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Your Business And Your Estate – Succession Planning

Jul 21

Posted by admin in Taxes

As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. Those businesses will either be sold to a third party or management team, closed down, or passed on to the next generation.

In this article I will focus on passing the business on to the next generation.

The government has also encouraged the passing of a business from one generation to the next with several favorable estate and gift tax rulings. Estate planning attorneys have utilized IRS ruling 5960 to minimize the estate and gift tax owed for a business either gifted to or inherited by the next generation.

The business is often placed in one or more LLC?s and divided up into minority pieces to take advantage of very substantial and legal minority discounts, often as high as 40%.

As is often the case, a business owner will have, for example, 4 children. Two sons will be actively involved in running the businesses and two daughters have built lives totally separate from the business. Because 85% of the value of the estate is tied up in the value of the business, to be ?fair? the business is gifted and willed to the four siblings in almost equal proportion. Because the sons are running the business, they will get slightly more of the business and slightly less of the remaining estate.

This gives them majority interest in the business. After dad leaves the business, the two sons will continue to run and grow the business without any input or participation from their two sisters. Typically the business does not pay any dividends and the two sisters? portions are non-liquid because there is not a good market for selling minority stakes in a privately held business.

Also, there is generally a very restrictive buy sell agreement that favors the majority holders. The sisters have no idea what the ?fair value? of the business is and the only indication they have ever gotten is an official IRS gift tax or estate tax return with 40% discounts applied. If the enterprise value were, for example, $50 million and the two sisters owned a combined 40%, you would think that they had an asset worth $20 million.
The only document they have seen, however, is the gift or estate return, valuing their portion at only 60% of that number, or $12 million.

The brothers feel entitled to the lions share because Ann and Julie had nothing to do with building this business. The brothers pay themselves big salaries and benefits and pay out little of no dividends. They may approach the sisters with gift tax return and restrictive buy sell agreement in hand and offer to generously buy out the sisters for a combined 8 million, because that is ?all the company can afford to pay.?

After this transaction takes place, let?s look at the result of how dad?s estate was fairly divided. Originally the brothers were left with 60% of the $50 million business, or $30 million and a minor portion of the remaining estate. The sisters were left with 40% of the business, or $20 million and the bulk of the remaining estate of $10 million.

That appears to be fair. However, the buyout of the sisters for a combined $8 million results in an effective estate distribution of $42 million to the brothers and $18 million to the sisters. This is not what dad intended, but it happens all the time.

This is a very complex and emotional issue and there are no simple answers. Generally, dad had his identity tied up in the business and wants it to live on through his sons after he is gone. This is a noble, yet impractical thought if all the siblings are not actively involved in the business. The children often inherit the restrictive buy sell agreements that favor the brothers running the business and scare off investors that may have been interested in a minority stake in the business.

Much of the value from a privately held business is derived from the benefits of working in the business. There is the very real concern that the integrity of the gift or estate tax business valuations will be compromised if the sisters are bought out at a price approaching a pro-rated division of total enterprise value.

Unfortunately, in most cases, nothing is done and as a result there are literally hundreds of billions of dollars of minority interests in privately held business that are providing little return or no return to their owners.

One of the keys to unlocking the liquidity in these minority interests is for the business owner to recognize this situation prior to building his estate plan. Unfortunately, we are often brought in after the fact and a fair outcome then is contingent upon the majority owners honoring dad?s original intent of fairness and working toward that end.

Dave Kauppi is a business broker and President of MidMarket Capital. We help business owners with all aspects of Mergers and Acquisitions.

Writen By : Dave Kauppi

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The Implications Of Income Tax Charge On Estate Planning

Jul 5

Posted by admin in Taxes

Overview

In the Pre-Budget Report of December 2003 the Chancellor Gordon Brown announced proposals to levy an Income Tax charge from 6th April 2005 in those circumstances where the transferor of an asset retains and interest or continues to benefit from that asset. In the instance of real property, the \’benefit\’ envisaged is the transferor continuing to reside in the property he/she has allegedly given away.

How the Charge Applies

The Government refer to such assets as \’pre-owned assets\’ and, broadly speaking, its intention is to tax the \’annual value\’ of such assets as a benefit-in-kind on the former owner still enjoying the use of the asset. The annual value on which the charge is based will be the open-market rental for a property or a fixed percentage of the capital value of most other assets to which the new charge applies. Any amounts which the transferor pays for the use of the asset – rent for example – will be deducted from the annual value in arriving at the taxable benefit.

The charge will also apply if a person provides the funds to purchase an asset which they go on to enjoy the benefit of after 5th April 2005.

Rationale Behind the Charge

The charge is intended to counter many Inheritance Tax planning schemes, but unfortunately, it will also impact many innocent and unintended victims. Thankfully, the legislation has included some exceptions to the application of the charge. The charge will not apply if;

The asset was gifted before 8th March 1986

The asset is owned by the transferor\’s spouse

The asset is, in fact, still caught by the \’Gifts with Reservation\’ rules and as such Inheritance Tax applies instead (hence, the Income Tax charge will not be levied on top).

The asset was sold at an arm\’s length price for cash (even if to a connected party).

The transferor of the asset had themselves inherited it and their ownership had ceased as a result of a Deed of Variation affecting that inheritance.

The transferor\’s continued enjoyment of the asset is merely incidental or has arisen only as a result of an unforeseen change in family circumstances.

The annual taxable benefit (after deducting any contributions by the transferor, where necessary) does not exceed ?2,500.

The Inland Revenue have also confirmed that the charge will not apply in most cases where a taxpayer has funded life insurance policies held on trust. Finally, there is also an \’Opt Out\’ option whereby the transferor can opt not to pay the charge provided the asset is included back into their estate and therefore consequently being subject to Inheritance Tax.

The Implications of the Charge

Most of the Inheritance Tax Planning techniques usually involve a widow or widower having continued enjoyment of their former spouse\’s share of the property and thus it would appear on first inspection that in the majority of cases the charge would not apply as the transferor themselves would not be around to continue to enjoy or benefit from the property.

However, a problem seems to arise where a couple own their property as joint tenants prior to commencing their tax planning strategy and subsequently changing their ownership title to tenants in common. Where the widow or widower formerly owned the property as joint tenants they had a share in ownership of the whole property. This means that the new Income Tax charge could conceivably apply to their continued occupation of the property after their spouse\’s death.

A possible consequence of this for the future might mean that instead of acquiring property as joint tenants which has been the general rule, the wise policy would be to own the property as tenants in common instead. But how many people are aware of this distinction? Will legal advisors be prepared to explain the tax implications of acquiring property with the different legal titles?

Conclusion

How far will the new charge impact on current Inheritance Tax Planning schemes? As yet, it is too soon to tell, as the rules have not been fully fleshed out and as yet, it is too soon to say with any certainty what will happen and which schemes will be affected.

But it seem fair to argue that the current Labour Government is doing its utmost to tax its citizens at every possible turn. Inheritance Tax avoidance schemes – indeed any tax avoidance scheme -are not unlawful. Planning for the future does not mean that people are engaging in tax evasion – which IS unlawful. But the policies being employed leave an uncomfortable impression of an angry parent chastising their child simply for being astute and planning for the future!

Needless to say, the whole approach leaves a somewhat bitter taste in one\’s mouth.

JsByrne
LLB (Hons) LPc.
www.Draft-Your-Will.com

Miss JsByrne holds a Bachelor of Law degree with Honours

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How Are Bonds Taxed Upon Death – A Sequel

Apr 6

Posted by admin in Investing, Taxes

Question: Thank you so much for your response. It was over and above what I needed to know, which is great. The more informed we are on this the better!

I do have one additional question. If we cash out the bonds with the estate, the interest will be around $300,000.00. If we cash them out individually (split 3 ways), won\’t the taxes be lower as they will be under $150,000.00 (including our other income) for each of us and in a much lower tax bracket? I am not clear on the advantages of cashing them out in the estate. Please explain this further. Thank you, R.

Answer: Dear R. – Your follow-up question raises some important issues that do need to be addressed – and understood – when making distributions from an estate or trust.

From your original question, you stated that your grandmother left bonds worth roughly $600,000 and that those bonds would be distributed equally to the three of you. So, each of you will receive an inheritance of roughly $200,000.

The problem I was alluding to is this: All three of you expect to receive the same amount from your grandmother\’s estate. However, in determining whether all three of you receive the \”same amount,\” you should not look at the gross amount distributed to each of you, you should look at the net amount distributed to each of you after all taxes have been paid on the distributions. This is especially true when there is a significant amount of income in respect of a decedent (IRD) involved, as there is in this case.

Here\’s a simple example that will help explain the problem. Let\’s assume that there are three bonds, each with a face value of $200,000. Bond A has no accrued interest; bond B has accrued interest of $100,000; and bond C has accrued interest of $200,000. The estate distributes bond A to your sister, bond B to your brother, and bond C to you. All three of you are in the 30% tax bracket, and all three of you redeem your bonds in 2006.

While all three of you received the face amount of $200,000, your net amount, after-tax, is not the same. Your sister\’s net amount is $200,000 because her bond had no accrued interest. Your brother\’s net amount is $170,000 because his bond had accrued interest of $100,000, which resulted in a $30,000 tax liability. Your net amount is $140,000 because your bond had accrued interest of $200,000, which resulted in a $60,000 tax liability.

If this were an actual case scenario, you can bet that there would be some unhappy campers here – and who can blame them? This result doesn\’t have to happen. And, it won\’t as long as the person in charge of making the distributions (i.e., the personal representative of the estate) is aware of this problem and takes the time to correct it.

How should distributions be handled in a case like this? Understand, first, that it\’s very difficult to equalize distributions of property when IRD is involved. Your grandmother, for example, probably had a good number of bonds, each purchased at different times and each with different amounts of accrued interest. Sure, you can equalize the face amounts easily enough, but you probably will find it very difficult to give each beneficiary the same amount of accrued interest.

A better way to handle these types of distributions is to have the estate liquidate the bonds and then distribute the cash proceeds to the beneficiaries. Let\’s see how this works with the hypothetical we used earlier. Remember, we assumed that your grandmother had three bonds: bond A with no accrued interest, bond B with accrued interest of $100,000, and bond C with accrued interest of $200,000. If the estate cashed in these bonds, it would have taxable interest of $300,000, which it would have to report on its tax return (Form 1041). Assuming the estate didn\’t distribute the money in the year the bonds were redeemed, the estate would then pay a tax on the accrued interest of roughly 35%.

While this course of action has the benefit of equalizing the net, after-tax, distributions to each beneficiary, there is a slight down-side in that the total taxes paid on the accrued interest will be higher than if the tax was paid directly by the beneficiaries. That\’s because (1) you lose the lower tax brackets available through income-splitting when the taxes are paid by the beneficiaries and (2) estates and trusts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate – in our hypothetical – redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won\’t pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let\’s assume that the estate redeems the three bonds in 2006. It now has $600,000 in cash, but it also has accrued interest of $300,000, which it reports on its Form 1041. If the estate then distributes $200,000 to each of you, it will be deemed to have distributed the entire $300,000 of accrued interest to each of you equally; i.e., $100,000 to each of you. In that case, the estate will be entitled to a deduction of $300,000 on its tax return, which completely eliminates any tax liability on the part of the estate.

Each of you will then be required to report your pro rata share of the $300,000 in accrued interest on your respective tax returns for 2006. You\’ll know to do this because the estate will send you a Form K-1 (Beneficiaries Share of Income, Deductions, Credits, Etc.) at the end of the year.

The net result is that each of you will receive the same inheritance from your grandmother. You\’ll each receive a distribution of $200,000 from the estate; you\’ll each have to report $100,000 of accrued interest; and you\’ll each pay roughly the same amount of income tax on the accrued interest. Moreover, you won\’t have to pay the high tax rates imposed upon estates and trusts and, in fact, you\’ll still be able to benefit from the favorable tax brackets available through income-splitting.

This approach may not always be the best solution, but it is an option that should always be considered when property in an estate or trust contains income in respect of a decedent (IRD). In all cases like this, you should work the numbers to see which alternative is best for you and the other beneficiaries, then proceed accordingly.

Attorney Michael Pancheri is a practicing attorney and the founder and CEO of the Living Trust Network. You may contact him by email at info@livingtrustnetwork.com. You may also contact him at the Living Trust Network\’s web site. Its URL is http://www.livingtrustnetwork.com

Copyright 2006. The Living Trust Network, LLC.

Writen By : Michael Pancheri

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How Are Bonds Taxed Upon Death

Apr 5

Posted by admin in Investing, Taxes

Question: My grandmother, recently deceased, left E, EE,

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Understanding The Benefits Of Forming Trusts

Feb 25

Posted by admin in Estate Plan Trusts, Finance

What is a Trust And Who Are The Settlor, Trustee And Beneficiaries?

A trust is an institute of a special type of structure capable of holding title of the property-providing benefits to one or more people. It is a lawful relationship between the two people, the settlor and the trustee. The person who hands over his assets is called the settlor; the person who gets the control of the said assets is known as the trustee. The intention of the settlor is usually either to provide benefits to some people known as beneficiaries or to form the trust for some specific purpose. The other terms used for the settlor are creator or granter of the trust.

Gaining Popularity

Benefits of forming trusts are attracting more and more people to structure their businesses and other personal matters in the form of trusts. However, before you opt to forming a trust to get the benefits, you must ascertain that you know the legal implications of forming trusts and be clear about the people involved. Do not make any haste to get the benefits of forming trusts without getting the advice of the experts in this field. Any lawyer is capable of helping you in this regard, yet it would be better if you took the advice of a person who has specialization in this area.

Trustees Cannot Use Property For Their Own Use

It does not matter much that the trustees are the legal owners of the property of the trust because they cannot use this property for their own use. In fact, trustees are the people who are chosen by the settlor to hold the property because they are reliable to him. The main role of the trustees is to make arrangements of providing the benefits to the actual beneficiaries according to the will of the settlor.

Saving Taxes

The structure of the trusts is often seen as too flexible, so many people feel that they can take the benefit of this flexibility in running their businesses and several other non-business activities. By forming a trust instead of a company, they can save a great amount on the tax liabilities. Some people believe that forming trusts is a method adopted by the wealthy people to avoid making payments to creditors while still enjoying the ownership rights.

Good For Every Family Member

However, not everyone uses trusts for such purposes. Some people want to take the benefits of forming trusts in a genuine way. Trusts are the best method as far as the protection of family assets is concerned. If constructed properly, trusts can provide several other benefits other than just being a tax-saving device. In large families, trusts can provide benefits to all the members of a family.

Alexander Gordon is a writer for http://www.smallbusinessconsulting.com – The Small Business Consulting Community. Sign-up for the free success steps newsletter and get our booklet valued at $24.95 for free as a special bonus. The newsletter provides daily strategies on starting and significantly growing a business.

Business Owners all across the country are joining \”The Community of Small Business Owners? to receive and provide strategies, insight, tips, support and more on starting, managing, growing, and selling their businesses. As a member, you will have access to true Millionaire Business Owners who will provide strategies and tips from their real-life experiences.

Writen By : Alexander Gordon

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Choosing Guardians For Children

Feb 25

Posted by admin in Estate Plan Trusts

The most important decision you\’ll make in your estate plan is appointing guardians for your minor children. Who you pick will impact not only your children but also the lives of your guardians. While you and your children may feel an affinity for a particular adult(s), that relationship could be strained in a 24-hour-a-day, 7-day-a-week environment. Where should you begin in picking a guardian?

Unless you have a parent or relative who has expressed in past conversations a overwhelming desire to be your child\’s guardian, start listing family and friends with similar aged children. Potential guardians with older children may be looking forward to becoming empty-nesters and recent empty-nesters are likely enjoying their new freedom.

Consider the reversal of roles since many families reciprocate in being guardians – look at families whose children you would be willing to take custody. Have their children been raised with similar values that compliment yours? More to the point: do the parents of a potential family handle any given situation in a similar manner to you?

Let potential guardians know you are just starting to explore potential guardians. Take time to talk to several families, your children if they are old enough for such discussions and talk to your extended family about whom you are considering to be guardians. These discussions can generate other considerations and reveal overlooked potential guardians.

Many estate plans list primary and backup guardians. Your guardians are appointed in your Will. Some families opt to include a Revocable Living Trust in their estate plan to control distribution of assets to children until they reach an age or set criteria to ensure they are responsible to inherit money. Your guardians do not need to manage your estate\’s finances and it\’s sometimes wise to have your guardians separate from your revocable living trust\’s successor trustees.

The alternative to not appointing guardians quickly is allowing the state your live in to appoint guardians for your children – possibly someone who is not your first or second choice to act as such.

Written by Jamie Kahn, owner of livingtrustarizona.com and writer for living-trust-phoenix and Estate Planning Phoenix

Writen By : Jamie Kahn

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