Business Succession Planning

<div class="Section1"><br /> <br /> In this type of&nbsp;partnership, disposition of&nbsp;partnership&nbsp;interests by will on the death of a partner is seldom a satisfactory solution. In the case of a married child, a bequest of his or her partnership&nbsp;interest often would be made to a surviving spouse, and in many instances might lead to the liquidation of the business as being preferable to taking the surviving spouse into the firm. The same result could follow should the parent bequeath his or her partnership&nbsp;interest to the surviving spouse. On the other hand, if the parent bequeaths his or her interest to the children and such interest comprises the major part of the estate, the surviving spouse may be able to elect to take against the will and thereby upset the bequest of the&nbsp;partnership&nbsp;interest.<br /> <br /> A specially designed buy-sell agreement usually will be a desirable solution. Under such an agreement the children will agree to purchase their parent&rsquo;s partnership interest upon death and to maintain insurance on the parent&rsquo;s life with which to finance the purchase. The insurance proceeds will be collected by the children, or by a trustee acting for them, and paid over to the executor of the parent&rsquo;s estate to meet the cash needs of estate administration and to fulfill bequests to the surviving spouse of the balance of the funds.<br /> <br /> Thus, the surviving spouse will be assured adequate income and will not be able to upset the plan, even though there is little other estate property. Where division of the estate is not a problem and the parent wishes to leave something to the children, the plan may be modified by giving the children a bargain price in the agreement, or by having them purchase a portion of the parent&rsquo;s interest while he or she bequeaths the remaining portion to them.<br /> <br /> In the case of a&nbsp;partnership&nbsp;between a parent and his married child, in most instances there should be a traditional cross-purchase agreement (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8992">8992</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8999">8999</a>). Where there are at least two children as partners with their parent, the parent may not desire to increase his or her interest in the firm if a child dies first. In this case, the agreement should provide for a cross-purchase between the children in the event of the death of one of them.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Using a qualified terminable interest property (QTIP) trust where the business interests at issue are subject to a buy-sell agreement can create estate tax problems if the stock value set by the buy-sell agreement does not meet the requirements of IRC Section 2703 (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9026">9026</a>). Generally, if the requirements of Section 2703 are satisfied, the price specified under the buy-sell agreement will control for estate tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> If the requirements are not satisfied, however, the price may be adjusted so that it reflects the true fair market value of the stock. As a result, if the value is adjusted upward, the shareholders who are subject to the buy-sell agreement may be deemed to have received an economic benefit from the surviving spouse&rsquo;s QTIP because those shareholders were granted the right to purchase the shares at a lower price.<br /> <br /> To qualify as QTIP property, no person may be given a power to appoint any part of the property to any person other than the surviving spouse unless the power is exercisable only at or after the death of the surviving spouse (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9020">9020</a>).<a href="#_ftn2" name="_ftnref2">²</a> If a third party is given the power to purchase shares that would otherwise be QTIP at a price that is eventually found to be lower than fair market value, the QTIP trust may be ineligible for QTIP treatment because, effectively, the difference between the lower price specified in the buy-sell agreement and the higher true fair market value is treated as income that is derived from the shares and granted to a party other than the surviving spouse.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Similarly, if the buy-sell agreement prohibits the QTIP trust from selling the stock without the consent of a third party, the shares will likely fail to qualify as QTIP. One of the essential requirements of a QTIP trust is that it must entitle the surviving spouse to receive all of the income derived from the trust principal. In order to give effect to this requirement, the regulations provide that the surviving spouse must be given the power to require that the trustee convert any unproductive property into income-producing property. Such a power will not disqualify the property as QTIP so long as applicable trust administration rules require the trustee to use the judgment and care in the exercise of the power that a prudent man would use if he were owner of the property. What&rsquo;s more, a power to retain a residence or other property for the spouse&rsquo;s personal use will not disqualify the interest passing in trust,<a href="#_ftn4" name="_ftnref4">⁴</a> If stock contained in a QTIP trust cannot be sold without the permission of a third party, the surviving spouse&rsquo;s income rights are not absolute and the property may fail to qualify for the marital deduction.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; <em><em>See, e.g.</em></em>, <em>Slocum v. U.S.,</em> 256 F. Supp. 753 (S.D.N.Y. 1966).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 2056(b)(5).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; TAM 9147065, where it was found that the first-to-die spouse granted an option for his sons to grant themselves the excess of the fair market value of the shares over the option price, thus defeating the property&rsquo;s QTIP status.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; Treas. Reg. &sect; 20.2056(b)-5(f)(4).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; TAM 9147065.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> When a taxpayer transfers property in which certain rights are retained, the value of that property will be included in the estate for estate tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a> IRC Section 2036 specifically provides that retaining the right to vote shares in certain corporations constitutes a right that will generate estate tax inclusion even if the shares themselves are actually transferred. This is the case whether the right to vote is retained directly or indirectly (such as through the use of a trust entity or informal agreement).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In order for the value of transferred voting stock to be included in the original shareholder's estate, the corporation must be considered a "controlled corporation." A corporation is a controlled corporation if, at any time after the transfer and during the three-year period ending on the date of the decedent's death, the decedent-transferor owned at least 20 percent of the combined voting power of all classes of the corporation's stock. In determining the 20 percent ownership test, the family attribution rules of IRC Section 318 apply.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> As a result, the transferring owner will be treated as though he or she owns (1) any stock owned (either directly or indirectly) by the spouse, children, grandchildren or parents, (2) a proportionate share of any stock owned by a partnership or estate in which the transferor is either a partner or beneficiary, (3) a proportionate share of any stock owned by a trust of which he or she is a beneficiary or grantor and (4) stock owned by a corporation if the transferring owner owns 50 percent or more of the value of that corporation. These broad attribution rules expand the reach of IRC Section 2036, making the transfer of nonvoting stock the most effective way to avoid the risk that the value of the shares will eventually be included in the transferor's estate.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 2036(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 2036(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 2036(b)(2).<br /> <br /> </div>

<div class="Section1"><br /> <br /> A grantor retained income trust (GRIT) is an irrevocable trust created by the grantor allowing the grantor to retain an income interest for a term of years. At the end of the term, the property held in trust is distributed to, or remains in trust for, the named beneficiaries. If the grantor survives beyond the retained income term, then the property transferred in trust—the remainder interest in the trust property—is not included in the grantor's estate. Although the transfer of a remainder interest is a taxable gift—a gift tax is due when the transfer is made—a GRIT can reduce a grantor's overall transfer tax liability because the gift tax is based on the value of the remainder when transferred. Thus, any appreciation in the remainder property (from the date of the gift to the date of the grantor's death) is effectively transferred estate tax-free. However, if the grantor dies before the retained income period expires, the trust property is included in the grantor's estate and will be subject to estate tax.<br /> <br /> A three-year GRIT is simply a GRIT whose specified term is three years—a time period that stems from the general rule that gifts that are made within three years of a donor's death will be brought back into the donor's estate.<a href="#_ftn1" name="_ftnref1">¹</a> In this context, a gift of stock is transferred to a GRIT that provides that all income from the trust will be paid to the parent generation for a period of three years. Because this income right is not a fixed amount or fixed percentage of the fair market value of the stock transferred, it is not a "qualified interest,"<a href="#_ftn2" name="_ftnref2">²</a> so that the value of the income interest—or the "retained interest"—will be zero.<a href="#_ftn3" name="_ftnref3">³</a> This means that, for gift tax purposes, the value of the interest that remains at the end of the term will be the entire value of the stock transferred.<a href="#_ftn4" name="_ftnref4">⁴</a> Effectively, this strategy is most valuable when the parent generation has determined that it is willing to pay the gift taxes on the stock transfer currently in order to avoid the inclusion of the appreciated stock in their estate.<br /> <br /> At the end of the three-year period, the stock will pass to the next generation. The risk of this strategy is that, if the parent generation dies within the three-year period, the value of the stock (including any appreciation that occurs within the three-year period) and all gift taxes paid will be included in the parent's estate (although the estate will receive a credit for the gift taxes already paid). If the parent outlives the three-year period, this risk is eliminated and any appreciation in the stock is transferred estate tax-free.<br /> <br /> The ability to use this technique has been limited with the advent of IRC Section 2702. This section provides that the retained interest is valued at zero, unless the retained interest is a "qualified retained interest." The rules of Section 2702 apply with respect to transfers to family members.<a href="#_ftn5" name="_ftnref5">⁵</a> Therefore, the ability to implement a GRIT is limited to those parties that are not family members within the statutory definition. This technique may have applicability to same sex couples who do not get married and other unrelated parties within the definition.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 2035.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Treas. Reg. § 25.2702-3(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  Treas. Reg. § 25.2702-1.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 2702; Treas. Reg. § 25.2702-1(b).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  Treas. Reg. § 25.2702-2(a)(1) for definition of "member of the family." This regulation defines member of the family as the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing. However, there are a few exceptions which will permit these transfers with retained interests among family members. These are GRATs and GRUTs, personal residence trusts and the qualified personal residence trusts.<br /> <br /> </div>

<div class="Section1"><br /> <br /> If a family partnership is formed between two spouses, in order to eliminate the possible problems and uncertainties that may arise, a buy-sell agreement should be formed between the partners. Moreover, each spouse should be assured there will be ample capital in order to purchase the decedent&rsquo;s business interest. This may become necessary through failure of the decedent&rsquo;s will (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9015">9015</a>), if no will had been executed, through a change in a previously executed will, or because of creditors&rsquo; claims.<br /> <br /> Family members (or any other person) will be recognized as partners only if one of the following requirements is satisfied: (1) if capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest; (2) if capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> One of the advantages of the buy-sell agreement is that the value of the business may be established through a valuation formula contained in the agreement (the valuation of shares is a frequent subject of litigation, with the IRS often taking the position that the estate has undervalued the reported value). If properly established, the stated value should be accepted for federal estate tax purposes. A recommended method in the case of a&nbsp;family partnership&nbsp;is to have an independent certified public accountant establish and certify the true value, and to attach this certificate to the buy-sell agreement. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9026">9026</a> for a detailed discussion of valuation issues that arise in the context of a buy-sell agreement.<br /> <br /> Adequate life insurance is as essential in financing the buy-sell agreement, as would be the case were the parties unrelated. Since the spouses are partners in the business, each should carry life insurance upon the life of the other.<br /> <br /> If the surviving spouse is to carry on the business after the death of the first-to-die as legatee, rather than as purchaser under a buy-sell agreement, insurance on his or her life payable to the surviving spouse for business purposes is advisable, if not essential. Without a special fund available to satisfy partnership&nbsp;creditors and to hire the assistance necessary to do some of the work previously performed by the first-to-die, the surviving spouse may find it difficult to continue the business. With adequate life insurance proceeds at his or her disposal, and with adequate experience in the business gained as an active partner, the surviving spouse is given an opportunity to continue the business successfully.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRS Pub. 541 (Rev. February 2019).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> In the context of a family-owned business, many business owners may consider creating a class of preferred stock to help provide for a smooth transition of business ownership to the next generation of family members. This can actually create problems that can complicate the transition process.<br /> <br /> First, small business owners must be advised that the creation of a second class of stock can cause a currently existing S corporation to lose its S corporation status, because S corporations are only permitted to issue a single class of stock.<a href="#_ftn1" name="_ftnref1">¹</a> Second, if a currently existing corporation wishes to convert to S corporation status in the future, the existence of the class of preferred stock will make the conversion impossible unless all existing preferred shareholders agree to exchange those shares for a single class of stock that is generally available to all shareholders.<br /> <br /> Further, the rules contained in IRC Section 2701 can thwart a business owner's plans to transfer interests gift tax-free to family members by setting the value of any retained preferred business interest (known as an "applicable retained interest," <em><em>see</em></em> below) that does not contain a right to receive a "qualified payment" at zero if there is a transfer of a common equity interest in the business to a family member.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Essentially, these rules require that the transferring family member treat the retained preferred stock interests as a taxable gift to the family member to whom the common stock interests are sold. The rules imposed under IRC Section 2701 are designed to prevent a scenario where the older generation creates a class of preferred shares (which is retained) in order to avoid paying gift taxes on common shares (which he or she transfers to the younger generation).<br /> <br /> For example, before the enactment of Section 2701, a business owner may have created a class of preferred shares with a value that was equal to the current value of the business, retaining these preferred shares. The business owner could then transfer a class of common shares to the child that had no current value, and thus generated no gift tax liability. By fixing the value of an applicable retained interest at zero (in the absence of a qualified payment right), Section 2701 seeks to prevent this result. Essentially, the rules provide that the taxable gift can only be avoided if the parent who retains the preferred stock receives a qualified dividend payment (which will establish the value of the preferred stock) on a fixed basis (either as a set amount or specified percentage of the stock value) going forward, and that such dividends are actually paid. This can create additional tax liability for the parent and also reduce the operating capital of the company itself.<br /> <br /> Where an applicable retained interest includes a distribution right which consists of the right to receive a qualified payment and there are one or more liquidation, put, call, or conversion rights with respect to such interest, the value of all such rights is to be determined by assuming that each such liquidation, put, call, or conversion right is exercised in a manner which results in the lowest value.<a href="#_ftn3" name="_ftnref3">³</a> IRC Section 2701 does not apply to distribution rights with respect to qualified payments where there is no liquidation, put, call, or conversion right with respect to the distribution right.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> The rules imposed under IRC Section 2701 also do not apply if, for either the transferred interest or the applicable retained interest, market quotations are readily available (as of the date of transfer) on an established securities market. Further, the rules do not apply if the applicable retained interest is of the same class as the transferred interest, or if the applicable retained interest is proportionally the same as the transferred interest (disregarding nonlapsing differences with respect to voting in the case of a corporation, or with respect to management and limitations on liability in the case of a partnership).<a href="#_ftn5" name="_ftnref5">⁵</a> An exception from the rules is also provided for a transfer of a vertical slice of interests in an entity (defined as a proportionate reduction of each class of equity interest held by the transferor and "applicable family members" (defined below) in the aggregate).For example, Section 2701 does not apply if John owns 50 percent of each class of equity interest in a corporation and transfers a portion of each class to his child in a way that reduces each of John's interests, as well as the aggregate interests held by any applicable family members, by 10 percent. This is so even if the transfer does not proportionately reduce John's interest in each class.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <p style="text-align: center;"><strong>Definitions</strong></p><br /> An "applicable retained interest" is any interest in an entity with respect to which there is (1) a distribution right and the transferor and family members control the entity immediately before the transfer, or (2) a liquidation, put, call, or conversion right (i.e, rights commonly granted to holders of preferred stock).<a href="#_ftn7" name="_ftnref7">⁷</a><br /> <br /> A "qualified payment" means any dividend payable on a periodic basis at a fixed rate (including rates tied to specific market rates) on any cumulative preferred stock (or comparable payment with respect to a partnership). With respect to the transferor, an otherwise qualified payment is to be treated as such unless the transferor elects otherwise. With respect to applicable family members, an otherwise qualified payment is not to be treated as such unless the family member so elects. A transferor or a family member can make an irrevocable election to treat any distribution right (which is otherwise not a qualified payment) as a qualified payment, payable at such times and in such amounts as provided in the election (such times and amounts not to be inconsistent with any underlying legal instruments creating such rights).<a href="#_ftn8" name="_ftnref8">⁸</a> The value assigned to a right for which an election is made cannot exceed fair market value (determined without regard to IRC Section 2701).<a href="#_ftn9" name="_ftnref9">⁹</a><br /> <br /> A "member of the transferor's family" includes the transferor's spouse, lineal descendants of the transferor or transferor's spouse, and the spouse of any such descendant.<a href="#_ftn10" name="_ftnref10">¹⁰</a> An "applicable family member" with respect to a transferor includes the transferor's spouse, an ancestor of the transferor or transferor's spouse, and the spouse of any such ancestor.<a href="#_ftn11" name="_ftnref11">¹¹</a> An individual is treated as holding interests held indirectly through a corporation, partnership, trust, or other entity.<a href="#_ftn12" name="_ftnref12">¹²</a> In the case of a corporation, "control" means 50 percent ownership (by vote or value) of the stock. In the case of a partnership, "control" means 50 percent ownership of the capital or profits interests, or in the case of a limited partnership, the ownership of any interest as a general partner.<a href="#_ftn13" name="_ftnref13">¹³</a> When determining control, an individual is treated as holding any interest held by an applicable family member (<em><em>see</em></em> above), including (for this purpose) any lineal descendant of any parent of the transferor or the transferor's spouse.<a href="#_ftn14" name="_ftnref14">¹⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 1361(b)(1)(D).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 2701(a)(3).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 2701(a)(3)(B).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.  IRC § 2701(a)(3)(C).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.  IRC § 2701(a)(2).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.  Treas. Reg. § 25.2701-1(c)(4).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.  IRC § 2701(b).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.  IRC § 2701(c)(3).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.  Treas. Reg. § 25.2701-2(c)(2).<br /> <br /> <a href="#_ftnref10" name="_ftn10">10</a>.  IRC § 2701(e)(1).<br /> <br /> <a href="#_ftnref11" name="_ftn11">11</a>.  IRC § 2701(e)(2).<br /> <br /> <a href="#_ftnref12" name="_ftn12">12</a>.  IRC § 2701(e)(3).<br /> <br /> <a href="#_ftnref13" name="_ftn13">13</a>.  IRC § 2701(b)(2).<br /> <br /> <a href="#_ftnref14" name="_ftn14">14</a>.  IRC § 2701(b)(2)(C).<br /> <br /> </div>

<div class="Section1"><br /> <br /> While each small business is different, many family-owned businesses prefer to structure the transfer of stock to the next generation as compensation, rather than making the transfer by gifts.<br /> <br /> The compensation structure, while generating taxable income for the successor generation, offers a tax deduction to the company that will often offset any income tax liability that is created.<a href="#_ftn1" name="_ftnref1">¹</a> While the income tax liability may be deferred under IRC Section 83 if the transferred stock is subject to a substantial risk of forfeiture, in the family business context, the income tax liability incurred by the successor-employee can often be eliminated through a bonus or other additional compensation.<br /> <br /> The compensation structure may be preferable to transferring stock to the successor generation via gifts because the successor-employee will receive a basis in the stock that is equal to its fair market value on the date of transfer.<a href="#_ftn2" name="_ftnref2">²</a> Conversely, if the transaction is structured as a gift, the successor-employee will receive a basis in the stock that is equal to its basis in the hands of the transferor (a carryover basis).<a href="#_ftn3" name="_ftnref3">³</a> For stock that has appreciated with time, this can reduce any gains that the successor would be required to recognize should the stock eventually be transferred again in the future.<br /> <br /> Further, the compensation structure eliminates any gift tax liability that would be incurred if the transfer were made through gifts. By structuring the transfer of company stock as compensation, the parent generation is not required to use up any of its gift tax annual exclusion or lifetime exemption amount by making the transfer—leaving it free to reduce its taxable estate further by making other gifts of property to the successor generation.<br /> <br /> However, as a practical matter, the higher estate and gift tax exemptions are reducing the number of individuals who will have difficulties in transferring their business free of estate and gift tax. Also, with respect to the compensation approach to transferring the business, the taxpayer is essentially trading the estate tax for the income tax. Since the estate tax rate is currently 40 percent and the income tax rates are less, this approach can be viable to the extent the federal estate tax is applicable.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC §§ 83(a), 83(h), 162(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 1012; Treas. Reg. § 1.83-4(b).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.  IRC § 1015(a).<br /> <br /> </div>

<div class="Section1"><br /> <br /> Yes. In the context of a family-owned business owned by one spouse, a qualified terminable interest property trust is a tool that may be used in reducing the estate tax burden upon the death of the first-to-die spouse if the business interests would otherwise be included in the taxable estate. Essentially, this strategy is used to remove a portion of the first-to-die spouse&rsquo;s interests from his or her estate so that the value of that estate is reduced to below the applicable estate tax exemption amount ($12.06 million in 2022, $12.92 million in 2023, $13.61 million in 2024 and $13.99 million in 2025).<br /> <br /> A qualified terminable interest property trust is a trust containing &ldquo;qualified terminable interest property&rdquo; (QTIP), which is property (1) which passes from the decedent, (2) in which the surviving spouse has a &ldquo;qualifying income interest for life,&rdquo; and (3) as to which the executor makes an irrevocable election on the federal estate tax return to have the marital deduction apply.<br /> <br /> The surviving spouse has a &ldquo;qualifying income interest for life&rdquo; if (1) the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, and (2) no person has a power to appoint any part of the property to any person other than the surviving spouse unless the power is exercisable only at or after the death of the surviving spouse.<a href="#_ftn1" name="_ftnref1">¹</a> Apparently, the last requirement is violated even if it is the surviving spouse who is given the lifetime power to appoint to someone other than the surviving spouse.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> An executor can elect under IRC Section 2056(b)(7) to treat an individual retirement account and a trust as QTIP if the trustee is the named beneficiary of decedent&rsquo;s IRA and the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually and to distribute that amount to the spouse. No person can have a power to appoint any part of the trust property to any person other than the spouse.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Importantly, this strategy allows the spouse who actually controlled the business to direct how the <em>principal</em> (the actual business shares) will be disposed of after the death of the surviving spouse. However, if the QTIP trust is funded with a minority interest in the business, and the estate contains a controlling interest, it is possible that a control premium and minority discount (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9034">9034</a>) may impact the valuation of the shares for estate tax purposes. In this case, the shares that form the controlling interest may be given a higher value than anticipated (and the shares included in the QTIP trust may be given a <em>lower</em> value than anticipated), thus increasing the estate value while correspondingly decreasing the value of the martial deduction that will result from the use of the QTIP strategy.<br /> <br /> As a result, the business owner should consider the impact of the control premium and minority discount valuation issues, and either (1) transfer additional assets from the estate to the QTIP trust in order to reduce the value of the estate to below the exemption level or (2)&nbsp;ensure that sufficient shares are transferred into the QTIP trust so that the estate will not be deemed to hold a controlling interest in the business.<br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9021">9021</a> for a discussion of the implications of using a QTIP trust to transfer small business interests in the context of a buy-sell agreement.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect; 2056(b)(7).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; TAM 200234017.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; Rev. Rul. 2000-2, 2000-1 CB 305.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Trust entities can be useful in business succession planning, whether the trusts are revocable or irrevocable. The two forms of trust are not mutually exclusive, and in many instances, a succession plan may contain more than one trust entity. The decision to have one or both depends on the business owner&rsquo;s goals, how much control the senior generation wants, when the assets will be transferred to the heirs and other restraints that are imposed.<br /> <br /> A grantor retained annuity trust (GRAT) is an irrevocable trust to which the business owner transfers shares in his business while retaining the right to a fixed annual annuity payout for a stated term of years.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> In response to a comment on the IRS&rsquo;s proposed GRAT regulations, the final regulations include and use interchangeably both the term &ldquo;GRAT&rdquo; (which does not appear in the statutes or the regulations) and its Treasury Regulation citation, &sect;&nbsp;25.2702-3(b).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> At the end of the term, the property remaining in the GRAT (the appreciation and income in excess of the annuity amount that is to be paid to the business owner) will pass to the trust beneficiaries (often the owner&rsquo;s children or grandchildren). Only the value of the remainder interest is subject to gift tax.<br /> <br /> The amount of the taxable gift to the beneficiaries can be reduced by structuring the trust with a larger annuity payout or a longer stated term. Further, the value is dependent on the IRS Section 7520 interest rate in effect at the time the trust is established&mdash;a lower interest rate can also reduce the value of the taxable gift.<br /> <br /> A GRAT may be structured so that there is little or no gift tax payable on the value of the remainder interest that passes to the trust beneficiaries. For gift tax purposes, this is known as a &ldquo;zeroed-out&rdquo; GRAT. If the zeroed-out GRAT produces a return in excess of the annuity amount payable to the business owner, the GRAT will succeed in passing on the reminder interest (the trust&rsquo;s excess income and appreciation) to the trust beneficiaries at little or no gift tax cost to the business owner. If the zeroed-out GRAT fails to produce a return in excess of the annuity amount and the remainder beneficiaries receive nothing, there is minimal downside risk since there was little or no gift tax cost to the business owner upon establishing the zeroed-out GRAT. The primary risk of using a GRAT (especially a short term GRAT) to transfer business interests is that if the business owner fails to survive the stated term, the GRAT may be included in his estate and subject to estate taxes.<br /> <br /> The Ninth Circuit confirmed this result. In a case where the GRAT creator died before the GRAT terminated, the court held that there was no actual transfer of the trust property.&nbsp;She had created the GRAT structure to transfer interests in a family business to her daughters, receiving a $302,529 annuity payment annually for 15 years. The business generated enough income so that the value of the partnership interest was not decreased by the monthly annuity payments. Under IRC Section 2036(a), because the decedent was still enjoying the economic benefit of the property at death, the entire GRAT value was included in her gross estate. The court rejected the argument that the value should be excluded because the statute does not specifically list &ldquo;annuities&rdquo; as property that may be pulled into the estate.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9012">9012</a> for a discussion of the use of intentionally defective grantor trusts in family business succession planning.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; TD 9414, 2008-35 IRB.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; <em>Badgley v. U.S.</em>, Case No. 18-16053 (9th Cir. 2020).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> IRC Section 1371 provides that an S corporation is subject to the same rules that apply in the context of a C corporation unless there is a specific rule that has been developed for S corporations. Despite this, one of the primary differences between an S corporation and a C&nbsp;corporation is their basic tax treatment, which has an important impact upon the issues that the entity will face during liquidation. Because S corporations are taxed at a single level, taxation of a sale or other liquidation of the business will usually occur only at the individual level, unlike in the context of the C corporation, where the corporation itself will be required to pay taxes on any gain before passing the profits through to shareholders, who will also be taxed on the amounts they receive.<br /> <br /> Many S corporation shareholders will have a higher stock basis than that of a C corporation shareholder. This is because the basis of an S corporation shareholder&rsquo;s stock is increased by any earnings of the S corporation that are passed through for tax purposes.<a href="#_ftn1" name="_ftnref1">¹</a> Depending upon how long the corporation had existed as an S corporation, and the level of earnings that were passed through to shareholders, S corporation shareholders may have substantially higher tax bases upon sale. Because tax basis decreases the amount of gain that the shareholders are required to recognize upon sale, the S corporation shareholder&rsquo;s total tax liability will often be lower than the C corporation shareholder&rsquo;s upon liquidation of the company.<br /> <br /> If the S corporation was ever a C corporation, however, the S corporation will be required to account for any built-in gains, which are taxed at the highest rate applicable to C corporations (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8955">8955</a>).<a href="#_ftn2" name="_ftnref2">²</a> The tax on built-in gains is designed to preserve a part of the double tax structure for certain S corporations that were formerly C corporations. The built-in gains tax applies if the S corporation sells an asset within a five year period (formerly 10 years) following its S corporation election.<a href="#_ftn3" name="_ftnref3">³</a> The tax on built-in gains is imposed at the S corporation level, in addition to any taxes that are paid by the S corporation&rsquo;s shareholders. This tax will only apply in situations where the S corporation was formerly a C corporation and liquidates within 10 years of making its S election.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&sect; 1367(a), 1366(a)(1)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect; 1374(b)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect; 1374(d)(7), as amended by PATH.<br /> <br /> </div></div><br />