on both parties, their heirs, successors, administrators and assignors, prevented defendant from transferring stock to anyone but plaintiff and was therefore an unreasonable restraint on alienation. 48 Similarly, in Rafe v. Hinden, a stockholder successfully invalidated a provision requiring him to get written permission from the other stockholder before selling to a third party where the other shareholder retained the arbitrary power to forbid a transfer. 49 However, in Levey v Saphies, a court upheld a restriction that afforded the defendant a ten year option to purchase plaintiff s stock at the original purchase price and entirely prohibited the plaintiffs from selling, pledging, hypothecating or disposing of it for that time period, thereby reserving the stock for the defendant s option. 50 As indicated above, in order to plan for the disposition of an interest in the business, it is important to know the type of entity and state law provisions that govern in the absence of an agreement. If there is any agreement among co-owners, it is important to determine whether the agreement permits the assignment of such business interests (and whether any restriction on transfer is enforceable) and the effect of death or other events upon the continued existence of the entity. B. Transfers to Family Members 1. Business Considerations. The terms of an agreement among owners will govern and supersede the terms of any purported disposition of an owner s business interest at death by will, trust or other inter vivos or testamentary transfer. However, in the absence of any agreement or limitation pursuant to state law (or if transfer of the business interest is permitted by agreement and not subject to any buy-sell provisions), the estate plan for a business owner should address how any equity and voting rights are transferred and consider whether the transferee is a permitted transferee under any agreement. As described above, a decedent s partnership or LLC interest may not be transferable and the decedent s heirs may merely inherit the decedent s economic rights as an assignee. The threshold consideration for most business owners is whether some or all of their interest in a business will pass to a spouse, children, further descendants or other family members. Obviously, this will depend upon whether any family member has the requisite knowledge, experience and desire to continue to run the business with or without other co-owners. If the succession plan is to transfer some or all of the business to one or more family members, further considerations include: 46 Ferolito v. Vultaggio, 911 N.Y.S.2d 323 (1st Dept. 2010). 47 Id A.D.2d 290 (1st Dept. 1995) A.D.2d 481 (2d. Dept. 1968), aff d, 23 NY2d 759 (1968) A.D.2d 959 (2d. Dept. 1976). 14

19 How much ownership will each family member receive; Will family members not involved in the business receive an ownership interest; if not, will they receive other assets to equalize transfers among family members; Will the ownership include voting rights or be limited to a nonvoting equity interest; Are there any legal restrictions on transfer, such as a shareholder or LLC operating agreement; Will some or all ownership be transferred during life, and if so, by gift, sale, redemption or some combination; What is the value of the business interest and are any valuation discounts available; If some or all ownership is to be sold or redeemed, how will this be paid and will there be any security for any future payment; How will the ownership interest be structured, either outright or in trust; If a trust structure is preferred, is there any limitation on the structure of the trust to qualify for any tax preference 51 ; What are the income tax consequences of any sale; What are the gift, estate and GST tax consequences to the transferor on any gratuitous transfers and income tax consequences to the transferee in the future 52 ; Are there sufficient liquid assets to pay any taxes; if not, will the business qualify for any extension of time to pay estate tax 53 ; To the extent any transfer will occur at death, will life insurance be used to fund some or all of the payment due the business owner or any estate taxes; Is the business properly structured or is any restructuring necessary; 51 Only certain trusts are eligible to be S corporation shareholders (see Section II, B, 3, below), or qualify for the gift or estate tax marital deduction (see I.R.C and 2056) or exemption from GST tax (I.R.C. Ch. 13). 52 Assets acquired from a decedent receive a stepped-up basis under I.R.C. 1014(a) which eliminates any income tax on pre-death appreciation. Conversely, under I.R.C. 1015, assets acquired by gift generally receive a basis equal to the transferors basis (if there is pre-gift appreciation) or fair market value (if there is pre-gift depreciation). 53 See I.R.C. 6161,

20 What documents or agreements are necessary to execute any transfer or which govern the relationship of multiple owners, e.g., Shareholder or LLC Operating Agreements; and If the entity is a pass-through entity, e.g., a partnership, LLC or S corporation, is there any requirement for the entity to make distributions for payment of income taxes on the owner s share of entity income. 2. Traditional Estate Planning Considerations. In addition to estate planning issues unique to the transfer of closely held business interests, traditional estate planning objectives need to be considered. For instance, it is important to determine who will inherit such property, whether part or all of such property will pass by specific or residuary bequest, outright or in trust, and how any estate or GST tax attributable to such property shall be allocated and paid by the estate or certain beneficiaries. In addition, in order for an Executor to continue to administer a sole proprietorship, 54 or to properly administer other types of businesses, the testamentary document should include special fiduciary provisions that give the fiduciary authority to handle issues unique to the operation of a business. Attached as Appendix B are sample fiduciary business provisions. It may be advisable for the closely held business owner to form a revocable trust and transfer ownership of business interests, and perhaps other assets, to such trust. As described below, this form of ownership is superior to the use of a general power of attorney in the event of disability. New York law allows for such trusts to be self-settled, i.e. the settlor (also commonly referred to as the grantor ) may be the sole trustee and beneficiary. 55 Co-trustees may also be appointed, but their responsibilities may be limited while the settlor is acting. A revocable trust will generally include the same dispositive provisions included in a will and appoint fiduciaries, or trustees, to act upon the death of the settlor. A will is still needed for any assets not transferred to such trust or in the event the trust is revoked. Assets held by a revocable trust pass by contract upon the death of the grantor without the cost or delay of any probate court proceedings. Successor trustees are immediately able to act without any disruption to the business. This is particularly helpful where the business owner has minor children (which requires the appointment of a Guardian Ad Litem to represent their interests in a probate proceeding), where heirs are in a foreign country, incompetent or potential contestants to a will. A revocable trust is tax neutral. Since the trust is revocable, it is considered a grantor trust for income tax purposes and the grantor, not the trust or any other beneficiaries, is taxed on any trust income. 56 Grantor trusts are also eligible S corporation shareholders. 57 Similarly, since the grantor is also the beneficiary and has not given up dominion and control, it is not a gift or 54 Under Surrogate s Court Procedure Act 2108, an executor may petition a court to continue to administer a sole proprietorship if not otherwise granted the power to do so. 55 See N.Y. Est. Powers & Tr. Law See I.R.C See I.R.C. 1361(c)(2)(A)(i) 16

21 generation-skipping transfer for tax purposes. 58 Lastly, since the grantor may revoke the trust during life, it is included in his or her estate at death. 59 Dispositions of shares of stock in S corporations in trust require special considerations since only certain types of trusts qualify as eligible S corporation shareholders. In addition to a grantor trust, two other trusts qualify as an S corporation shareholder: a Qualified Subchapter S Trust ( QSST ) and an Electing Small Business Trust ( ESBT ). A trust qualifies as a QSST if (1) there is only one income beneficiary, (2) principal may be distributed only to the income beneficiary, (3) the income beneficiary s interest terminates at the earlier of the income beneficiary s death or the trust s own termination and (4) any principal remaining at the trust s termination is distributed to the income beneficiary (if then surviving). 60 By contrast, the ESBT requirements place fewer restrictions on a trust s terms. A trust qualifies as an ESBT if (1) its beneficiaries are limited to individuals, estates or charitable organizations, (2) it cannot acquire interests by purchase and (3) it has elected to be an ESBT. 61 Likewise, if it is necessary for any trust funded with an interest in a business to qualify for the estate tax marital deduction, it must meet the requirements of an Estate Trust under I.R.C. 2056(b)(1), a General Power of Appointment Trust under I.R.C. 2056(b)(5) or a Qualified Terminable Interest Property ( QTIP ) Trust under I.R.C. 2056(b)(7). 62 Also keep in mind a surviving spouse s elective share rights under Estates, Powers and Trusts Law A, which, in the absence of waiver, may conflict with any proposed transfer of a business interest in trust. Similarly, bequests of business interests to public charities or private foundations require special planning to determine if such charitable entity is willing and able to accept such property without jeopardizing its tax-exempt status. It must also be determined whether ownership of such business interests by a private foundation will result in unrelated business income tax ( UBIT ) and/or substantial excise taxes Transfer Tax Planning. From a transfer tax standpoint (i.e. from a gift, estate, and GST tax standpoint) it is typically beneficial to transfer an asset during life, rather than at death, since future appreciation will be in the hands of the transferee. In addition, gifts of a present interest are excluded from the calculation of taxable gifts and do not require use of the gift tax credit. In 2017, the annual gift tax exclusion, indexed for inflation, is $14,000 and the maximum federal gift tax 58 See I.R.C. 2652(a)(1)(B); Reg (b)-(c). 59 See I.R.C and Treasury Regulations thereunder. 60 See I.R.C. 1361(d)(3). 61 See I.R.C. 1361(e)(1). 62 Estate trusts do not require income to be distributed to the surviving spouse. By contrast, general power of appointment trusts and QTIP trusts require the distribution of income. As for income amounts, general power of appointment trusts require a specific portion and QTIP trusts require all income to be distributed to the surviving spouse. Accordingly, these trusts may present a problem if they are funded with business interests that are not income producing. 63 See I.R.C. 511, ; see also Eberl and Berti, Planning for a Bequest of a Closely Held Business Interest to a Private Foundation, NYLJ, January 5,

22 credit for the amount of tax on taxable gifts is $5,490, New York has no gift tax but until January 1, 2019 will include gifts made within three years of death in the New York taxable estate. 65 These general gift tax planning concepts are particularly useful when dealing with the transfer of an interest in a closely held business since the value of an interest in the company may be discounted for tax purposes based upon the unique attributes of a closely held business. For example, the transfer of a 10% interest in a $1,000,000 closely held company is not worth $100,000 but may more likely be worth $65,000 to $85,000 for tax purposes. Thus, there is some financial advantage, called leverage, when transferring an interest in a closely held business, since the sum of the parts does not equal the whole. The federal tax law recognizes that unlike marketable securities, the fair market value of a closely held business is often tied to the talents, knowledge, experience and relationships of one or more of the owners. The balance sheet of the company merely reflects the historical and/or depreciated book value of company assets and does not include the value of these self-created, intangible assets. Similarly, the company income statement and tax return may show the results of one year s operation, but it is difficult to ascertain the effect of the owner s talents, knowledge, experience and relationships upon the results of operations. In addition, any computation is complicated by the organizational, operational, financial and legal limitations unique to a closely held business, as well as by agreements among owners concerning the transferability and value of an interest in the business. As a result, owners of a closely held business lack a readily ascertainable market to sell their ownership in the business. Furthermore, the value of an owner s interest in the business depends upon whether such interest includes voting rights, and if so, whether the owner has voting control of the company (that is, more than 50%, as required by law or agreement. The Internal Revenue Service and many court cases have long recognized that the value of a closely held business may be discounted by certain factors unique to this business structure including discounts for lack of marketability and minority interests. 66 You don t need to be an economist to understand the justification for these discounts. For example, if we assume there are two companies in the same market with similar equity and revenue, but one is closely held and the other is publicly traded, would you pay the same amount for a 25% interest in the closely held business as you would for a 25% interest in the publicly traded company? The answer is no since your shares in the closely held company are not marketable; i.e. they cannot be readily sold on a stock exchange and represent a minority interest in the company controlled by a small group of other owners. Based upon these rules, it is often beneficial from a transfer tax perspective 67 for a business owner who intends to transfer ownership of the business to family to make a lifetime gift of some 64 See I.R.C. 2503(b) and See N.Y. Tax Law 954(3). The three year look back rule for taxable gifts applies only to NY residents. 66 See Rev. Rul , C.B. 237, which is discussed in more detail below. 67 Gifts during life are not as advantageous for income tax planning purposes since pursuant to I.R.C. 2015, the donee s basis in the asset is the lower of the fair market value or donor s basis. Conversely, the basis of assets received from a decedent are the fair market value at death, i.e., stepped-up basis if fair market value is greater than decedent s basis. I.R.C

23 or all of the business during life to take advantage of these valuation discounts. Such gifting strategy may also result in the owner having a minority interest or no interest in the company at death. Any gift of 50% or less of the company will take advantage of both marketability and minority interest discounts, which reduce the value of the gift and the amount of gift tax credit to be used. In addition, owners can make unlimited tax-free gifts to a spouse 68 or annual exclusion gifts to a spouse or others. 69 The discounted value also applies if any business interest is sold to a family member or others. In addition to annual exclusion and marital deduction gifts, lifetime transfers can be structured as taxable gifts, either outright or in trust, that are offset by the gift tax credit or not. Alternatively, more sophisticated transfer tax planning techniques such as grantor retained annuity trusts ( GRATs ) 70 and sales to intentionally defective grantor trusts ( IDGTs ) may be used to further reduce or eliminate the amount of the taxable gift. While transfer tax planning makes sense, the owner may have difficulty giving up control of, or income from, the entity. Legal control will depend upon the type of entity, state law governing the entity, and any agreements among owners. If an owner is not willing to give up control, changes may be made to the entity structure to reduce the voting percentage necessary to retain control for the owner. Similarly, it may be possible to transfer equity in the company without any vote. This would apply to transfers of limited partnership interests or LLC membership interests that have no voting rights or that assignees are not entitled to automatically become members. Similarly, corporations may have voting and non-voting shares that may be transferred. If the entity does not distinguish between voting and non-voting interests, the capital structure of the entity may be changed. For example, a corporation may file an amended certificate of incorporation to create a new class of non-voting stock. 71 Obviously, to the extent the owner retains control of the company until death, the owner s interest in the company would not be entitled to any discount for lack of control, and in fact, may be subject to a premium. However, if the owner has gifted most of the equity of the business, the premium will only relate to such retained interest. 72 In addition to planning to take advantage of valuation discounts and to reduce the estate of the business owner for estate tax purposes, other planning should involve an analysis of the estate s liquidity to pay estate taxes from (1) any future sale or redemption of some or all of the business interests, (2) any life insurance payable upon the owner s death or (3) from other estate assets. If the estate will not have sufficient liquidity, the advisor should determine whether the estate will qualify for any deferment or installment payment of tax on the business I.R.C I.R.C. 2503(b). 70 See special valuation rules for certain grantor retained annuity interests pursuant to I.R.C Non-voting stock is not considered a second class of stock for S corporations, which are only allowed to have one class of stock. See I.R.C A shareholder should not retain the right to vote (directly or indirectly) any transferred shares of stock of a controlled corporation. Such retention is considered the enjoyment of the transferred property and such property will be included in the gross estate of the decedent. I.R.C. 2036(c). 73 See the discussion of I.R.C. 6161, and 6166, below. 19

24 C. Transfers to Non-Family If successor ownership and/or management is not available within the family or is not permitted by any agreement of multiple owners, then the owner s business succession options generally are (i) sale to co-owners (or redemption by the business), (ii) the development of an employee within the company to either assume ownership and/or management, (iii) a plan to dispose of the business to third parties, or (iv) plan to liquidate the business. Development of a management succession plan may involve incentive compensation programs designed to recruit and/or retain talent. 1. Sale or Redemption. It is recommended that partners of general partnerships enter into partnership agreements and shareholders of closely held corporations enter into shareholder (or buy-sell) agreements to address the sale or redemption of owners interests in the entity. Members of a New York LLC are required to enter into a written operating agreement at the time of or within 90 days after filing the articles of organization. 74 In addition, at least the general partners in a New York limited partnership are also required to have a written partnership agreement. 75 A typical LLC operating agreement or shareholder agreement will address: The purpose of the entity; Voting rights and any delegation of responsibility to Managers (LLC) or Directors (corporation); Economic rights of owners, i.e., salary, allocation of profits and losses, required or discretionary distributions, etc.; Permitted assignees (e.g., company, other owners, family members, trusts for family members) and whether such assignees may become an owner; Any restrictions on transfer; Rights of first refusal by the entity or co-owners upon any proposed transfer to third parties; Any events than trigger the entity s and/or other owners option or requirement to buy and the shareholder/llc Member s option or requirement to sell such owner s interest. Examples include death, disability, or termination of employment; How to value an interest in the entity; 74 N.Y. LLC Law 417(a); however, failure to adopt an operating agreement does not invalidate the existence of the entity and when there is no operating agreement or it does not address certain subjects, then the entity is bound by the minimum requirements set forth in the LLC Law. See Spires v. Lighthouse Solutions, 778 N.Y.S.2d 259 (Sup. Ct. Monroe Cnty. 2004); Matter of Eight of Swords, LLC, 946 N.Y.S.2d 248 (2d Dept. 2012); Merrell-Benco Agency, LLC v. HSBC Bank USA, 799 N.Y.S.2d 590 (3d Dept. 2005). 75 See N.Y. Partnership Law

25 Payment terms, including insurance proceeds upon death; 76 and When the company terminates. 2. Management Succession. If successor ownership and/or management is not available within the family or among co-owners, and the business owner would like to avoid a sale of the business to third parties or liquidation of the business, then the business owner may attempt to develop one or more employees within the company to assume ownership and/or management. A management succession plan may involve the implementation of some form of incentive compensation plan to recruit and/or retain talent. Incentive compensation plans come in many shapes and sizes and range from simple, informal bonus plans to equity-based compensation plans and qualified retirement plans under the Internal Revenue Code. While the many rules, restrictions and income tax consequences that apply to employers and employees under these plans is beyond the scope of this outline, the following is a brief description of various plans designed to provide some financial incentive to reward employees, particularly for their continued employment and contributions to the success of the company. Subject to the requirements of I.R.C. section 409A (concerning taxation of deferred compensation), each of these plans typically withholds some or all of the payment to the employee until a future date. As a result, some plans are commonly referred to as golden handcuff agreements since employees only earn the economic benefit by not terminating their employment with the company. Examples of incentive compensation plans include: Informal bonus plans based upon the discretion of management from time to time; Formal bonus plans based upon objective criteria, such as an increase in the earnings of the business; Bonus plans tied to the value of the company s stock, e.g., phantom stock plans, or to any appreciation in value of the stock of the company, e.g., Stock Appreciation Rights ( SARs ); Stock bonus plans, including restricted stock plans, which vest ownership of such stock over a period of time, perhaps subject to individual or company performance criteria; While not common, restrictions on transfer and rights of first refusal and/or buy-sell options or requirements may be established by corporate resolutions of directors and shareholders. 77 See I.R.C. 83 and the Treasury Regulations thereunder concerning the income taxation of property transferred in connection with performance of services. 21

26 Stock options, 78 including incentive stock options, and employee stock purchase plans, which provide more favorable income tax treatment to employees and their employers; 79 and Qualified retirement plans subject to ERISA rules, such as profit sharing and 401(k) plans, pension plans, and employee stock ownership plans ( ESOPs ) (funded with cash and stock of the company held in trust for the benefit of eligible employees). 80 While cash compensation may be sufficient to retain certain management employees, if the owner wants to create a market to sell some or all of his or her ownership in the business during life and/or at death, then some type of stock-based compensation plan is usually implemented. In such event, the employees/co-owners would usually be required to enter into an ownership agreement, e.g. a shareholder or operating agreement, which (as described above) includes buysell provisions upon certain events such as death, disability or termination of employment. 4. Disability Planning When representing an owner of a closely held business, careful consideration must also be given to the effect of disability upon the business, other owner, employees, customers and creditors. For instance, if the business is a corporation, is the corporate book up to date with minutes designating current officers and directors, with bylaws that adequately describe their role? Similarly, are there multiple owners, who may vote the shares of a disabled shareholder? Is there a shareholder agreement, voting trust agreement, stock proxy or the like that addresses these issues? Alternatively, is there a valid durable general power of attorney ( POA ) that gives the Agent the power to act for the principal? 81 Unfortunately, neither the Business Corporation Law, the General Obligations Law, nor the common law fiduciary rules authorize an agent under a POA to assume the fiduciary duties of a director or officer. However, the POA, with power to act on behalf of a shareholder, can participate in any vote necessary to appoint directors, and such directors can appoint officers. If the business owner does not have a POA, then it may be necessary to commence a proceeding to appoint a guardian. Oftentimes, a much better solution is for the business owner to transfer his or her business interest to a revocable trust. In a self-settled trust, the owner, as trustee, retains control of the business interest but, in the event of disability, a co-trustee or successor can immediately act without court intervention. Moreover, unlike a POA, a trust typically provides more specific guidance concerning the trustee s authority, and, as a result, those dealing with a trustee generally have a greater comfort level than dealing with a POA. Also, as described above, there are no adverse tax consequences upon forming and funding a revocable trust. It is tax neutral. If properly structured, the owner should still be the owner for income and estate tax purposes and no gift or 78 Id. 79 See I.R.C See, generally, I.R.C., Subchapter D, Deferred Compensation ( ) and the Treasury Regulations thereunder. 81 See N.Y. General Obligations Law E. 22

27 generation-skipping transfer should have occurred upon formation and operation of the trust (unless, of course, gifts are made from the trust to others). III. ESTATE ADMINISTRATION 5. Dispositions of Business Interests at Death As discussed above, the disposition of an interest in a closely held business upon death will depend upon the type of entity, state law, any agreements among owners and the form of ownership. In the absence of an agreement among the owners, state law will determine whether or not the interest is transferrable upon death and the effect of an owner s death upon the business. The terms of an agreement among owners will govern and supersede the terms of any purported disposition of an owner s business interest at death by will, trust or other testamentary transfer. However, in the absence of any agreement or limitation pursuant to state law (or if transfer of the business interest is permitted by agreement and not subject to any buy-sell provisions), the terms of the decedent s will, trust or other testamentary transfer will govern the disposition of the business interest. When dealing with interests in a closely held business, the first step in the estate administration process is to gather the documentation necessary to determine whether or not the interest is transferable, and if so, to whom and how, and also to assist with the next phase of determining value and any transfer tax consequences. In addition to reviewing the decedent s will and any trusts and applicable state law governing a particular type of entity, it is critical to review business, financial and tax information including the following: Decedent s last three to five years of federal and state income tax returns; All gift tax returns filed; Decedent s personal financial statement, if any; Business financial statements for last five years; Business tax returns for last five years; Any business valuations; Any financing documents, including loans, guarantees, mortgages, security agreements and UCC filings, etc.; Corporate organizational documents, including: o List of all documents filed with Secretary of State o Certificate of Incorporation and any amendments o Organizational minutes o Bylaws o Stock subscription agreements 23

28 o Director and shareholder minutes o Stock certificates o Stock ledger o Any agreements among owners, e.g., stock proxies, voting trust agreements, shareholder (buy-sell) agreements, etc. o Any private placement memoranda concerning any previous stock offering and any agreements related thereto LLC organizational documents (similar to corporations) including: o Articles of Organization o Operating Agreement, as amended o Manager and member minutes o Any membership interest certificates General or limited partnership organizational documents (similar to corporations and LLCs) including any partnership agreements Website (which may provide other information about the business not reflected in legal, tax or financial documentation If the business interest is transferable, the next step is to determine to whom it will be transferred and how. Will the interest pass in accordance with the terms of the decedent s will, to any trust, to a joint tenant, or perhaps by beneficiary designation? 82 There are also many ancillary questions that will need to be answered concerning any business interest that is transferred, including: What documents will need to be executed to transfer the business interest and govern the ownership of the transferee? What rights, if any, does the transferee have to liquidate the business interest? What rights to income? How will the transferee be taxed on his or her share of the company income? If the business interest will pass pursuant to the terms of the decedent s will and any delay is expected concerning the probate of the will (such as where any guardian ad litem needs to be appointed for minor distributees), should preliminary letters of administration be sought? Also, consider whether the will should include the necessary fiduciary powers for the executor to administer business property and properly run the business, or should further court approval be necessary? N.Y. Est. Powers & Tr. Law generally provides for the registration of a security for the transfer on death. 83 See Section II, 3, B, 2, above, and Appendix B. 24

29 Similarly, if the interest will pass in trust, rather than outright, does the fiduciary have the necessary administrative powers to administer the business property and run the business? 84 Special consideration is necessary if the trust is intended to qualify as an S corporation shareholder or for the marital deduction. If the interest is not transferrable, will the transferee continue as an assignee, with an economic interest only, or is there any mandatory or optional requirement for the business or other owners to buy the decedent s interest? If so, when and how does this occur? How is the price determined and paid? 6. Taxation A. Estate Tax. A federal estate and GST tax return, Form 706, is required if the date of death value of a citizen or resident s gross estate exceeds the basic exclusion amount under I.R.C. section 2010(c) 85 in the year that the decedent died. However, the filing threshold is reduced (but not below zero) by the amount of adjusted taxable gifts (as defined in I.R.C. section 2001(b)) made by the decedent after December 31, The New York basic exclusion amount is currently $5,250,000 and after two years will increase to match the federal tax basic exclusion amount. 87 The value of a prior gift used in determining the applicable estate tax rate under I.R.C. section 2001(c) and available exemption under I.R.C. section 2010 is the value of the gift as finally determined for gift tax purposes. 88 The IRS may not revalue prior gifts if the gift was adequately disclosed on a gift tax return and the statute of limitations for assessing gift tax has expired. In order for there to be adequate disclosure, the gift transfer must have been disclosed on a gift tax return (or in a statement attached to a gift tax return) in a manner adequate to apprise the IRS of the nature of the transfer, even if no gift tax was imposed on that transfer. 89 In the case of a transfer of a closely held business interest, this includes a detailed description of the method used to determine fair market value of the property transferred. 90 However, the IRS will accept the submission of appraisals and related information in satisfaction of this required valuation information Id. 85 I.R.C. 6018(a)(1). 86 I.R.C. 6018(a)(3)(A). Also reduced by aggregate amount allowed as specific exemption under I.R.C with respect to gifts made by the decedent after September 8, See I.R.C. 6018(a)(3)(B). 87 See NYS Department of Taxation and Finance Technical Memorandum (TSB-M-14(6)M) concerning recent changes to New York s estate tax system. 88 I.R.C. 2001(f). 89 Id. See Treas. Reg (c)-1(f)(2) for the information that must be provided on the gift tax return to meet the adequate disclosure requirement for the transfer, start the running of the statute of limitations, and prevent revaluation of the transfer for purposes of computing the estate tax liability. 90 Id. 91 Treas. Reg (c)-1(f)(3). 25

30 The general information section of Form 706 (Page 3, Part 4, Question 10), asks Did the decedent at the time of death own any interest in a partnership or unincorporated business, or any stock in an inactive or closely held corporation? All stock, including closely held stock, held by the decedent individually, as tenant in common and all community property interests in stocks are reported on Schedule B. Other business interests, e.g., sole proprietorships, partnership and LLC interests, are reported on Schedule F. However, stock and other business interests held jointly are disclosed on Schedule E and on Schedule G if held in trust, including revocable trusts. A description of closely held stock should include: number of shares, whether common or preferred; issue; price per share; exact name of corporation; and par value, if needed to identify the stock. The IRS requires financial records for the last five years of a closely held corporation, including balance sheets and statements of net earnings or operating results and dividends paid. In addition, any valuation report should be attached. Similarly, if the valuation is supported by a buysell agreement, a copy of the agreement must be attached. The instructions require, and it is generally recommended, to provide the same information for sole proprietorships, partnerships and LLCs. As discussed above, the valuation of shares of a closely held business is more of an art than a science. Accordingly, it is generally recommended that the executor pay for a quality professional appraisal of any stock that is a significant asset of the estate. However, if the decedent had a small interest, it may be appropriate to forgo a formal appraisal, especially if there are some comparables available, including recent sales of stock or other valuations. The many factors which influence fair market value are discussed in Rev. Rul , C.B. 237, and other rulings. 92 The relevant factors include, but are not limited to: 1. The nature of the business and its history from inception; 2. The economic outlook in general and the outlook for the industry; 3. The current and book value of assets and financial condition of the business; 4. The earnings and capacity of the business to pay dividends; 5. Whether or not the business has goodwill or intangible value; 6. The market price of stocks of corporations engaged in the same or similar line of business; 7. The extent of decedent s control of the business or if the decedent was a key manager; 8. A binding bona fide buy-sell agreement; 93 and 92 See also Rev. Rul , C.B. 370; Rev. Rul , C.B. 319; Rev. Rul , C.B. 102; and Rev. Rul , C.B If the agreement was executed or amended after October 8, 1990, to be respected by the IRS for valuation purposes, it must: (1) be a bona fide business arrangement; (2) not be a device to transfer property to family members for less than adequate consideration; and (3) have terms which are comparable to those of an arms length agreement. 26

31 9. Options or other restrictive agreements concerning the stock. In general, if a buy-sell agreement is binding on the IRS, it will determine the sales price, but if not, then the stock must be valued at fair value at the date of death. The proper determination of the value of a closely held business interest, particularly any valuation that includes valuation discounts or premiums, has an effect upon possible audit and litigation risks and the possible application of any over or undervaluation penalties. 94 It also may have an effect upon meeting certain percentage tests to qualify for any special use valuation 95 or installment payment of taxes. 96 In addition, the estate tax value of a closely held business interest will be used for purposes of funding testamentary bequests, including bequests determined by a formula, and will be used to establish the basis of such business interest for future income tax purposes. 97 Form 706 must be filed within nine months after the decedent's death. The due date is the same day on the ninth calendar month after death. The executor may obtain an automatic sixmonth extension to file Form 706 by filing Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, on or before the due date for the Form 706. Form 4768 must include payment of the full amount of estimated tax due. However, an estate may apply for an extension of time to pay some or all of the estate tax due pursuant to I.R.C. section 6161(a)(2). In addition, I.R.C. section 6166 provides for a special election for extension of time to pay estate and GST tax for any portion of such taxes attributable to a closely held business interest. The extension to pay is for up to five years, and thereafter may be amortized with up to 10 annual installments of tax plus interest. Subject to certain attribution rules, a closely held business interest includes (1) a sole proprietorship; (2) partnership carrying on a trade or business if the partnership has 45 or fewer partners, or the decedent owned at least 20% of the partnership; or (3) stock in a corporation if the corporation has 45 or fewer shareholders, or if the decedent owned 20% or more of the voting stock. In addition, the value of the estate's interest in a closely held business (without regard to the attribution rules) must exceed 35% of the adjusted gross estate 98 B. GST Tax. Form 706 is also used to report any GST tax on direct skips occurring at death and Schedule R is used to allocate the decedent s unused GST exemption remaining as of death including any reverse QTIP election pursuant to I.R.C. section 2652(a)(3) which allows property to be treated as if the QTIP election had not been made for GST tax purposes. This results in the decedent, rather than the surviving spouse, being treated as the transferor for GST tax purposes, even 94 I.R.C I.R.C. 2032A. 96 I.R.C I.R.C I.R.C. 6166(a)(1). The adjusted gross estate is generally defined as the gross estate less the sum of expenses, debts, taxes and losses deductible under I.R.C and

32 though the QTIP property will be included in the surviving spouse s gross estate for estate tax purposes pursuant to I.R.C. section C. Income Tax - Generally. The death of an owner of a closely held business also has income tax consequences. In general, I.R.C. section 1014(a) provides that the income tax basis of property acquired from a decedent is the fair market value of the property at the date of the decedent s death. 99 The fair market value of a closely held business interest as reported on the estate tax return of the decedent will be the income tax basis for future sales, redemptions or other dispositions of some or all of the business interest. If the date of death fair market value is greater than the decedent s basis in the property prior to death, there will be a step-up in basis at death. In the corporate context, any adjustment to the shareholder s basis will not have any effect upon the basis of the assets held by the corporation, whether it is a C corporation or S corporation. Thus, any built-in gain on corporate assets will be unchanged. However, entities taxed as partnerships, e.g., LLCs, may adjust the decedent s share of partnership assets to the date of death value under I.R.C. section 743(b) if an I.R.C. section 754 election is in effect. These adjustments will eliminate double taxation of ordinary income. A special income tax benefit is also available to corporate shareholders. In general, a corporate distribution for partial redemption of a shareholder s stock is treated as a dividend subject to ordinary income tax rates. 100 However, under I.R.C. section 303 a partial redemption of stock can be made to pay for federal and state estate tax and interest thereon and funeral and administrative expenses without such redemption being characterized as a dividend. The redemption will be characterized as a sale or exchange of the stock subject to capital gain treatment rather than as an ordinary dividend. To qualify for this treatment, the value of all stock of the corporation must exceed 35 percent of the excess of the value of the decedent s gross estate over the sum of amounts allowable as a deduction under I.R.C. section 2053 and This income tax relief is particularly beneficial to estates that have insufficient liquid assets to estate taxes. Estates, trusts and beneficiaries of pass-through entities such as partnerships, LLCs, and S corporations must also consider and plan for payment of tax on their share of phantom income, i.e., income from the entity without a corresponding distribution of cash to pay tax on such income. It is important to understand how items of income, gain, loss, deduction and credit are allocated among owners and if there is any agreement concerning required tax distributions. D. Fiduciary Income Tax and Accounting Concepts. Estates and trusts may be recognized as separate taxable entities or may be required to pass through income to their beneficiaries. The rules governing the income taxation of estates and trusts are complex. Part of the reason for this complexity is a dichotomy between the legal ownership of the fiduciary and the equitable, i.e. beneficial, ownership of the beneficiaries. In addition, the 99 I.R.C This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under I.R.C See I.R.C See I.R.C. 303(b)(2). 28

33 beneficiaries are classified as income and principal beneficiaries, and present and future beneficiaries. These concepts create difficulty in determining who is the proper taxpayer for a particular tax accounting item. I.R.C. Subchapter J considers these issues and provides the rules to determine what should be taxed, who should be taxed, and when and how such taxation should occur. In general, estates and trusts are taxed like individuals, except as otherwise provided in Subchapter J or elsewhere in the Internal Revenue Code. One of the most important distinctions for fiduciary accounting and income tax purposes is the determination of what is principal and what is income. This classification is necessary from an accounting standpoint to determine who receives the economic benefit of any receipt or detriment of any expenditure. The federal tax law uses the state law concept of accounting income to determine the income tax consequences for an estate or trust. It defines fiduciary accounting income (FAI) as: The amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocated to principal under the terms of the governing instrument and applicable local law shall not be considered income. 102 Unless otherwise provided in the governing instrument, New York s fiduciary accounting rules require a fiduciary to allocate certain receipts to income and other receipts to principal. 103 Similarly, certain disbursements are required to be charged to income and other disbursements are charged to principal. 104 In New York, income is generally money or property that a fiduciary receives as current return from a principal asset. 105 Traditional trust accounting income includes interest, dividends and rents. 106 Principal is the property held in trust for distribution to a remainder beneficiary when the trust terminates. 107 However, Estates, Powers and Trusts Law section 11-A-4.3 contains a very important exception to these general rules concerning the classification of trust receipts and expenditures related to a closely held business. A trustee who conducts a business or other activity may determine that it is in the best interests of all the beneficiaries to account separately for the business or activity instead of accounting for it as part of the trust s general accounting records, whether or not its assets are segregated from other trust assets. 108 The trustee may further determine the extent to which its net cash receipts must be retained for working capital, the acquisition or replacement of fixed assets, and other reasonably foreseeable needs of the business or activity, and the extent 102 I.R.C. 643(b). 103 See N.Y. Est. Powers & Tr. Law 11-A See generally N.Y. Est. Powers & Tr. Law 11-A, Part See N.Y. Est. Powers & Tr. Law 11-A-1.2(4). 106 See N.Y. Est. Powers & Tr. Law (b) (replaced by 11-A-1.2(4) on January 1, 2002). 107 See N.Y. Est. Powers & Tr. Law 11-A-1.2(10). 108 See N.Y. Est. Powers & Tr. Law 11-A

34 to which the remaining net cash receipts are accounted for as principal or income in the trust s general accounting records. 109 Activities for which a trustee may maintain separate accounting records include retail, manufacturing, service and other traditional business activities, farming, and management of rental properties. 110 In addition, state law and/or the terms of the governing instrument may authorize a fiduciary to make adjustments between what is categorized as principal versus income. 111 The governing instrument may also provide for the use of generally accepted accounting principles ( GAAP ) to determine the income or loss of an entity owned by an estate or trust. 112 In particular, it is important for the governing document to provide flexibility concerning the proper accounting treatment of receipts and disbursements and the permissible adjustments between principal and income, since fiduciary accounting rules under state law may not be consistent with the traditional accounting practices related to the conduct of the business. 109 Id. 110 Id. 111 See N.Y. Est. Powers & Tr. Law 11-A-1.3(a)(1). 112 See Appendix B, 1.1(f). 30

35 APPENDIX A Business Entity Initial Filing Fees 113 Annual Filing Fees Statement Fees NY Corp. $125 filing fee for certificate of incorporation; $9 filing fee for biennial statement $10 organization tax (provided minimum share of stock authorized) -- NY LLC $200 filing fee for articles of organization; $50 filing fee for certificate of publication; For LLCs treated as partnerships for federal income tax purposes, graduated filing fees based on NY source gross income (ranging from $25 to $4,500) $9 filing fee for biennial statement *Additional publication fees Filing fee for an LLC disregarded as an entity is $25 NY LLP $200 registration fee; $50 filing fee for certificate of publication *Additional publication fees For LLPs treated as partnerships for federal income tax purposes, graduated filing fees based on NY source gross income (ranging from $25 to $4,500) $20 filing fee for five year statement 113 For source of initial, annual, and statement fees, see 31

36 Business Entity Initial Filing Fees Annual Filing Fees Statement Fees NY Limited Partnership $200 filing fee for certificate of limited partnership; $50 filing fee for certificate of publication If NY source gross income is $1 million or more, the annual filing fee is graduated (ranging from $500 to $4,500) -- *Additional publication fees 32

37 APPENDIX B Sample Fiduciary Business Provisions 1.1 It is my expectation that I shall have an ownership interest in closely-owned corporations, limited liability companies, limited or general partnerships, or other businesses (collectively referred to as the "business"), which will be included in this will at my death. My Executor or Trustees may continue to conduct the business for whatever period of time and in whatever form of organization they think proper. Therefore, my Executor or Trustees is granted the following powers which, in addition to those conferred by law and to any granted elsewhere in this will (the applicability of which to the business I confirm), my Executor or Trustees may exercise in their discretion with respect to the business: (a) To retain and continue the business for such time as they deem advisable; (b) (c) (d) (e) (f) To direct, control, supervise, manage or operate the business. My Executor or Trustees shall have the discretion to determine the manner and degree of their respective active participation in the management of the business and are authorized to delegate all or any part of their powers to supervise, manage or operate to such persons as they may select, including any partner, associate, director, officer or employee of the business; To engage, compensate and discharge or, as stockholders, members, or partners in the business, to vote for the engaging, compensating and discharging of managers, employees, agents, attorneys, accountants, consultants or other representatives as they deem advisable, including anyone who may be a beneficiary or fiduciary under this will, which compensation for themselves shall be in addition to any fiduciary commission they are entitled to for this practice; To use in the business only those assets of my estate devoted to the business at my death. Other assets of my estate shall not be used or be liable for the obligations and contracts of the business; Specifically, to organize one or more corporations or limited liability companies under the laws of this state or of any other state or country, to transfer thereto all or any part of the property of the business; and to receive in exchange those shares of stock or membership interests, of one or more classes, or bonds or other obligations of the corporations or limited liability companies as my Executor or Trustees deem advisable in order to carry on effectively any existing business or a business in a similar or related line of activity; In any accounting by my Executor or Trustees with respect to the operation of the business, it shall be sufficient if they report the earnings and condition of the business in a manner conforming to the standard accounting practice; and for the determination of what is income and what is principal, standard practices observed in the management of businesses of like character may be but need not be adopted 33

38 by the business, including, but without limiting the generality of the foregoing, obsolescence and depreciation, and allocations made in pursuance thereof as may be accepted by my Executor or Trustees; (g) (h) (i) (j) (k) To sell or liquidate all or any part of my business at times, for a price, on terms, including terms of credit, with or without security, and to a person or persons, or entity, as my Executor or Trustees may deem advisable, including a sale to a beneficiary of a trust, to a Trustee of a trust, and to any director, officer or employee of the business; To retain in the business part or all of the business income for its purposes and to the extent it is retained, it shall not be considered net income of a trust which would otherwise be available for distribution to income beneficiaries, provided the retention of income does not disqualify any trust for which a Qualified Subchapter S Trust or Electing Small Business Trust election has been made. To the extent income is retained and not distributed, no adjustment shall be made between principal and income beneficiaries of the trust; To enlarge, diminish or change the scope or nature of the activities of any business; To make any elections or give any consents which are required to achieve or maintain S corporation status for stock held and to enter into stock purchase, sale, redemption, voting, and other agreements as my Executor or Trustees determines in their sole and absolute discretion as necessary or appropriate for the protection of the shareholders of the S corporation and/or the deemed shareholders of the S corporation; and To retain any shares of the stock of an S corporation regardless of lack of diversification, risk, or nonproductivity, as long as my Executor or Trustees deem it advisable. Being aware of the fact that, in operating a business, risks must be taken, my Executor or Trustees shall not be held to personal liability for shrinkage of income or loss of capital value that may be incurred in the course of their operation of the business, unless that loss is occasioned by their gross negligence or willful misconduct, their actions to be considered in relation to the inherent risks involved in the operation of a business of the character represented; and that in judging their acts it be considered that they have engaged in a speculative enterprise upon my insistence and request. 1.2 In the event that all or any portion of any trust created hereunder consist of stock in a company that has made or desires to make an election to have the net profits and losses of the company taxed directly to its shareholders under Subchapter S of the Internal Revenue Code (an S Election ) and the trust would not then currently qualify as a shareholder eligible to hold such stock in a Subchapter S corporation (an Eligible S Shareholder ) or the trust under its then current terms will cease to qualify as an Eligible S Shareholder in the future, the Trustee shall in a timely manner amend the terms of the trust to the degree that would allow the trust to qualify as an Eligible S Shareholder as determined by tax counsel retained by the Trustee. Notwithstanding the preceding 34

39 sentence, the Trustee shall not amend a trust if such amendment would cause the assets contained in such trust to be subject to estate tax on the death of my wife or cause the assets contained in such trusts to cease to qualify for the estate tax marital deduction. In determining whether any such amendment shall be made, the Trustee may consider any then applicable grace period under the Internal Revenue Code during which a trust which is not otherwise an Eligible S Shareholder is allowed to hold shares in a Subchapter S corporation without terminating a corporation s S Election Business v2 35

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41 ESTATE PLANNING FOR THE CLOSELY-HELD BUSINESS OWNER Presented for The New York State Bar Association September 14-15, 2017 Thomas J. Collura

42 Overview Estate planning and administration for business owners involves consideration of financial, business, tax, personal and family issues. Business owners and advisors need to consider: What is the best form of entity for the business? Who should be transferred equity and/or control of the business? When should any transfer occur? How should any transfer be structured? How do you value a business interest? What are the legal requirements and restrictions on such transfer? What are the tax consequences upon any transfer during life or at death? Will there be sufficient liquid assets to fund any payment due the owner or for taxes? 2

43 Estate Planning Considerations Choice of Entity Business Succession Dispositions of Business Interests upon Death Transfers to Family Members Transfers to Non-Family Disability Planning 3

44 Choice of Entity Business Entities Sole Proprietorship Partnership (General or Limited) S Corporation ( Sco ) C Corporation Limited Liability Company ( LLC ) 4

45 Choice of Entity Business Considerations Limited Liability Centralized Management Investors Transferability Continuity Nature of Business 5

46 Choice of Entity Financial Considerations Tax Considerations Tax-free formation Flow-through vs entity-level income taxation of profits Employment tax distinctions Taxation on sale or liquidation of business Scorp Shareholder vs. LLC Member basis 6

47 Tax Basis Example Example: S Corp Shareholder vs. LLC Member Basis S Corp shareholders invest $100K; entity borrows $900K on non-recourse basis, i.e. no shareholder guarantees. What is shareholders basis in S corp? What is shareholder s basis after 5 years, assuming $20K of depreciation each year? What is shareholder s depreciation deduction in Year 6? Would results be different if entity was an LLC? 7

48 Choice of Entity: Comparison Factor C-Corp S-Corp Partnership LLC Method of formation Articles of incorporation Articles of incorporation Partnership agreement Articles of organization Number of owners No limit For tax years 2005 and after, 100 Equity structure No limits (multiple classes of stock permitted) Only one class of stock permitted Two or more for a general partnership; one or more general and one or more limited for a limited partnership No limits No limit No limits Status determination: election by entity No federal tax election requirement Required federal tax election (IRS Form 2553) No federal tax election requirement No federal tax election requirement Liability Limited to shareholder s capital contribution Limited to shareholder s capital contribution General partners: jointly and severally liable Limited partners: generally limited to capital contribution Limited to member s capital contribution Tax on income Corporate level Owner level Owner level Member level Character of income No flow-through to shareholders Flow-through to shareholders Flow-through to partners Flow-through to members Sale of interest by owner to 3 rd party Capital gain: no effect on basis of corporation s assets Capital gain: no effect on basis of corporation s assets Capital gain, subject to ordinary income classification (Sec. 751) Capital gain, subject to ordinary income classification (Sec. 751) Death of owner Estate continues as shareholder Estate continues as shareholder Dissolution; estate as assignee, subject to agreement Estate as assignee, subject to agreement 8

49 Dispositions of Business Interests at Death General Partnership subject to agreement = dissolution; assignee Limited Partnership subject to agreement, death of GP = dissolution; assignee. Death of LP = no dissolution; assignee LLC subject to agreement, death of member = no dissolution; assignee S or C corporation subject to agreement, death of shareholder = no dissolution; heirs become shareholder 9

50 Transfers to Family: Legal, Business and Financial Considerations How much ownership will family members receive? How to treat family members not involved in the business? Voting or non-voting rights? Legal restrictions on transfer? Transfers during life? If so, how? Value of the business interest? Any discounts available? If sale or redemption, how paid? Any security? Any restructuring necessary? Which documents or agreements are necessary to execute a transfer, and which govern the relationship of multiple owners? Income tax consequences? 10

51 Transfers to Family: Estate Planning and Tax Considerations Outright or in trust? Any limitations on trust? Gift, estate and GST tax consequences? Liquid assets to pay any estate taxes? If not, is any extension of time to pay available? Will life insurance be used to fund purchase price or estate taxes? 11

52 Transfers to Family: Other Estate Planning Considerations Allocation and payment of estate and GST taxes Fiduciary Powers Revocable Trust Special Concerns S corporations Marital trusts Charitable bequests 12

53 Gift Tax Planning Annual Gifts Marital Deduction Gifts Taxable Gifts Valuation discounts GRATs Sales to IDGTs Legal Control Issues What is control? Voting/non-voting Recapitalizations Shareholder agreements/operating agreements 13

54 Transfers to Non-Family Members Buy-Sell Agreements Management Succession Informal bonus plans Formal bonus plans Phantom stock plans/sars Restricted stock plans Stock options Qualified plans including ESOPs 14

55 Select Buy-Sell Agreement Provisions Voting rights; delegation of responsibility to managers (LLC) or directors (corporation); Economic rights of owners, e.g., salary, allocation of profits and losses, required or discretionary distributions, etc.; Permitted assignees (e.g., company, other owners, family members, trusts for family members), and whether assignee may become owner; Restrictions on transfer; Rights of first refusal; Events than trigger buy-sell options or requirements, e.g., death, disability or termination of employment; Valuation methodology; Payment terms, including insurance proceeds; and Termination provisions. 15

56 Disability Planning Shareholder Agreement Voting Trust Agreement Stock Proxy Limited or General Powers of Attorney Revocable Trust 16

57 Estate Administration of Business Interests State law or entity agreements trump Will Document review Personal income and gift tax returns Business tax return Personal and business financial statements Any business valuation Financing documents Organizational documents Buy-sell agreements 17

58 Estate Taxation Form 706 due if date of death value of citizen s or resident s gross estate > basic exclusion amount less adjusted taxable gifts See pages for required description NYS basic exclusion amount is $5.25M as of April 1, 2017 and will increase to federal level in 2019 No revaluation of gifts if adequately disclosed 18

59 Rev. Rul , C.B. 237 Factors to determine fair market value include: 1. The nature of the business and its history from inception; 2. The economic outlook in general and the outlook for the industry; 3. The current and book value of assets and financial condition of the business; 4. The earnings and capacity of the business to pay dividends; 5. Whether or not the business has goodwill or intangible value; 6. The market price of stocks of corporations engaged in the same or similar line of business; 7. The extent of decedent s control of the business or if the decedent was a key manager; 8. A binding bona fide buy-sell agreement; and 9. Options or other restrictive agreements concerning the stock. 19

60 Filing and Payment Due Dates Form 706 must be filed within 9 months of date of death. Form 4768 may be filed for 6 month extension with full payment of estimated tax. May apply for extension of time to pay under I.R.C. 6161(a)(2) IRC 6166 allows special election of time to pay estate and GST tax for any portion of such taxes attributable to closely held business interest for 5 years (interest only) and amortized over 10 annual installments. 20

61 Income Tax Issues IRC 1014(a) step-up in basis No step-up of assets within a corporation, but partnerships may adjust inside basis of partnership assets under IRC 743(b) if IRC 754 election is in effect. IRC 303 permits a partial redemption of stock without being characterized as a dividend. Consider pass-through entity phantom income. 21

62 Fiduciary Income Tax and Accounting Estates and trusts are separate taxable entities. IRC Subchapter J rules are complex given dichotomy between legal ownership of fiduciary and beneficial ownership of beneficiaries. Federal tax law generally follows state law accounting rules concerning what is principal and what is income Principal is the property held in trust for distribution to a remainder beneficiary when the trust terminates. EPTL 11-A-1.2(10). Income is generally money or property that a fiduciary receives as current return from a principal asset EPTL 11-A-1.2(4). Examples: interest, dividends and rents. 22

63 EPTL 11-A-4.3 Exception to general rules concerning classification of trust receipts and expenditures Allows trustee who conducts a business or other activity to separately account, rather than include as part of trust activities May determine which net cash receipts must be retained for working capital, acquisition/replacement of fixed assets or other foreseeable needs of business, and whether remaining net cash receipts are principal or income Applies to retail, manufacturing, service, other business activities and management of rental properties 23

64 Power to Adjust and Other Fiduciary Provisions EPTL 11-A-1.3(a)(1) authorizes a fiduciary to make adjustments between what is principal versus income. Generally recommended that governing instrument provides for (1) use of generally accepted accounting principles to determine the income or loss of an entity owned by an estate or trust and (2) flexibility concerning accounting treatment of receipts and disbursements See Exhibit B 24

65 Questions 25