Family-Controlled LLCs and Partnerships – How Can the Business Lawyer Avoid Estate and Gift Tax Traps?

1. Family-Controlled LLCs and Partnerships – How Can the Business Lawyer Avoid Estate and Gift Tax Traps? Steven B. Gorin Thompson Coburn LLP St. Louis, MO Sharon L. Klein Fiduciary Trust Company International New York, NY

2. Overview • Analyzing business issues in the family context, including transferring wealth to the next generation • Drafting buy/sell agreements; planning to avoid estate tax traps caused by common buy-sell techniques • Profits interests: great for income tax and incentive planning, but watch out for gift and estate tax

3. Business Issues in Family Context • Fair vs. equal • Insiders vs. outsiders • Solutions

4. Fair vs. Equal • Equal values perceived as fair • Value creation by parents • Value creation by children

5. Insiders vs. Outsiders • Outsiders want distributions • Who controls insiders’ compensation? • Who benefits from insiders’ creation of value?

6. Solution – Benefit Outsiders • Bequeath other assets (allocation of equal shares) • Life insurance • Separate real estate from business operations

7. Solution – Buy-Out Outsiders • Cross purchase vs. redemption (business issues) • Life insurance vs. promissory note (business issues) • Promissory note vs. preferred equity

8. Solution – Control Insiders • Tax distributions to avoid K-1 K-0 • Limit insiders’ compensation • Give outsiders a put right

9. Solutions – Fair to Insiders? • Freedom to operate business • Incentives for creating value • Source of well-paying job • Need separation from outsiders

10. Shifting Value to Insiders During Life • Business opportunities; loans • Leveraged transfers • Discount planning • Financial security to parents to encourage above

11. Business Opportunities – Business Expansion • New operating entity owned by insiders • New real estate entity owned by outsiders or combination • Financed by parents

12. Parents Trust(s) for Insiders Gift Loan or loan guarantee Small equity investment New Operating Business

13. Gift Parents Trusts for Outsiders (and Insiders?) loan or loan guarantee small equity investment New Real Estate LLC lease payments Operating Business Note: Can use for existing or new operating business

14. Business Opportunities – Loans • At or above applicable federal rate (AFR) • Credit risk ignored but need intent to repay • Loan guarantee controversy • Back-to-back loans

15. loan loan Bank Parents Entity security interest security interest Note: Loan from parents to entity should be at or above AFR but may be below market

16. Leveraged Transfers • Sale to irrevocable grantor trust • Grantor retained annuity trust

17. Sale to Irrevocable Grantor Trust • What is an irrevocable grantor trust? • Irrevocable – grantor can’t change, so outside estate tax system • Grantor trust – treated for income tax purposes as if owned by grantor • Dichotomy caused by estate and income tax statutes not harmonized

18. Sale to Irrevocable Grantor Trust • Sale disregarded for income tax purposes but respected for transfer tax purposes • Grantor pays income tax on trust’s income • Grantor can turn off grantor trust status

19. Funding Trust Grantor Initial gift (1/9?) Irrevocable Grantor Trust (IGT) Note: Annual exclusion gift if obtain private letter ruling

20. Sale Grantor Promissory Note Equity in S Corp.or p’ship Irrevocable Grantor Trust Note: No tax on sale (Rev. Rule 85-13)

21. Note Repayment S Corp. or P’ship K-1 cash IGT (TIN = grantor’s SSN) K-1 note repayments Grantor tax payments IRS

22. Sale to Irrevocable Grantor Trust • Note – interest only plus optional prepayment • Ideal – distribute most of business’ income • OK – IGT uses tax distributions to repay interest and some principal • Works even if business does not grow

23. Sale to Irrevocable Grantor Trust • Valuation risk – gift tax • Valuation risk – estate tax inclusion • Defined value clause – either variable consideration or trustee creates separate share for gift element

24. Grantor Retained Annuity Trust (GRAT) Grantor initial gift annuity payments GRAT Note: A GRAT is also a grantor trust

25. GRAT – Structuring Annuity Payments • Defined as percentage of initial value • Nominal initial gift – practically audit proof • Payments increase by 20% each year

26. GRAT – Making Annuity Payments • If long-term GRAT, use operating cash flow • If short-term GRAT, use equity interests or loan from third party • If use equity interests, no income tax issue but significant valuation issues (appraisal every year; bad consequences if miss the mark)

27. GRAT vs. Sale to IGT • GRAT – safer for gift tax • GRAT – estate inclusion if die during term • IGT – more flexible • IGT – better for multi-generational planning

28. Discount Planning • Lack of marketability • Lack of control • Use non-voting equity interests • Recapitalization often required (19 for 1)

29. Discount Planning • Simple for gifting but beware appraiser penalties • Audit risks more pronounced for sales • Estate tax risks – tax apportionment discussed later – marital deduction discussed now

30. Discount Planning – Marital Deduction Issues • Control premium • Voting equity to marital trust • Spouse withdraws voting equity

31. Discount Planning – Voting Equity Example 25% Marital Trust Surviving Spouse Over time 70% Decedent 30% Credit Shelter Trust Ending: Credit Shelter 30% Marital Trust 45% Surviving Spouse 25%

32. Discount Planning – Marital Deduction Issue • Marital deduction includes control premium • Marital trust not aggregated with surviving spouse’s own property • Valuation discount for surviving spouse even though actual control as trustee of various trusts

33. Protecting Grantor’s Cash Flow • Partnership freeze • Preferred profits interest • Code § 2701 very complicated

34. Protecting Grantor’s Cash Flow • Deferred compensation • Qualified plans • Defined benefit • Defined contribution • Employee stock ownership plan (ESOP) • Nonqualified plans (Code § 409A)

35. Protecting Grantor’s Cash Flow • Code § 409A • Violation – income, interest, 20% penalties • Cannot accelerate payment • Defer payment – 12 months + 5 years

36. Protecting Grantor’s Cash Flow • Qualifying events • Fixed date • Separation from service • Disability (narrow) • Death • Change in control (narrow)

37. Protecting Grantor’s Cash Flow • Fixed date • Informally reduce or defer compensation or work past fixed date (example next slide)

38. Protecting Grantor’s Cash Flow • Example: Payments 2021-2030 • 2020 wants to continue working in 2021 • 2020, agree that part or all of compensation earned in 2021 will be paid in 2031 • Net effect – defer retirement by one year • No deferral of original payment stream

39. Protecting Grantor’s Cash Flow • If earn over time to ensure “reasonable” compensation, can protect against failing to serve – • Grantor retains voting stock, so can avoid termination by employer without cause • Provide death benefit • Provide disability benefit • Consider bonus to provide disability insurance instead

40. Trusts as S Corporation Shareholders • Grantor trust (one grantor) • Grantor as owner • Beneficiary as owner (includes QSST) • Electing small business trust (ESBT) • Revocable trust after death (and other exceptions)

41. Trust as S Corporation Shareholders • Marital trusts are QSSTs • Dynasty trusts are often ESBTs • Can construct trust with primary beneficiary treated as the owner

42. Fiduciary Duties – Investment • Diversify unless special circumstances • Trust could explicitly state the special circumstances • Prohibiting a sale is troublesome

43. Fiduciary Duties – Investment • Regarding Undiversified Holdings Consider: • Investment Direction Agreements • Indemnifications • Directed Trusts • Document factors leading to determination not to diversify

44. Fiduciary Duties – Loyalty • Keep control to provide employment to beneficiary? • Trustee’s duty to beneficiary vs. duty to other owners of the business

45. Administering Trust Income issues if mandatory income provisions and nongrantor trust • Trust might need to keep distribution to pay income tax • Disappoint beneficiary if trustee, as manager of the business, does not have authority or inclination to make distributions

46. Administering Trust Issues if QSST or other 678 Trust • Beneficiary taxed whether or not receives distribution • Trustee might consider utilizing power to adjust • QSST + surviving spouse second marriage – need tax account cut-off in shareholder agreement

47. Buy-Sell Agreement – Overview • Estate tax • Income tax • Securing the buy-sell

48. Buy-Sell Agreement - Overview • Valuation formula • Estate tax apportionment • Marital deduction problems

49. Buy-Sell – Valuation • Control adjustment – insider’s compensation • Control adjustment – distribution policy • Marketability adjustment • Fair value vs. fair market value

50. Buy-Sell – Fixing Estate Tax Value? • Must bind during life and after death • Controlling owner might have rights that make non-binding – Blount • Family business – Code § 2703 comparability