Estate Planning Tools

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General Business
by Jack Veale

For many years, estate and gift taxes have been undercutting the wealth of successful family businesses. For instance, though married couples with children may double the tax-free amount they can pass on to their families, there is relatively little shelter if one parent dies. In such a case, tax rates can quickly reach as much as 55% on the fair market value of the deceased parent’s property.

Many families take this harsh tax treatment lying down. But you can prevent these oner-ous circumstances. A generation-skipping transfer allows families to transfer wealth into irrevocable trusts either during the par-ents’ lifetime or at death. Then subsequent generations can use the trust’s property to receive income and principal during their life-times. But the trust restricts their control enough that the IRS cannot consider the trust’s property theirs for estate tax pur-poses. Let’s look at several reasons why you should consider using this valuable estate and tax planning tool.

Understandably, the word “irrevocable” scares many family business owners. Like most executives, you probably like to have the power to make changes to your wealth management strategies. Perhaps you’ve heard that a generation-skipping trust is not changeable and, therefore, immediately dis-missed this approach. But think again — you may find this trust more flexible than you previously believed.

Although, as grantor, you generally cannot change an irrevocable trust, you can build flexibility into it. For instance, an independ-ent trustee or trust protection com-mittee can alter some irrevocable trusts within certain parameters. And some irrevo-cable trusts allow you to update asset trans-fers should circumstances or tax laws change. In rare situations, the gran-tor can even serve as trus-tee of his or her own trust. Thus, you can give your family mem-bers and trustees broad discretion while avoiding adverse tax consequences.

Ignorance Isn’t Always Bliss
Recently, thanks to the exploding stock mar-ket and a robust economy, many family businesses have experienced unprecedented growth. The upside to this is that many families have quickly become wealthy. But the downside is that their tax planning has not kept up with their success.

Many family business owners avoid generation-skipping trusts simply because they don’t understand them. Because these trusts are complex, many family business owners become frustrated and end up doing nothing. Don’t shortchange your success — take the time to plan correctly. Plenty of information exists, but you won’t find it unless you look for it.

The Inevitable Limitation
You can avoid a large amount of tax if you make transfers that skip the estate tax for several generations. But the government lim-its how much you can transfer without incur-ring an extra tax. Congress indexes this limitation — $1,030,000 in 2000 — for inflation.

If you transfer more than this amount to grandchildren and younger relatives, you must pay a 55% generation skipping tax in addition to gift taxes, which can also be 55%. Thus, plan your generation-skipping trusts carefully to avoid this tax liability.

Don’t Skip Your Chance
Like any successful family business owner, you’re concerned about spending too much on anything. But remember, when planning your estate, you may not recognize tax bene-fits until many years from now. Many fam-ily business owners do not want to invest the kind of money it takes to properly plan for such eventualities.

Make no mistake, the planning process is not cheap. But spending the time and money today can save you thousands in the future. Not only will you gain some peace of mind, but your heirs will heartily thank you for your foresight. Don’t skip this chance to keep your money in the family.


Prior to the 1990 tax changes that brought us the Internal Revenue Code Chapter 14 valuation rules, a popular succession planning technique was the preferred stock recapitalization. In partnerships — and now limited liability companies — the corollary is the partnership freeze.

Here is an example of how this technique works:
John owns 100% of the stock of JM Inc., a C corporation worth $5 million. The company is poised to explode in value and John would like the appreciation in value to inure his children’s benefit. One way to accomplish this would be to recapitalize the company and exchange his voting common stock for nonvoting common and voting preferred stock. If the preferred stock carries a sufficiently high dividend preference, it could be valued close to $5 million. But, because it has only a dividend preference and not an interest in the appreciation in value of the company, it probably would not appreciate much in the future. If the company does not increase in value, the preferred stock will continue to be more valuable than the common stock. John will then gift the common stock to his children and retain the preferred stock.

When To Use This Technique
There are, however, still two situations where these techniques may still be useful. The first is when the requirements of Chapter 14 are met. Chapter 14 refers to rules enacted by Congress to prevent related owners from taking advantage of loopholes designed for unrelated parties. When they were enacted, the Internal Revenue Service was not concerned as much about the transfer of appreciation to family members as it was concerned that the donor did not retain sufficient value to warrant the low gift value for the common stock or appreciation interest in a partnership.

In the example above, under new law, the IRS treats John as making a gift of $5 million if he gives all the common stock to his children, unless the preferred stock he retains has a right to cumulative preferred dividends that must be paid or accumulated for later payment. Similarly, the partnership units retained by John must have a distribution preference that must be paid. Because the retained right to payments has real value, it will keep the value of John’s estate at least at its present level.

Traditional Recapitalization
The second and more intriguing possibility is traditional recapitalization which takes effect on the death of the donor’s spouse. Assume in the example above that John is married to Mary. The company is still a C corporation and John trades his common stock for nonvoting common stock and voting preferred stock. But John retains both blocks of stock and then dies. The preferred stock contains a noncumulative preferred dividend and the right to vote.

When John dies, Mary inherits the preferred stock as part of her bequest. The common stock, which has little value, goes either to the children outright or into the family trust for the benefit of Mary and the children. Thereafter, the value of the common stock appreciates while the value of the preferred stock is frozen.

This works because the valuation provisions of Chapter 14 apply only to lifetime transfers. If Mary is expected to live longer than John and if the business has been transitioned effectively to new management, the traditional estate freeze can be a valuable tool. Or Mary can own the stock and leave it to John and the children if she dies first.

Owners can use this technique in partnership and limited liability company situations as well as C corporations. But not in S corporations, because these corporations may not issue preferred stock and their various classes of stock may differ only as to voting rights — not dividend or liquidation rights. If you have an S corporation, other techniques are usually better for transferring wealth to the next generation.

Pros and Cons
As with all planning techniques, corporate and partnership freezes have their strengths and weaknesses. When appreciation is expected to be significant, the estate tax savings from the removal of the appreciation from the estate will be exceedingly valuable. But using a preferred stock recap and actually paying the dividend on the preferred stock back to the transferor will result in costly income taxes. The corporation gets no deduction for the payment and the recipient owes tax on receipt of the dividend. This double tax on dividends is avoided for partnerships or limited liability companies. Therefore, the best tax strategy is to not pay the dividend. This is possible when the preferred stock dividend right is noncumulative. A noncumulative dividend, however, is only allowed when the common stock is owned by someone not closely related . For example, an uncle or niece qualifies, but a child or spouse does not.

While not paying any dividends in the noncumulative preferred situation without losing value is possible, the IRS hotly contested this before the 1990 tax act. Its position was that by not taking the dividend in years when the company could afford to pay it, the donor was making a further gift to the donees. That  issue has cooled in the past several years. A qualified appraiser can give you the correct valuation for the preferred stock with a noncumulative dividend preference. Despite the fact that a dividend need not be paid at all, the appraiser often can assign a relatively large value to the preferred stock based on similar instruments in the market.

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