Retirement Watch : small business

What Your Heirs Should Know About IRAs

Bob Carlson — Thu, 12 Nov 2009 18:28:00 GMT

Heirs routinely lose a large percentage of inherited IRAs to unnecessary taxes. The rules are simple, but they aren't obvious and most heirs don't know about them or to ask about them. If you don't want a large portion or your hard-earned wealth and careful plans wasted, be sure your heirs know how to manage their new IRAs. Here are some key points.

* Spouses vs. non-spouses. A spouse who inherits an IRA has one big advantage over other beneficiaries. He or she can roll over the IRA to an IRA in his or her own name, providing the spouse with a fresh start for the IRA. The beneficiaries and required minimum distribution schedule can be reset. This often is a good idea for an inheriting spouse. But non-spouses who are beneficiaries cannot rollover the IRA to a new IRA.

* Naming the IRA. Other than a spousal rollover, heirs should not make the mistake of changing the IRA to their own names or allow the custodian to do so. That would require a rapid distribution of all the IRA. An inherited IRA needs three things in its title: the name of the deceased owner; the word "IRA"; and the statement that it is "for the benefit of" the beneficiary. An appropriate title is "Max Profits IRA (deceased), F/B/O Hi Profits, beneficiary.

* Deadlines. After inheriting an IRA, beneficiaries have options and reuirements. Required minimum distributions must begin, for example, and joint beneficiaries can split the IRA into separate IRAs for each beneficiary. But these actions must be taken by the end of the year after the year in which the owner died. Failure to act by the deadline ends the right to take an action and can result in higher taxes than would otherwise be paid.

* Splitting the IRA. A single IRA can be left to multiple beneficiaries. For example, Max Profits can name his three children as equal beneficiaries. If they decide to share the IRA, required minimum distributions are based on the age of the oldest beneficiary. The owners also would have to agree on how to invest the IRA and on rules for taking distributions beyond the required minimums. An alternative is to split the IRA into a separate one for each beneficiary. Most IRA custodians allow the IRA to be split in this way. Beneficiaries need to know this option is available and how to exercise it.

* Distributions. Most heirs tend to withdraw all the money from an inherited IRA quickly, pay taxes, and spend the after-tax amount. When beneficiaries prefer to use the IRA’s tax deferral, they should know how to compute required minimum distributions. The amount of the RMDs depends on whether or not the original owner was already taking RMDs, and the beneficiary also has two options in each case.

Suppose the deceased owner was not over age 70½ and had not begun RMDs.

The first option for the beneficiary is to begin taking distributions using the beneficiary's life expectancy. The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the fifth year following the year of the original owner's death. In the second option, the distributions can be taken on any schedule the heir wants. For example, the entire amount could be left in the IRA until the end of the fifth year. Or roughly equal amounts could be taken each year. Or money could be withdrawn as needed, with whatever is left in the IRA distributed by the end of the fifth year.

The first option is best for an heir who wants to use the IRA's tax deferral for as long as possible. Remember, an amount exceeding the RMD for the year can be withdrawn at any time. The second option is for an heir who doesn't intend to use the long-term tax deferral of the IRA. The five-year period gives the beneficiary time to search for ways to reduce income taxes on the distributions.

The options are a little different when the deceased owner already started RMDs.

The first choice again is for the heir to take annual installments over the beneficiary's life expectancy. The second option does not include a five-year rule. Instead, the heir can continue the RMDs on the schedule begun by the deceased owner, using what would have been the deceased’s age and life expectancy each year. The IRS says that the second method is the default method if the beneficiary does not make a selection or the IRA custodian does not name the other method as the default.

* An overlooked deduction. Most taxpayers and even many tax advisers are unaware of the deduction for "income in respect of a decedent.” Many people who inherit a substantial IRA are eligible for this deduction, which essentially is a deduction for the estate taxes that were paid on the IRA. The deduction is best explained with an example.

Suppose someone left a large estate with an IRA. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA's dollar share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators, available free on the IRS web site, www.irs.gov.

* Disclaimers. The details of who should inherit an IRA can be left to your executor who, along with family members, can determine from both a financial and tax standpoint who should be the Designated Beneficiary. The Designated Beneficiary does not have to be selected until Sept. 30 of the year following the year of the owner's death. The first required distribution does not have to be made until Dec. 31 of that year. But the Designated Beneficiary must be one of a group of primary and contingent beneficiaries named by the account owner.

The way to take advantage of this provision is for you to name both primary and contingent beneficiaries. After your heirs and executor decide who should inherit, those who are ahead of that person in the beneficiary chain can disclaim their interests.

There is a procedure in the tax law for making qualified disclaimers. Your heirs and executor should be aware of your intentions and this process, and you should give the executor guidelines for making the decision and advising the beneficiaries.

All your work of growing and preserving the IRA over the years and planning your estate could come to naught when your heirs mishandle the IRA. Be sure they know their options and obligations and have good advice on how to handle the inherited IRA.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

The Four Goals of Legacy Planning

Bob Carlson — Fri, 14 Aug 2009 00:29:00 GMT

Perhaps one of the worst effects of high estate taxes is the way tax planning diverts attention from other important estate planning issues. For many years, I have stressed that estate planning is about much more than taxes, but most people believe estate planning and estate tax planning were the same thing. Though wrong, it was understandable when the lifetime estate tax exemption was $600,000. Many "modest millionaires" who considered themselves middle class would be hit by high estate and gift taxes without planning.

Unfortunately, the idea that estate planning is all about tax reduction still is widely held. With the estate tax exemption at $3.5 million and likely to stay there or higher, many people simply are neglecting estate planning. Since estate taxes are not going to be a problem for them, they see no reason to put together a plan.

One way to avoid falling into this trap is to think about legacy planning instead of estate planning. Everyone needs a legacy plan, even those with less than $1 million in assets. With a new estate tax law likely to come down the pike this year and stabilize the tax picture, 2009 is a good time to put together your legacy plan.

Legacy planning has four key goals. Consider these goals and how to accomplish them. Working with an estate planner will be easier and faster when you understand legacy planning this way, and it will make meeting these goals easier and more likely.

Financial security for you and the objects of your affection is a priority of legacy planning.

Though few people realize it, putting yourself first should come be the priority of legacy planning. Establishing a legacy involves giving to or providing things (not necessarily money) for others. Yet, you are best able to give to others when your own standard of living is secure. You won’t be able to give to or provide for others when your own situation is precarious. As the plan is developed, keep returning to the question of whether a strategy would put your standard of living at risk under some circumstances. The sharp decline in asset prices in 2008 brought that home to many people.

Once comfortable with your financial security, establish goals for the ultimate disposition of your wealth. Often, the spouse is the first beneficiary of the wealth. After that, children, grandchildren, and charities are the usual recipients of the wealth. You need to decide who will benefit from your estate, the order in which they will benefit, and the amount or percentage of your wealth they should receive.

After determining who should benefit from the wealth, the next issue is how they will benefit. That issue often is determined by the other goals of legacy planning.

Continuing the management and caretaking of the estate is the next goal. If you are like most people, you have been calling the shots if not doing all the management. Too many estates, regardless of their size, dwindle rapidly after the first owners pass them on. Often the successors did not understand how the assets were to be managed or did not share the values and outlook of the founder.

This issue is particularly important with small businesses. The founding owner must decide who will own the business, who will benefit from its income, and who will manage the business. Those are three separate categories and do not have to consist of the same person or people. A key to successful legacy planning for a business, however, is to have a succession plan in place and to follow it. Succession planning is an issue we have discussed in my newsletter, Retirement Watch from time to time.

Even estates without businesses need to address the issue of the stewardship transition. It could be that the people you want to benefit from the wealth are not likely to manage it well over the long term. In that case, you want to consider trusts and other arrangements that separate management and ownership. It is important to recognize that those who benefit from the assets do not have to be the managers.

Protecting the estate is another key element of the plan. This goal is particularly important to small business owners and professionals. They feel a greater need to protect assets from potential creditors and lawsuits. But others might need asset protection from those sources as well as disgruntled family members, irresponsible family members, and ex-family members in divorces.

There are simple, low-cost vehicles that will protect assets, including different ways to hold title to assets, IRAs, annuities, and umbrella liability insurance. These work for estates of any size. For larger estates, there are vehicles that can be used to protect assets, including trusts and limited partnerships. Your fears, needs, and the various methods can be discussed with your estate planner. The key is to identify the assets you want protected and the potential harms from which you want protection. Surprisingly, the size of the estate often is not a factor. Many estate planners report that the worst fights are over the smaller estates.

The legacy plan must address the potential tax burden. Once you have established who should benefit from the wealth, you want to transfer the wealth to them in the ways with the lowest possible tax bill that meet your other goals. For many estates, that has become easier each year for about a decade, but easier tax reduction probably won't continue after 2009.

One reason many people do not develop estate plans is they do not realize how valuable the estate is and the potential tax burden. There often are "hidden assets" that are included in the taxable estate such as annuities, life insurance, IRAs, and some trusts. Other people "forget" about some of their assets or do not know their true value.

Even when federal estate taxes are not a problem, state inheritance or estate taxes could be. A number of states have these taxes, and some impose taxes on estates or assets with values as low as $250,000.

Income taxes on beneficiaries also need to be considered in the plan. For example, the beneficiaries of IRAs face an income tax burden many people overlook. That burden is one reason it might benefit you or your heirs to empty an IRA early, pay the taxes, and put the IRA assets in a taxable account to compound over the years. If you do not consider income taxes, your beneficiaries could benefit from far less of your wealth than you expected.

Planning a legacy involves far more than reducing estate taxes. It is time to start determining your goals and putting your plan together. Once the new estate tax law is final, push forward with the final details and implementation.

Avoiding Rags to Riches to Rags

Bob Carlson — Thu, 11 Jun 2009 19:57:00 GMT

The pattern for family wealth seems fixed. Different times and different cultures display the same pattern. The first generation builds wealth, and the second generation shepherds or preserves it. The third and succeeding generations spend until it is dissipated.

There are a few examples of families in which wealth lasted many generations. The fact that people can name these families shows they are exceptions. There are many more families in which little of the wealth makes it past the second generation. The pattern inspired the adages "shirtsleeves to shirtsleeves in three generations" and "rags to riches to rags." These adages have counterparts in other cultures.

After securing their own standard of living, the financial and estate planning concern of most affluent Americans is to provide some financial security for their grandchildren and perhaps later generations. This is possible, but most people try to accomplish it the wrong way.

Estate planning, or wealth transfer planning as some like to call it, tends to focus on the mechanics. Advisors discuss the most efficient ways to transfer assets to the next generations. The emphasis is on reducing taxes and other transfer costs. In recent years, incentives and controls have taken a greater role in many plans. Parents and grandparents seek to transfer wealth in ways that encourage the recipients to develop solid values and a work ethic and protect the wealth if they do not. For example, income or principal might be paid out of trusts only if a beneficiary meets certain goals, such as completing college or holding a job.

The shortcoming of most estate plans is their focus on ways to transfer financial capital. The real, enduring wealth of a family is not financial capital. More important assets to sustaining the family's long-term financial security are intellectual capital and human capital.

Intellectual capital is the accumulated knowledge of the family members. Human capital is the members of the family and their individual qualities and talents.

James Hughes, a semi-retired estate planning attorney, said in Financial Planning that identifying and transferring these non-financial forms of capital between generations is what ensures family wealth will grow through generations. Hughes believes that primitive societies recognize the importance of transferring human and intellectual capital between generations, because they do not have much financial capital to transfer.

Hughes says that primitive societies have formal processes in which older generations initiate younger generations from childhood into adulthood. Older generations seek to identify the gifts of younger members and nurture those gifts. The older members also pass on the knowledge they have acquired. The younger members provide energy to supplement the intellectual capital of the older members.

Hughes believes that estate planning should focus on more than financial capital and the techniques for transferring it. Instead, wealth transfer planning should be values-based and focus on transferring intellectual capital and maximizing human capital. Family mission statements and a governing structure should be established. The governing structure should not be top down or vertical. Instead, it should be more vertical or a combination of horizontal and vertical.

Importantly, there should be a mentoring process in which the older members teach the younger members about the family's values and its techniques for building wealth. Techniques for transferring financial capital, such as trusts, should focus on the very long term, not just the next generation.

Here is an important point that many people get wrong. It is important to transfer principles to the next generation but not necessarily methods of preserving and growing wealth. The methods that will be effective change over time. For wealth to grow over time, strategies must change and adapt. Values can be preserved, but methods might have to change. Each generation needs to do more than preserve and manage what it is given. Instead, it needs to act like the first generation and focus on creating wealth rather than investing and living off the financial capital created by the first generation.

A good example of this process is the Marriott family. The Marriott business empire began as a cafeteria chain, Hot Shoppes. Eventually the company, which was run by the family, invested its earnings in hotels and other real estate. When the cafeteria business seemed mature, it was sold and the family focused on hotels.

After a while, family managers realized that owning hotels was capital intensive and subject to the economic cycle. The hotels were sold. Marriott Corporation now manages hotels under contract from the owners of the properties. Less capital is required; the income stream is more reliable; and the effects of the business cycle are less pronounced. Marriott owns a number of brand names and trademarks it licenses to hotel owners—such as a range of Marriott hotels and Ritz-Carlton. But it does not own many properties.

Marriott Corporation has been controlled by the same family. But it has changed dramatically and continued to grow as each generation has acted as entrepreneurs instead of caretakers.

Each generation must be dynamic if wealth is to be preserved and especially if it to grow. When a generation views wealth or a business as static, the financial capital will begin to decline. That is why it is more important for the first generation to transfer its values and knowledge to the following generations than to transfer financial capital.

There are several ways to do this. In some families the first generation personally transfers the intellectual capital. In other families, formal education and contact with family advisors transfer the values. The transfer process can be informal through daily contact or formally through annual family retreats or other events. In most cases, a combination of these methods should be used.

Few estate planners or other advisors assist in the transfer of nonfinancial capital. Each family must develop a system that works for it.

The real wealth of a family is not its financial capital or its business. Financial capital can be dissipated, and a business must change and evolve to be sustainable. Values and intellectual capital must be transferred from the older generation. The younger generations must add their energy to build on what the earlier generations built. Otherwise the financial capital will dissipate even if the best wealth transfer techniques are used.

Dos and Don'ts of IRA Investing

Bob Carlson — Fri, 03 Apr 2009 14:18:00 GMT

Many people own substantial IRAs and have the bulk of their investment portfolios in IRAs. Some of these investors might not realize there are investments that are prohibited from IRAs and others are allowed but incur tax penalties. The issue of how to invest an IRA is more important in today's climate, because "hard assets" and other nontraditional assets—those that investors prefer today—are primarily those prohibited or discouraged in IRAs.

IRA investment disincentives fall into three categories. There are prohibited investments, taxable investments or transactions, and prohibited transactions.

The prohibited IRA investments are labeled “collectibles.” When an IRA purchases a collectible, the amount used to make the purchase is treated as distribution to the owner. It is included in the owner's gross income, and if the owner is under age 59½ and does not qualify for one of the exceptions, a 10% early distribution penalty is imposed on top of the income taxes. In addition, there is a penalty each year the IRA continues to own the prohibited investment.

Collectibles are defined in the tax code as works of art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS is allowed to define other items as collectibles but has not done so.

Note that an IRA may purchase securities of firms that produce collectibles, such as mining companies and alcohol producers or distributors. But the IRA may not purchase the collectibles themselves.

There are other investments an IRA may own, but those investments could cause the IRA to owe income taxes on income from the investments or the owner might be taxed as though distributions were made.

An IRA is most likely to be taxed when it earns unrelated business taxable income (UBTI). The UBTI rules apply to all qualified retirement plans, not just traditional IRAs. If an IRA earns UBTI exceeding $1,000 it must pay income taxes on that income. The IRA might have to file Forms 990-T or 990-W. It also must pay estimated income taxes during the year if the UBTI exceeds $500.

The IRA owner essentially will be taxed twice on UBTI. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. There is no deduction or credit available to the owner for UBTI paid by the IRA, and the tax on the IRA does not increase the tax basis of the IRA.

The UBTI rules are supposed to prevent a tax-exempt entity such as an IRA from unfairly competing with tax-paying businesses. The rules are fairly broad, however, and apply to situations in which the IRA is not operating a business. An IRA potentially has UBTI if it does any of the following:

operates a trade or business,

receives certain types of rental income,

receives certain types of passive income from a business entity it controls,

invests in a pass-through entity, such as a partnership, that conducts a business, or

uses debt to finance investments.

A "trade or business" is any activity carried on for the production of income from the sale of goods or performance of service. Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes certain types of income from the definition of trade or business income for UBTI purposes. The exempt types of income include interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt.

Even exempt income, however, can be converted into UBTI.

Real estate rental income generally is exempt from UBTI, but becomes UBTI if the amount of rent is computed as a percentage of the tenant's profits.

Controlling a business entity also can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, any rent, interest, or royalties paid by the entity to the IRA is UBTI if the payments have the effect of reducing the business income of the entity. Another way to look at this rule is that if the business entity deducts the payments to the IRA, they are UBTI to the IRA.

When an IRA owns an interest in a pass-through business entity (partnership or limited liability company), the IRA's share of the entity's income is UBTI. Pass-through entities generally do not pay federal income taxes. Instead, their income and expenses are passed through to their owners' income tax returns.

This rule most often trips up individuals who invest in master limited partnerships (MLPs) or real estate partnerships in their IRAs. MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Individuals generally are urged not to purchase MLPs through IRAs.

It is not illegal to own an MLP through an IRA. The ownership, however, triggers the UBTI rules and the requirement to possibly file a version of Form 990 and pay estimated taxes. There is no tax advantage to owning MLPs through an IRA. Some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of filing a separate Form 990 for the IRA.

An IRA also has UBTI when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. Real estate mortgages also are debts that convert exempt income into UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

The prohibited transaction rules are the final category of taboo investments. The rules are fairly detailed and can get complicated. Generally they prohibit transactions between the IRA and its owner or a person related to the owner (including businesses).

The penalty for violating the prohibited transaction rule is severe. The entire IRA will be considered fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized. Other IRAs escape the penalty unless they also engaged in prohibited transactions.

It is easy to state the prohibitions in clear, plain English: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner. Yet, there are some "prohibited transactions" allowed by IRS regulations or rulings, and IRA owners can receive waivers from the Department of Labor for specific transactions.

A detailed discussion of the prohibited transaction rules would be too much for this posting. While it is possible for an IRA to engage in transactions with the owner’s small business, real estate, or other interests, such transactions should not be considered without good tax or legal advice.

IRAs do not have complete investment freedom. IRA owners who prefer investments other than publicly-traded stocks and bonds and mutual funds need to be wary of the potential pitfalls.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of numerous books and reports, including The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

Planning Tips for Family Businesses

Bob Carlson — Thu, 28 Aug 2008 18:44:00 GMT

Business owners have unique concerns in addition to the usual estate and retirement planning issues. Business owners fear their heirs might sell or dismantle the business or the wrong people might run it. Those results can be avoided, but the owner must plan carefully and implement the plan.

Small business succession can be divided into two major issues. The first issue is the personal aspect of succession. Who will manage the business or have a say in its operations? The second major issue is the financial aspects of transition: estate taxes, cash flow, and the like. I will focus on this second issue in this posting.

The financial aspects can be divided in two parts. The first part is ensuring that the estate has enough cash flow to pay the taxes and other estate expenses. The second part, which can help with the second part, is to reduce the estate taxes related to the business.

While most people focus on estate taxes in their planning, the plan also must ensure the estate will have the cash to pay those taxes and other expenses without selling the business or taking other drastic action. Often, the solution is to get cash from the business to the estate, and the owner must ensure that the business has enough cash to meet the estate’s needs.

Let’s look first at a few tax strategies to improve the estate’s cash flow.

One seemingly-attractive tool is the deferral of estate taxes under Section 6166 of the tax code. This section allows the estate taxes to be deferred over 14 years. Only interest is paid for the first four years; then principal and interest are paid for the next 10 years. The interest rate charged is low.

While enticing, many small business owners should not rely on this tool. First, you cannot be sure that Congress won't change or repeal the section when it is too late for you to do additional planning. Second, many small businesses won't qualify for the extension. The business must meet the section’s definition of “closely held,” and its value must be at least 35% of the owner's estate. The owner also must own a minimum percentage of voting power, and the business must be an “active trade or business,” which can exclude real estate and other significant operations. Another complication is that the IRS can put a lien against the business until the tax bill is paid, even when the election is made properly.

Another strategy to consider is tax code section 303, which is an efficient way to get cash from a business to an estate. Stock can be redeemed from the estate. The estate pays the long-term capital gains rate if the amount of stock redeemed equals the cost of estate taxes, funeral expenses and estate administration. But this provision also has limits. For one, it applies only to regular corporations. S corporations and LLCs cannot use it. Like Section 6166, it would be risky for most estate owners to rely on it.

Another way to get cash from the business to the estate is known as a Graegin note, after the Tax Court case that approved it. The estate can borrow from the business to pay estate taxes, and it can deduct the interest as an estate administration expense. The case generally is interpreted as allowing a lump sum deduction against the value of the estate of the interest to be paid, though the interest is paid over time. This deduction can reduce estate taxes significantly.

The IRS is looking closely at Graegin note transactions. The estate must show that the interest expense is reasonable and necessary. That generally means showing that the estate needs the cash and that it is not feasible to sell assets to pay the taxes. Some estate planners recommend borrowing from a third party instead of directly from the business. The business can guarantee the note.

Cash flow also can be established with non-tax strategies, such as life insurance, loans, and cash management by the estate owner.

Now, let’s look at estate tax reduction strategies unique to business owners.

In recent years, two key estate planning strategies for business owners have come under attack from the IRS: private annuities and family limited partnerships. Private annuities are in limbo because of recent IRS rulings and regulations in the works. FLPs still are viable for those who follow the guidelines set in court cases, and we have covered them in past issues of Retirement Watch.

Fortunately, there are a host of other viable strategies for the business owner to consider without the risk of locking horns with the IRS.

An installment sale, and its variation known as a self-canceling installment note (SCIN), allows the owner to sell the business to one or more family members (or to employees). The owner controls the tax bill, defers taxes, and establishes a manageable payment plan for the buyers.

Taxes from the sale are deferred, because they are recognized only as payments are received. Taxes can be accelerated if the seller cancels the note, transfers the note, or sells the business to a related party who sells it to someone else within two years. The future appreciation of the business is out of the seller's estate. At the seller's death, only the present value of the note is included in the estate.

With a SCIN, the note is canceled on the seller's death; no value is included in the seller's estate. But the term of the note should be no longer than the seller's life expectancy on the date of the sale, and the buyer will have to pay a premium above the business's value to justify the cancellation feature. The SCIN needs to be carefully structured with an experienced estate planner to avoid gift taxes and other potential pitfalls.

If done properly, either a SCIN or straightforward installment sale removes future appreciation from the estate and reduces estate taxes. Each also allows heirs or other buyers to use future business cash flow to buy the business. In either version, the owner is selling the business now, not at some point in the future.

A little-used tool for business owners is the gift (or sale) and leaseback. Suppose the owner wants to remove assets from the estate but wants to continue running the business. If there are assets used by the business that the owner holds outside the business, the owner can give assets to the children and have the business lease them back. The owner must possess the assets individually for this to work. Or the business can sell the assets to the children and lease them back.

The arrangements can provide both cash flow and tax benefits to the children, in addition to the estate planning benefits. The IRS scrutinizes closely these types of transactions between related parties, so they need to be planned and executed carefully.

An effective tool that can be difficult to explain is the intentionally defective grantor trust (IDIT). This allows the seller to remove a property from the estate and still retain control. The strategy’s success depends on the different definitions of ownership under the estate and gift tax on the one hand and the income tax on the other hand.

The owner creates a trust and sells appreciating assets such as a business or key property to it in return for an installment note. The seller retains enough control of the trust to treat him as owner under the income tax rules but not enough control to include the trust assets in his estate. An experienced estate planner needs to draft the trust to meet this requirement.

The assets and their appreciation are out of the seller's estate, though the installment note's present value might be in the estate. The seller also is taxed on the income of the trust, which is a way of making a gift to the trust beneficiaries without paying estate and gift taxes. If the owner pays the income taxes, the trust assets are able to compound without the burden of income taxes.

For the business owner with enough cash flow to pay the income taxes, the IDIT is worth a look.

A strategy that probably is not used enough is the employee stock ownership plan (ESOP). The tax law provides a number of incentives to use an ESOP.

In a typical ESOP, a small business owner creates the ESOP and a related trust. The company borrows money from a bank and in turn lends that money to the trust. The owner sells some or all of his stock to the trust. Over time, the company makes annual contributions to the trust, which are deductible. The trust uses the money to repay the loan from the company, which the company uses to repay the loan from the bank.

Special tax breaks allow the company to deduct both the interest and principal it pays on the loan. It also deducts contributions made to the trust as well as dividends paid on stock owned by the trust.

The owner also receives individual tax breaks. Gains from the sale of the stock are deferred if within a year the owner uses the proceeds to purchase securities issued by domestic companies and meet other restrictions. Taxes are due only as the owner sells those investments. The owner can sell whatever percentage of his stock he wants. In many ESOPs, the owner still retains a majority share of the company.

An ESOP is best for an owner whose children do not plan to run the company and do not want to own it. The ESOP gives a share to each employee and must meet nondiscrimination rules; the owner cannot pick and choose which employees get greater shares in the ownership distribution. When an employee leaves the company, he receives cash equal to the value of his ESOP account. Employees generally are allowed to vote on major corporate changes, such as mergers and acquisitions.

When done right, the estate plan of a business owner enhances the value of both the business and the owner's estate. It also provides more for the heirs and avoids potential problems involving taxes, cash flow, and the survival of the business.

Five Myths of Business Succession

Bob Carlson — Thu, 21 Aug 2008 13:48:00 GMT

Few small firms survive past the first generation of owners. That is well-known. Most people assume the business failures are due to the inadequacies and mistakes of the owners and managers after the first generation. Yet, at least an equal share of blame goes to the founding owners who do not properly develop and implement succession plans. With proper planning and implementation of that plan, a small business's probability of survival is increased by putting it in the control of competent managers.

A number of small business owners do not plan for succession because they do not want to face their own mortality—the same factor that keeps many people from developing estate plans. For those who do try to plan for succession, another important hurdle is that owners typically believe succession planning myths. Shattering these myths is a key if more business owners are to successfully sell their businesses, retire comfortably, and see the businesses thrive under new management.

Let’s take a look at those myths and why they are wrong.

It's too soon. Most business owners and even their financial advisors believe exit planning can wait until about five years before the owner is ready to leave, according to an article in the Wealth Planning issue of May 2007. In fact, the probability of success is enhanced if the planning begins much earlier. By waiting, the owner forecloses many opportunities that would increase the net cash received from the transition.

Even a good small business often needs a couple of years to find a buyer willing and able to pay the owner's price. In addition, the economy has cycles. If the owner decides to retire when the economy is in a recession or interest rates are high, a buyer near the owner's price might not be found or financing might not be available.

If the owner plans to transfer the business to family members, waiting forecloses valuable options. Gifts of ownership made over a period of years can avoid or reduce gift and estate taxes. Early planning also would allow the owner to take assets out of the business in tax-advantaged ways, prefunding retirement. The optimum tax structure from which to sell the business also might not be available if the owner waits to plan.

Succession means loss of control. Control is important to many business owners for both financial and emotional reasons. Many do not realize is that a succession plan can shift ownership without giving up control. There are strategies that allow ownership and control to be separated. The owner can begin transferring ownership while running the business and drawing income from it.

For example, the business could be transferred to a family limited partnership. Or a corporation could be recapitalized so there are voting and non-voting ownership interests. There are other solutions that depend on the type of business and who the eventual owners will be.

The value is in the numbers. An examination of the financial statements is the way to determine the value of many large businesses. With a small business, however, the value often depends on the owner. Relationships with customers, suppliers, and employees might be the key to success. The owner also might be the sole source of innovations and plans for the company. Because of the importance of the owner, many times a buyer is willing to pay only based on one year's income or the market value of the tangible assets. There is little value in the goodwill or owner’s equity.

A business owner can avoid this situation with advance planning. The work force should be bolstered with a strong management team that has long-term incentive compensation. The owner should give responsibilities to employees and establish relationships between key employees and customers and suppliers.

In addition, the owner might be able to add value by showing the business has a market niche protected by barriers to entry, patents, trademarks, long-term contracts, or other unique advantages.

While numbers are not everything for a small business, the financial statements can support the argument that the business is financially solid and not entirely dependent on the current owner. Advanced succession planning creates the opportunity to show a buyer consistent growth of earnings and cash flow for several years. The buyer will be asking, "What is the value of this business without the owner?"

The contract price is what counts. Many small business owners decide that the business has a certain value or that they need a particular sale price to fund retirement. With small business sales, the details and structure of the sale can be more important than the contract price. A key is to structure the transaction to minimize taxes. In a standard sale, the seller pays taxes (usually at capital gains rates) while the buyer pays for the business with after-tax dollars.

Instead of focusing on the contract price, business sellers should work to structure the deal for maximum tax savings for both the seller and the buyer. If the owner begins considering the options well in advance of a sale, the tax planning potential increases.

Buyers are self-funding. Few buyers are able to pay cash or borrow from a third party to pay for the business. In most cases, the business finances its sale. A buyer will pay in cash (or borrow from a third party) only if he or she expects the business to generate enough cash flow to offer a good return on that cash. Otherwise, a buyer with cash would buy bonds or publicly-traded stock.

An owner often finances the sale of the business. This can be done by taking money out over time, by arranging things so that employees or family members can own the business, or by selling to a third party on terms.

Owners who realize this will start exit planning well in advance of their retirement. They will take money out of the business over time to provide for retirement. Or they will explore how to set up an employee stock ownership plan, leveraged buyout, or other financing strategy. The point is that the seller needs to consider how a purchase of the business will be financed. The money to pay for the sale ultimately must come from the business. The owner can start the planning early and expand the options available or can wait until a buyer with ready cash appears.

An owner spends many years building a business. For much of that time, an exit strategy should be under consideration. Only a few businesses are able to go public or be sold to larger companies for a multiple of earnings. For most small businesses, the owner must plan well in advance to increase the business's probability of survival and to maximize the cash received from the business.