Estate Planning for Family Business Succession

Many of us have heard the family business statistics before, but they’re worth repeating. Approximately 90% of U.S. businesses are family firms.1 They range in size from small “mom-n-pop” businesses to the likes of Walmart, Ford and Marriott. There are more than 32.4 million family businesses in the United States, representing 54% of gross domestic product and employing 59% of the U.S. workforce.2 Thirty-five percent of the businesses that make up the S&P 500 are family controlled.3 Family businesses are also more successful than non-family businesses, with an annual return on assets that’s 6.65% higher than the annual return on assets of non-family firms.4 Unfortunately, only a little more that 30% of family businesses survive through the second generation,5 even though 70% would like to keep the business in the family.6 By the end of the third generation, only 12% of family businesses will be family controlled, shrinking to 3% through the fourth generation and beyond.7

The disconnect between what 70% of families desire and the far bleaker reality can primarily be attributed to the failure to plan for the big three issues of family business succession planning: (1) family dynamics;8 (2) management succession; and (3) ownership succession through effective estate planning. Dealing with these three complex issues can seem overwhelming in the best of circumstances. It’s no wonder that in the 2007 American Family Business survey, of the top 10 challenges facing family-owned businesses, succession was number one.9 While family dynamics and management succession are extremely important for proper business succession, they’re beyond the scope of this article, which will focus on the estate-planning aspects of family business succession.

The complexity of estate planning for family business succession and the sometimes hidden objections to ownership transfer decisions can result in a kind of analysis paralysis for the business owners where nothing gets executed. The result of not planning can be tragic; at best leaving the next generation to clean up the mess and at worst resulting in a fire sale of the business to pay estate taxes. By breaking down the estate-planning process into bite-sized pieces (what we call “phases”) and identifying and overcoming certain key personal concerns of the business owners, even the most controlling business owner often will take steps to do at least basic succession planning.

Two Phases

Estate planning for the family business owner can involve virtually all of the tools in the estate planner’s toolkit, including testamentary planning, advanced gifting strategies, liquidity planning for estate taxes and philanthropy. If we attempt to address all of these issues at once, it can be overwhelming, and we run the risk that little or no estate planning gets done. Our experience has shown that planning is more effective if we break it into two phases:

Phase 1. This is basically “what if I get hit by a bus” planning. Have I done enough to provide for my family in a tax-efficient manner, and do I have the liquidity to pay estate taxes so that the business can continue without the burden of a crushing debt to pay estate taxes? It also deals with making sure that any irrevocable trusts that hold common stock, established at the death of the business owner for future generations, are structured to protect against creditors and divorcing spouses of the beneficiaries. Typically, Phase 1 planning includes wills, revocable living trusts, durable powers of attorney, living wills and appointment of health care agents. These documents are revocable and don’t require any lifetime transfer of control by the business owner. When properly drafted and combined with a buy-sell agreement that’s adequately funded with life insurance and ensures proper next-generation control of the business, a Phase 1 plan can be highly effective for succession planning. Generally, Phase 1 planning can be accomplished over a period of weeks or months at a reasonable cost.

Phase 2. Once business owners have completed Phase 1 planning, typically they’ve become more comfortable with the estate-planning process and are willing to begin the discussion of gifting some of the business interests to trusts for family during their lifetime to mitigate estate taxes. If the issues of cash flow and control (discussed below) can be overcome, effective use of dynasty trusts and installment sales to avoid estate taxes for potentially multiple generations on the business interests can be completed. This thoughtful planning can take significant stress off of the next generation involved in the family business by removing the pressure of paying estate taxes at each generation. Phase 2 planning typically evolves over a period of months or years.

Phase 1 Planning

We’ll focus on the irrevocable trusts set up at the first spouse’s death for the benefit of the surviving spouse (the estate tax sheltered trust and the marital trust) and the irrevocable trusts set up at the death of the surviving spouse for the benefit of children and other descendants.

Estate tax sheltered trust (also known as the bypass or family trust). This trust should be funded with the first spouse to die’s remaining estate and generation-skipping transfer (GST) tax exemption at the first spouse’s death. Because this trust is inoculated with the first spouse’s estate and GST tax exemptions, any assets in this trust as well as any growth not distributed will be excluded from the surviving spouse’s estate (provided the trust has been properly designed and administered). This should be the last bucket that the surviving spouse touches during their lifetime. While the trust is primarily for the benefit of the surviving spouse, children and other descendants can also be beneficiaries.

Marital trust. The remaining assets in the first spouse’s probate estate in excess of those passing to the estate tax sheltered trust typically flow into a marital trust exclusively for the benefit of the surviving spouse. This trust isn’t exempt and will be included in the surviving spouse’s taxable estate. To qualify for estate tax deferral until the surviving spouse’s death, the surviving spouse must receive all the income of the trust at least annually pursuant to Internal Revenue Code Section 2056. They can also receive principal distributions pursuant to the standard set forth in the trust instrument.

The marital trust can provide a planning opportunity for certain business owners in connection with business succession planning. For example, assume the business owner holds 90% of the stock in a family business with the remaining 10% owned by outside shareholders. If the business owner leaves the stock outright to their U.S. citizen spouse at the owner’s death, the spouse will inherit the shares free of estate tax. However, when the spouse later dies, they’ll now own a 90% interest in the stock, which, presumably will be valued in the spouse’s estate with a control premium. Now let’s change the facts and assume that during their lifetime, the business owner gave 45% of the company stock to their spouse. Each spouse would own 45%. Now, let’s assume the business owner dies and instead of leaving their 45% to their spouse, they leave it to a qualified terminable interest property marital trust for the spouse’s benefit. At the spouse’s later death, instead of their taxable estate including one 90% block of stock, it includes a 45% block owned by the estate and a second 45% block owned by the marital trust. If the marital trust is properly designed, case law10 supports the estate taking the position that the two blocks of stock should be valued separately, with the result that a minority interest discount (discussed below) should be available, rather than a control premium. For business owners in a long, happy marriage, this technique is a simple and effective way to reduce the value of the business owners’ estates for estate tax purposes.11

Trusts for descendants. At the surviving spouse’s death, the probate estate (including the business interests) typically passes to two lifetime trusts for each child and that child’s descendants. The first trust is the GST tax-exempt trust, which won’t be included with the child’s taxable estate. The second is the GST non-tax-exempt trust, which will be included in the child’s taxable estate. Each trust will have identical terms and require an independent trustee to make any distributions to beneficiaries. Structured properly, the trust should generally be protected from creditor and divorce claims in
50 states and Washington, D.C., along with protecting the business interests held in the trust if the beneficiary is a spendthrift.

Phase 2 Planning

The tax goals for tax-efficient gifting are threefold: (1) removing value; (2) freezing value; and (3) locking in the higher exemption values.

Removing value. Removing value from the transfer-tax system is difficult to do in the context of transferring shares of a closely held business. In most cases, if an individual makes a lifetime gift, that gift (at its date-of-gift value) is technically included in determining the amount of the estate at death for estate tax purposes. The lifetime exemption is then used to reduce the size of the taxable estate. However, there are three exceptions to this general rule. First, if the business owner makes a gift using their annual gift tax exclusion (which is $17,000 in 2023), the gift is completely removed from the taxable estate. Second, if the business owner transfers shares representing a minority interest in the business, they may be entitled to valuation discounts substantiated by a qualified appraisal for lack of control and lack of marketability, among other factors. These discounts may sometimes exceed 30% depending on the facts and circumstances, effectively removing that amount from the taxable estate, as long as the Internal Revenue Service doesn’t successfully challenge the transfer or the valuation discount on audit. Third, if the shares are transferred to an irrevocable trust that won’t be included in the business owner’s gross estate, the trust can be drafted so that the trust creator can pay the trust’s income taxes during their lifetime, as opposed to having the trust be its own separate taxpayer. This effectively reduces the business owner’s taxable estate by the taxes paid on behalf of the trust without being considered to have made a gift. This technique is highly effective in removing value from the business owner’s taxable estate.

Freezing value.Freezing value involves the business owner making a gift (outright or in trust) using some or all of their gift tax exemption. On the owner’s death, the amount of exemption used to make the gift is brought back into the estate for purposes of calculating their estate tax as described above. Any appreciation on the gift from the date of the gift until the business owner’s death is excluded from the taxable estate. The business owner succeeds in “freezing” the value of the gifted property for estate tax purposes at its date-of-gift value rather than at its date-of-death value.

Locking in the higher exemptions.On Jan. 1, 2018, the gift/estate and GST tax exemptions doubled under the Tax Cuts and Jobs Act of 2017. Unfortunately, because of certain Senate procedural rules, the higher exemptions will sunset without additional Congressional action at the end of 2025. This means that the exemptions will return to where they were prior to the new law (indexed for inflation). If, however, the business owner uses a portion or all of the higher exemption amounts by making gifts prior to the sunset date, those amounts transferred in excess of the exemption amount at sunset generally will be locked in and exempt from transfer tax going forward pursuant to guidance from the IRS.

Wealth transfer techniques. When a business owner considers making gifts to family for business succession purposes, there’s an alphabet soup of gifting techniques that can be considered. Some of the most common techniques are:

Gifts to irrevocable trusts. These gifts have many advantages. Trusts can be created to protect the trust assets from the beneficiary themself, divorcing spouses and the beneficiary’s creditors. If GST tax exemption is allocated to the trust, the assets typically won’t be includible in the beneficiary’s taxable estate. Finally, if the trust is drafted to be a grantor trust for income tax purposes as described above, the grantor can continue to pay the income taxes on behalf of the trust (effectively allowing the trust to compound income tax free).

An irrevocable trust can be created for any of your client’s loved ones. For example, a trust can be created by one spouse for the benefit of the other and any joint descendants, known as a spousal lifetime access trust (SLAT). Typically, the spouse is the primary beneficiary, and the descendants are secondary beneficiaries or even remainder beneficiaries. To avoid an argument that the trust should be included in the grantor-spouse’s estate under IRC Section 2036, the grantor must not have any legal rights to the assets held in the trust, nor can there be any prearrangement or understanding between the grantor and their spouse or the grantor or trustee that the grantor might use the assets in the trust. Moreover, there are additional considerations for those individuals who live in community property states, and community property may need to be partitioned prior to transfer to this type of trust.

Nonetheless, if the grantor is in a happy marriage, it can be comforting to know that their spouse will have access to the property in the trust (unless they get divorced or the beneficiary spouse predeceases the grantor). It should be noted that each spouse can establish a SLAT for the benefit of the other spouse, but the terms of the two trusts can’t be identical. If they are, the IRS can disregard the trusts and bring the assets back into each grantor’s taxable estate under the reciprocal trust doctrine.

A trust may also be created for children, grandchildren and more remote descendants, typically referred to as a “descendant’s trust.” Such a trust merely excludes the spouse as a beneficiary. One potential drawback of a descendant’s trust versus a SLAT is that the children are the primary beneficiaries and, in most states, have a right to know about the trust at a certain age and, depending on distribution standards in the trust, can make demands on the trustee for distributions. This may fly in the face of the business owner’s intention not to have young adult beneficiaries know that they have significant assets before they’ve established themselves as responsible adults.

Grantor retained annuity trusts (GRATs) and sales to intentionally defective irrevocable trusts (IDITs). The basic concept behind a GRAT is to allow the business owner to give stock or interests in the business to a trust and retain a set annual payment (an annuity) from that property for a set period of years.12 At the end of that period, ownership of whatever property that’s left in the GRAT passes to the business owner’s children or to trusts for their benefit. The value of the owner’s taxable gift is the value of the property contributed to the trust, less the value of their right to receive the annuity for the set period of years, which is valued using interest rate assumptions provided by the IRS each month pursuant to IRC Section 7520. If the trust is structured as a zeroed-out GRAT, the value of the business owner’s retained annuity interest will be equal or nearly equal to the value of the property contributed to the trust, with the result that their taxable gift to the trust is zero or near zero.

If the assets contributed to the GRAT appreciate and/or produce income at exactly the same rate as that assumed by the IRS in valuing the owner’s retained annuity payment, the children won’t benefit because the property contributed to the GRAT will be just enough to pay the owner their annuity for the set period of years. However, if the assets contributed to the trust appreciate and/or produce income at a greater rate than that assumed by the IRS, there will be property left over in the GRAT at the end of the set period of years, and the children will receive that property—yet the business owner would have paid no gift tax on it and won’t have used their exemption amount. The GRAT is particularly popular for gifts of hard-to-value assets like closely held business interests because the risk of an additional taxable gift on an audit of the gift can be minimized. If the value of the transferred assets is increased on audit, the GRAT can be drafted to provide that the size of the business owner’s retained annuity payment is correspondingly increased, with the result that the taxable gift always stays near zero. One downside of a GRAT funded with closely held business interests is that if the business isn’t sold (as in succession planning), a qualified appraisal needs to be obtained not only in the year of the gift but also in any year that the GRAT continues to own interests in the business, to determine the number of shares needed to make the GRAT payment in a particular year.

When a GRAT is suggested to a business owner, it should always be compared to its somewhat more aggressive cousin, the IDIT. The general IDIT sale concept is fairly simple.

Example: The business owner makes a gift to an irrevocable trust of $100,000 cash. Sometime later, the business owner sells $1 million worth of stock in their company to the trust in return for a promissory note made by the trust. Typically, the note is secured by the stock that’s now owned by the trust. The note provides for interest only to be paid for a period of nine years. At the end of the ninth year, a balloon payment of principal is due. The interest rate on the note is set at the lowest rate permitted by the IRS regulations, which is the applicable federal rate (AFR). This doesn’t constitute a gift because the transaction is a sale of company stock for fair market value. There’s no capital gains tax either, because the sale transaction is between a grantor and their own grantor trust, which is an ignored transaction under Revenue Ruling 85-13.

If the property sold to the trust appreciates and/or produces income at exactly the same rate as the interest rate on the note, the children won’t benefit, because the property contributed to the trust will be just sufficient to service the interest and principal payments on the note. However, if the property contributed to the trust appreciates and/or produces income at a greater rate than the interest rate on the note, there will be property left over in the trust at the end of the note, and the children will receive that property, gift tax free.

GRAT vs. IDIT. Economically, the GRAT and IDIT sale are very similar techniques. In both instances, the owner transfers assets to a trust in return for a stream of payments, hoping that the income and/or appreciation on the transferred property will outpace the rate of return needed to service the payments returned to the owner. Why, then, do some clients choose GRATs and others choose IDIT sales?

The GRAT is generally regarded as a more conservative technique than the IDIT sale. It doesn’t generally present a risk of a taxable gift in the event the property is revalued on audit. In addition, it’s a technique that’s specifically sanctioned by IRC Section 2702. The IDIT sale, on the other hand, has no specific statute warranting the safety of the technique. For example, if the trust to which assets are sold in the IDIT sale doesn’t have sufficient assets of its own to enter into this transaction (typically 10% of the sale amount), the IRS could argue that the trust isn’t a creditworthy borrower and that assets should be brought back into the grantor’s estate at death under Section 2036. Also, with a GRAT, if the transferred assets don’t perform well, the GRAT simply returns all of its assets to the grantor, and nothing has been lost other than the professional fees expended on the transaction. With the IDIT sale, on the other hand, if the transferred assets decline in value, the trust will need to use some of its other assets to repay the note, thereby returning assets to the grantor that they had previously gifted to the trust—a waste of gift tax exemption if exemption was used to initially fund the trust.

Although the IDIT sale is generally regarded as posing more valuation and tax risk than the GRAT, the GRAT presents more risk in at least one area, in that the grantor must survive the term of the GRAT for the GRAT to be successful. This isn’t true of the IDIT sale. In addition, the IDIT sale is a far better technique for clients interested in GST planning. The IDIT trust can be established as a dynasty trust that escapes gift, estate and GST tax as long as the trust is in existence, which in some cases will be until the funds are exhausted. Although somewhat of an oversimplification, the GRAT generally isn’t a good vehicle through which to do GST tax planning.

As important as it may be for the business owner to understand the risks and benefits of a GRAT versus an IDIT sale, in some cases the primary driver of which technique to choose is cash flow. With an IDIT sale, the note can be structured such that the business owner receives only interest for a period of years, with a balloon payment of principal and no penalty for prepayment of principal. This structure provides maximum flexibility for the business to make minimal distributions to the IDIT to satisfy note repayments when the business is having a difficult year and for the business to make larger distributions in better years. With the GRAT, on the other hand, the annuity payments to the owner must be structured so that the owner’s principal is returned over the term of the GRAT, and only minimal back-loading of payments is permitted. For the reasons stated above, the IDIT sale has become a very common planning technique over the past 30 years for business owners engaging in succession planning.

Other Estate-Planning Issues

Replacing cash flow. According to the 2007 Laird Norton Tyree Family Business Survey,13 an astonishing 93% of family businesses depend on the business as their primary source of income. This statistic has far-ranging ramifications for the success or failure of family business succession. A family business owner’s dependency on the business for cash flow is often an unspoken obstacle to beginning a healthy succession process. Why would a business owner transfer management and ownership of the family business to the next generation without being certain about their own retirement security and that of their spouse? Advisors to family businesses have seen clients who fit the following description: an entrepreneurial business owner with a very valuable business and business real estate, a large principal residence and vacation home, but little money in a brokerage account or retirement plan. The business owner supports their lifestyle by taking distributions from the business. Aside from the lack of investment diversification, this approach is all well and good until the business owner begins thinking about passing ownership of the business to the next generation with a minimum of transfer taxes.

The culmination of Phase 1 of the estate-planning process typically leads to discussions of ownership succession through gifting. This is sometimes the first time that a business owner contemplates how they’ll maintain their lifestyle when the children own the business. This can be a frightening process for anyone, particularly in the context of having to deal with the loss of control that comes with transferring ownership of a business that they may have spent a lifetime building. Many times, however, the cash flow concern remains unspoken, as many advisors are more concerned with the tax-efficient transfer of shares to the next generation than they are with taking time to discuss the cash flow needs of the business owner. But the business owner often realizes that once ownership is transferred, access to the business as a “personal piggybank” may be over. Failing to solve the cash flow problem can result in the business succession process effectively ending before it even begins.

This is where thoughtful advisors can help. They can show the business owner that there are many ways to replace some or all of the necessary cash flow from sources other than the ownership of the business. Addressing the cash flow needs of the business owner and their spouse is the first step in a successful family business succession plan. A frank analysis of the owner’s and spouse’s cash flow needs through cash flow-based financial planning helps to frame the issue. Once the advisor determines annual cash flow needs, they can propose alternatives to satisfy those needs. It’s likely that the family business will remain the best way of satisfying the business owner’s cash flow needs. But, with a succession plan in place, how the business will satisfy those needs will change. Historically, the business owner’s cash flow has come from what’s been described by estate-planning attorney Michael D. Allen as “control assured income.”14 While the business owner controls the business, cash flow comes from control assured income such as salary, bonuses, and C corporation dividends as well as S corporations (S corps), limited liability companies (LLCs) and partnership distributions. Before a business owner transfers control to the next generation, Allen recommends that the business owner replace “control assured income” with what he refers to as “contract assured income,” such as rents from business real estate, deferred compensation, salary continuation agreements, buy-out payments and income from such estate-planning vehicles as GRATs and installments sales to grantor trusts (or simple sales directly to family members). Following the business owner’s death, life insurance on their life may supplement or replace income from these other sources for the surviving spouse.

Once business owners’ cash flow and financial security issues are resolved, they frequently become more amenable to discussing transfers of ownership and control to the next generation. By reducing dependence on the business for cash flow, business owners free themselves to focus on effective succession planning.

Maintaining control. The desire of the senior generation to maintain control over the family business is commonly a significant obstacle to effective family business estate and succession planning. Family business owners tend to fall into one of two categories when it comes to control. The “Monarch” seeks to maintain control even if it’s at the expense of a successful succession plan. The less common “Steward” seeks to nurture the business and willingly cedes control to the next generation. Unfortunately, there are far more Monarchs than Stewards in the family business world. Particularly if the senior generation founded the business, there’s a tendency to want to maintain control even to the grave.

Even Monarchs often will do effective succession planning if shown that they can recapitalize the business into voting and nonvoting ownership interests. This can be done for partnerships, LLCs and corporations. Even S corps can have both voting and nonvoting stock without violating the rule that S corps aren’t permitted to have two classes of stock.

For example, assume that a Monarch business owner owns 100% of an S corp and is willing to do succession planning as long as they don’t have to give up any voting control. Further assume that they recapitalize the corporation into voting shares equal to 10% of the value of the corporation and nonvoting shares equal to 90% of the value of the corporation. The business owner keeps all of the voting shares, so that they completely control the corporation. But they’re willing to use most of the nonvoting shares to do estate planning to reduce the taxable estate. If the business owner gifts the nonvoting shares to the children, either outright or in some type of irrevocable trust, the owner has frozen the value of the shares for gift tax purposes, and any income and appreciation on the gifted nonvoting shares won’t be included in the business owner’s estate. If the business owner leaves the voting shares to the children active in the business at the owner’s death, they’ve done effective succession planning. If, however, there are children who are active in the business who get the voting shares and nonactive children who only own nonvoting shares, the business owner is setting up a possible conflict. The children with nonvoting shares who aren’t active in the business will typically seek distributions, while the active children would prefer to reinvest in the business or take distributions in the form of compensation that doesn’t have to be shared with the non-active children. In this case, the estate plan potentially can be structured in such a way (perhaps through a buy-sell agreement) whereby active children can buy out the non-active children at a fair value payable over a period of years that wouldn’t cripple the business.

Buy-sell agreements. A buy-sell agreement is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest, either by: (1) other shareholders (in a cross-purchase agreement); (2) the business itself (in a redemption agreement); or (3) some combination of the other shareholders and the business (in the case of a hybrid agreement) on the occurrence of certain events described in the agreement (the so-called “triggering events”). The most important of the triggering events is the death of a shareholder, but others include the disability, divorce, retirement, withdrawal or termination of employment or bankruptcy of a shareholder.

A buy-sell agreement’s primary objective is to provide for the stability and continuity of the family business in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer to unwanted third parties by setting forth how, and to whom, shares of a family business may be transferred. The agreement also usually provides a mechanism for determining the sale price for the shares and how the purchase will be funded.

Other reasons for a buy-sell agreement depend on the party to the agreement:

The founder—For someone who’s built the business from nothing and feels that no one can run it as well as they can, a buy-sell agreement allows the founder to maintain control while providing for a smooth transition to their chosen successors on their death or disability. Structuring a buy-sell agreement can provide a non-threatening forum for the founder to begin thinking about which children should be managing the business in the future and which shouldn’t. Typically, a founder will want only those children who are active in the business to own a controlling interest in the stock but will want to treat all children equally in terms of inheritance. A buy-sell agreement allows the founder to sell control to children who are active in the business and use some of the proceeds from the sale to provide for the children who aren’t active in the business. By specifically carrying out the founder’s intent, a properly structured buy-sell agreement avoids the inevitable disputes between the two sets of children with their competing interests.

The next generation—For those children who are active in the business, a properly structured buy-sell agreement will allow them to purchase the founder’s shares over time on terms that have been negotiated at arm’s length, won’t cripple their ability to operate the business and may be at least partially paid by life insurance proceeds on the life of the founder. The agreement also provides a mechanism for not having to go into business with siblings (or spouses of siblings) who aren’t active in the business.

The business—A buy-sell agreement can help keep the business in the family and assure a smooth transition to the next generation. The agreement can also void transfers that would result in the termination of the entity’s S corp status.

The founder’s estate—A buy-sell agreement can provide: (1) a market for an illiquid asset avoiding a fire sale because the sale price is determined by the agreement; (2) liquidity to pay any estate taxes; and (3) money for a surviving spouse. But under virtually no circumstances in the family business context will the IRS respect a “low ball” value for selling the business (so you shouldn’t try it).15

The role of life insurance. Business owners’ estates are inherently illiquid, with the business and the business real estate often representing the lion’s share of the value of the estate. Family business owners are often good candidates for life insurance, which can provide instant liquidity at the business owner’s death to pay estate taxes, provide for children who aren’t active in the business, fund the buy-sell agreement and provide for a spouse from a first or second marriage.

We typically suggest that the business owner consult with a highly qualified insurance professional in connection with liquidity planning. We find that the type of life insurance the insurance professional usually recommends in the family business succession context is permanent insurance. Although life insurance proceeds aren’t income taxable to the beneficiary, such proceeds are typically taxable in the insured’s estate. That’s why it’s so important for the insurance to be owned by an irrevocable life insurance trust (ILIT) in which the proceeds won’t be subject to estate tax because they aren’t considered owned by the business owner’s estate. ILITs can be structured to own single life insurance policies that pay out on the death of the business owner or second-to-die life insurance policies, which pay out on the death of the survivor of the business owner and their spouse, which is typically when estate taxes are due. It’s important to remember that if a business owner transfers an existing life insurance policy without full and adequate consideration and dies within three years of the transfer, the proceeds are brought back into their taxable estate under IRC Section 2042. Whenever possible, structure the transaction to have the insurance trust be the initial purchaser of the policy so the insurance is out of the business owner’s estate from day one.

Paying for the insurance depends on who owns the policy. If the other shareholders or the corporation owns the insurance in the context of a buy-sell agreement, there should be no gift consequences on paying premiums. Sometimes, the insurance ownership is bifurcated between the business owner and the corporation or between the business owner and certain family trusts. This bifurcated ownership is known as “split dollar,” and it’s crucial that the business owner work with an attorney and an insurance professional who are both highly experienced in the area of split-dollar planning, because it’s filled with tax traps. If the insured is providing money to pay the premiums on the insurance owned by the ILIT, they can often avoid using their gift tax exemption or paying gift tax by qualifying the transfers as present interests gifts to the trust following the process set forth in Crummey v. Commissioner and its progeny.16 Alternatively, the business owner may consider funding the insurance trust with some or all of their federal gift tax exemption if they plan to use their annual exclusion elsewhere or to simplify the trust’s administration (for example, no tracking of lapsing withdrawal powers).

Holding closely held business interests in trust. Under the Uniform Prudent Investor Act, which has been adopted in most jurisdictions, trustees are required to diversify trust assets unless special circumstances or a specific direction justify not diversifying. Diversifying many times defeats the purpose behind most trusts holding family business interests—which is to preserve the business in the family. How do we protect trustees of trusts that hold concentrated positions in family businesses from surcharge liability for failure to diversify? One way is to indemnify the trustee for failure to diversify out of the family business interests by specifically referencing the business in the trust instrument and instructing the trustee to continue to hold the stock unless certain specified events occur. These events could include continued poor performance of the business over a period of years or the consent of all or a supermajority of the beneficiaries. If the trustee is still concerned, even with the protective language, it would be prudent to establish the trust as a directed trust in a state like Delaware, New Hampshire or South Dakota (or any other state that permits directed trusts, allows the duty to diversify to be waived and that waiver has typically been upheld by their courts). Under a directed trust, the trustee would serve primarily as an administrative trustee and a committee typically not involving the administrative trustee (but likely including family members) handles investment issues regarding the family business.

Post-mortem planning. Sometimes, the family business owner never gets around to doing effective estate or liquidity planning. If that’s the case, the Tax Code provides assistance by offering the ability under certain circumstances for the estate tax to be paid over a period of years to avoid a fire sale of the business to pay estate taxes. IRC Section 6161 allows a 1-year hardship extension (renewable with IRS approval) for reasonable cause in the discretion of the IRS. IRC Section 6166 allows a 14-year extension if the business interest exceeds 35% of the decedent’s adjusted gross estate. The first five years are interest only. Rigid rules accelerate the tax if there’s a disposition of more than 50% of the value of the stock. An additional means of financing estate taxes is known as a “Graegin loan,” in which the business owner’s estate borrows funds needed to pay estate taxes on the business from a commercial lender—or, in an aggressive form of the technique, from a related entity—and deducts all of the interest on the loan in a lump sum on the estate’s tax return.17

— This article provides general information on the topic discussed and is not intended as a basis for decisions in specific situations. The views expressed herein are those of the author and may not necessarily reflect the views of UBS Financial Services Inc. UBS Financial Services Inc., its affiliates and its employees are not in the business of providing tax or legal advice. As a firm providing wealth management services to clients UBS offers both investment advisory and brokerage services. These services are separate and distinct, differ in material ways and are governed by different laws and separate contracts.

Endnotes

1. Daniel Van Der Vliet, “Measuring the Financial Impact of Family Businesses on the U.S. Economy,” https://familybusiness.org/content/measuring-the-financial-impact-of-family-businesses-on-the-US-ec (June 2, 2021), an update to Joseph H. Astrachan and Melissa Carey Shanker, “Family Businesses’ Contribution to the U.S. Economy: A Closer Look,” Family Business Review (Sept. 2003), at pp. 211-219.

2. Ibid.

3. FamilyBusiness Alliance, “Cited Stats,” www.fbagr.org/resources/cited-stats/.

4. Ibid.

5. Conway Center for Family Business, “Family Business Facts,” www.familybusinesscenter.com/ resources/family-business-facts/.

6. Ibid.

7. Ibid.

8. David T. Leibell, “Succession Planning,” Trusts & Estates (March 2011).

9. Seesupra note 3.

10. See, e.g.,Mellinger v. Commissioner, 112 T.C. 4 (1999), action on decision, 1999-006 (Aug. 30, 1999).

11. In most states, there are exception creditors who may be able to reach trust property, or at least distributions.

12. Internal Revenue Code Section 2702(b).

13. “Family to Family 2007,” Laird Norton Tyee Family Business Survey, https://businesswealthsolutions.net/files/2113/5933/8121/LairdNortonTyee.pdf.

14. Michael D. Allen, “Representing the Patriarch in Family Business Succession,” ALI-ABA Course of Study Materials, “Estate Planning for the Closely Held Business Owner” (July 2006).

15. David T. Leibell and Daniel L. Daniels, “A Practical Guide to Buy-Sell Agreements,” Trusts & Estates (March 2008).

16. Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968).

17. See Daniel L. Daniels and David T. Leibell, “Post-Mortem Planning for the Closely Held Business Owner,” ALI-ABA Audio Seminar (Oct. 29, 2008), www.ali-aba.org.