Even with the allowable exemptions and exceptions available to you when planning for federal estate taxes, there is the real possibility that the remaining assets will be taxed at very high rates. To legally avoid this outcome, a number of strategies have been developed over the years that will allow you to pass on wealth to your family.
- the family limited liability company
- discounted business interests
- tax-free gifts
- trusts and S corporations
Before you decide to use any of these strategies, carefully consider the implications of your transfer, because you will be diluting your ownership in what you worked so hard to build, as well as affecting the tax status of all the parties involved.
It is always wise to consult an estate planning professional for advice before undertaking any planning strategies.
Understanding the implications of business interest transfers is crucial
When executing estate planning strategies, the result of transfers to children will often be income-splitting that lowers the family's overall income taxes.
Traditionally, income in a limited liability company (LLC) is divided according to the relative balance in the owners' capital accounts. Because the children will own much, or nearly all, of the business, according to the capital accounts, most of the income would be attributable to the children, if this traditional allocation scheme is used.
The children's share of income would be "passive" income in this instance. The first $2,000 of this passive income will be taxed at the child's tax rate, while the remainder is taxed at the parent's tax rate. However, if the children actually provide services to the business and were paid for those services, any payments to them would not be passive income. Accordingly, all of this non-passive income would be taxed to the children at their lower rates.
For 2013, the first $10,000 (the amount of the child's current standard deduction plus the child's personal exemption amount) would be tax-free. Moreover, it should be noted that parents could provide the cash necessary to pay the taxes incurred by the children.
Further, when children actually work in the business, this will mean retirement plan contributions can be made on their behalf. It also will allow the retirement plan to qualify under the Employee Retirement Income Security Act (ERISA), where, otherwise, with only the two parents participating in the plan, it would not qualify. This will mean the retirement plan benefits will be protected as exempt assets in a bankruptcy or state court proceeding.
The use of this allocation scheme also will mean that the wealth represented by the business's earnings will not be subject to the estate tax. Nearly all of the income drawn out from the business would be attributable to the children and, thus, not taxable in the parents' estate.
Transfers to the children also offer flexibility with respect to income taxes. Because the parent retains control, and provides all of the labor and planning for the business, all (or most) of the business' earnings can be drawn out by the parent as salary, if that is desired. This obviously is an advantage to the parents in terms of control of the cash flow.
Moreover, transferring ownership interests to the children serves a useful asset exemption purpose. The value of the business is divided among the parent and the children, leaving the parent with complete control of the business, but with a lower-valued ownership interest. This makes it easier to exempt the parent's ownership interest.
Finally, when transfers are made into a trust with a spendthrift clause, the interests transferred are protected from the children's creditors. Ultimately, asset protection strategies should be designed to work together, as part of a comprehensive asset protection plan.
Factors to consider in transferring assets
If you are going to use the estate planning strategy of transferring ownership interests to family members, several caveats are in order.Warning
Estate planning is an especially complex and ever-evolving area of law. It is wise to consult an estate planning practitioner before undertaking any planning measures.
While the parents retain control of the management of the business, and control over withdrawals during the life of the business, the children in fact will own a significant portion of the business. They will receive this share on liquidation of the business. Some parents would not want this result or would want the ability to revoke the transfers, which is not possible.
Parents still must plan for the transfer of control of the business (i.e., the manager interest) to the next generation. This decision involves many other factors, such as the children's desire, or competence, to operate the business, etc.
Capital must be material income-producing factor
The IRS has approved the transfer of interests both to children directly and to trusts that hold the interests for the children. Accordingly, the children or the trust will be recognized as partners for federal tax purposes. However, in both cases, the IRS will recognize the children, or the trusts holding their interests, as partners, only if capital is a material income-producing factor.
This rule exists to prevent parents from shifting what really is income from their personal services to the children. If the profits are generated principally by services provided by the parents, the children (or their trust) will not be recognized for federal tax purposes and the income will be taxed to the parents.
Note that the IRS cannot control who is a partner under state law, or for any other purpose, except for purposes of federal taxation and, in this case, for purposes of deciding who will be taxed on the business's income.
This IRS rule on which partners are taxed may not present a problem for the small business owner, even in a personal service business, because the children will be gifted interests in the holding entity. The holding entity will produce income primarily from the provision of capital to the operating entity (providing leased equipment, purchasing receivables, etc.). This is yet another reason to use a holding entity and an operating entity.
Finally, where capital is not a material factor in producing income, there is another option. The IRS will recognize the children, or their trust, as partners if the children provide significant services to the business, and income is allocated according to the relative services provided, rather than on the basis of relative capital interests.
Trusts must be managed for benefit of beneficiaries
In addition, where trusts hold the interests of the children, the trustee, especially if this is the parent, must manage the interests solely for the benefit of the beneficiaries of the trusts--the children. This prevents parents from using the principal or income in the trust for their own personal benefit.
This strategy has recently come under IRS scrutiny, precisely because of its effectiveness in significantly reducing estate taxes. Basically, the IRS has scored successes when individuals have created an entity and transferred interests to their children on their death-bed, as a tax-avoidance tool, and when entities have been formed and funded solely with marketable securities and, thus, had no business purpose. Neither of these situations will be likely to apply to the small business owner.
Family LLCs can transfer wealth, protect assets
Many different estate planning strategies can be used to eliminate or, at the very least, significantly reduce estate taxes, ensuring the family's wealth is passed on to the next generation.
One such strategy involves transferring business interests to the family through the use of a limited partnership (LP) or a limited liability company (LLC). Parents transfer to their children "discounted" shares in their LP or LLC, without giving up control of the business.
Parental control of the business is ensured in the LP because limited partnership interests are transferred to the children, while the parents retain the general partnership interest (limited partners may not participate in the management of the business.) Historically, the LP has been used in estate planning strategy because of this attribute.
Today, the LLC can be used to accomplish this same purpose, but with all of the owners having limited liability for the business's debts. An LLC can be structured as a "member-managed" entity, wherein all of the owners participate in management, similar to the partners in a general partnership. However, the LLC can also be formed as a "manager-managed" entity, wherein the owners who are also the managers control the business, while the owners who are not managers act in a capacity similar to limited partners. In short, the "manager-managed" LLC is well suited to accomplish this estate planning objective.
Parents can transfer ownership interests, in the form of non-voting non-manager interests, to the children without giving up control of the business. In the immediate future, many practitioners will continue to use the LP in employing this estate planning strategy, because a body of favorable case law has built up over the years supporting the use of the LP for this purpose. However, many practitioners are already embracing the LLC as a better alternative to the LP, because all of the owners of the LLC enjoy limited liability.
Sometimes an LP is created solely to transfer wealth tax-free. In this case, it is usually funded with the family's securities or real estate holdings. However, its best use exists when the family is using the entity to operate a legitimate business.
As the limited liability limited partnership (LLLP) begins to become more common, the limited partnership form may, once again, be the choice of practitioners employing this estate planning strategy, at least in those states that allow the owner's personal creditors to foreclose on the owner's business interest, and force a liquidation of the business to satisfy the debt.
In contrast, the corporation has never been used for this purpose. The corporation does not offer the same protection to owners from the claims of the owners' personal creditors. In many states, the personal creditors of the owner of a corporation, but not an LLC, may foreclose on the interest of the owner and force a liquidation of the business, or simply vote in favor of liquidation.
Moreover, the subchapter S corporation limits estate planning opportunities because the law places restrictions on the types of trusts that may be shareholders. Although an estate planner can avoid nearly all of these limitations, the need for specialized advice can make estate planning with an S corporation somewhat more burdensome than with an LLC. Therefore, the LLC generally is a better choice than the corporation.
Most small business owners operating a corporation will make the subchapter S election, which requires that there be only one class of stock in the corporation. However, voting and non-voting stock are considered to be the same class of stock for purposes of the S corporation election.
For this estate planning transfer strategy to work, there would have to be two types of stock--voting for the parents and nonvoting for the children. While it is possible to employ this strategy using an S corporation, it is not widely used.