Most of us have at least one client who has a family-owned or closely held business that is a major part of their estate, yet they have done nothing to plan for the succession of that business. Business exit/succession planning can be challenging because of the tax issues, family dynamics and egos. But it can also be very rewarding. As we help our clients solve these issues, we develop a closer relationship with them, and we begin to build a relationship with the next generation. This planning also strengthens our professional relationships, as we must work together with other professionals to bring about the best results for our mutual clients.
In this issue of The Wealth Counselor, we will examine a case
study that uses a Limited Liability Company (LLC) in the transfer of a
family business to the next generation.
Case Study Facts
Frank (age 62) is married to Betty (age 58). Frank has an older son,
Tom, from a previous marriage who is active in Frank's business. Betty
has a daughter, Susan, from her previous marriage. Together they have a
son, Charlie, who is a minor. Betty, Susan and Charlie are not involved
in Frank's business.
Frank owns 100% of an S-corporation. It has a fair market value of $10
million and generates very good cash flow. Frank and Betty have
significant other assets, including a home and investments. They own
some jointly and Frank brought some into the marriage - they are held in
his individual name. Their $5 million lifetime gift/estate/GSTT
exemptions are fully available.
Consequences of No Planning
If Frank does nothing, according to the probate laws of the state in
which they live, Betty will receive 50% of Frank's estate including the
business; his son Tom will receive 25% of Frank's estate including the
business; and Charlie will receive 25% of Frank's estate including the
business. Because Charlie is a minor, Betty will control his share until
he is 18. So, in effect, Betty will control 75% of the business if
Frank dies intestate. Susan, Betty's daughter, will receive nothing.
Frank would like to ensure that ownership of the business will go to his
son Tom, and Tom would like the security of knowing that one day the
business will be his. Tom does not have the cash to buy the business.
Frank would also like to control the timing of the transfer of the
business and he would like to treat his stepdaughter and younger son
fairly. He is concerned about maintaining enough cash flow to support
himself and Betty now, and providing for Betty if he dies first. And he
would like to minimize estate taxes.
Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, the S-corporation is converted to an LLC
that is taxed as an S-corporation. The LLC is organized under the laws
of a "charging order only" state. Frank's ownership is changed from 100%
voting shares in the corporation to 1% voting and 99% non-voting
memberships in the LLC. Frank still effectively owns and controls 100%
of the business, but now it is comprised of 10 LLC membership units (1%)
that are voting units and 990 (99%) that are non-voting units.
Phase 2: Create Dynasty Trusts
Frank next establishes three irrevocable trusts, one for each child, in a
jurisdiction that permits perpetual trusts. The trusts (irrevocable
grantor trusts, aka intentionally defective grantor trusts) are
disregarded by the IRS for income tax purposes, but not for estate and
gift tax purposes. (Alternatively, one trust with three separate shares
can be established.) The trusts are also designed to own life insurance
on Frank's life.
Frank makes an initial gift of $600,000 to each trust. These are taxable
gifts that must be reported on Form 709, but no gift tax will be due
because it will be applied to Frank's and Betty's lifetime gift tax
exclusions. $600,000 of their generation skipping transfer tax (GSTT)
exclusions will also be allocated to each trust, giving each a zero
inclusion ratio - so that it is not subject to GSTT in the future.
The trustee of Susan's and Charlie's trusts uses their initial gifts to
purchase life insurance policies on Frank and/or Betty, providing
substantial assets upon Frank's or their deaths.
Phase 3: Tom's Trust Buys All Non-Voting Units with an Installment Note
A business valuation is performed to determine the fair market value of
Frank's business. As part of this process a qualified valuator first
values the assets the business owns (real estate, equipment, good will,
inventory, etc.). The valuator then determines whether and to what
extent the value of the assets should be adjusted due to lack of
control, liquidity and marketability.
When these valuation adjustments are applied to non-voting interests in
an LLC, the fair market value is often depressed by a significant amount
when compared to the fair market value of the entire business: in this
hypothetical case, 40%. In other words, the non-voting units will each
have a value of $6,000, making the total value of the 990 non-voting
units $5,940,000. Alternatively, voting units will have a premium value
to reflect the control value. In this hypothetical case, the voting
units have an appraised value of $12,000 per unit, making the total
value of the 10 voting units $120,000.
Tom's dynasty trust buys Frank's 990 non-voting units for $5,940,000
using a 20-year installment note, payable annually. Based on the current
IRS published interest rates, the trust will pay Frank $447,197 every
year for 20 years. The note is adequately secured by the LLC units and
the $600,000 of other assets in Tom's trust. The cash flow from 99% of
the business is more than sufficient to cover the note payments.
The installment note should be handled just like an installment sale to
a non-family member or a loan from a bank. A pledge or security
agreement should be signed, required taxes should be paid, required
filings should be made, etc. A fully documented paper trail should exist
for the transaction and the payments made on the note.
Why Reorganize the Corporation to an LLC?
Corporate stock is freely transferable, making it very easy for a
judgment creditor to foreclose on corporate stock and become a
shareholder. In most states, the percentage required for shareholder
voting to liquidate a corporation is less than 100%, generally ranging
from 51% to 80%. If a judgment creditor forecloses on enough shares of
stock to allow the creditor to liquidate the corporation, the creditor
would be able to seize the assets of the corporation to satisfy the
Alternatively, LLC interests are usually not transferable without the consent of all
members. Due to this limitation on transferability, an LLC offers much
greater asset protection from creditors. Many states limit a creditor's
remedy to a "charging order" on distributions to LLC members. (Only when
a distribution is made will it go to the creditor; when the claim has
been repaid, the charging order is stopped.) The creditor can never
become a substitute member, and will only become an assignee with no
ability to vote on admission of new members or the liquidation of the
LLC. In most states, it takes a 100% vote of all members to liquidate an
LLC. Because a creditor can never become a member, it can never vote on
liquidation of the LLC.
Outcome of the Planning
Frank owns the 10 voting units, giving him 100% control of the business
and 1% of the equity. Tom's dynasty trust owns 990 non-voting units,
giving Tom no control over the business and 99% of the equity. Tom's
trust also has $600,000 in cash that Frank gifted to it as seed capital.
This cash is invested, and the income tax attributes of income, gains
and losses are passed through to Frank to be reported on his tax return,
as is the income, gains and losses attributable to Tom's trust's 99%
ownership in the business.
Income Tax Reporting
As long as Frank is deemed the owner of Tom's dynasty trust for purposes
of reporting trust income, the dynasty trust does not have to file a
Form 1041 fiduciary income tax return. A corporate income tax return
(1120S and K-1) is filed for the business and Frank reports the trust's
income on his tax return.
Income Tax Effect of Sale of Units
Because Frank is the deemed owner of the trust for income tax purposes,
the sale of the LLC units to Tom's trust is a non-recognition event;
i.e., a sale by Frank to himself. No gain or loss is recognized on the
sale. No interest income is recognized on the installment note payments
and no interest deduction is allowed to the trust.
Include a "toggle" provision to turn each dynasty trust's grantor
status off or on as needed, so that the income being taxed to Frank can
be stopped if that should become undesirable later. Consider giving this
power to a trust protector.
Pass Through Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their
ownership percentages. Let's assume the business has $500,000 in net
income. Frank owns 10 voting units, equal to 1% of the equity, so he
will be allocated $5,000 on the 1120S as K-1 income. Tom's dynasty trust
owns 990 non-voting units, which is equal to 99% of the equity. So
Frank, on behalf of the trust, will also be allocated $495,000 on the
1120S as K-1 income.
Because the dynasty trusts are grantor trusts for income tax purposes,
Frank must pay the income tax on all their income, including the
S-corporation income that is allocated to Tom's trust. But that is what
he was doing before the sale, so he is paying the same income tax before
Frank's payment of income taxes in dynasty trust income is not an
additional gift to the trusts, so every year he is effectively
transferring additional estate assets to the trusts for the children
without additional transfer tax.
How the Dynasty Trust Makes the Required Note Payments
In this case study, we assume that the LLC will have $500,000 per year
of cash flow to distribute to the unit holders. Tom's dynasty trust will
receive a cash distribution of $495,000 ($500,000 times 99% =
$495,000). At the end of the first year, it will have $1,095,000 in cash
($495,000 from the LLC plus $600,000 that Frank gifted to it as seed
capital). The trustee uses this money to pay the $447,197 note payment
If the business does not make enough income to pay the note, the
payment can be deferred until the business recovers or the term or
interest rate of the note can be adjusted.
Results after One Year
At the end of the first year, the note has been reduced to $5,745,847
and Tom's trust has a cash balance of $647,803. This cash can be
invested and saved, distributed to Tom (gift tax-free), or used to buy
and pay for a life insurance policy on Frank's life.
Frank has received $5,000 from the LLC and $447,197 from the note
payment for a total of $452,197 in income. He pays income taxes on the
full $500,000 of S-corporation income. If, after all deductions, he has a
25% effective income tax rate, he would pay $125,000 in income taxes,
leaving him with $327,197 in income to support his and Betty's
A higher income tax rate means less net income, but the client can also
receive additional (reasonable) compensation as an LLC manager or as a
Director. If he needs less income, his salary can be reduced, but ensure
that it is not so much that he loses benefits.
When Frank Dies
Frank and Betty also establish estate plans, so the assets in Frank's
estate will pass as planned, not according to the state's default rules.
If Frank and Betty have consumed or gifted the net after-tax proceeds of
each note payment from Tom's dynasty trust, only the unpaid balance of
the note will be included in the value of his taxable estate. Tom's
dynasty trust is GSTT exempt, so its assets will never be subject to
estate, gift or GST taxes. Frank's estate plan leaves the 10 voting
units to Tom's dynasty trust, giving Tom 100% ownership of the business.
The dynasty trusts for Susan and Charlie are also GSTT exempt, and the
life insurance proceeds will be exempt from probate and income, estate
and GST taxes. Betty will continue to receive the remaining note
payments for her support.
Estate Tax Results
Frank has removed 0.99 x $10,000,000 + 3 x $600,000 = $11,700,000 of
appreciating assets from the value of his gross estate that, at his
death, would have been subject to estate taxes. He and Betty have used
$1,800,000 of their lifetime gift/estate/GST exemptions. (Remember,
unless Congress acts before the end of 2012, the top estate tax rate in
2013 is scheduled to go back to 55% with a $1 million exemption.)
Frank has received an asset (the $5,940,000 note) that, in his estate,
may have a discounted value due to lack of marketability, etc., and that
will not appreciate; in fact, the note is depreciating because the principal will decrease over the 20-year term.
If Frank does not accumulate the note payments, at the end of the note
term he will have completely removed the $10,600,000 and all future
appreciation from his gross estate without making a taxable gift other
than the initial $600,000 seed capital gifts to the dynasty trusts.
The trust assets are not subject to generation-skipping transfer tax,
will be protected from creditors, and will not be included in the
children's or grandchildren's or great-grandchildren's gross estates at
All of Frank's objectives have been met. His son Tom will receive the
business without having to buy it, and Frank can control the timing of
the business transfer. He was able to provide for his other children and
his wife, and he saved substantial estate taxes.
While this kind of planning can be complicated, the above example
demonstrates that the rewards are many. We have the opportunity to help
our clients solve their problems, strengthen family relationships, save
money and have peace of mind. At the same time, we have the opportunity
to strengthen our relationships with clients, their children
and the other planning professionals with whom we collaborate. This type
of planning is truly a win-win opportunity.