Effective Planning Strategies for Family Businesses

Effective Planning Strategies for Family Businesses
By: Robert J.M. Scranton, M.T., J.D.
(719) 477-0333

Introduction

Family businesses are different from other types of businesses in that the owner/principal of the business often times would like the business to continue after his/her death as a family owned business. But, there is a problem that arises in many family owned business situations that often times thwarts the principal’s plan to pass the business to family members without creating a financial crisis for the family and the business because of the Federal Death Tax (Estate Taxes). Currently, a Colorado business owner may pass to his family free of federal and state estate taxes $1,000,000 (for 2002 & 2003; please see the chart below) worth of property at death. The $1,000,000 estate tax exclusion includes the fair market value (“FMV”) of all property owned by the deceased business owner (the “decedent”) and include the face value of any insurance policies owned by the decedent, retirement plans and the FMV of the family owned business held by the decedent. The FMV of the family owned business is likely NOT the “book” value of the business as listed on the business financial statements. Thus, many business owners find that they have estates that are subject to estate taxes upon their death. Where will the money come from to pay the estate taxes? Simply stated, from the decedent’s estate. And, often times that means the business must be liquidated or leveraged (loans placed against its assets) to obtain the necessary “cash” to pay the estate taxes which are due nine (9) months after the decedent’s death.

With the Tax Relief Act of 2001, the Unified Credit has gradually been increasing. In addition, the top estate tax rate will be decreasing until 2010, when estate and gift taxes are fully repealed. However, in 2011, estate taxes return to their 2002 levels.

Here's a breakdown of the new Unified Credit and top estate tax rates:

Year Unified Credit Top Estate Tax Rate

2002 $1 million 50%

2003 $1 million 49%

2004 $1.5 million 48%

2005 $1.5 million 47%

2006 $2 million 46%

2007 $2 million 45%

2008 $2 million 45%

2009 $3.5 million 45%

2010 Tax Repeal 0%

2011 $1 million 50%

2012 $1 million 50%

2013 $1 million 50%

This article explores not only the various methods to avoid the payment of estate taxes in situations where such payment would inevitably force the surviving family members to liquidate, sell or encumber the business thereby either ending family control or endangering the continuation of the business by the family, but also the practical management structural considerations as well.

Family Business Continuation Issues

Family business continuation issues differ from traditional business continuation issues in that, estate planning traditionally entails the division of assets. Thus, if an individual is worth $1 Million dollars and has four beneficiaries, simple math would imply that each individual should inherit $250,000 upon the death of the family member. But, in a family business context, often times, not all the family members are actively engaged in the business or even are otherwise employable individuals. That is, some family members may not have readily marketable business skills, such that, the family member could readily find gainful employment in a business in the same industry as the family business. Yet, the business owner might contemplate that that family member should enjoy the benefits of his/her life’s work through the inheritance of a proportional share of the family business.

From a practical standpoint in a family business, transferring an interest in a family business to family members who are otherwise not capable of contributing meaningful work or management skills to the family business is counter productive to those surviving family members that are actively engaged in the family business and do have meaningful work or management skills essential to the business’s continuation. And, the patriarch or matriarch of the family may not have confidence in their offspring relative to the requisite business skills necessary for successful management of the business. Thus, traditional estate planning techniques, separating the value of the decedent’s estate equally, are insufficient when contemplating the continuation of a family owned business to the next generation. The business owner, estate planner and financial planner should look beyond the mere financial and technical aspects of dividing the family business owner’s estate proportionally based solely on valuation. The threshold question to be answered is, will the surviving family members possess the requisite skills to successfully manage the family business and can those surviving family members work in a cohesive united business unit as well.

Family Business Organizational Strategies

Trust among business associates is essential in any small business. In a family owned business, the issue of trust is paramount, especially as it relates to the business continuation plan. In the typical family business the parent/owner is the person with the management, financial and familial power and who uses such power to exert control over the children who are involved in the business. Once this control is removed from the managerial structure in a family business, the once well-defined management structure is turned on its head. That is, those individuals that often times only reacted to top down management policies, procedures and instructions are now in a position of management and usually without a controlling figurehead with sufficient power to maintain balanced control over all aspects of business operations.

The family business owner should plan for the problems that are inherent and arise from dramatic changes in management structure by introducing, early on, a hierarchical family management structure. Thus, the family business should adopt a policy of regular management meetings complete with an annual shareholder meeting with all the requisite formalities. While this may appear on its face to be somewhat frivolous, creating a management structure will help reduce the likelihood that the inevitable power vacuum that will arise upon the parent’s death will be catastrophic to the normal operations of the business in the short run. Additionally, creating a well-defined management structure will help nurture trust among family members and thereby reduce the likelihood of a power struggle among managing family members upon the parent’s death.

To aid in enhancing the balance of power in a family business, it may be advisable to provide a seat on the board of directors for a non-family member professional who is paid for financial, legal or managerial services on behalf of the business. Including an outside board member may provide the necessary balance on the board of directors necessary to facilitate the transfer of power in an orderly fashion upon the death of the business owner. Additionally, providing for structured resolution of disputes among family members in a formal setting may help reduce the likelihood that any potential dispute will rise to the level of litigation, thereby essentially destroying the ability of the family members to manage the business effectively.

Retirement and the Business Owner

Traditional estate planning encompasses the single goal of avoiding estate taxes. A proper advanced business continuation plan will encompass the retirement goals of the business owner as well. Thus, as outlined above, of great importance in any such plan is the structured transition of power upon the diminished physical or mental capacity of the business owner. Thus, senior family members must determine if they will have sufficient assets to retire without requiring continuing support from the family business. In situations where the senior family member’s retirement and financial security are closely tied to the success of the younger family member’s business acumen, it may be impractical for the senior member to ignore the business and acquiesce control to the younger family members. In this situation, a poor business decision will directly affect the retiring senior member’s security.

Thus, retirement necessarily requires providing a nest egg sufficient to provide for the needs of the retiring senior family member. Without sufficient resources otherwise freely available to the retiring family business owner, any planned retirement may be in name only and will not result in the desired transfer of control to the younger family members.

Transferring Control

Once it is determined that the family owned business may not be transferred upon the business owner’s death free of estate taxes, and the business owner has dealt with the issues of how management of the business should be structured and which family members should succeed to such positions of management, the fundamental issue of conveying ownership in the business thereby reducing the estate tax liability may be properly addressed. Of course, the common sense approach would suggest that to avoid including a portion of the value of the business in your estate you must convey ownership to your heirs before your death. But, if you convey ownership are you not also conveying the power to control the business as well? Yes, in some instances; and No, in certain other instances. Thus, to maintain control and yet convey an ownership interest the appropriate business vehicle should be selected.

This article will not examine all the various ownership vehicles available nor will it attempt to analyze in thorough detail the numerous taxable results in every circumstance. The reader is encouraged to seek the counsel of a qualified tax professional, either a tax attorney or a Certified Public Accountant who possesses an advanced degree in the area of Taxation.

The Family Limited Partnership

A family limited partnership is an excellent vehicle well suited to convey the ownership of a family business to family members before death. Some of the benefits are:

	Reduce the value of your estate
	Reduce estate tax liability
	Convey ownership to family members
	Maintain control until retirement or death
	Maintain your income during lifetime

A Colorado Family Limited Partnership (“FLP”) employs a planning technique for reducing federal and state death taxes through the use of a flow-through entity for making gifts of FLP interests during life to family members. Also, the FLP is designed to shift present as well as future appreciation in value away from the parent to the children.

Generally, the mechanics for implementing the FLP are:

The parent/grandparent transfers the family business and/or its assets to the FLP in exchange for a general and limited partnership interest

The parent/grandparent transfers by gift, immediately and over time (annual gifting) a substantial portion or all of the equity interest in the FLP to family members

The value of the gifts of the equity interests in the FLP are discounted for one or more of the following reasons:

Lack of marketability

Minority interest

Other reductions

The parent/grandparent retains control as the “General” partner who:

Makes all management decisions

Receives a salary for management (usually the same as the parent/grandparent received as owner)

Retention of 2% equity as the general partner allows the parent/grandparent to maintain the same status and control as sole owner while gifting away 98% of the value of the business

The FLP operating agreement contains provisions designed to avoid the parent’s/grandparent’s retention, directly or indirectly, of the ability to liquidated his/her or other interests in the FLP

Upon death the parent/grandparent all the post-date of gift appreciation in the gifted FLP interest is excluded from the gross estate as well as the value of the gifted interest

The IRS has attacked the validity of many FLPs over the years. Most of the successful attacks resulted from the desire of the parent or owner to retain too much continuing control over the gifted interests. Thus, the practical application of the results of the litigation surrounding FLPs is that the parent/grandparent must actually gift the interest in the FLP and retain no powers over such interest. Thus, the gifting partner, the parent/grandparent, must avoid the following:

	Retained rights over liquidation or sale of the partnership interest conveyed
	Restrictions on the sale of a gifted partnership interest
	Create the FLP close to death while terminally ill (business reason test)
	Using FLP interests (assets) without proper compensation to the partnership

Thus, a properly constructed Colorado FLP can yield the desired results of maintaining control and reducing the estate of the owner/parent/grandparent and thereby the resulting estate taxes upon death. There are some negatives relating to the issue of “Phantom Income” to the limited partners. Phantom Income arises when a flow-through entity like an FLP has income which is passed on to the “owners” (limited partners) and the limited partners do not receive any cash distributions from the business to pay the tax liability associated with such deemed Phantom Income. Thus, the general partner must be aware of this issue and make distributions to the limited partners accordingly to pay any tax liability arising in such Phantom Income situations.

Other IRS Family-Owned Business Estate Tax Exclusion & Benefit Rules

Family-Owned Business Exclusion

Congress provided limited assistance to family business owners by adding a special section to the Internal Revenue Code, the Family-Owned Business Exclusion. The purpose of the new Code section was to provide a reduction in estate taxes for “qualified” family-owned businesses, primarily to preserve family farms and other family-owned businesses. Generally, Congress created this section to save family-owned businesses in areas where the family-owned business would impact the local communities in which the enterprises are located. Thus, as you can imagine, the rules are complex and generally favor larger family owned businesses and are of little significance for the vast majority of family owned businesses.

Because this Exclusion is very complex, the author will do a follow-up article to discuss in detail this IRS Code section.

Special Use Valuation

Under the IRS Special Use Valuation Code section, the value of real property may be based upon the use of the property as opposed to the fair market value of the property. This may be useful to the owner and estate of a family owned business if the family owned business is engaged in farming or other business enterprise and the value of real property used by the business has a higher value than its present use.

Because this Exclusion is very complex, the author will do a follow-up article to discuss in detail this IRS Code section.

Fifteen-Year Deferral of Estate Taxes

Generally, this is a post-death planning strategy employed by the Personal Representative of the decedent business owner where payment of estate taxes due would otherwise force the sale or liquidation of the family owned business.

Under the IRS Code section relating to deferral of estate taxes, the personal representative may elect to defer the estate taxes attributable to the decedent’s interest in a closely held business and pay such taxes, after a five-year deferral, in ten annual installments. For decedent business owners dying after December 31, 1999, the interest rate is two percent (2%) on the tax attributable to the first $1,010,000, indexed for inflation thereafter, of the value of the closely held business interest. To take advantage of this special deferral provision, the decedent must have:

Been a citizen of the United States at death

More than 35% of the decedent’s estate must be in the closely held business

If a partnership, 20% of the partnership must be owned by the decedent and there may be no more than 15 partners

If a corporation, 20% of the stock must be owned by the decedent and there may be no more than 15 shareholders

The personal representative must make an election on a timely filed estate tax return

There are numerous other tests related to this deferral provision, but generally all the rules relate to verifying that the deferral may only be used for a verifiable trade or business and that the business is closely held as defined by the IRS Rules and Regulations.

Conclusion

Thus, effective planning strategies for family owned businesses include, focusing on the results, considering how the business will be managed and control will be shifted over time to other family members and how that will impact the overall operations of the business, how family trust may be enhance thereby reducing the likelihood of power struggles between family members in the future, and consideration for the owner’s/principal’s retirement goals and how those goals will impact business management and control issues. And, the FLP provides a balanced approach for gifting while maintaining control for the owner/principal with minimal tax complications. Finally, there are other tax exclusions and post-death techniques, but in the end these post-death remedies are very limited, lack flexibility and have numerous pitfalls for the unwary. As with any area of law, the reader is encouraged to seek professional legal and financial advice before embarking on any long-range business planning, especially where the ramifications of improper planning affect those closest to us.