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Presentation for the Estate Planning Council of Greater Miami 4th Annual Estate Planning Symposium Tuesday, February 9, 2016 “Both Sides Now” – A view of the IRS’s Audit Process and Trends from the Perspective of both the IRS and Taxpayer Having worked as a supervisory attorney in the IRS Estate & Gift Tax Division for over thirty years, and for the past 4 years representing private clients in audit disputes, I’ve looked at audits, as Joni Mitchell so eloquently penned, “from both sides now.” This session will discuss the IRS audit process in detail, looking at potential issues from both the perspective of the IRS, and that of the taxpayer’s representative. We will also cover audit trends as well as recent case law dealing with valuation of art, closely held businesses, easements, penalties, and other relevant issues to those who practice in the area of estate and gift taxation. Presentation by: Martin E. Basson, Esq. Former Supervisory Attorney IRS Estate & Gift Tax Division mbasson@aol.com / (954) 234-8151 IRS Return Selection Process for Audits • All returns, both estate & gift, are initially screened and reviewed at the Cincinnati Service. Your reputation can play a role in the selection process as well as the reputation of the experts you chose. • Returns can be sent anywhere in the USA for audit depending on local workloads and inventories. Domicile of taxpayer no longer controlling factor. • Second review is performed by local estate tax manager • If case assigned to an estate tax attorney he/she still has the ability to approve it without an audit with secondary management approval • Larger and more complex business valuation issues should be referred to the IRS Engineering & Valuation Division. However, there are no “set-in- stone” mandatory referral guidelines for businesses (artwork is different) Current Hot IRS Valuation Related Issues - LL.C.'s & Partnerships containing art. The leading case in this area is -Art transactions are also being scrutinized in income tax

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- See N.Y. Times “Tax Break Used by Investors in Flipping Art Faces Scrutiny” (April 26, 2015) – discussed later in detail. - Older gift tax returns & adequate disclosure (8/5/97 magic date) - IRC Section 2036 issues (most litigated issue) – see later detailed analysis - Use of formula clauses to discourage audits

- The use of “defined value clauses” or “value definition formulas” in making gifts has received much attention and possibly a boost from the decision of the United States Tax Court in Wandry v. Commissioner, T.C. Memo 2012-88. Wandry seems to extend the effectiveness of such techniques beyond what previous case law permitted. But Wandry is not well-settled law on this subject, its reasoning is troubling, and it should not be relied on except with great care, especially since the IRS has filed a Notice of Appeal

- Since 1985, the IRS has become less sympathetic and has challenged such audit-resistant formulas, often citing Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), a case with unusual facts in which the court found a provision in a document of transfer that “the excess property hereby transferred which is deemed by [a] court to be subject to gift tax ... shall automatically be deemed not to be included in the conveyance” to be contrary to public policy because it would discourage the collection of tax, would require the courts to rule on a moot issue, and would seek to allow what in effect would be an impermissible declaratory judgment.

- Field Service Advice 200122011 (Feb. 20, 2001) addressed, negatively,

the facts generally known to be those of McCord v. Commissioner, 120 T.C. 358 (2003), in which the taxpayers had given limited partnership interests in amounts equal to the donors’ remaining GST exemption to GST-exempt trusts for their sons, a fixed dollar amount in excess of those GST exemptions to their sons directly, and any remaining value to two charities. The IRS refused to respect the valuation clauses. The IRS acknowledged that the approach in question was not identical to Procter, because it used a “formula” clause that defined how much was given to each donee, while Procter involved a so-called “savings” clause that required a gift to be “unwound” in the event it was found to be taxable. Nevertheless, the IRS believed the principles of Procter were applicable, because both types of clauses would recharacterize the transaction in a manner that would render any adjustment nontaxable. The IRS reached similar conclusions in Technical Advice Memoranda 200245053 (July 31, 2002) and 200337012 (May 6, 2003).

- Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (reviewed by the court), addressed the use of value formulas in the different context of a

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disclaimer of a testamentary transfer. The decedent’s will left her entire estate to her daughter, with the proviso that anything her daughter disclaimed would pass to a charitable lead trust and a charitable foundation. The daughter disclaimed a fractional portion of the estate, with reference to values “finally determined for federal estate tax purposes.” Noting that phrase, the Tax Court, without dissent, rejected the Service’s Procter argument and upheld the disclaimer to the extent of the portion that passed to the foundation. (The court found an unrelated technical problem with the disclaimer to the extent of the portion that passed to the charitable lead trust.) In a pithy eight-page opinion, the Eighth Circuit affirmed. 586 F.3d 1061 (8th Cir. 2009).

- In Estate of Petter v. Commissioner, T.C. Memo 2009-280, the Tax Court

upheld gifts and sales to grantor trusts, both defined by dollar amounts “as finally determined for federal gift tax purposes,” with the excess directed to two charitable community foundations. Elaborating on its Christiansen decision, the court stated that “[t]he distinction is between a donor who gives away a fixed set of rights with uncertain value—that’s Christiansen —and a donor who tries to take property back—that’s Procter.... A shorthand for this distinction is that savings clauses are void, but formula clauses are fine.” The court also noted that the Code and Regulations explicitly allow valuation formula clauses, for example to define the payout from a charitable remainder annuity trust or a grantor retained annuity trust, to define marital deduction or credit shelter bequests, and to allocate GST exemption. The court expressed disbelief that Congress and Treasury would allow such valuation formulas if there were a well-established public policy against them. On appeal, the Government did not press the “public policy” Procter argument, and the Ninth Circuit affirmed the taxpayer-friendly decision. 653 F.3d 1012 (9th Cir. 2011).

- Hendrix v. Commissioner, T.C. Memo 2011-133, was the fourth case to approve the use of a defined value clause with the excess going to charity, although the court emphasized the size and sophistication of the charity, the early participation of the charity and its counsel in crafting the transaction, and the charity’s engagement of its own independent appraiser.

In Wandry v. Commissioner, T.C. Memo 2012-88, the donors, husband and wife, each defined their gifts as follows: I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my Units as a Member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such Units for federal gift tax purposes shall be as follows: [Here each donor listed children and grandchildren with corresponding dollar amounts.] Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the

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date of the gift but must be determined after such date based on all relevant information as of that date. The court stressed the now familiar “distinction between a ‘savings clause’, which a taxpayer may not use to avoid [gift tax], and a ‘formula clause’, which is valid.... A savings clause is void because it creates a donor that tries ‘to take property back’.... On the other hand, a ‘formula clause’ is valid because it merely transfers a ‘fixed set of rights with uncertain value’.” The Tax Court then compared the Wandrys’ gifts with the facts in Petter and determined that the Wandrys’ gifts complied. Most interesting, the court said (emphasis added): It is inconsequential that the adjustment clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined Norseman percentage interest expressed through a formula. The gift documents do not allow for petitioners to “take property back”. Rather, the gift documents correct the allocation of Norseman membership units among petitioners and the donees because the [appraisal] report understated Norseman’s value. The clauses at issue are valid formula clauses.

- This is a fascinating comparison, because it equates the rights of the charitable foundations in Petter that were the “pourover” recipients of any value in excess of the stated values with the rights of the children and grandchildren in Wandry who were the primary recipients of the stated values themselves. In a way, the facts of Wandry were the reverse of the facts in Petter. The effect of the increased value in Petter was an increase in what the charitable foundations received, whereas the effect of the increased value in Wandry was a decrease in what the donees received. The analogs in Wandry to the charitable foundations in Petter were the donors themselves, who experienced an increase in what they retained as a result of the increases in value on audit.

- Closely held businesses & partnerships - Tax affecting - built in capital gains - Graegin Loans - E/O John F. Koons III v. Comm. T.C. Memo 2013-94 (4/8/13) - Newest case in area, win for IRS, interest not a deductible expense - Easements - highest & best use (exaggeration of)

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Estate Tax Returns Filed (Historical Perspective) Year Number Taxable # CHC/Partner 2014 11,931 5,158 9,052 2013 10,568 4,687 5,051 2012 9,412 3,738 4,430 2011 12,582 1,480 2,164 2010 15,191 6,711 6,361 2001 108,071 51,736 13,464 Examination Coverage of Estate Tax Returns Year # Examined % $5-10 m. % Over $10 m. 2014 2,853 21.1% 27.0% 2013 3,250 23.7% 31.2% 2012 3,762 58.6%. 116 % 2011 4,195 24.9%. 40.3% 2010 4,288 20.8% 30.8% Gift Tax Returns Filed (Historical Perspective) Year Total Taxable $1 Million Plus 2014 264,968 2,977 1,243 2013 369,063 5,638 114,190 2012 249,000 2,469 31,529

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2011 219,544 10,982 3,040 2010 223,093 9,645 1,732 2004 224,987 4,994 930 Exam Coverage of Gift Tax Returns Year # Returns Examined % Audited 2013 2,775 1.1% 2012 3,164 1.4% 2011 2,623 1.2% 2010 1,777 .7% 2009 1,569 .6% Hot IRS Valuation Issues in Greater Detail 1. Discounted Works of Art and Art in General – Why emphasis on art? In 2013, most recent year with available figures, the IRS Art Advisory Panel recommended accepting 44% and adjusting 56% of the appraisals it reviewed. IRS Art Advisory Panel Average Adjustments Year Donation Estate/Gift 2008: -51% +91% 2009: -34% +66% 2010: -58% +43% 2011: -46% +51% 2012: -52% +47% 2013: -32% +33% 2014: -55% +23% (+76%)

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E/O Elkins v. Commissioner, 767 F.3d 443 (5th Cir. 2014), aff’g in part and rev’g in part 140 T.C. 86 (2013) – Deals with fractional interest in art. On his estate tax return, the estate claimed valuation discounts for the partial interests in artwork of 44.75% from the pro rata portion of the total undiscounted value, based on appraisals reflecting the lack of marketability of a partial interest and the time and expense of a partition action. (The artwork was valued by Sotheby’s, and the discount set by Deloitte LL.P.) In its notice of estate tax deficiency, the Service assessed a $9 million deficiency, based on denial of discounts in valuing the artwork. Prior to litigation, the Service and the estate agreed to the undiscounted values of the art. In litigation, the estate claimed a valuation discount of nearly 67%, based on new appraisals by art and other experts that question whether anyone would really want a partial interest in the artwork without a very substantial discount. The Service, relying on Estate of Scull v. Commissioner, T.C. Memo 1994–21, and Stone v. United States, 103 A.F.T.R. 2d 2009-1379 (9th Cir. 2009) for its position that little or no discount would be allowable. The Tax Court (later affirmed by the Fifth Circuit Appeals Court) held that the cited cases did not support the IRS position. The court also rejected the discounts proposed by the taxpayer’s as unrealistically high. The appeals court agreed with the Tax Court’s rejection of the IRS’s “no discount” position. The court emphasized that the IRS offered no evidence of the proper amount of discount if any discount is allowed. In contrast, the estate attached an appraisal to the form 706 and offered even more evidence of discounts at trial. The court noted that the taxpayer had the burden of proof, but the burden shifted to the IRS when the estate offered credible evidence. Because of the failure on the part of the IRS to offer evidence of the amount of an appropriate discount, the court fully sustained the taxpayer’s original 44.75% discount. Lesson: Experts do matter! Discussion: I have been working with two extremely wealthy taxpayers on Elkins issues. My advice to practitioners based on my recent experience is……… 2. Older gift tax returns and adequate disclosure If a taxpayer does not file a tax return, the statute of limitations for most federal taxes never commences. Thus, in theory, the IRS can go back as many years as it wants to an ‘open’ year to audit and assess tax. In practice, the IRS really goes back too far. In the income tax area, six years is the general rule of thumb. In a recent case, the IRS has raised eyebrows by seeking to assess gift taxes on a transfer that occurred 41 years ago.

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In 1972, Sumner Redstone transferred stock in a family company to other family members and settlement of a family dispute. The IRS is now seeking $1.1 million in gift taxes and penalties, plus interest per its view that the transfer was a gift. The interest alone has been estimated to be at least equal to, or more than the original tax and possible penalties combined. 3. IRC Section 2036 Issues (the most litigated)

Section 2036 provides that: General Rule —The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained . . . (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom

Ramifications ― If IRS successful, all assets of entity might be brought back into estate

Even if interests in partnership transferred during life (Harper, Korby) Bona Fide Sale for Adequate and Full Consideration Exception

Two part test: (1) Adequate and Full Consideration ― Interests proportionate and value of contributed property credited to capital accounts (2) Bona fide Sale ― "Significant and legitimate non-tax reason" for creating the entity Case-by-case analysis:

Centralized asset management (Stone, Kimbell, Mirowski, Black) Involving next generation in management (Stone, Mirowski, Murphy) Protect from creditors/failed marriage (Kimbell, Black, Murphy, Shurtz) Preservation of investment philosophy (Schutt, Murphy, Miller) Avoiding fractionalization of assets (Church, Kimbell, Murphy) Avoiding imprudent expenditures by future generations (Murphy, Black)

2036(a)(1) ― Retained Right to Possess or Enjoy Assets Contributed or Income From Assets

Case-by-case analysis Factors considered by courts: Non pro-rata distributions (Harper, Korby, Thompson) Personal expenditures with partnership funds (Strangi, Hurford, Rector) Personal use assets in partnership (Strangi)

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Payment of estate tax and expense when assets transferred to partnership close to death (Miller, Strangi, Erikson)

Accurate books and records not kept (Harper) Insufficient assets outside of partnership (Thompson, Miller, Strangi,

Rector) 2036(a)(2) - Retained Right to Designate Persons Who Will Possess or Enjoy Assets Contributed or Income From Assets

Strangi, Turner, Cohen Investment powers not subject to 2036(a)(2)

(Byrum v. U.S.) Distribution powers? Cohen/Byrum ― "If the agreement may be said to give the trustees

unlimited discretion . . . , so that dividends could be arbitrarily and capriciously withheld or declared, then the dividend power would constitute a 'right' under section 2036(a)(2); if, on the other hand, the power is circumscribed by cognizable limits on the exercise of discretion, then no such 'rights' exists."

Should senior family member be general partner? How about co-general partner?

Prepare for Audit at Planning Stage

IRS issues broad requests "All documents relating to the creation of the entity from any attorney,

accountant or firm involved in recommending the creation of the entity . . ."

Your files could be subpoenaed ― including emails You might have to testify about reasons for creating entity Help your client ― best evidence of non-tax reasons comes

from contemporaneous correspondence (see Stone, Schutt) Okay to discuss tax attributes, but talk about non-tax

attributes and reasons too (see Stone, Schutt, Mirowski)

Recent Valuation Decisions T/P (Year) Type of Assets Court of Jurisdiction Discount Strangi I (2000) securities Tax 31% Knight (2000) securities/real estate Tax 15% Dailey (2001) securities Tax 40% Adams (2001) securities/real estate/minerals Fed. Dist. 54% Church (2002) securities/real estate Fed. Dist. 63% McCord (2003) securities/real estate Tax 32% Lappo (2003) securities/real estate Tax 35.4% Peracchio (2003) securities Tax 29.5%

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Deputy (2003) boat company Tax 30% Green (2003) bank stock Tax 46% Thompson (2004) publishing company Tax 40.5% Kelley (2005) cash Tax 32% Temple (2006) marketable securities Fed. Dist. 21.25% Temple (2006) ranch Fed. Dist. 38% Temple (2006) winery Fed. Dist. 60% Astleford (2008) real estate Tax 30% (GP); 36% (LP) Holman (2008) Dell stock Tax 22.5% Keller (2009) securities Fed. Dist. 47.5% Murphy (2009) securities/real estate Fed. Dist. 41% Gallagher (2011) publishing company Tax 47% Koons (2013) cash Tax 7.5% Richmond (2014) marketable securities Tax 46.5% (37% LOC/LOM & 15% BIG)

WHAT ARE THE FORMS IN WHICH THE SERVICE PROVIDES ADVICE TO TAXPAYERS?

The Service provides advice in the form of letter rulings, closing agreements, determination letters, information letters, and oral advice.

A “letter ruling” is a written determination issued to a taxpayer by an Associate office in response to the taxpayer’s written inquiry, filed prior to the filing of returns or reports that are required by the tax laws, about its status for tax purposes or the tax effects of its acts or transactions. A letter ruling interprets the tax laws and applies them to the taxpayer’s specific set of facts. A letter ruling is issued when appropriate in the interest of sound tax administration. One type of letter ruling is an Associate office’s response granting or denying a request for a change in a taxpayer’s method of accounting or accounting period. Once issued, a letter ruling may be revoked or modified for a number of reasons. A letter ruling may be issued with a closing agreement, however, and a closing agreement is final unless fraud, malfeasance, or misrepresentation of a material fact can be shown.

A “closing agreement” is a final agreement between the Service and a taxpayer on a specific issue or liability. It is entered into under the authority of IRC § 7121, and it is final unless fraud, malfeasance, or misrepresentation of a material fact can be shown.

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A taxpayer may request a closing agreement with a letter ruling or in lieu of a letter ruling, with respect to a transaction that would be eligible for a letter ruling. In such situations, the Associate Chief Counsel with subject matter jurisdiction signs the closing agreement on behalf of the Service.

A closing agreement may be entered into when it is advantageous to have the matter permanently and conclusively closed or when a taxpayer can show that there are good reasons for an agreement and that making the agreement will not prejudice the interests of the Government. In appropriate cases, a taxpayer may be asked to enter into a closing agreement as a condition for the issuance of a letter ruling.

A “determination letter” is a written determination issued by a Director that applies the principles and precedents previously announced by the Service to a specific set of facts. It is issued only when a determination can be made based on clearly established rules in a statute, a tax treaty, the regulations, a conclusion in a revenue ruling, or an opinion or court decision that represents the position of the Service.

An “information letter” is a statement issued by an Associate office or Director that calls attention to a well-established interpretation or principle of tax law (including a tax treaty) without applying it to a specific set of facts. An information letter may be issued if the taxpayer’s inquiry indicates a need for general information or if the taxpayer’s request does not meet the requirements of this revenue procedure and the Service concludes that general information will help the taxpayer. An information letter is advisory only and has no binding effect on the Service. If the Associate office issues an information letter in response to a request for a letter ruling that does not meet the requirements of this revenue procedure, the information letter is not a substitute for a letter ruling. The taxpayer should provide a daytime telephone number with the taxpayer’s request for an information letter.

Information letters that are issued by the Associate offices to members of the public are made available to the public. Information letters that are issued by the Field offices are generally not made available to the public.

Because information letters do not constitute written determinations as defined in § 6110, they are not subject to public inspection under § 6110. The Service makes the information letters available to the public under the Freedom of Information Act (the “FOIA”). Before any information letter is made available to the public, an Associate office will redact any information exempt from disclosure under the FOIA. See, e.g., 5 U.S.C. § 552(b)(6) (exemption for information the disclosure of which would constitute a clearly unwarranted invasion of personal privacy); 5 U.S.C. § 552(b)(3) in conjunction with § 6103 (exemption for returns and return information as defined in § 6103(b)).

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The following documents also will not be available for public inspection as part of this process:

(1) transmittal letters in which the Service furnishes publications or other publicly available material to taxpayers, without any significant legal discussion;

(2) responses to taxpayer or third party contacts that are inquiries with respect to a pending request for a letter ruling, technical advice memorandum, or Chief Counsel Advice (which are subject to public inspection under § 6110 after their issuance); and

(3) responses to taxpayer or third party communications with respect to any investigation, audit, litigation, or other enforcement action.

Oral Advice

No oral rulings and no written rulings in response to oral requests. The Service does not orally issue letter rulings or determination letters, nor does it issue letter rulings or determination letters in response to oral requests from taxpayers. Service employees ordinarily will discuss with taxpayers or their representatives inquiries about whether the Service will rule on particular issues and about procedural matters regarding the submission of requests for letter rulings or determination letters for a particular case

Discussion is possible on substantive issues. At the discretion of the Service and as time permits, Service employees may also discuss substantive issues with taxpayers or their representatives. Such a discussion will not bind the Service or the Office of Chief Counsel, and it cannot be relied upon as a basis for obtaining retroactive relief under the provisions of § 7805(b).

Service employees who are not directly involved in the examination, appeal, or litigation of particular substantive tax issues will not discuss those issues with taxpayers or their representatives unless the discussion is coordinated with Service employees who are directly involved. The taxpayer or the taxpayer’s representative ordinarily will be asked whether an oral request for advice or information relates to a matter pending before another office of the Service or before a Federal court.

If a tax issue is not under examination, in appeals, or in litigation, the tax issue may be discussed even though the issue is affected by a nontax issue pending in litigation.

A taxpayer may seek oral technical guidance from a taxpayer service representative in a Field office or Service Center when preparing a return or report.

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The Service does not respond to letters seeking to confirm the substance of oral discussions, and the absence of a response to such a letter is not a confirmation.

Important: Oral guidance is advisory only, and the Service is not bound by it. Oral guidance is advisory only, and the Service is not bound by it, for example, when examining the taxpayer’s return.

IRC Section 9100 Relief

The stated purpose of this Section is to grant taxpayers extra time to make elections. For an excellent detailed analysis of IRC Section 9100 see the 2015 Heckerling Outline prepared by M. Reade Moore titled “Important Procedural Rules for Estate Planners.” There are three types of relief available under this section. All require that you act in good faith and granting relief will not prejudice the interests of the government. Reasonable action is presumed if the request is made before the government discovers the failure to timely elect (one small benefit to the IRS being so slow to audit estate tax returns).

The taxpayer is deemed to have acted reasonably and in good faith if they:

1. inadvertently failed to make the election because of intervening events beyond their control;

2. failed to make the election because, after exercising due diligence (taking into account the taxpayer’s experience and complexity of the issue) the taxpayer was unaware of the necessity for the election;

3. reasonably relied on the written advice of the IRS; or 4. reasonably relied on a qualified tax professional who failed to make, or

advise the taxpayer to make, the election.

Prejudice is deemed to exist only if granting the requested relief gives the taxpayer a lower tax liability than if the election had been timely made.

Type 1 - 9100(2)(a)(2) - automatic extension to elect up to 12 months after filing a timely return to elect only Section 2032(a) or alternate valuation treatment. Total can be up to 27 months after d/d if return was filed with a timely 6 month extension.

Type 2 - 9100(2)(b) – automatic extension of 6 months from filing of return, including extensions, to elect most 706 elections. Must file request with statement on top saying “Filed Pursuant to Section 9100 – 2.” Taxpayer must demonstrate they acted in good faith and granting relief will not prejudice the government.

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Type 3 – 9100(3)(b)(3) – This is a last resort measure when no other type of relief is still available. Is actually a request for a revenue ruling and requires payment of appropriate fee. Can be used for missed portability, QTIP, reverse GST, etc.

Note: Nothing can cure a blown section 6166 election. This election must be made on a timely filed return.

User fees - Letter Rulings Before 2/5/14 After 2/5/14

(c) (i) Letter ruling request for relief under § 301.9100–3 $10,000 $6,900

Reason Cause for Abatement of Late Filing Penalties

Surprisingly I am now involved in my third estate having failure to file timely penalties being assessed by the IRS.

If for some reason you miss the legal filing date, mail the return as early as possible after that date. The longer you wait to file after the due date has passed, the more difficult it will be to have the penalties abated. The leading authority in the estate tax area on reasonable cause for late filing is the Supreme Court case of United States v. Boyle, 469 U.S. 241 (1985). The Court in Boyle gave us the following guidelines on this issue: To avoid a penalty for a late-filed return, the taxpayer bears the "heavy burden" of proving its failure to file timely was due to reasonable cause and not willful neglect. Boyle, 469 U.S. at 245 (citing I.R.C. § 6651(a)(1)). In order to prove "reasonable cause," a taxpayer must show that it "exercised 'ordinary business care and prudence' but nevertheless was 'unable to file the return within the prescribed time.'" "Willful neglect" requires a "conscious, intentional failure or reckless indifference." In Boyle, the Supreme Court observed that "[c]ourts have differed over whether a taxpayer demonstrates 'reasonable cause' when, in reliance on the advice of his accountant or attorney, the taxpayer files a return after the actual due date but within the time the adviser erroneously told him was available." The Court's decision in Boyle did not resolve those differences. The Court did state, however, that: “When an accountant or attorney advises a taxpayer on a matter of tax law, such

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as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a "second opinion," or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. "Ordinary business care and prudence" do not demand such actions. By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. In short, tax returns imply deadlines. Reliance by a layperson on a lawyer is of course common; but that reliance cannot function as a substitute for compliance with an unambiguous statute. Among the first duties of the representative of a decedent's estate is to identify and assemble the assets of the decedent and to ascertain tax obligations. Although it is common practice for an executor to engage a professional to prepare and file an estate tax return, a person experienced in business matters can perform that task personally. It is not unknown for an executor to prepare tax returns, take inventories, and carry out other significant steps in the probate of an estate. It is even not uncommon for an executor to conduct probate proceedings without counsel. “ Also see recent cases of Estate of Morton Liftin v. United States, 110 Fed. Ct. Cl. 119 (2013) and Knappe v. United States, 713 F.3d 1164 (9th Cir. 2013) for additional examples of just how difficult it is to overcome the assessment of late filing penalties for estate tax returns. Future Portability Audits or how important is getting an appraisal for hard to value assets when the first to die has a below the level exclusion amount and you are only filing to protect portability when and if you file a return for the second to die? Answer – it depends Update on Estate & Gift Tax Appeals (thanks to Maricarmen Cuello) Appeals Mission – to resolve tax disputes, without litigation, on a basis which is fair and impartial to both the government and the taxpayer and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the IRS. Independence is the most important of Appeals’ core values. Currently there are two Estate & Gift Tax Teams

- East Coast – Maricarmen Cuello, Mgr. (Miami) New York (3)

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Philadelphia (1) Jacksonville (2)

- West Coast – Kym Taborn, Mgr. (Los Angeles) Seattle (1)

Los Angeles (1) Houston (1) Dallas (1) Chicago (1) Indianapolis (1) Sources of Cases

- Appeals from 706 and 709 examinations - Denial of 706 and 709 claims - 6166 qualification denials - Terminations of 6166 elections - Denials of 6161 payment extension requests - Penalty appeals stemming from estate and gift tax returns - Occasionally, unagreed 1041 cases

Fast Track Settlement

- Settling issues at the earliest possible stage in the examination or collection process reduces the burden on taxpayer and IRS resources.

- Appeals’ Fast Track programs provide taxpayers with an opportunity for quality, accelerated case resolutions by having Appeals employees serve as mediators while cases are still in Compliance’s jurisdiction.

- As of July 2013, the SB/SE Fast Track Settlement Process was expanded nationwide.

- All parties participate in the FTS session - The FTS official is trained in mediation techniques and has been delegated

settlement authority. - The resolution goal is 60 days for SB/SE cases & 120 days for LB&I cases

Fast Track Settlement Procedures

- Exam will complete the FTS application - Form 14017 - Exam group manager ensures the FTS qualifications are met - If case qualifies, Exam will send the FTS package to Appeals to confirm

and accept the case into the FTS program - FTS session arranged by FTS Official - FTS Official facilitates discussions utilizing mediation techniques and

settlement authority. - If an agreement is reached, the parties sign Form 1400 FT Session Report

agreeing to the settlement. - Report of final agreement will be prepared by Exam and executed by

taxpayer and/or representative.

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- Generally Exam will prepare agreement forms. - Appeals will prepare agreement forms if 870AD, or 890AD, or closing

agreement is required. - Case is closed by SB/SE

Fast Track Eligibility

- Non-docketed cases - Fully-developed cases

Fast Track Exclusions

- TEFRA cases - Collection Due Process, Offer in Compromise, and Trust Fund Recovery

Penalty cases - Whipsaw issues - Correspondence cases worked solely at a campus - Frivolous issues - Uncooperative taxpayers

Summary of Fast Track Benefits to Taxpayer

- Significantly reduces case resolution time - Reduced interest costs - Fewer IRS contacts - Prompt resolution

Appeals Judicial Approach and Culture (AJAC)

- AJAC clarifies the independence and impartial role of Appeals - It clarifies the distinction between the roles of Compliance and Appeals - It emphasizes a quasi-judicial approach to dispute resolution

Statute of Limitation Requirements for Appeals

- In general, all new case receipts in Appeals from Compliance must have at least 365 days remaining on the statute of limitations (SOL) when received in Appeals

- Estate Tax cases must have at least 270 days remaining on the SOL. The Three (3) News & Appeals Jurisdiction

- New information - New issues - New argument/theory

New Information (first new)

- What is “new information?” – New information or new evidence is any item

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that the taxpayer did not previously share with the examiner, and in the judgment of the Appeals Hearing Officer, merits additional analysis or investigative action by Examination.

- What is Additional Analysis? – Additional analysis means anything that is not self evident, or involves voluminous information. Simply adding up items that are not voluminous does not constitute additional analysis. Categorizing, sorting, reviewing large volumes of records, or requiring additional steps or reasoning to reach a conclusion constitutes additional analysis.

- What is an investigative action? – Investigative action means actions

required for fact finding, to make inquiries or to verify the authenticity of an item.

- If Appeals receives new information from the TP that, in the judgment of

the Appeals Hearing Officer, merits additional analysis and/or investigative action, the case will be returned to the originating function (jurisdiction released) to examine the new information. The rationale behind this procedure is that a first review by Compliance ensures that the TP is afforded a true appeal with respect to their position/issue. If Appeals conducts the initial review, the TP is not getting a “true appeal” or second look at their case.

New Issue (second new)

- Appeals will not raise new issues and will focus its efforts on resolving points of disagreement by the parties.

- Appeals will attempt to settle a case on factual hazards when the case submitted by compliance is not fully developed and the TP has presented no new information or evidence.

- When a TP raises a new issue to Appeals on a non-docked case and sufficient time remains on the SOL, jurisdiction of the case will be released to the originating function to allow for their examination of the new issue. The new issue must be relevant to the case.

- Docketed Cases: Appeals will consider a new issue affirmatively raised by the government in pleadings and may consider any new evidence developed by Compliance or Counsel to support the government’s position on the new issue. The Appeals hearing officer’s consideration of a new issue on a docketed case will take into account that the government has the burden of proof. Disagreements between Appeals and Counsel on whether a settlement offer should be accepted is resolved by Area Counsel, with the advice and assistance of the Appeals Area Director and Associate Chief Counsel responsible for the issue.

Releasing Jurisdiction to Compliance: There are three factors to consider prior to

19

releasing jurisdiction: - Statute Date: There must be at least 210 days remaining on the SOL if

case is to be returned to Compliance to consider new information. Compliance must then return case back to Appeals with at least 180 on the SOL.

- Relevance - Additional Analysis/Investigative Action

New Argument/Theory (third new)

- Appeals may consider new theories and/or alternative legal arguments that support the parties’ positions when evaluating the hazards of litigation.

- The Appeals hearing officer will not develop evidence that is not in the case file to support the new theory or argument.

- If a TP presents a relevant new theory or alternative legal argument to Appeals:

a. Appeals will send the information to the Estate Tax Attorney for an opportunity to review and comment. Jurisdiction is not released.

b. EXAM function has 45 days to provide written comments (can be extended by mutual agreement).

c. The originating function’s response will be shared with the TP, who will be allowed time to review and provide a response.

Additional Administrative Expenses

- There is a special exemption for administrative expenses defined under IRC 2053

- Appeals will not release jurisdiction - Information will be sent to Compliance for review and comment. - Compliance will have 45 days to review and provide their determination.

Key messages to PRACTIONER

- Raise a new issue or provide new information to the examiner and DON’T wait until your case is in Appeals

- Raise new issues or provide new information in the protest to a 30-Day Letter.

- Very important to document the items you provided to the examiner.

"Both Sides Now" - An Insider's

View of the IRS's Audit & Appeals

Processes and Current Trends Martin E. Basson

Semi-Retired Former Supervisory Attorney

IRS Estate & Gift Tax Division

IRS Return Selection

Process for Audits

• All returns, both estate & gift, are initially screened and reviewed at the

Cincinnati Service. Your reputation can play a role in the selection process

• Returns can be sent anywhere in the USA for audit depending on local

workloads and inventories. Domicile of taxpayer no longer controlling factor

• Second review is done by local estate tax manager

• If case assigned to an estate tax attorney he/she still has ability to approve

it without an audit with secondary management approval

• Larger and more complex business valuation issues should be referred to

the IRS Engineering & Valuation Division. However, there are no set in

stone mandatory referral guidelines for businesses (artwork is different)

Estate Tax Returns

Filed • Year Number Taxable # CHC/Partnerships

• 2014 11,931 5,158 9,052

• 2013 10,568 4,687 5,051

• 2012 9,412 3,738 4,430

• 2011 12,582 1,480 2,164

• 2010 15,191 6,711 6,361

• 2001 108,071 51,736 13,464

Examination Coverage of Estate Tax Returns

Year # Examined % $5-10 m. % Over $10 m.

2014 2,853 21.1% 27.0%

2013 3,250. 23.7% 31.2%

2012 3,762 58.6% 116 %

2011 4,195 24.9% 40.3%

2010 4,288 20.8% 30.8%

Gift Tax Returns Filed • Year Total Taxable $ 1 Million Plus

• 2014 264,968 2,977 1,243

• 2013 369,063 5,638 114,190

• 2012 249,000 2,469 31,529

• 2011 219,544 10,982 3,040

• 2010 223,093 9,645 1,732

• 2004 224,987 4,994 930

Exam Coverage of Gift Tax

Returns • Year # Returns Examined % Audited

• 2014 3,098 0.8%

• 2013 2,775 1.1%

• 2012 3,164 1.4%

• 2011 2,623 1.2%

• 2010 1,777 .7%

• 2009 1,569 .6%

Current Hot IRS Valuation

Related Issues • LL.C.'s & Partnerships containing art and fractional interest discounts for

gifts of art (E/O Elkins)

• Older gift tax returns & adequate disclosures

• IRC Section 2036 issues (most litigated issue)

• Use of formula clauses to discourage audits (Petter & Wandry)

• Graegin Loans - E/O John F. Koons v. Comm.

• Closely held businesses & partnerships

• Tax affecting - built in capital gains

• Easements - highest & best use

Summary of 2014 Art Panel

Recommendations

• Reviewed 315 items with total value of $251 million

• Accepted 38% of appraisals at original value -

adjusted remaining 62%

• Recommended total net adjustments of $56 million

on estate & gift tax appraisals, a 23% increase

• Recommended total net adjustments of $2.1 million

for charitable contribution appraisals, a 55%

reduction

E/O Elkins v. Commissioner, 767

F.3d 443 (5th Cir. 2014), aff'g in

part and rev'g in part 140 T.C. 86

(2013)

Leading estate tax case dealing with discounts for fractional

interests in works of art

The 5th Circuit Court of Appeals reversed Tax Court (limited

discount to 10%) and allowed the taxpayer's original 44.75%

combined LOC and LOM discounts

IRC Section 9100 Relief

• The stated purpose of this Section is to grant

taxpayers extra time to make elections.

• There are three types of relief available under this

section. All require that you act in good faith and

granting relief will not prejudice the interests of the

government.

• Reasonable action is presumed if the request is

made before the government discovers the failure

to timely elect.

Taxpayer is deemed to have acted

reasonably and in good faith if they:

• Inadvertently failed to make the election because of intervening

events beyond their control;

• Failed to make the election because, after exercising due diligence

(taking into account the taxpayer's experience and complexity of the

issue) the taxpayer was unaware of the necessity for the election;

• Reasonably relied on the written advice of the IRS; or

• Reasonably relied on the advice of a qualified tax professional who

failed to make, or advise the taxpayer to make, the election

• Finally, prejudice is deemed to exist only if granting the requested

relief gives the taxpayer a lower tax liability than if the election had

been timely made.

• Type 1 - 9100(2)(a)(2) - automatic extension to elect up to 12

months after filing a timely return to elect only Section 2032(a) or

alternate valuation treatment. Total can be up to 27 months after

D/D if return was filed with a timely 6 month extension.

• Type 2 - 9100(2)(b) - automatic extension of 6 months from filing of

return, including extensions, to elect most 706 elections. Must file

request with statement on top saying "Filed pursuant to Section

9100-2". Examples of elections are QTIP, reverse GST, QDOT, etc.

• Type 3 - 9100(3)(b)(3) - this is a last resort measure when no other

type of relief is available. Is actually a request for a Revenue Ruling

and requires payment of appropriate fee. Can be used for missed

portability, QTIP, reverse GST, etc.

• Note: Nothing can cure a blown Section 6166 election. This

election must be made on a timely filed return.

Reasonable Case for Abatement

of Late Filing Penalties • Leading case in the estate tax area is the United States Supreme

Court case of United States v. Boyle, 469 U.S. 241 (1985)

• Taxpayer bears a "heavy burden" of proving failure to file timely

was due to reasonable cause

• Reasonable cause = exercised ordinary business care and

prudence but still couldn't file timely

• Reliance on a tax professional does not automatically qualify as

meeting reasonable cause criteria

• Most recent cases on this issue is Liftin v. United States, 110 Fed.

Ct. Cl. 119 and Knappe v. United States, 713 Fed.3d 1164 (9th

Cir.2013)

Update on Estate and

Gift Tax Appeals

Thank you Maricarmen

Cuello!

Appeals Source of Cases

• Appeals from 706 and 709 audits

• Denial of 706 and 709 claims

• 6166 qualification denials

• Terminations of 6166 elections

• Denials of 6161 (hardship) payment extension requests

• Penalty appeals stemming from estate and gift tax cases

• Occasionally, unagreed 1041 cases

Appeals Fast Track

Settlement (FST) • Provides TP's with an opportunity for accelerated

case resolutions by having Appeals employees

serve as mediators while cases are still in

Compliance jurisdiction.

• All parties participate in the FTS session. FTS

official has been delegated settlement authority.

• Resolution goal is 60 days for SE/SE cases

• TP retains normal appeal rights if agreement can't

be reached.

Fast Track Settlement

Procedures • Exam completes the FTS application - Form 14017

• Exam sends FTS package to Appeals to confirm and accept the

case

• Session arranged by FTS official who is is trained in mediation

techniques and has settlement authority

• If agreement is reached all parties sign Form 1400 FT Session

Report agreeing to settlement

• Final agreement and report is prepared by Exam and executed by

TP or authorized representative.

• Case is closed by Exam in normal manner.

Summary of Fast Track

Benefits

• Significantly reduces case resolution time

• Reduced interest costs

• Fewer IRS contacts

• Prompt resolution

Appeals Judicial Approach

and Culture (AJAC)

• AJAC clarifies the independence and impartial role

of Appeals

• It clarifies the distinction between the roles of

Compliance and Appeals

• It emphasizes a quasi judicial approach to dispute

resolution

Statute of Limitations

Requirements for Appeals

• In general, all new case receipts in Appeals from

Compliance must have at least 365 days remaining

on the SOL when received in Appeals

• Estate Tax cases must have at least 270 days

remaining on the SOL when received in Appeals

The Three (3) News and

Appeals Jurisdiction

• New Information

• New Issues

• New Argument / Theory

Key Messages to

Practitioners

• Raise a new issue or provide new information to the

examiner and DON'T WAIT until your case is in

Appeals

• Raise new issues or provide new information in the

protest to a 30-Day Letter

• Very important to document the items you provided

to the examiner

Questions?

Estate Planning Council of Greater Miami

4th

Annual Estate Planning Symposium

Estate Planning for

Business Owners

Tuesday, February 9, 2016

Charles D. Fox IV

McGuireWoods LLP

310 Fourth Street, N.E., Suite 300

Charlottesville, VA 22902

(434/977-2500

Cfox@mcguirewoods.com

Copyright 2016 by

McGuireWoods LLP

All rights reserved

ESTATE PLANNING FOR BUSINESS OWNERS

TABLE OF CONTENTS

Page

I. INTRODUCTION ............................................................................................................. 1

II. CHARACTERISTICS OF A FAMILY BUSINESS ......................................................... 2

III. ADDRESSING THE EMOTIONAL AND PSYCHOLOGICAL CONFLICTS AT

WORK IN BUSINESS SUCCESSION ............................................................................. 5

IV. TOWARD AN ANALYSIS OF FAMILY BUSINESS CONFLICTS: MODELS

OF BASIC FAMILY BUSINESS FORMS ..................................................................... 11

V. ADDITIONAL SOURCES OF CONFLICT ................................................................... 19

VI. PLANNING FOR BUSINESS SUCCESSION ............................................................... 24

VII. PLANNING FOR BUSINESS SUCCESSION IN A DOWN ECONOMY ................... 37

VIII. CONCLUSION ................................................................................................................ 40

IX. INTEGRATING ESTATE PLANNING STRATEGIES WITH FAMILY

BUSINESS SUCCESSION ISSUES ............................................................................... 41

X. CONCLUSION .............................................................................................................. 120

1

ESTATE PLANNING FOR BUSINESS OWNERS 1

I. Introduction.

A. Presence of Conflict. Conflict is especially likely to occur in a family business

when the owner and the other family members consider and examine the transfer

of the ownership and control of the business. The conflict often arises between

older generation family members and younger generation family members,

between family members in the same generation, and between family members

and non-family employees and shareholders.

B. Issues Arising. Many issues arise when a family owned business embarks upon

its possible succession. These include:

1. Lifetime Sale: Should the business be sold during the owner’s lifetime?

2. Continuance after Death: Should the business be continued after the

owner’s death?

3. Ownership of Business: Who will own the business after the succession

of the business?

4. Control of Business: Who will control the business after the change of

ownership?

5. Treatment of Children: Will the owner’s children be treated equally in the

distribution of the owner’s estate either before death or after death?

6. Treatment of Owner: What provisions will be made for the present owner

after transfer of the business?

C. Issue of Succession. Experts estimate that 85% of the crises faced by family

businesses focus around the issue of succession.2 Therefore, in addition to

addressing the legal aspects of passing a family business from one generation to

the next, attorneys, accountants, family business consultants, trust officers, and

other professionals must help families meet and overcome the conflict that will

inevitably occur when a family plans for the succession of the control and/or

ownership. In fact, such conflict is, in most situations, inescapable. Experts tell us

that conflict is a necessary part of human relationships. Human beings are

incapable of spending any significant time together without having differences.3

D. Surmounting the challenges of this conflict requires both sensitivity to family

dynamics and an extensive knowledge of the wide range of legal disciplines that

impact succession issues.

E. Lack of Succession Planning. Despite the importance of succession planning, a

2007 survey of family businesses found that 40.3% of business owners expected

to retire within 10 years. But of those business owners expecting to retire in 5

2

years, only about half (45.5%) had selected a successor, and of those expecting to

retire in 6–11 years, only 29% had selected a successor.4 But 30.5% had no plans

to retire, ever; and since the median age of the business owner was 51, many

planned to die in office.5

F. Human Planning Requirements. A business owner who fails to prepare and

execute a succession plan – and especially one who dies in office – leaves his or

her family, business, and wealth in a uncertain state subject to questions about

what should be done with the business and attacks by those who wish to take

control or have ownership or those who think that they are entitled to ownership

and control. These materials examine the human conflicts that arise when

business succession occurs or even when it is first broached as a subject, and offer

techniques either to avoid those conflicts or to diffuse them when they inevitably

occur.

II. Characteristics of a Family Business.

A. What Is a Family Business? For the purposes of these materials, a family

business will be defined as one in which a family has effective control of the

strategic direction of the business and the business adds significantly to the

family’s assets, income, or identity in the community.6 Consequently, family

businesses encompass a wide scope of enterprises ranging from Mom and Pop

grocery stores to some of America’s most successful and largest businesses, such

as Cargill, Mars, Inc., and Estee Lauder.

B. Statistics on Family Businesses.

1. More than 90% of all U.S. businesses are family businesses.7 These 22.9

million family businesses account for 40% of the nation’s private sales,

and account for 97% of all employers.8

2. 78% of all new jobs created in the United States from 1977 to 1990 were

created by family businesses.9

3. Over 150 of the Fortune 500 companies are family businesses.

C. Advantages of Family Business. There are many perceived advantages to a

family business when compared to a non-family business, including the

following:

1. Humane working environment. Family business owners often feel

emotionally connected to their business and their employees, leading to a

supportive relationship between employee and employer.

2. Long-term view. Instead of managing from quarter to quarter, family

businesses tend to manage from generation to generation.

3

3. Investments. Family businesses often afford one of the best available

(albeit possibly risky) investment opportunities.10

4. Flexible and Adaptive. Family businesses often have a centralized

management structure that makes them more flexible and immediately

responsive to change in the marketplace.11

5. Common Values. Family businesses often share common values and

ethos that bind the family members and workers together in a strong

support network.12

These values often give additional meaning to the

work of the firm, and these values include the following.

a. Family businesses often exert a powerful influence for good in the

local community.

b. Family businesses focus on personal service and customer

loyalty.13

6. Flexibility of Work. Despite long hours and hard work, family businesses

often offer freedom and flexibility in the use of their time and considerable

freedom from outsiders.14

D. Survival of Family Businesses.

1. Despite the many perceived advantages of family businesses, it is

estimated that only 30% of family businesses pass to the second

generation, 12% pass to the third generation, and only 3% reach the fourth

generation.15

2. There are two primary reasons for this high failure rate:

a. Failure to do Succession Planning. The failure to plan adequately

for the succession from the older generation to the younger

generation from a psychological and emotional perspective.

b. Failure to do Tax Planning. The failure to do adequate estate

planning to minimize the income and transfer tax consequences of

succession from one generation to the next.

c. Succession planning seems to be the key element here. For

example, while Birmingham, Alabama attorney and former

President of the American College of Trust and Estate Counsel,

Daniel H. Markstein, III, has never seen a family business that was

sold to pay estate taxes, he has seen many family businesses sold

out of necessity because of poor succession planning.16

3. Succession planning in family businesses is particularly difficult for

several reasons: 17

4

a. Smaller Pool of Potential Successors. When a business aims to

keep its leadership within the family, the family business must

choose its next leader from a smaller pool of candidates, not all of

whom may be interested in leading the family businesses.

Moreover, the family may be reluctant to fill management

positions with experienced non-family members. Further, the

choice of successor is fret with the following difficulties:

(1) Nepotism. Related to a family business’ small pool of

successors, family businesses are more likely to suffer from

nepotism. A 2007 survey by PricewaterhouseCoopers

found that almost 2/3ds of family businesses award family

members a place in the business without measuring them.18

Thus, a founder might successfully pass on the business to

the second generation, only to realize too late that the

second generation will be unable to keep the business

afloat.

(2) Sibling Rivalries. Even where there are family members

available to fill the leadership positions, the ability to

manage as a team can be impeded by competition among

siblings or other relatives.

b. Failure to Separate Home and Work. Because families often

identify themselves with the family business, conflicts within the

business can spill over into the family arena, and vice versa.19

c. Larger Age Differentials. In contrast to non-family businesses,

succession in family businesses typically involves a larger age

differential. In one study, of those business owners who had

selected a successor, the median age of the successor was eighteen

years younger than the current chief executive.20

But this is merely

the median; succession in family businesses often spans an entire

generation, which can mean a 20 to 25-year age differential.

d. Different Outlooks and Expectations. The owners of a family

business often have different views of life and of business than do

their possible successors. In fact, unlike first-generation

businesses, in which parties choose to go into business with one

another, multi-generational family businesses are often an

“accidental partnership” of people with very different values and

goals who find themselves in a common venture.21

Because the

family business is already an emotionally-charged environment,

this can lead to clashes.

(1) Long-Term and Short-Term Expectations. Some of those

involved in the family business, such as the founders and

5

active family members, have a long-term view. But others,

such as employees, non-family management, and passive

family members, might have a short-term view of the

business and might care more about dividend

performance.22

(2) Differing Entrepreneurial Styles. The founders of

businesses often have an entrepreneurial outlook, and they

are comfortable taking risks. But the second generation,

however, is usually much more risk averse, and is focused

on preserving the gains of the first generation.23

These

differing values can lead the founder to feel that the second

generation is not ready; or, if the transition does occur, then

the business might suffer from this radical change of

management.

e. Inability to Let Go. Psychological factors can prevent family

business leaders from letting go of their roles. For example, a

leader may associate the loss of power in the business with the loss

of power in the family. In addition, founders of family businesses

whose self-reliance was critical in the establishment and early

success of the business may be averse to delegating power to

others in preparation for succession.

f. Aversion to Succession Planning. The management of family

businesses, especially in first-generation businesses, often does not

address the issue of succession. A 2003 survey of 387 small

family-owned businesses found that only 50% had succession

plans. Of those without succession plans, 31.4% stated that they

were “uncomfortable making the necessary decisions,” and 14.4%

stated that “it’s a difficult topic to deal with.”24

III. Addressing the Emotional and Psychological Conflicts at Work in Business Succession.

A. To ensure a smooth transition, family members must take into consideration the

complex emotional issues that are usually absent in a non-family corporation or in

the transfer of other assets.

EXAMPLE: Family business experts Glenn A. Ayres and Michael J. Jones

point to one example of how a party’s neglect of these issues cost his family. In

one business, the father passed on the business to the eldest son; in so doing, the

father minimized adverse tax consequences, and he was able to maximize the

transfer of wealth to all of his children. But the rest of the family did not see it

that way. The other family members saw the father as a “mean-spirited, old

miser” who had secretly favored the eldest son in what they called “the Big Lie.”

Conflicts ensued between that son and the other members of the family, who

happened to control other assets on which the business was dependent. The

6

family’s harmony was ruined, as was the smooth interplay of assets that were all

owned by the same family.25

B. The Complex Transitions of Family Business Succession. The special challenges

faced by family businesses demonstrate the complexity of ensuring a smooth

transition from one generation to the next.

1. The Six Transition Model. Business expert Ernie Doud suggests that there

are actually six transitions that must be navigated,26

each of which comes

with its own questions and challenges.

a. The founder’s (current leader’s) transition.

(1) After the transition, what will be the founder’s personal and

professional direction and identity?

(2) What will be the founder’s financial resources after the

transition? Will these be independent of the day-to-day

operation of the business?

b. The family’s transition.

(1) How will roles, power relationships, and identity change

within the family?

(2) How will the family maintain harmony as those new roles

and relationships are negotiated? Family councils,

mediation, and family counseling might help with this step.

c. The business’ transition.

(1) To survive the transition, a strategic plan is necessary.

(2) What is that strategic plan? To what extent will it be tied to

the business’ previous operations, in order to provide

stability? To what extent will it be tied instead to other

goals, in order to allow the business to remain flexible

during and after the transition?

d. The management’s transition.

(1) Will the management be made up of family, non-family, or

both?

(2) How will new leadership be evaluated?

e. The ownership’s transition.

(1) Who will have ownership?

7

(2) How will that ownership be transferred efficiently?

f. The estate’s transition

(1) How will the estate plan of the founders ensure that the

other transitions properly occur?

C. Differences in Family Values and Business Values. There are great differences

between family values and business values. These differences, which are

summarized in the table below, often lead to the conflicts that occur in family

businesses.27

Characteristic Family Values Business Values

Focus Inward Outward on customers,

competition, markets

Admittance Birth, Adoption,

Marriage

Recruitment and Resumes

Acceptance No Conditions Performance and

Contribution

Rewards Equally Responsibility and

Performance

Orientation Emotional Analytical

Evaluation Rare Frequent

Education Members’ interests

and aptitude

Practical Training

Change Minimize Maximize

D. Sources of Tension. There are five main sources of tension in a family business.

1. Older generation’s resistance to retirement or desire to maintain control

after retirement.

2. Money.

3. Sibling rivalries.

4. Emotion and control issues.

5. Fear of crippling effects of estate and gift taxes.

E. Reasons for Family Conflicts in Succession Planning.

1. Some experts in this area have examined the personality traits of the

family members in a family business and have developed models, which

8

they believe help to explain the conflict. While all such models are

subject to numerous exceptions, they can help us understand many of the

underlying causes of conflict.

2. Gerald LeVan, a noted expert on family business succession, for example,

has developed the following profiles of family members in a family

business, which can help in dealing successfully with the conflict.

However, while the focus of this model is likely less applicable now that

many of the veterans of World War II who started family businesses have

retired or passed away, many of the points made by model are still

applicable.

3. Entrepreneur.

a. Likely to be a veteran of World War II who made his money

during the post war boom.

b. Enormous ambition, energy, and drive, but often egotistical,

compulsive, and impulsive. He can be stubborn, arrogant and

eccentric.

c. Poor delegator.

d. Often a poor teacher and communicator. He will rely upon

intuition, not analysis in making decision. He pays little attention

to detail.

e. Often tends to dominate everyone around him.28

4. Wife of Entrepreneur.

a. Often worked in business in early days. While she may have

departed the business to take care of children, she may still have

strong opinions about the business.

b. Husband may use wife as a sounding board.

c. There is a strong possibility (75% probability) that the wife will

outlive the husband. As a result of husband’s estate plan, wife may

control the family business after the husband’s death or disability.

d. Often, there is a communication gap between the husband and the

rest of the family. Because of this, the children may communicate

with the husband through the wife. Thus, the wife becomes what

LeVan refers to as the “Chief Emotional Officer.” Because of this

role, even though the wife may no longer be involved in the

business, involving the wife in succession planning is often crucial.

9

Failure to involve the wife may cause her to sabotage any

succession plan that she does not approve of.29

5. Children.

a. Family business owners are often troubled by the fear that a child

who has not really struggled cannot develop the leadership

qualities necessary to run a business.30

b. Children entering the family business from school rarely receive

the same experiences provided by outside employment.

Experiences which such a child may lack include:

(1) Competing for initial employment opportunity and

promotions;

(2) Formal evaluations;

(3) The trauma of being transferred;

(4) Formalized training sessions; and

(5) Gripe sessions from the boss.31

c. Sibling Rivalry.

(1) Sibling rivalry is another frequent problem in a family

business. Children often compete for the approval of their

parents.

(2) The family business owner’s dominant personality often

intensifies the sibling rivalry. As one study put it:

“Founders of businesses are usually innovative,

ambitious, self-confident, hardworking, persistent,

visionary, and risk-taking. Entrepreneurs also

tend to be self-reliant and need to feel in control .

. . . For example, the need to be in control and

the enjoyment of controlling all aspects of their

business often make it difficult for entrepreneurs

to delegate responsibility, which discourages

collaboration with and the development of

subordinates . . . .” 32

(3) When more than one child is involved in the business,

family business owners often separate the children by

geography or function in order to minimize the sibling

rivalry.

10

(4) It can be very difficult to have one sibling reporting to

another. Moreover, family values usually militate against

favoring one child over another. This makes the choice of

one sibling to lead the next generation agonizing for the

family business owner. In turn, this might cause the family

business owner to avoid the decision, thus putting off

retirement or any succession planning, thereby causing far

more problems later on.33

(5) There is another side to the sibling problem which is

discussed in a study by the American College of Trust &

Estate Counsel in 1993:

“Entrepreneurs often convey to their offspring that

the business is being built for them and that it will

be theirs soon. Entrepreneurs of this type expect, of

course, that the offspring will not leave the

business, and, if they do leave, they are sometimes

viewed as ungrateful or disloyal.”34

F. Management Problems in Family Businesses. Family businesses often suffer

from numerous management problems not faced by other businesses:

1. Inadequate Organization. The lack of realistic organizational charts or

specific job descriptions often causes family members to duplicate

functions or lack true responsibility. This informal structure is often a

benefit in a small firm with authority concentrated on one owner, because

decisions can be made more quickly; but this decision-making process

lacks the rigor of a more complex process, and when carried to a larger

corporation or to a larger number of owners, it can lead to inefficiencies

and poor decisions.35

2. Attempting to Ignore Conflicts. While some families fight and others

negotiate, many families simply ignore conflicts. This causes long-

smoldering conflicts to flare in stressful situations such as after the death

of the family business owner.

3. Disgruntled Family Members. Some disgruntled family members leave

the business. Often, however, when a disgruntled family member leaves

the business, he or she continues to second-guess the decisions of the

family members who remain in the business.

4. Compensation. Some family businesses pay children the same amount,

regardless of the value of the contributions. This causes some children to

be over-worked and underpaid, while other children are under-worked and

overpaid.36

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IV. Toward an Analysis of Family Business Conflicts: Models of Basic Family Business

Forms.

A. Models for Conflict Analysis. Family business experts have examined and

continue to examine the dynamics of family business succession and the conflicts

they engender. As the era of post-World War II business owners disappears, the

next generation faces a wide range of new issues. These issues include collective

ownership, shared leadership responsibilities, and multifamily succession. These

experts have developed profiles of family businesses, which they believe, help to

explain the conflict. While all models are subject to exceptions, they are

nevertheless useful in helping us understand many of the underlying causes of

conflict.

B. Models of the Entrepreneur. The founder is often the most crucial element in a

business succession plan; the founder must be open to discussions about difficult

subjects, and must be open to change. Doud provides a distinction between three

types of entrepreneurs:37

1. Basic entrepreneur.

a. This is the entrepreneur who started a single entity and built it from

the ground-up. This entrepreneur is ambitious and energy-driven.

His or her personality is egotistical, compulsive, obsessive, and

impulsive, and at the worst can be characterized as stubborn and

arrogant. The basic entrepreneur is not practiced in delegating

tasks or providing information.

b. The succession plan of this entrepreneur is usually dynastic, with a

particular emphasis on sons.

2. Technical entrepreneur.

a. The technical entrepreneur is a problem-solver, and is more

analytical in nature.

b. Because the technical entrepreneur is more analytical, he or she

will be more likely to consider issues of business succession.

However, the technical entrepreneur is more likely to have a

simple succession plan in mind: cashing out, and passing the

wealth on to his or her family.

3. Controlling entrepreneurs (i.e., the ones with capital)

a. The controlling entrepreneur is the investor who has taken capital –

either self-created capital or capital contributed by family – and

has invested it wisely. The controlling entrepreneur is less

interested in large returns, and is more interested in minimizing

risk.

12

b. The succession plan of this entrepreneur usually involves passing

on the company to the next generation, who will continue to

maintain the assets with minimal risk. In fact, this entrepreneur is

more likely to be comfortable with a succession plan, since he or

she may have received wealth from another generation, or at least

is more comfortable with delegation and the proper flow of

information.

C. Basic Forms of Family Business. For example, Ivan Lansberg, a family business

expert, has developed profiles of family businesses, which can help in

successfully dealing with the conflict as a family business goes through

succession. Lansberg identifies three basic forms of family business:38

1. Controlling owner.39

Characteristics of the controlling owner form

include:

a. The controlling owner takes part in all aspects of the family

business.

b. Delegation is difficult for many controlling owners.

c. The controlling owner determines which family members receive

employment and benefits and the terms of the employment and

benefits.

d. This structure works well during early stages of business, when

quick responses to customers and markets are necessary.

e. This is the form of ownership often found when the first generation

controls the business. However, not all controlling owner

companies are first-generation.

EXAMPLE: When Malcolm Forbes died in 1990, he left 51%

control of Forbes magazine to his oldest son, Steve. The balance

was divided among his four other children. Forbes discussed his

estate plan freely with his children prior to his death and his

children all agreed to it. Forbes feared that dividing his estate

equally among his children could lead to infighting and leave the

company rudderless.40

EXAMPLE: The Beretta family, owners of the Italian family

business manufacturing guns, is an example of a company that has

successfully utilized the controlling owner form for many years.

The family has passed the family business, which was founded in

1526, down in a straight line for fifteen generations.41

2. Sibling partnership.42

Features of a sibling partnership include:

13

a. Ownership is divided relatively equally among siblings.

b. Coordination of siblings’ ideas takes time and can be frustrating,

especially when the siblings are not all involved in the business’

management.

c. Two basic forms of sibling partnerships exist. In the first-among-

equals form, there is a sibling group with one acknowledged

leader. In the shared leadership arrangement, the siblings lead the

company as a team.

(1) Acknowledged Leader.

EXAMPLE: ABC Corporation is a family-owned

business whose founder is deceased. The business is

currently in the hands of the founder’s three sons, Alan,

Brian, and Christopher, with each owning an equal amount

of stock. Brian had spent many years while his father ran

the company involved with all aspects of the company’s

operations and developed the necessary experience and

expertise to manage the company. Although Alan and

Christopher have had some involvement with the

Company, neither developed an expertise in the company’s

operations and neither is well equipped to manage the

company. All three sons agree that Brian should manage

the company. Alan and Christopher sit on the company’s

board of directors with Brian, and Brian consults them from

time to time about company matters, but they are employed

outside the company. The three sons share equally in the

company’s profits. Brian, however, also receives a salary

as the company’s president, whereas Alan and Christopher

receive nothing from the company other than their share of

the profits. As long as Alan and Christopher are

comfortable with this arrangement, the company will run

smoothly. However, if either or both of them takes the

position that he is entitled to manage the company on an

equal or greater footing with Brian, despite a demonstrated

lack of expertise and management ability, there can be

severe disruptions, particularly if Alan and Christopher

combine their votes to overrule Brian. A three-way split in

beliefs as to how the company should be run can lead to

deadlock.

(2) Shared Leadership.

EXAMPLE: Mother Parker’s Coffee and Tea is located in

Missisauga, Ontario. Paul, Sr., the founder, remains the

14

current president and chairman, but in 1989 he passed on

the day-to-day operation of the company to his sons. Paul,

Jr., 48, handles the finance, administration, and operations.

Michael, 46, handles sales and marketing. Both of the

brothers have a sense of ownership and connection to the

company – they both began working for the firm the same

day in 1974, when they were in their 20s. But Michael and

Paul, Jr. have not let their emotional ties to the company

spill over into rivalry and infighting. They believe that

they are able to work effectively together because they

have divided the leadership of the company between

themselves, and they each have a sphere of management.43

d. Sibling partnerships are most common when the family business

has passed to the second generation.

3. Cousin consortium.44

Characteristics of this form include:

a. A fragmented ownership structure divided among branches of an

extended family, many times over multiple generations.

b. The business must manage political dynamics among various parts

of the business.

c. Shareholders who are not active in the business operation may be

interested only in dividends.

d. Cousins running the business may have to spend significant

amounts of time organizing the cousins who do not participate in

the business operations into a group.

e. This type of ownership structure often exists when the family

business has passed to the third generation.

EXAMPLE: Grandfather founded a successful construction

company in 1925. After his death in 1958, his two children, Tom

and Victoria, ran the company. Tom and Victoria each had three

children. However, Tom’s son, George, and Victoria’s daughter,

Hannah, are running the company. The other cousins have been

kept out of management by a conscious decision of Tom and

Victoria, but they are now upset with their limited role in which

they are only entitled to dividends. The other cousins are jealous

of George and Hannah’s salary and benefits, such as use of the

company plane, and have hired lawyers to raise questions about the

management of the company. This, in turn, has distracted George

and Hannah from running the company.

15

4. Active and Non-Active Owners. Keep in mind that in each family

business, the involvement of family members differs. Each of the above

forms of family business can include active and non-active owners,

particularly after the first generation. “Active” members are involved in

the running of the business, and they usually hold management positions

within the business. “Non-active” members own shares in the family

corporation, but otherwise they are similar to passive investors. The

potential conflicts are discussed infra.

D. Transitions between Forms of Business.

1. Each of the three basic family business forms has a different structure and

culture, and requires different leadership styles. A succession that

replaces only the leader but maintains the basic business form allows the

business to build on its knowledge of how leadership is exercised. When

succession involves not only a change in leadership but also a change in

the business form, however, the family business must invest significant

additional time and energy if the business is to continue successfully.

2. Lansberg identifies three types of transitions:45

a. “Recycling succession” describes a succession in which the senior

leadership is replaced without changing the basic business form.

This type of transition is the most common form of succession.

EXAMPLE: The Beretta Company and Forbes, Inc. have

successfully undergone controlling owner to controlling owner

recycles. Sibling partnership recycles often happen when one

sibling partner buys out the other and passes the family business to

his children, who then run the business with the same basic

structure. Michelin and Cargill have succeeded as cousin

consortiums for multiple generations.

b. “Evolutionary succession” describes a transition from a simpler

form of business toward a more complex form. In a transition

from a controlling owner form to a sibling partnership, a team now

must make decisions that were once made by an individual. When

a sibling partnership transitions into a cousin consortium form, the

business must coordinate complex management decisions among a

diverse group of people.

These types of transition periods are dangerous because those

involved in moving toward a more complex leadership structure

often underestimate the difficulty. Two types of structures may

attempt to coexist, albeit uneasily. For example, an older founder

may lead the company in name while a group of sibling partners

tries to establish themselves as the future leadership team.

16

EXAMPLE: John, age sixty-six, had founded the family business,

and all his employees knew that John’s children, Mary and

Matthew, would succeed John in running the company.

Fortunately, Mary and Matthew collaborated well together. As did

most of the employees, Mary and Matthew knew that the company

needed to focus less of its energy on a money-losing product line,

and they invested energy working together to develop a strategic

plan for the business. However, John was still officially in charge,

and this product line was a personal favorite of his.

c. “Devolutionary succession” refers to transition from a more

complex form of business to a simpler form. Although these types

of succession are rare, they can occur. A transition from a sibling

partnership to a controlling owner form may occur when siblings

sell to one of the siblings or the siblings decide to divide the family

business into smaller companies, each headed by one of the

siblings. While these might be rare, they might be necessary.

Malcolm Glazer manages various industries valued at over $1

billion, and he plans to pass on his fortune to his 6 children, who

have already had a total of 10 children of their own.46

This

succession plan would eventually result in a transition from a

controlling owner form to a cousin consortium, which might find it

difficult to make the necessary decisions to manage a large set of

assets. In such situations, Johan Lambrecht and Jozef Lievens call

for “pruning the family tree” to reduce the number of interested

parties in a business and to make sure that only committed parties

have an ownership stake.47

3. Whether the family business is recycling the same form of business or

moving to a different form determines many of the substantive issues

involved in succession, including:48

a. Who gets involved in the transition?

b. What kinds of resistance are encountered?

c. How the seniors in control will depart?

d. How those taking charge will assume and consolidate their

authority?

4. Challenges. Each form of business involves a different philosophy

about authority and leadership. Changing the business form poses special

challenges because the business has no experience with the new business

form. In order for a family business succession to work, the family

members must be aware of the challenges that each form of business

brings.49

17

a. Challenges of the controlling owner form:

(1) One must not overlook the fact that businesses that are still

controlled by their founder are already in the “controlling

owner” form. Furthermore, if a founder only half-heartedly

passes control on to the next generation, tension might

grow between the rising generation and the founder, who

controls the date of his or her departure.

EXAMPLE: The leadership of Wilson & Associates, Inc.,

in Montgomery, Alabama, includes the founder/father and

his two sons. One son handled financial issues for a

manufacturing company, and he now handles finances for

the family business. The other son worked for a real estate

development firm, and after joining the family firm he

manages issues related to development. But while the

father has even passed on official control to his sons, he is

unofficially still the head of the company. “There are three

votes,” says one son, “but only one counts.” There is no

sign that the sons resent the fact that the father has retained

such control. But in the future, if the father continues to

delay retiring or even passing off the reigns, the sons might

increasingly resent the father’s actions.50

(2) The choice of a single leader risks abuse of power and can

set up a “horse race.” Concentrating leadership in one

family member can disrupt family relationships. The

unwillingness of parents to favor one family member over

another can lead to drawn out periods of ambiguity as

candidates wonder which one will be chosen to lead the

family business.

(3) A strong parent-successor relationship is crucial when the

family business goes through a controlling owner to

controlling owner recycle. Feelings of tension and rivalry

can arise when the new leader is compared with the

outgoing leader, and a strong relationship between both

increases the chances of success.

(4) The creation of minority shareholders can lead to

disappointment and conflict for the new controlling owner.

Family members holding minority shares are forced to

depend on the success of a new controlling owner and a

business over which they have little control.

(5) When there are minority shareholders, resources should be

set aside in case a buyout becomes necessary.

18

EXAMPLE: After moving to the United States in the

1940s, George and Maria von Trapp of The Sound of Music

fame built the Trapp Family Lodge in Stowe, Vermont and

formed a corporation in 1962 to oversee the family’s “mini-

empire” that grew to include the lodge, condo units,

restaurants, thousands of acres of property, and royalties

from the film. After Maria’s death, family members ousted

Johannes, the youngest child and company president. The

next year he regained control and began to restructure the

company. However, many relative minority shareholders

objected and decided to cash in their shares to show their

displeasure. The dispute over the value of the shares

reached the Vermont Supreme Court,51

as Johannes stated

that he was strapped for cash and may be forced to sell the

family business.52

b. Challenges of the sibling partnership form:

(1) Sibling partnerships that are formed as a last resort – to

preserve family unity – are likely to fail.

(2) The toughest call: Are the siblings capable of

collaborating?

(3) For a sibling partnership to succeed, there must be evidence

of strong commitment to collaboration and an even

distribution of complementary skills and talents.

(4) Harmony requires a clear division of labor and agreement

on titles.

(5) Sibling partners must find ways to manage conflict in their

business relationships.

(6) Relationships with in-laws must be managed effectively.

(7) The emergence of a lead sibling may pose a strain that must

be resolved by the group.

(8) The sibling partners must take steps to counteract divide-

and-conquer strategies, as well as the bias against shared

leadership.

(9) Seniors should not let tax and estate planning issues dictate

the choice of a sibling partnership. Attorneys, accountants,

and other advisors should determine the appropriate tax

strategies only after a decision has been made on the type

of ownership structure.

19

EXAMPLE: Eric Lidow taught his sons, Derek and Alex,

to play to win, but this philosophy nearly ruined his

company. After each talented son received a Ph.D. in

physics, both went to work for International Rectifier

Corporation, their father’s semiconductor business. After

Alex’s ideas stole the spotlight, Derek grew resentful, and

the sons feuded. Eric split the business and let each son run

different product lines, which proved to be a disaster. The

two sides became increasingly separate and inefficient, as

each developed its own support staff, sales, and marketing

groups. Tension became so bad that the brothers barely

spoke. Finally, with the help of outside consultants, the

sons resolved to work together to put the two halves of the

company back together. As a result, the company

developed a powerful new product, stock rebounded, and

sales rose. After watching his sons work together for three

years, Eric named his sons co-chief executives.53

c. Challenges of the cousin consortium form:

(1) Institutional structures need to be put in place to manage

the complexities of a cousin company.

(2) The new system needs to maintain a balance of power

among the branches.

(3) The seniors must be able to discuss-and assess-one

another’s children openly.

(4) Both family managers and passive shareholders must be

trained to respect their different roles and responsibilities.

(5) To avoid friction among the branches, ways need to be

found to prevent the disillusionment of the younger

cousins. This system must maintain balance among the

various family branches.

EXAMPLE: The Dorrance family owned the Campbell’s

Soup Company. When the company’s profits began to fall,

a group of cousins threatened to sell their stock. The sale

of this group’s stock may have forced the sale of the $6.6

billion business. After a new CEO was installed and

profits improved, the cousins decided not to sell their stock.

V. Additional Sources of Conflict.

In addition to the change in business form and change of leader, other issues can add to

the conflict in family business succession.

20

A. Active and Non-Active Members. Tension can grow between family members

with similar ownership interests but different levels of involvement in the running

of the company.

1. Sources of Tension.

a. Differing Expectations. First, active owners might have a more

long-term vision for the company, while non-active owners might

worry more about a quarterly performance and dividends and be

suspicious of sacrificing immediate value for a nebulous long-term

goal. But this might not be the case; financial incentives might

make active owners more interested in maximizing profits so they

can maximize salary and bonuses, while non-active members

might think of their interest as a long-term investment.

b. Salaries and Benefits. Non-active members might be suspicious of

the salaries that active owners receive from the corporation.

Conceptually, the suspicion of a family member is no different

from a shareholder’s suspicion of the salary received by the

officers of a corporation. But in a family business, because of the

emotionally-charged atmosphere and the fact that the shareholders

are familiar with one another, non-active members might be

especially sensitive to the idea of an active member getting rich at

the expense of the other shareholders of the family business.

c. Free-Loader Problem. The tension over salaries and benefits

works both ways. If the management of a family business

perceives that they are sacrificing for the good of the family

business—such as taking a pay-cut during lean times, or working

extra hours—they might resent the non-active shareholders who sit

back and enjoy the fruit of their labors.

2. How to Transfer Interests to Prevent and/or Diffuse These Situations. St.

Louis attorney, Charles A. Redd, provides a few ways to prevent these

tense situations and to deal with them if and when they arise.54

a. Transfer the business equity to all the children, so they share

equally.55

(1) Advantages. This will help to balance each child’s stake in

the company.

(2) Disadvantages. However, if not all of the children will be

equally active in the firm (or active to the same extent), or

if the children don’t get along, then this might be a recipe

for later tensions.

21

b. Transfer the business equity to the active children, and make

equalizing transfers of other assets to the inactive children.56

(1) Advantages. This broad initiative would prevent any

disputes between active and non-active family members.

(2) Disadvantage: Liquidity Needs. The founder might have

insufficient financial resources to provide his children with

equal transfers.

(A) Solution 1: Give the business to some children, and

solid assets to others. This solves a liquidity

problem, but the founder should be careful about

future tensions between the property owners. For

example, if the founder gives the active members

the business, and the inactive members the building

in which the business is located, this can lead to

conflicts down the line

(B) Solution 2: Sell part of the business to provide

sufficient liquidity to make the transfers.

(C) Solution 3: Take out a life insurance policy for the

founder, and schedule the transfers upon his or her

death.

(3) Lingering Disadvantage: Valuation. Even if the founder

has sufficient resources to transfer the business to the active

members and assets or cash to non-active members, some

family members might value the business more than others

(for emotional or other reasons). This division might leave

some feeling like they got the short end of the stick.

c. Transfer business equity to all of the children, but include

redemption provisions.57

(1) Advantages. In this scenario, the founder would give the

active and/or non-active members the ability to sell their

share in the company or to buy the shares of the others.

This does not have the liquidity problem presented in the

above foregoing option, because the transfer is funded by

the company or the purchasing members – not by a founder

who is at the end of his life and earning potential.

(2) Valuation. There are different ways to value the business.

The parties can agree beforehand on an appraiser. The

parties could also go through the “kindergarten method.”

In this method, one of them names the price, and the other

22

gets to decide whether to purchase or to sell at that price –

just like kindergarteners who share a brownie by having

one cut the brownie and the other choose which piece he or

she wants.

(3) The Danger of Delay. However, these redemption

provisions create uncertainty for the business’ future, and

the longer the provision lasts, the more tension can build

among family members. Redd suggests placing an

expiration provision on these options, so that the members

have to make a prompt decision, and so that the above

tensions do not have an opportunity to build among family

members. This will help the business and the family.

B. Role of women. Women are becoming more active in a wider range of roles in

business. Women own approximately one-third of all businesses in the United

States,58

and a 2007 survey of family businesses revealed that 24% had a female

President or CEO (compared to just 10% in 2002), and 57.2% had women in top

management positions.59

Family businesses are more open to having women

involved. While that 2007 survey revealed that nearly one-quarter of family

businesses had a female President or CEO, only 2.5% of Fortune 1,000 companies

are led by women.60

Although gender issues are increasingly becoming irrelevant

as families plan succession, they can still exist in family businesses founded by

entrepreneurs in an era when women were not heavily involved in business.

EXAMPLE: The eldest son, Frank, was raised knowing he would inherit the

family manufacturing business from his father. His father had often told him that

someday the business would be his, and if he did well, Frank could also pass it on

to his son. Now, both Frank’s son, John, and Frank’s daughter, Ellen, work in

the business. Ellen recently asked Frank whether he intended to name John as the

next leader or whether Ellen would be allowed to compete for the position.

Frank feels caught. Thus far, Ellen has shown more potential and motivation, but

family tradition has been to pass the business on to the oldest son.

C. Step-family and in-laws. The presence of step-parents, step-children, or in-laws

adds a further level of complexity to a family business. The role of an in-law can

become especially difficult at the sibling partnership stage when the in-law, who

has not grown up with the family business, encounters the family business for the

first time.61

EXAMPLE: Business experts Glen Ayres and Michael Jones point to the estate

plan of one founder which put the ownership of a family business into a trust,

with the spouse as the trustee and the spouse and the founder’s children as the

beneficiaries. This seemed to be an ideal solution: it gave the children ownership

of the business, but it also made sure that the spouse was provided for and had

control over her finances. But the founder overlooked the fact that his children

were not the children of his spouse. Conflict ensued because the children viewed

23

the family business as their family legacy, but their stepmother viewed it

primarily as her income.62

1. Although a family owning a business may believe in-laws bring a negative

force into the family business, the negative results most often occur when

siblings or parents neglect the in-law. Family business members must

seek to make in-laws feel like important members of a team. If they do

not, an unhappy spouse can destroy a sibling partnership.

2. Family business members should strive to view the situation from the in-

law’s perspective. In-laws may experience culture shock when they enter

a family business. One new daughter-in-law stated, “The family business

is the central topic every time family members get together. If you aren’t

closely involved in the business, you feel left out.” In-laws can also feel

overwhelmed by the tightness of the families into which they marry. In-

laws may feel uncomfortable asking too many questions about the family

business for fear of appearing too inquisitive, while other family members

may perceive a lack of questions as a lack of interest.

3. The family behind the family business can take several steps, which can

result in a feeling of belonging for in-laws and can avoid ruining family

relationships. Including spouses in family meetings and ensuring that the

extended family has fun together are valuable ways to make spouses feel a

part of the team.

4. Siblings can also take several affirmative steps. First, siblings can vow

not to complain about each other to their spouses. Next, siblings can

include spouses in meetings, even if mainly business issues are discussed.

Including spouses builds unity and allows spouses to hear information

firsthand. Siblings can also develop individual relationships with in-laws

and deal with the in-law one-on-one if problems arise.

5. Parents can spend time educating in-laws about the family business and

involving in-laws. When prenuptial agreements are required, parents can

explain to the future in-law the reason for the agreement and make clear

that the agreements apply to all family members.

6. Siblings’ spouses can recognize the demands of a sibling partnership.

They can also learn about the family business while not taking sides in

family business disputes. They can also develop friendships with

members of the spouse’s family to help build trust and positive

relationships.63

D. Divorce. When owners of a family business divorce, the spouse who was once

the business ally now often becomes the adversary as assets are divided. While

some divorces are handled amicably, many are not. The presence of a family

business as one of the assets can add to already strong feelings.

24

1. When assets are divided, the person who gets to keep the business may

depend largely on who started the business, especially if the business has

been in one family for more than a generation.

2. A prenuptial agreement or other contract may determine the business’s

ownership if the business began before marriage. Thus, prenuptial

agreements can be quite important in the family business context.

3. Valuation of family businesses can be difficult, and a divorce is certainly

not the best setting for parties to reach an amicable agreement on the

asset’s worth. A prenuptial agreement can help. That agreement should

specify not only the means of dividing up the business or compensating

one spouse, but it should also specify the means by which the business

should be valued in the event of a divorce.64

4. Each person’s expertise may determine who keeps the business if the

couple started the business together. For example, the sales manager may

keep control while the creative force receives a royalty.65

VI. Planning for Business Succession.

A. Basic Questions. In planning for the succession of a business, the adviser can

start by asking several basic questions and exploring these with the family

members.

1. Should the business be sold or should it go forward?

2. If it is sold, what will happen to family members?

3. If it goes forward, what is required to make the transition successful?

4. How much change is required either in the way the family runs the

business or in the business itself?

a. How can family harmony be achieved while maintaining family

values and lifestyles?

b. Clarify career paths for family members.

5. What is the best way to accomplish these changes?

6. What personal factors are involved?

7. What business factors are involved?

8. How capable are the family and the individual family members of making

these changes?

9. How should one provide for contingencies and revision of the plan?

25

B. Developing a Plan. Management consultant, Bernard Kliska, as a rough outline to

be used in developing successful succession planning, has suggested six of the

following seven steps. The author suggests the final step and also provides

comments to Kliska’s other steps.

1. Get a commitment from all family members to work on succession

planning.

a. Family members may be more willing to participate if they

understand the consequences, financially and personally, of the

failure to achieve successful succession planning.

b. Family members must be patient and willing to compromise.

2. Help family members set aside competitive ways and teach them more

constructive ways to work together.

3. Adopt a business planning process that begins with a mission statement

and strategic plan.

a. Have one mission statement for the family.

(1) “Accidental Partnership.” Founders of businesses chose to

go into business together, but second- and third-generation

family business owners often did not. In those families,

both the business owners and the family members find

themselves in an “accidental partnership”66

not of their own

choosing. This obviously leads to tensions between the

owners of the business.

(2) “Family of Affinity.” A strategic plan for the family can

help to re-shape the family’s identity as a “family of

affinity.” In his book Family Wealth, family expert James

E. Hughes uses this term to encourage families to identify

themselves as more than a group linked by genetics or a

group of shareholders of a common venture.67

A strategic

plan for a family can focus them not on genetics or the

actual assets of the business, but on the core values behind

that business, such as community involvement,

entrepreneurship, stewardship, and dedication.

b. Have a second mission statement for the business. In fact,

consider developing both a statement of Business Vision and a

statement of Core Values.

(1) Business Vision. This is a vision of where the business is

headed. This might change.

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(2) Core Values. This is a statement of the values of the

company. This should never change.

EXAMPLE: The J.M. Smucker Company has been

careful to maintain this distinction. Their business vision is

to own or market “number one” food brands in North

America. But at times, this conflicted with their core value

of independence. In the 1980s, they decided against being

bought out by a larger company; this would have served

their business vision, but they worried that the move would

result in a loss of their autonomy.68

But in 2002, the

company merged with Procter & Gamble brands Jif and

Crisco because the company believed that the merger would

allow them to continue their core values.69

c. Lessons from the J.M. Smucker Company.

(1) From its inception, the Smucker family emphasized not just

profitability, but certain values that could be passed on to

children. When James Monroe Smucker first began selling

jars of preserves, he signed every jar; in fact, Smucker’s

jars still have J.M.’s signature pressed into the glass.

(2) But keep in mind: a values statement is just a statement.

Although explicit statements of values are important, one

should not focus too much on those statements. The key is

to act out those statements. Smucker’s did not develop a

written set of values until the 1970s.70

Bob Ellis, the

company’s Vice President for Human Resources, says,

“What differentiates us from other organizations – since

most have a strategy and mission statement on their walls –

is that we attempt to have people really understand what the

values are and mean to them, and put these basic beliefs

into action.”71

(3) The Core Values of the Smucker Company:

(A) The Basic Rule: treat everyone the way you wish to

be treated.

(B) Five Beliefs: Quality, People, Ethics, Growth,

Independence72

(1) These were written down in 1982, after

strategy sessions in which a dozen family

members met with three outside directors

and family business consultant Ben Tregoe

to define those values.73

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(C) Actions, not words. CEO Paul Smucker laid out the

following guidelines in the 1980s:

(1) Tell people thank you for a job well done

(2) Listen with full attention

(3) Look for the good in others

(4) Have a sense of humor; this maintains

perspective – “not at the expense of others,

but as a brief relief from difficult tasks, can

make our working atmosphere more

pleasant and enjoyable.”74

d. Strategic plans are often overlooked. A 2007 survey found that

only 36.6% of family businesses surveyed had a written strategic

plan, and only 31.1% of those businesses with a plan had a formal

process for establishing a strategic plan.75

4. Create a personal development plan for family members who work in the

business.

a. Informal methods.

EXAMPLE: The children of Malcolm Glazer, who owns various

industries and has a net worth of $1 billion, are all involved in

running his empire. The children remember that Glazer used to

take them to work and teach them about business. Glazer

envisions his descendents taking over his enterprises, and he

encourages his children to begin speaking with their children about

business as soon as they have children.76

EXAMPLE: Schostak Brothers & Co., founded in 1920, owns

various commercial properties in Michigan. When one member of

the fourth generation was in college, the active members of the

business helped to ensure that his time in college prepared him for

work at the firm. For example, they helped him choose college

courses that would suit his career at the family firm.77

b. Formal methods.

EXAMPLE: The J.M. Smucker Company, founded by J.M. in

1897, currently has employees in the fifth generation of the

Smucker line. Family members must apply for a job at the

company, and they know that as a Smucker they are under the

spotlight. The family members will not necessarily end up in top

management; that will be decided by their performance on the job.

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The family has established a formal internship program for family

members, and they are rotated around the Ohio plant. But family

members are also expected to work outside the company first and

to earn an advanced degree before returning to work. Four of the

fifth-generation Smuckers have an MBA or other advanced

degree.78

5. Develop the appropriate governance structure.

a. Different Forums for Different Needs. Having separate forums

will help to keep separate issues of work and family life, such as:

(1) Board that handles business.

(2) Family forum to deal with family problems.

b. Family Council. Family business owners often have difficulty

separating home and work life. One way to help diffuse the

tensions is to get them out into the open, using a Family Council,

to identify and deal with the inevitable conflicts that arise.79

Business expert Mike Cohn emphasizes the aspects and benefits of

a Family Council.80

(1) A legal entity. Integrating the Family Council into the

legal papers for a family business can give the Family

Council an official status. Johan Lambrecht and Jozef

Lievens even suggest creating a Family Constitution that

provides for rights and duties of family members.81

(2) Official duties. A Family Council can have official duties,

such as electing all of the board members or selecting

which members of the family will occupy family seats on

the board, or making decisions about philanthropic

activities in which the family is involved. The Council can

also address family employment policies, negotiate pre-

nuptial agreements, and help to address conflicts of interest

policies if family members get involved in outside business

activities.

(3) Setting expectations. A Family Council need not have any

official power to be effective. The Council can serve to set

and to communicate the family’s expectations for the

operating businesses, including risk and performance.

(A) One recurring conflict between active and non-

active family business owners is about expectations.

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(B) As noted above, non-active members might be

suspicious of the salaries taken by active members,

while active members might resent non-active

members as freeloading off of their hard work.

Family Councils can get these disputes out into the

open so that the family can recognize and resolve

these issues as a whole.

(4) An important supplement, but not a panacea. A Family

Council can supplement, but cannot replace, other ways of

resolving conflicts. Family businesses should still provide

exit avenues for family members, especially through buy-

sell agreements with specific valuation procedures.

EXAMPLE: The Cator family runs Cardinal Meat

Specialists Ltd. in Mississauga, Ontario. For 15 years, the

Cators have held Family Councils. The meetings include

the active members (the father and his two sons) and the

inactive members, for a total of 11 family members,

including spouses. Meetings are held 7 to 9 times per year,

and they last 3 hours. There is no formal agenda, but the

meetings are balanced between business and family matters.

They deal with urgent matters first, and discussions of

business only take up about half of the time. Families are

also welcome to discuss personal problems, in order to head

off any negative impact that those might have on business

and family relationships. The meeting always ends with a

social outing, such as a dinner.82

EXAMPLE: The J.M. Smucker Company is now in its

fifth generation of family ownership and employment.

There are currently around 35 family members who own

stock in their own names or in trusts. Brothers and co-

CEOs Tim Smucker (Chairman) and Richard Smucker

(President and CFO) listen carefully to the concerns of the

family shareholders. The family members meet to discuss

business informally, at family picnics and other gatherings.

But they also formally gather once or twice per year, with

their spouses, to review the company. Tim and Richard try

to treat the family like an institutional investor, taking

special care to keep them informed, and like a shareholder

constituency, taking special care to keep them united.83

6. Put in place the legal and financial structures to implement the succession

plan.84

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7. Create a culture in which key employees (whether they are family

members or not) are expected to be owners. Properly tailored option plans

will increase the value of the current owners’ holdings, and may provide

additional sources of capital and facilitate additional borrowings.

C. When to Begin Planning. For the following reasons, the earlier succession

planning begins, the better:

1. Succession planning also dovetails with estate planning for the business

owner.

2. The business owner may want to begin to diversify his or her holdings.

Partial redemptions of equity interests may be appropriate. Opportunities

may be available to do tax-free redemptions of S corporation shares if the

shareholder’s basis and the corporation’s accumulated adjustments

account are large enough.

3. There may be a strong need to offer incentives to key employees to stay

with the business. Their contributions will enhance the value of the

business owner’s holdings.

4. Force the business owner to do retirement planning and to begin tax-

deferred compounding of returns in qualified plans.

5. Allow for gradual buy-back, gifting or cross purchase of equity over time

rather than in lump sum fashion at the time of death, disability or

retirement.

D. Business or Organizational Considerations. The plan must make business sense if

it is to succeed. One key distinction is to separate out issues of ownership

succession from issues of management succession.85

The following factors must

be considered:86

1. Nature of the industry in which the business is engaged and its competitive

relationship in the market.

2. Cash flow and capital needs of the business and how the liquidity demands

arising at the owner’s death will impact them.

3. Management structure and identity of key employees and their willingness

to participate in the owner’s succession plan.

4. Availability of a successor.

5. Ability to create the appropriate management structure.

6. Creation of an uncomplicated and understandable ownership structure.87

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7. Whether and how non-family members should be involved in

management. Every family is different; some will want to bring in an

outsider who can be dispassionate and disconnected from the family’s

affairs; for others, it will be better to bring in an individual who

understands the role of the family.

EXAMPLE: The Warburtons recently decided to bring in a non-family

CEO to manage their business. But they nevertheless believed that it was

important for the manager to understand the relationship between the

family and the business. Therefore, they decided to promote a CEO from

inside, and they gave the nod to the current CFO. The Chairman remains a

family member, and the Chairman is the conduit through which the family

communicates with the CEO.88

E. Family Business in a Trust. One option that often is considered is to place the

family business in a multi-generation trust. This is done for both tax and business

succession planning reasons.

1. An important consideration in this case is often the division of the

trustee’s duties and powers among different fiduciaries. For example, a

trust holding closely held business interests could name individual family

members active in the business and a corporate trustee as co-trustees and

vest all decision-making authority related to the business in the family

members. The corporate trustee would be in charge of all administrative

functions as well as the management of other trust assets.

2. The trust could name multiple co-trustees and require the trustees to

designate one of their number as a “managing” trustee. The trustees as a

whole would act like a board of directors that sets policy for

administration of the trust, and the managing trustee could handle either

all aspects of daily administration of the trust (investments, discretionary

distributions, etc.) or certain designated aspects. This structure mirrors the

corporate structure of a board of directors and CEO.

3. Many clients who wish to divide the fiduciary’s duties in this manner

prefer to create a separate “committee” rather than naming multiple

trustees. It may be administratively more efficient to have a single trustee

(often a bank) who handles daily administrative matters such as carrying

out investment decisions, acting as a custodian of assets, preparing

monthly or quarterly statements, and preparing tax returns. Third parties

dealing with the trust will have only one entity or person to deal with and

there generally will be less confusion about who to contact about trust

matters. The most frequent use of an advisory committee is in managing

closely held business assets. In some cases, the client wishes to delegate

all investment authority to the advisory committee and reduce the trustee’s

role to that of acting as the committee’s agent.

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4. There is an unlimited number of ways to structure an advisory committee

in a trust. It can consist solely of family members or a combination of

family members and non-family members. The number of members can

be fixed, or the committee can be given authority to expand or contract.

The trust agreement can set forth minimum qualifications necessary for

committee membership, such as minimum and maximum ages, business or

professional experience, and minimum net worth or annual income.

5. The trust agreement also should contain provisions regarding appointment

of successor committee members similar to those that address appointment

of successor trustees. A common method for appointment of successors is

to have the committee appoint successor non-family members, and have

adult trust beneficiaries select successor family members to serve on the

committee. Another option is to have the committee nominate successors

and require a confirmation vote by adult trust beneficiaries.

6. For both trustees and advisory committee members, the client should

consider giving designated individuals the power to remove the fiduciary.

The removal power can be unlimited or for specified causes.

7. An attractive alternative to removal provisions is to create term limits for

the fiduciaries serving under the trust agreement. This is especially useful

in an advisory committee because it gives trust beneficiaries an

opportunity to evaluate a committee member’s performance and, if

necessary, replace the member in a manner that may be easier, and less

stigmatized, than removal.

F. Agreement of Owner. One hurdle is to get the family business owner to even

agree to do the succession planning. Often this can be done in the context of

retirement planning. One place to start is to help the client develop a clear picture

of what the business will look like after completion of the transfer.

1. What will the financial profile of the retiring owner be?

2. What plan can best assure the ongoing financial stability of the enterprise?

3. What governing structure will exist in the business?

4. What qualifications must the successor have?

5. Who are the candidates for successor?

6. What special provisions must be made for children who may eventually

own company stock?

7. What specific plans must be made to affect the full and complete transfer

to the successor?89

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G. Liquidity Considerations. There are two basic forms of addressing liquidity needs

upon the death of the owner.

1. Methods designed to increase the ability of an estate to obtain cash.

a. Sale or lease of estate assets.

b. Obtaining loans from beneficiaries.

c. Life insurance, including the use of “split dollar” arrangements.

d. Apportionment of taxes to non-probate assets.

e. Collecting all assets that are available.

2. Methods to decrease needs for liquidity.

a. Reduce administration expenses.

b. Take advantage of all available postmortem elections to minimize

current tax payments.

c. Distribution of assets in kind to satisfy pecuniary gifts.

d. Extension of payment schedule for loans.

e. Assumption of payments of loans by beneficiaries.

f. Deferral of estate taxes.90

H. Team to Assist in Planning.

1. The Team Approach. In the complex arena of business succession

planning, no individual has sufficient expertise to handle all of the

complex issues that arise. Moreover, while a single owner might contact

each of these experts individually and thus go about the process

piecemeal, an attorney can properly organize and manage this team to save

the client time and money.91

a. Perceived Concern: The Owner. It is indeed difficult to get the

business owner and family members to discuss the issues of

business succession in a productive way. Some attorneys also

worry that a business owner will reject the need for experts to help

in that transition. But today’s businessmen are used to relying on

teams and on different experts.

b. Proper Concern: The Existing Structure. A 2007 survey of family

business owners found that they ranked their “most trusted

advisor” as Spouse, Accountant, Business Peer, Parent, Lawyer,

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Financial Services – in that order.92

Perhaps the biggest challenge

for a succession planner is existing advisors, who might feel

threatened by the arrival of a large team. While the existing

advisors might not have the expertise needed to put together a

successful plan, the manager of the team should be especially

careful not to offend any existing advisors.93

It is especially

important not to overlook these other informal advisors in the

process, such as spouses and business peers, who might be hurt by

and suspicious of an outside team. If those trusted advisors are

critical of the plan, the succession planner faces an uphill battle

from the start.

c. Proper Concern: Egos! In general, the various experts must all

check their egos at the door and realize that they are part of a

team.94

2. Team Members.

a. Attorney. The attorney has several roles in the preparation of any

business succession plan.

(1) Preparation of documents.

(2) Counselor (which requires the attorney to do a very

difficult thing — LISTEN).

(3) Specialist (the client must be convinced of the need to

involve specialists in every aspect of the transaction to

ensure the achievement of the tax and non-tax goals).

(4) Conflicts. Often the attorney represents both the business

and some or all family members. Careful consideration

must be given to the potential or actual conflicts inherent in

such a multiple representation.

b. Accountant. The accountant often has a more constant relationship

with the client and his or her involvement is crucial to the

successful implementation and development of the plan.

(1) Probably knows the nuts and bolts of the business better

than the other outside advisors.

(2) Increasingly called upon for financial planning advice.

c. Insurance Advisor. Insurance is often the best solution to the

liquidity problems that arise in business succession planning.

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(1) Consider obtaining independent quotes from at least two

agents in order to get the best possible coverage and price.

(2) An alternative is to use an underwriter to provide advice

with the clear understanding that no sale is involved.

d. Financial Advisors.

(1) Banker. He or she can provide advice on obtaining credit

and financing.

(2) Trust Officer.

(A) A professional fiduciary can often fill a need for

interim control before the next generation is ready

to handle the business.

(B) A professional fiduciary can also be the best person

to coordinate the planning.

e. Appraiser. An appraiser is usually necessary to determine the

value of a business, whether a sale or transfer to family members is

contemplated.

f. Family Business Consultant. A business consultant, especially in

more complex cases, is often crucial to a successful succession

plan.95

g. Others. The planner should feel free to add members to this team

as needed; for example, a psychologist might help with particularly

sensitive family issues, and an actuary might be able to offer

insight into more complex financial calculations.96

It also might be

necessary to involve a mediator or even an arbitrator to resolve

family disputes that already exist or which arise during the

planning process.

I. Practices of Successful Families. Danny Markstein identifies eight practices of

successful families.97

But not all families naturally practice these – recall that in

one survey of family business owners, 31.4% stated that they avoided discussions

of succession because they were “uncomfortable making the necessary

decisions.”98

In fact, the family might be the exception that is able to speak

openly about emotionally-charged issues like retirement, death, money, and

passing on power and control. The planner should be careful to identify,

encourage, and nurture Markstein’s eight practices:

a. articulate a clear vision;

b. cultivate entrepreneurial strengths;

36

c. plan ahead to reduce risk and act on opportunities;

d. build unifying structures that connect family, assets, and

community, such as philanthropic activities/entities and family

councils;

e. clarify roles and responsibilities;

f. communicate;

g. help individuals develop competencies; and

h. foster independence and provide exit options.

J. Symptoms of a Plan in Trouble. Even if the family develops a plan, it still must

be implemented. If family members exhibit any of the following symptoms of a

succession plan in trouble, implementation will be difficult:

1. Being excessively or obsessively secretive about matters that affect others

in the family or the business, such as withholding business financial

information or refusing to disclose ownership or management succession

plans for fear of losing individual power.

2. Asserting rights where none exist, such as demanding a job, a promotion,

or a board seat because of ownership of a minority stock position.

3. Refusing to acknowledge or consider other views.

4. Taking unilateral action that others have refused to support. For example,

some family members try to sell the business without authorization or

shareholder agreement.

5. Breaking explicit agreements, rules, policies, or laws in pursuit of personal

goals or agendas, such as incurring frivolous expenses.

6. Blaming others inappropriately for frustrations, failures, or lack of

achievement, such as accusing the CEO of not providing opportunities

when, in fact, such opportunities were not earned.99

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K. Possible Solutions. Solutions to possible assaults on the plan include:

1. Building a culture that emphasizes family first or business first, but not

individual egos first. The family culture should respect individuals and

their needs but should make clear that teamwork and professional

practices are more important than any one person.

2. Limiting individual power with written policies, codes of conduct, family

constitutions, mission statements, or other jointly produced statements of

family norms and values.

3. Educating everyone in the family business so they can constructively

understand and carry out their rights and responsibilities as employees,

owners, and family members.

4. Emphasizing communication, openness, information sharing and the

importance of giving feedback.

5. Making it clear to family business participants that promotions, pay,

power, and credibility depend on accomplishments, preparation, ability,

and willingness to accept accountability.

6. Demonstrating commitment to accountability by having an active board of

directors that includes strong outsiders (such as other business owners)

and by keeping shareholders and managers informed. This assumes the

long-range viability of the business, because it gives the right signals to

high quality key employees.

7. Crediting successes to teams, principles, and values, not to individual

leaders.100

8. Not being afraid to fill critical management or operational slots with

experienced non-family members.

VII. Planning for Business Succession in a Down Economy.

A. Family Businesses Generally.

1. Perceptions. The conventional wisdom holds that family businesses are

hit especially hard during an economic downturn. This is partly true:

family businesses in industries that have dried up during the recession,

such as housing, real estate, financial services, and luxury retail, will

suffer. But in reality, family businesses have some real advantages.

Downturns are the greatest time of development, growth, and opportunity,

and new businesses typically grow during down times and the recovery

period.101

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2. Advantages.102

a. Long-Term View. Family businesses are usually not governed by

quarterly reports, so they can exercise prudence during upswings

and downswings.

b. Less Debt. Family businesses are typically more risk averse, so

they have less debt. This is especially important during times such

as the current financial crisis when many banks are forced to call in

lines of credit.

c. Flexible and Agile. In a family business, there is often no

disconnect between shareholders and managers.

(1) This avoids the situation where shareholders’ and

managers’ interests are not aligned.

(2) This allows the business to make quick decisions and

changes to respond to economic difficulties.

d. Strong Social Network. Family businesses are often closely tied to

their communities and are built on relationships with clients.

3. Disadvantages.103

Nevertheless, family businesses often suffer from

contention, nepotism, and weak strategic planning, and while boom times

have enabled those businesses to survive, economic downturns present a

particular challenge.

a. Divergent values. A family with strong shared values can be in a

better position to survive economic trouble. But if discord already

exists in a family, then tough economic ties can exacerbate the

tensions that already exist.

b. Difficulty separating home and work life. Because family business

owners often have difficulty separating home and work, a

downturn at work can easily spill over into difficulties at home.

Family councils and other forums can help diffuse these tensions.

c. Nepotism. Boom times offer few opportunities to test whether a

family member is able to guide the business. A 2007 survey by

PricewaterhouseCoopers found that nearly two-thirds of family

businesses award family members a place in the business without

measuring them. Difficult economic times tests the ability of any

employee, and it might reveal that the managers are not up to the

task.

d. Different expectations. The different constituencies of a family

business might have different goals for the firm; boom times make

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this worse by raising everyone’s expectations. In a time of

economic distress, family members might have long-term goals for

the firm, while non-family members might be more focused on

short-term earnings. Similarly, non-active family members might

blame active family members when dividends decrease, while

active family members who have suffered a pay cut might resent

the criticisms of non-active members who have merely suffered a

reduced dividend.

e. Governance problems. The simple power structure of a family

business might enable quick decision-making. But those decisions

might also lack the rigor of more formal decision-making

processes. Moreover, family business owners might be especially

reluctant to bring in outside assistance or management.

4. Greatest Challenge: Lack of Experience. Family businesses, particularly

those in their first generation, might not have experienced a serious

recession. From 1990 – 2007, there were only 2 recessions (July 1990 –

March 1991, and March 2001-November 2001), each of which only lasted

eight months. These boom times have fostered all of the above bad habits,

including overconfidence, weak planning, and unreasonable expectations.

Moreover, advisors are often less experienced as well in how to handle

this downturn.104

The attorney who is less experienced with these

downturns should consider adding to the succession team an individual

who is experienced with planning during a recession.

5. Solutions. During these times, the business advisor should work to create

or to reinforce Family Councils and other mechanisms to communicate

expectations and to diffuse tensions.

B. Difficulties in Succession Planning in a Down Economy. Business expert

Suzanne Mcgee lists specific challenges that succession plans face during a

recession:105

1. Liquidity problems. Planning during a down economy can be especially

difficult for the family business owner, because most of his or her wealth

is often tied up in the family business.

2. Capital markets. Even if the business owner is not significantly hurt by

the recession, the lack of access to capital markets might lead to

difficulties. Given the lack of capital, it might be difficult to fund a

transition, for example, to an ESOP, because it would be difficult to

finance the plan.

3. Magnifies family tensions. Succession planning is already a difficult

emotional time for families. The heated environment of a recession

creates new tensions and exacerbates existing ones.

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4. Timing. The downturn is likely to force family business owners to

reconsider the nature and timing of the transaction. Generally, this will

mean that the owner continues to run the business longer than anticipated.

To the family that has already negotiated a succession plan, this might

look like a power grab by the owner.

5. Plunges in Asset Value: A Silver Lining? In the downturn, assets –

particularly real estate – have declined in value. The owner can use this

time to transfer those assets at a substantial tax savings.

6. The Real Advantage of the Family Business: Flexibility. In an economic

downturn, the other benefits of a family business might not help a

succession plan. Long-term planning does not help the owner who feels

that he or she must stay on board to steer the business through these

exceptionally tough times. The low debt ratio of a family business does

not help the owner who is denied access to capital markets to fund a

transition. However, the flexibility of the family business remains in a

recession. Succession plans in family businesses are carefully crafted

agreements between parties. But unlike a large merger deal, the

succession plan of a small business can be tweaked to respond to changing

circumstances.

VIII. Conclusion.

A. With the proper plan in place, a family business can be strengthened and allowed

to grow and benefit future generations of family members.

B. Closing Lessons from the J.M. Smucker Company:

1. Even after a merger, the J.M. Smucker Company has kept a focus on the

Smucker family and their values. After the merger with Jif and Crisco in

2002, the ownership of the Smucker family dropped from 55% to 13%.106

But the Smucker family has taken focus off of family ownership; instead,

they value having shareholders who share their common values.

2. First, the Smucker family values long-term performance and reputation

instead of short-term profits, and they have incorporated this value into

their shareholder system. Each new shareholder of Smucker gets 1 vote.

But after four years of ownership, the shareholder gets 10 votes. This

ensures that people who share the long-term vision of the Smucker family

– whether family members or not – have the biggest voice in the

company.107

3. Second, despite this technical change in ownership, the corporation has

kept a focus on the Smucker family as a symbol of quality and of

employees who are experts at making quality products. An advertising

campaign begun in 2008 features Tim and Richard Smucker, now co-

CEOs, as children growing up in Orville, Ohio in 1954. One commercial

41

shows Richard staring at a fruit on a tree, waiting for the exact moment to

pick it. The announcer explains, “Tim and Richard Smucker grew up

learning that you have to pick fruit at the peak of perfection if you want

jam to taste extra delicious.” In another ad, Richard complains that no one

asks him what he’ll do when he grows up. The announcer again explains,

“When your last name is Smucker and you live in Orville, everyone

knows what you’ll do when you grow up. You’re gonna make the world’s

best jam.” Smucker’s has been able to take the focus off of the

“accidental partnership” of brothers Tim and Richard, who run the

company of their grandfather. Instead, the commercials focus on them as

a “family of affinity” who grow up learning about what is needed to

ensure quality. Each of the commercials in this campaign concludes, “For

five generations, with a name like Smucker’s, it has to be good.”

As the Smucker example shows, counseling owners of family businesses,

especially in succession matters, is one of the most difficult tasks facing an estate

planning professional. It requires tact and diplomacy, especially if the owner’s

desires are to accomplish the business succession with a minimum of family

conflict on the one side and a minimum of taxes on the other. Fortunately, there

are a wide variety of planning techniques available to owners of a family

business. Through the effective use of the techniques discussed above, advisors

can greatly benefit clients who own a family business in undoubtedly what is the

most challenging situation the family members will face.

IX. Integrating Estate Planning Strategies with Family Business Succession Issues.

A. Tax Planning. After the business succession plan is developed, the estate

planner’s challenge is to create a tax effective plan to ensure the passage of the

business to the desired family members while still maintaining harmony within

the family and within the business. An effective estate plan will both minimize

the transfer tax cost of transferring the business and take into account the various

financial and emotional needs of family members. Each particular estate planning

technique available can have ramifications on the family side of the equation, and

these must be taken into account.

B. Direct Lifetime Gifts.

1. Lifetime giving helps to reduce estate taxes by removing assets, and future

appreciation on assets, from the business owner’s estate. Lifetime direct

gifts can take the form of annual exclusion gifts or larger taxable gifts that

use applicable exclusion amount or result in the payment of gift tax.

2. In addition to removing current value and future appreciation of the

business from the donor’s estate, lifetime gifts of business interests can

provide several significant benefits.

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a. Gifts of small blocks of company stock put the donor in the

position to take maximum advantage of valuation discounts. The

IRS has conceded that it cannot attribute family control to gifts of

non-controlling blocks of stock. Rev. Rul. 93-12 1993-1 C.B. 202.

It is clear that such stock should be valued on a non-marketable,

minority basis.

b. For dividend paying businesses, gifts of stock will give family

members a stake in the income from the business and perhaps

instill more of an interest in the business’ success, as opposed to

personal agendas.

c. Many businesses are operated as pass-through tax entities such as

S Corporations, Limited Liability Companies or partnerships.

Often these pass-through entities generate high taxable income.

Direct gifts to a defective grantor trust can allow the donor/grantor

to pay the taxes on that income from the donor’s other funds, thus

allowing for a tax free gift of that tax.

d. Gifts of stock, particularly voting stock, will give family members

an opportunity to participate more in the governing of the business.

Even if the stock received by a child represents only a small

interest in the business, it will give the child the opportunity to

attend shareholder meetings and receive financial information. It

is important to give family members who own interests in the

business a sense of participation by actually holding annual or

more frequent meetings. Many families combine these meetings

with family meetings that focus more on personal issues and how

those integrate with the family business.

C. Capital Structure Devices.

1. Many business owners want to make gifts for tax planning purposes but

adamantly refuse to give up voting rights or permit certain family

members to participate in the business other than as a silent investor.

Other owners may want to address the differing needs of family members

while giving away interests in the business.

2. A traditional way of handling these issues is through the use of trusts.

a. An individual can transfer stock in the business to a trust for

certain family members and name a trusted advisor or business

colleague as trustee. The family members will receive income

from the stock and benefit from its appreciation, but the trustee

will vote the stock. The donor of closely held stock should not act

as trustee because his or her retained right to vote the stock will

bring it back into the estate under Section 2036(b).

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b. A family member who does not participate in the business can be

given an income interest for life, with the businesses interest

eventually passing to another family member who is actively

involved in the business.

3. A business owner also can change the capital structure of the business to

address various non-tax goals.

4. Voting and Nonvoting Stock. One of the easiest structural changes

available to a business owner is to create a class of nonvoting stock (or for

a general partnership, to convert to a limited partnership and create limited

partner interests).

a. An owner who will not relinquish absolute control can use

nonvoting stock to give away equity in the company without

reducing his or her voting control.

b. If the owner wants to leave the business equally to his or her

children, but fewer than all the children participate in the business,

the owner can give voting stock to the children who are active in

the business and nonvoting stock to the children who are not.

c. From a tax-planning standpoint, nonvoting stock often is issued to

isolate the voting stock in a small percentage of the value of the

company. This makes it easier to eventually pass control to the

next generation.

EXAMPLE: Oliver Owner owns 100% of a business worth

$10,000,000. He wants to pass control to a dynasty trust that will

be controlled initially by his son and then by a trio of independent

trustees. Oliver recapitalizes the business and issues nine shares of

nonvoting stock for each outstanding share of voting stock. The

voting stock is now worth $1,000,000. Oliver transfers the voting

stock to a dynasty trust, and allocates part of his GST exemption to

the trust to completely shelter it from future transfer taxes for

several generations.

d. By making gifts of nonvoting stock, an individual can eliminate

Section 2036(b) issues. These issues can arise, for example, if the

individual transfers closely held stock to a family limited

partnership of which the individual is general partner.

e. Nonvoting stock can be used in S corporations. An S corporation

can have only one class of stock, but nonvoting stock that is

identical in all respects other than voting rights to voting stock is

not considered a second class of stock under the S corporation

rules.

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5. Preferred Equity Interests. Preferred stock, or preferred partnership

interests in a business organized as a partnership, can be issued to

concentrate income from the business in one or more family members who

require extra revenue.

a. The traditional estate planning use of preferred stock has been to

use it to freeze the value of a senior generation owner’s estate and

shift future appreciation to the next generation.

EXAMPLE: Eddie Entrepreneur owns a small but promising

business worth $2,000,000. His children and trusts for their

benefit own about 50% of the business, which they have received

through gifts. Eddie recapitalizes the company and exchanges his

$1,000,000 of common stock for $1,000,000 of fixed value

preferred stock with an 8% preferred dividend. Over the next ten

years, the value of the company grows to $20,000,000. Eddie’s

interests is still worth $1,000,000, and his children and their trusts

own common stock worth $19,000,000.

b. Often the goal now in issuing preferred stock is to let some family

members participate more in the income of the business while

others receive more of the growth.

(1) Preferred stock can be issued to a retiring family member to

ensure that he or she receives a steady income stream after

retiring.

EXAMPLE: One of the siblings in a family-owned

business is approaching retirement. She owns $1,000,000

of common stock in the business. The company pays a

modest dividend, and she receives about $10,000 of

dividend income annually. The company issues $500,000

of preferred stock to her in exchange for $500,000 of her

common stock. The preferred stock pays a 10% preferred

dividend. After the exchange, she will have about $55,000

of dividend income per year.

(2) An individual may want to leave preferred stock to a

surviving spouse to provide funds to maintain his or her

lifestyle.

c. For some companies, it may be preferable to continue to pay a

salary to a retiring shareholder, since a reasonable salary is

deductible by the corporation and dividend payments are not.

Other companies may want to minimize salary payments in an

effort to improve the net revenues from operations shown on their

financial statements.

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6. Impact of §2701 on Capital Structures

a. The Chapter 14 special valuation rules enacted as part of the

Revenue Reconciliation Act of 1990 eliminated some of the

benefits of using preferred stock or preferred partnership interests.

b. Section 2701 generally provides that, where an individual who

controls a closely held business transfers an equity interest in the

business (usually common stock or an equivalent partnership

interest) to younger family members, while retaining preferred

stock or certain other interests in business immediately after the

transfer (called applicable retained interest ARIs), the retained

interest will normally be assigned a zero value for gift purposes

unless it provides for cumulative dividends (called “qualified

payments”) or meets certain other exceptions. If the retained

preferred stock other interest is assigned no value, the amount of

its actual value will constitute an immediate gift from the

transferor to the person receiving the common stock.

c. Despite the general requirement of cumulative dividends, the rules

do permit a transferor to qualify a noncumulative distribution right

as a qualified payment by irrevocably electing (where such an

election is not inconsistent with the terms of the underlying legal

instrument) to treat the distribution as a qualified payment, to be

paid in the amounts and at the times specified in election. Such an

election permits the retained distribution right to be valued as if it

were a qualified payment at the time that the junior interest is

transferred and avoid the zero-value result under Section 2701.

Conversely, a transferor can irrevocably elect to have a qualified

payment right fall within the scope of Section 2701 and thus have a

zero value for transfer tax purposes.

EXAMPLE: ABC Corp. is worth $1,000,000. Mother owns all of

the outstanding common stock. ABC Corp. converts it’s common

stock to common stock and noncumulative preferred in a

recapitalization. After the recapitalization, Mother has common

stock worth $500,000 and 8 percent, noncumulative preferred

stock worth $500,000. Mother gives her common stock to

Daughter. Section 2701 applies, and, as a result, Mother makes a

gift to Daughter of $1,000,000. However, assume that Mother

elects to treat her preferred dividend right as a right to receive

qualified payments in the amounts and at the times specified in the

notice of election, consistent with the terms of the preferred stock.

If Mother elects such treatment, her preferred stock will be valued

at $500,000 for purposes of the common stock gift to Daughter.

However, dividends not paid at the times specified in the notice of

election or the applicable grace period thereafter become subject to

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special compounding rules that increase the value of Mother’s

estate by the amount of unpaid dividends compounded at a

designated rate of return based on the IRS Section 7520 rate.

d. As a result of Section 2701, most individuals engaged in a

preferred stock recapitalization either will issue cumulative

preferred stock or will elect to treat noncumulative stock as a

qualified payment right. However, this may not always be the case.

e. Providing for cumulative dividends at a market rate and paying

them in a timely manner (i.e., within the four-year grace period).

will accomplish a “leaky freeze,” in that the preferred owner’s

estate will be enhanced in value by the cumulative dividends. Such

a freeze should be beneficial so long as the business continues to

appreciate at a rate that exceeds the annual dividend payments.

f. A partial freeze also would be possible, especially where the

company is already paying some dividends to the common

shareholders. For example, if the company pays $100,000 in

dividends, and an applicable market rate for preferred stock of the

type the company would issue is 8 percent, then the company

could issue its senior shareholder $1,250,000 of 8 percent,

cumulative preferred stock without concern that the preferred

would be worth less than par value or that the company could not

pay the dividends. If the senior owner’s common stock is currently

worth $2,500,000, then half of it could be converted into preferred.

This type of freeze is less likely to impose a cash drain on the

company, since dividends will not be increased above current

levels. It does cause the senior shareholder to receive all dividends,

however, and that shareholder will continue to participate in the

company’s future growth, although to a lesser extent than before

the freeze. Whether such a freeze leaves the junior equity owners

better off economically than no freeze should be evaluated in each

particular case.

g. Senior owners should be able to retain many types of nonequity

interests in corporations (and partnerships and LLCs) after the

transfer of an equity interest to younger family members without

running afoul of Section 2701. For example, installment debt,

employment or consulting agreements, and deferred compensation

or retirement benefits generally should not be subject to Section

2701.

h. Because Section 2701 only applies to lifetime transfers, transfers at

death should not be subject to the section. This should permit

business owners to create a “delayed” freeze. Thus, for example, it

should be permissible for the sole shareholder of a closely held

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company to convert old common stock into new common and

noncumulative preferred stock shortly before death, and at death

leave the preferred stock to one beneficiary (e.g., spouse), while

leaving the common stock to a different beneficiary (e.g.,

children). It also may be possible for an individual’s estate plan to

mandate that the individual’s executor accomplish the

recapitalization, with the stock distributed in the manner indicated

above. IRS personnel have stated informally that either of the

above testamentary freezes should be allowable under the statute.

Such an approach might even have generation-skipping tax

benefits, for example, if the common stock is worth $2,000,000 or

less and is distributed to a GST-exempt trust for the benefit of the

decedent’s descendants. All future growth in the company

thereafter would be sheltered from transfer taxation for several

generations. In a similar vein, the sole shareholder, after

recapitalizing the company, could give preferred stock to the sole

shareholder’s children and the common stock at the same time to

any grandchildren. Since neither the transferor nor an applicable

family member would retain an interest in the corporation after the

transfer, Section 2701 would not apply.

i. Payment of cumulative dividends on preferred stock raises the

problem of double taxation of income generated by the business.

Many business owners are reluctant to pay dividends for this

reason, and choose to take their income out of the corporation in a

deductible form, such as salary and benefits. This problem can

impose a significant obstacle to a successful freeze, because in

some cases the income tax costs may outweigh the transfer tax

benefit. The double-tax problem can be avoided if the business is

in a partnership or LLC form. Thus, in many cases, the partnership

or LLC freeze, if an available option will be the vehicle of choice

to accomplish a freeze.

j. An S corporation will be unable to engage in a preferred stock

recapitalization, since it cannot have a preferred stock. It also will

not be possible to use the stock to fund a frozen partnership, since

a partnership is not a permissible holder of S corporation stock.

7. If voting shares already are in the hands of several family members (e.g.,

brothers or sisters), consider using shareholder agreements to provide for

pre-arranged agreements concerning such issues as succession to key

officer or director positions, dividend and borrowing policies,

compensation, sale of the business, etc. Many states now allow for the use

of such agreements without the 10-year termination periods that still may

apply to voting trusts.

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D. Buy-Sell Agreements.

1. The buy-sell agreement is a contract among the owners of a business, or

between the owners and the company, which sets out what will happen to

their various ownership interests upon the occurrence of certain specified

future events (such as death or withdrawal). Buy-sell agreements are used

primarily to achieve non-tax goals. They can serve a number of useful

purposes in a family business, before, during and after a period of

succession.

a. Control. A typical agreement will give the entity, the owner, or

both a right of first refusal on certain proposed transfers by a

shareholder. This protects the existing owners from unwillingly

becoming business partners with an undesirable owner. It may

permit a senior family member who controls the business to

become comfortable with making gifts of stock, since the

agreement will give him or her some control over what his children

do with the stock.

b. Liquidity. A buy-sell agreement can provide a withdrawing family

member with a market for his or her interest by providing a put

right in certain circumstances. The most common point in time to

grant a put right is at the death of a shareholder. It allows a

surviving spouse or children who are not interested in continuing

in the business to liquidate their interest. Put rights also can be

granted at retirement or when the shareholder ceases to be

employed with the business for other reasons.

c. Planning. A buy-sell agreement helps push a family toward further

succession planning by focusing them on what options should be

given to the family of a deceased shareholder and how to fund the

repurchase of stock under the agreement.

d. Preservation of Tax Benefits. It is also possible to include in a

buy-sell agreement prohibitions against certain actions by the

shareholder that would threaten tax elections. A buy-sell

agreement for an S corporation typically prohibits a shareholder

from transferring stock to an entity or person that is not a

permissible shareholder of an S corporation, or from taking any

other action that would threaten the S election.

2. Once it is determined that a buy-sell agreement is desirable, the next

determination must be who the operative parties to the agreement will be.

Obviously, the withdrawing party will be the seller, but the purchaser may

be the other owners (a cross purchase), the business itself (an entity

purchase), or a combination of the two. Except to the extent that tax

consequences may vary, the seller is generally not concerned with the

49

question of who acts as the purchaser (assuming that the purchase price is

paid in full at closing). He is concerned only with getting the appropriate

amount of money for his interest. However, it is important that the

purchaser be identified and that steps be taken to ensure that the purchaser

has the funds necessary to make the required purchase.

3. Cross-Purchase Agreement

a. A buyer will often prefer a cross-purchase agreement since this

will result in an increase in the buyer’s basis in his stock. If the

other shareholders are to make the purchase, it is often desirable

for them to take out insurance on one another’s lives so that funds

will be available to make the purchase. Obviously, with a large

number of shareholders, this can be very expensive as well as

administratively cumbersome. If this type of cross-purchase

arrangement is structured, at the death or withdrawal of one

shareholder, the policies he holds on the lives of the other

shareholders must be assigned to the remaining shareholders.

Younger shareholders may bear a disproportionate burden of the

cost of such agreements because the policies on the lives of the

older stockholders, which they must purchase, will have higher

premiums than the policies on their lives, which the older

stockholders must purchase.

b. Generally, the cross purchase of insurance by the shareholders is

not associated with any adverse income tax consequences. When

the surviving shareholders receive the insurance proceeds on the

deceased shareholder’s life at his death, those proceeds will not

normally constitute taxable income to them. When they purchase

the stock from the decedent’s estate, no significant taxable gains

should occur because, by reason of the decedent’s death, the estate

has received a step-up in the income tax basis of the stock being

sold. Moreover, the full amount paid for the stock so acquired is

included in the surviving stockholders’ income tax basis for that

stock, so any subsequent sale of the business by them would result

in their realizing less capital gain.

c. Although no income tax problems generally result from cross-

purchase agreements, if the insurance policies are transferred

among the remaining owners, problems can arise as a result of

changes in stock ownership. In these cases, assignments of the

policies may run afoul of the “transfer for value” rules of the tax

law (IRC § 101(a)(2)) and may cause the proceeds of the insurance

to be fully income taxable when the transferee shareholder collects

them.

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d. If corporate earnings are to be the principal source of premium

payments, additional problems are created. When the shareholders

own the policies, any premium payments by the corporation will

be income to the shareholders. If the company owns the policies

but distributes the proceeds to the surviving shareholders to allow

them to make the purchase, the proceeds may be a taxable

dividend.

4. Entity Purchase Agreement

a. Alternatively, the buy-sell agreement can be structured to have the

business itself (rather than the other owners) be the ultimate

purchaser at the time of the withdrawal or death of any of the

owners.

b. This alternative may seem attractive if the corporation has

sufficient funds to affect the purchase; however, accumulating

such funds could cause the corporation to run afoul of the

“unreasonable accumulation of earnings” provisions in the income

tax law. IRC §§ 531-537.

c. If the corporation does not have sufficient funds to affect purchases

at the death of an owner, it could acquire insurance for such

purchases. Only one policy on the life of each shareholder would

be necessary, and there would be no need for transfers of policies,

eliminating concern over the “transfer for value” rules. Further,

the cost differences of policies between shareholders of various

ages are equalized (because the corporation pays for all policies).

d. The receipt of insurance proceeds by a C Corporation could have

income tax consequences. While insurance proceeds received by

the corporation are not subject to regular income tax liability, they

may now be subject to the corporate alternative minimum tax.

Under the alternative minimum tax, the corporation must add to its

tax base one-half of the amount of the proceeds received for the

taxable year. This may result in additional tax owed by the

corporation, which will either reduce the amount of after-tax

proceeds available to be used for the stock purchase, or reduce the

corporation’s surplus (and thus, its value to the remaining

shareholders). While this potential tax cost itself can be insured

for by increasing the amount of insurance coverage carried on the

shareholders, this could be expensive.

e. Although having the corporation serve as the purchaser in the buy-

sell agreement may appear desirable, there are certain

disadvantages. First, such purchases constitute redemptions for

income tax purposes. As is discussed in detail later in this chapter,

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unless certain very specific requirements are met, the amounts

distributed from the corporation for the stock interest constitute

dividend income to the recipient. The tax consequences of this to

the recipient would be undesirable in that the proceeds, instead of

being nearly tax free, would be taxable as ordinary income.

Accordingly, in structuring a corporate redemption, one must

ensure that the redemption will qualify as (a) substantially

disproportionate, (b) a complete termination of interest, or (c) a

redemption to pay death taxes.

f. Moreover, the remaining shareholders may face potential capital

gains problems. When the corporation purchases the selling

shareholder’s shares, the value of the remaining owners’ shares

may increase, although their income tax basis in the shares will

not. The value of the corporation, and accordingly the outstanding

stock, may also be increased by the receipt of insurance proceeds

by the corporation. A subsequent sale of a remaining shareholder’s

interest may thus result in a large capital gain.

g. One final potential tax trap with regard to buy-sell agreements

should be recognized. Sometimes such agreements are structured

to require the surviving shareholders to purchase the stock at the

death of one of them, but then, at the time of sale and purchase, it

is determined that the corporation has adequate funds to make the

purchase. Even if it is possible to structure a purchase by the

corporation that will not be taxable as a dividend to the recipient,

an unintended dividend to the surviving shareholders may be

imputed for income tax purposes. This would be the case if a

primary, unconditional obligation of such shareholders (the

requirement to purchase the stock) were satisfied by the

corporation. To avoid this result, the buy-sell agreement should

generally not impose a primary unconditional obligation on the

surviving shareholders but should give the corporation the first

right to purchase and should make the shareholders obligated to

purchase only if the right is not exercised.

5. A buy-sell agreement can also be used to help limit or freeze the value of

the business for federal estate tax purposes. While it is difficult under

current law to structure a buy-sell agreement that will fix the price of

stock, it is an achievable result if the shareholders are not overly

aggressive.

a. Section 2703, will generally cause restrictions under a buy-sell

agreement to be ignored for transfer tax purposes. The rule applies

to agreements entered into after October 8, 1990, and those that are

substantially modified after that date. However, this rule can be

avoided, and the value specified in the agreement may be

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recognized for estate tax purposes if several requirements are met.

The statute sets out the following three requirements:

(1) the agreement is a bona fide business arrangement;

(2) the agreement is not a device to transfer the business to

members of the owner’s family for less than full and

adequate consideration; and

(3) the terms of the agreement are comparable to similar

arrangements entered into by persons in an arm’s-length

transaction.

b. The following regulatory and case law requirements also must be

met:

(1) the agreement must contain restrictions on the owner’s

lifetime disposition of the business interest;

(2) the agreement must obligate the decedent’s estate or

beneficiaries to sell the interest either without any choice or

at the option of the other parties to the agreement; and

(3) the price must be fixed or determinable under the terms of

the agreement, and reasonable when the agreement was

made.

c. These requirements are not easily satisfied, but if they can be, the

buy-sell agreement should at least favorably impact the value of

the business for transfer tax purposes, and it might even determine

that value. The key factor in satisfying the requirements is to have

an agreement that is a “fair bargain,” similar to what would have

been entered into by unrelated business partners. The existing case

law and regulations suggest that the method used to determine the

price set in the agreement is an important element in this

determination.

(1) A price determined by an appraiser will be far more likely

to be treated at arm’s length than an arbitrary use of book

value or another factor.

(2) The client’s accountant should play a key role in

determining, with reference to industry custom or

otherwise, whether the purchase price can be expressed as a

formula (e.g., 5 x EBITDA).

(3) In addition, if a formula is not appropriate, the price in the

agreement is more likely to be accepted if the agreement

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requires that it be updated on a regular basis. This does not

necessarily mean that annual updates are necessary. It may

be commercially reasonable to have modifications to the

price every two or three years.

d. Some clients may ask what is being gained by drafting an

agreement to fix the price of stock or partnership interests where

the value is being determined by a professional appraisal and

updated regularly. There are a number of potential advantages:

(1) If the agreement is found to fix price, then the IRS is not

free to adjust values because of significant changes in the

business that have occurred since the last appraisal. For

example, if the price of a company’s stock was last set on

January 1, 2012, pursuant to the buy-sell agreement and

will not be modified until January 1, 2014, the January 1,

2012 price may be binding even if the company has

appreciated significantly at the time of a stockholder’s

death in 2013.

(2) The agreement can build-in discounts for lack of

marketability. For example, based on statistical

information on lack of marketability discounts, it could be

considered reasonable and in conformance with general

business practice to dictate a 35% discount in the

agreement. Discounts attributable to built-in gains taxes

also can and should be taken into account.

(3) A buy-sell agreement negotiated at arm’s length usually

does not require consideration of a control premium in

valuing the stock of a majority stockholder. Usually, the

agreement sets one method for determining price that is

applicable to all stock, regardless of the holder. This has

been recognized in at least one case concerning buy-sell

agreements. See Rudolph v. United States, 93-1 U.S.T.C. ¶

60,130 (February 5, 1993). Thus, an agreement that is

found to fix price can be very beneficial to a controlling

stockholder by preventing the IRS from using a control

premium in valuing his or her stock.

6. Conflicts Between Agreement Price and Estate Tax Price. A family that is

implementing a buy-sell agreement must recognize that the agreement

terms, including price, are legally binding among the parties even though

the price may not be binding on the IRS for estate tax purposes. As a

result, a family of a deceased shareholder can be hurt by a price in the

agreement that is found to be substantially below fair market value.

54

EXAMPLE: Sister owns 1,000 shares of stock in XYZ Co., a family

corporation. The other shareholders are her three siblings and a trust

created by her parents. The stock is subject to a buy-sell agreement that

gives the company an option to buy the stock at a shareholders death for

$2,000 per share. The company exercises the right at sister’s death and

pays her estate $2,000,000. The IRS determines that the fair market value

of the stock for estate tax purposes is $3,500 per share. If sister is in a

40% estate tax bracket, the estate pays estate tax on the stock of

$1,400,000, but receives only $2,000,000 for it. Sister’s family nets

$600,000. Note that this can be particularly unpleasant when the estate

otherwise was expecting no tax because of an optimum marital deduction

plan.

7. In Blount v. Commissioner, 426 F.3d 1338, (11th Cir. 2005), the Court

found that a stock purchase agreement did not fix the value of stock for

estate tax purposes, but also insurance proceeds should not have been

added to the value of the corporation.

a. George Blount and his brother-in-law each owned 50% of the

outstanding shares of Blount Construction Company. In 1981,

George, the brother-in-law, and Blount Construction Company

entered into a buy-sell agreement restricting the transfer of stock

both during the shareholders’ lifetimes and at death. Lifetime

transfers required the consent of the other shareholders. At death,

the shareholder’s estate was required to sell and Blount

Construction Company was required to buy the shareholder’s

shares at a price set in the agreement. The agreement could only be

modified by the written consent of the parties to the agreement.

Subsequently, George and the brother-in-law transferred shares to

an ESOP established by Blount Construction Company. The

brother-in-law then died and Blount Construction Company

redeemed the brother-in-law’s shares pursuant to the agreement.

This left George and the ESOP as the only remaining shareholders,

with George owning an 83% interest in Blount Construction

Company.

b. In 1996, without obtaining the consent of the ESOP, George and

Blount Construction Company, which George controlled, modified

the agreement. They changed the price and the terms under which

Blount Construction Company would redeem George’s share on

George’s death. They left unchanged the provision requiring the

consent of the other shareholders for lifetime transfers. The

modified price was substantially below the price that would have

been payable pursuant to the then modified agreement and which

was paid for the brother-in-law’s shares. George died and Blount

Construction Company redeemed his shares as set forth in the

modified agreement. George’s estate reported the value of the

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shares held at death as equal to the price set forth in the modified

agreement. The Tax Court held that the modified agreement should

be disregarded for purposes of determining the value of George’s

share for federal estate tax purposes because George had the

unilateral ability to modify the agreement rendering the agreement

nonbinding during George’s lifetime.

c. The court focused on the fact that to qualify for the exception to

the general rule, under Section 2703, the restrictive agreement

must be binding during the life of the decedent. It noted that by the

time the 1996 agreement was consummated, the only remaining

parties were the construction company and Blount. Blount owned

an 83% interest in Blount Construction Company, was the only

individual shareholder of Blount Construction Company, and was

the President of the company. The estate argued that ESOP’s

approval was required for changes. However, the court noted that

ESOP was not a party to the buy-sell agreement and thus that its

consent was not necessary to modify the agreement. As a result,

Blount essentially had the unilateral ability to modify the

agreement during his life and he did so during his life and the

value of the shares in George’s estate had to be determined using a

fair market valuation as required by Section 2703.

d. In valuing the company, the Tax Court had added $3.1 million in

insurance proceeds that the construction company received on

Blount’s death to the value of the company and concluded that the

value of the company was $9.85 million. The 11th Circuit held that

the Tax Court erred in doing so. Relying on Estate of Cartwright v.

Commissioner, 183 F.3d 1034 (9th Cir. 1999), the 11th Circuit

accepted the rationale that insurance should not be taken into

account to the extent that it is offset by an obligation to pay those

proceeds to the estate in a stock buy-out. The sole purpose for

which the construction company acquired the stock was to fund its

obligation to purchase the shares of stock in accordance with the

stock purchase agreement. The case was remanded to the Tax

Court to determine the appropriate value.

E. Value Shifting Techniques That Provide Liquidity

1. Retention of Income Stream. Several techniques are available for

accomplishing a freeze of the value of a senior family member’s interest in

the business assets and transfer of future appreciation to the younger

generation while at the same time maintaining an income stream for the

senior family member. The income stream may give the senior family

member the comfort needed to give up control of his or her interests. In

some cases, the senior family member also may be able to retain voting

rights with respect to the stock for a period of time. The techniques

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available to accomplish these multiple benefits include an installment sale,

a private annuity, a self-canceling installment note and a grantor retained

annuity trust.

2. Installment Sales. An installment sale involves the sale of a business

interest or other assets by an individual to the business or a third party in

exchange for an installment obligation (e.g., a promissory note). The sale

limits the value of the individual’s retained interest to the amount of any

down payment plus the face value of the note (or other evidence of

indebtedness) received, reduced by the income tax liability on the

payments made to him. A market rate of interest normally must be paid

on the installment obligation in order to avoid having the face value of the

note discounted for tax purposes and a gift imputed. However, the courts

have concluded that interest at the applicable federal rate will avoid an

imputed gift. This is advantageous to the taxpayer since the applicable

federal rate is usually lower than the prime lending rate.

a. Any gain from an installment sale of a closely held business

interest is generally reportable on a proportionate basis over the

time period in which the payments are actually received, unless the

individual elects otherwise. IRC § 453. Thus, income tax

resulting from the gain can be deferred and spread over more than

one year. Exceptions exist, such as if the property is sold within a

certain period (generally two years) or if the repayment obligation

is forgiven. If the individual dies before the obligation is paid in

full, any unpaid principal balance is included in his estate, and the

deferred gain is taxed as payments under the note and received by

his beneficiaries. Finally, if the installment obligation is

transferred by bequest or inheritance to the obligor or is canceled

by the deceased seller’s executor, the seller’s estate will recognize

any unreported gain. IRC § 453B.

b. Under IRC § 453A, an interest charge is imposed on the capital

gains tax deferred under such installment obligations to the extent

the amount of such obligations held by the taxpayer resulting from

sales in a single year have an aggregate face value which exceeds

$5 million. The interest rate is the rate charged by the IRS for

underpayment of tax.

c. The installment sale could be made to a “defective” grantor trust.

When using a grantor trust as the purchaser in the sale, the trust is

not treated as a separate taxpayer for income tax purposes. As a

result, the transaction is not treated as a sale for tax purposes and

the resulting capital gain from the sale is eliminated

EXAMPLE: Client creates an irrevocable gift trust and funds it

with a gift of $100,000 of stock in his closely held company. The

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trust is structured as a grantor trust. Client then sells $1,900,000 of

the stock to the trust for a 17-year installment note, bearing an

interest rate of 6.50% (the long-term applicable federal rate). The

company is an S corporation that distributes cash of about 11% per

year, and the stock is also appreciating at about 5% per year. The

trust will receive distributions of $220,000 per year. The

amortized payments to Client under the note are about $188,000

per year. At the end of 17 years, the stock and the other

investments from the accumulated distributions in excess of the

note payments will have an aggregate value of $5,527,800.

(1) The special twist when using a grantor trust as the

purchaser in the sale is that the trust is not treated as a

separate taxpayer for income tax purposes, so the sale does

not cause the seller to realize capital gain. A regular

installment sale reported under Code Section 453 permits

the seller to recognize capital gain as payments are received

over the term of the installment note. When a grantor trust

is used, even this deferred gain can be avoided entirely.

(A) Because the trust is a grantor trust, interest paid on

the installment note will not be taxable to the

grantor. It is as if the grantor is paying interest to

himself. (Of course, any income earned by the trust

is taxed to the grantor.)

(B) In addition, the trust can make payments on the note

without concern about the tax consequences of the

form of payment. For example, the trust can

transfer appreciated assets to the grantor to make

payments. This is not treated as a sale of the assets,

as it would be if done by a third party purchaser.

(C) A sale to a defective grantor trust is especially

advantageous if the assets sold are shares of stock in

an S corporation or interests in another type of

flow-through entity, like a partnership or LLC. The

taxable income attributable to the interests in the

entity held by the trust will be reportable by the

grantor of the trust. Distributions made by the

entity to permit its owners (shareholders, partners or

LLC members) to pay income taxes can be used to

satisfy the note payments.

(2) There are several potential advantages to an installment

sale to a grantor trust, as compared to a GRAT.

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(A) An installment sale allows the client to use a lower

discount rate. The interest rate required for the

promissory note in an installment sale should be

lower than the rate used for determining the value

of an annuity interest in a GRAT. If the promissory

note uses the applicable federal rate (AFR), the rate

should be adequate to avoid gift tax consequences.

See Frazee v. Comm’r, 98 T.C. 554 (1992). In a

GRAT, the value of the annuity is calculated

pursuant to Section 7520 using 120% of AFR. The

lower rate for the note often results in less property

being paid back to the grantor.

(B) An installment sale does not involve a direct

mortality risk. If the client engages in an

installment sale and dies before the end of the term

of the note, only the value of the unpaid balance of

the promissory note will be included in his estate.

If he dies during the GRAT term, the entire value of

the transferred property is included in his estate. As

described below, however, there are some indirect

tax consequences to dying during the term of an

installment note.

(C) An individual could engage in generation-skipping

tax planning with a sale to a grantor trust. The

individual could make the trust a generation-

skipping trust and allocate GST exemption to it.

The individual would only need to allocate GST

exemption in an amount sufficient to cover the

initial gift. The GRAT is subject to the estate tax

inclusion period (ETIP) rules. IRC § 2642(f). The

grantor cannot allocate GST exemption to the

GRAT until the end of the annuity term, at which

time the then-current value of the trust is used for

the allocation.

(D) There is more flexibility in structuring the payments

to the grantor in an installment sale. For example, a

balloon principal payment can be used, the interest

rate can be tied to the prime rate, or the term of the

note and interest can be renegotiated after the sale is

completed. A GRAT must pay the annuity every

year and the annuity may change only as provided

in the regulations. See Treas. Reg. § 25.2702-

3(b)(1)(ii)(B).

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(3) There are two significant risks inherent in a sale to a

grantor trust.

(A) If the grantor dies while the note is outstanding, the

IRS could treat the note as a retained interest in the

trust, resulting in application of Section 2036 or

2702. The IRS is in the best position to make this

argument when virtually all the trust income is

being used to pay interest on the note. In that case,

the grantor’s note begins to look a lot like a retained

income interest. Many tax professionals believe the

trust should be separately funded with assets having

a value equal to at least 10% of the purchase price

in the installment note, in order to minimize the

possibility that the sale will be treated as not bona

fide and recharacterized.

(B) If the grantor dies while the note is outstanding, the

IRS could treat the conversion of the trust to a non-

grantor trust as a taxable event for income tax

purposes. Upon the grantor’s death, the trust will

lose its grantor trust status. If the note is still

outstanding, the weight of authority is that the

grantor’s death should be treated for income tax

purposes as a new exchange, in which the grantor

transfers property to the trust equal in value to the

amount of the note outstanding. In other words, an

actual sale is deemed to occur simultaneously with

the cessation of grantor trust status. See Treas. Reg.

§ 1.1001-2(c), Example 5; Madorin v. Comm’r, 84

T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B.

222.

EXAMPLE: Client previously sold $1,900,000 of

stock to a grantor trust for a 17-year installment

note. The stock has a basis of $190,000. Client dies

10 years later, when the principal balance on the

note is $1,000,000. For income tax purposes, as of

the date of death, Client is treated as having sold

$1,000,000 of stock for a 7-year installment note

(the remaining term on the original note). Client,

and his successor’s-in-interest, have realized gain of

$900,000 ($1,000,000 less $100,000 of basis) that is

reportable under the installment rules.

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d. In Karmazin v. Commissioner, Tax Court Docket No. 2127-03

(Settled October 15, 2003), a favorable settlement was reached

with the IRS involving a sale to a defective grantor trust.

(1) In Karmazin, a New Jersey resident created a family

limited partnership and used family limited partnership

interests in sales to grantor trusts. In 1999, she gifted

family limited partnership units to trusts for the benefit of

her two children. In making the gifts and in the sale, a 42%

discount from the value of the underlying assets was used.

These family limited partnership units represented 10% of

the total value of the trust principal. On the same day she

sold limited partnership units to the trust, using a

promissory note bearing interest of 5.8%. The promissory

note had a term of 20 years with a balloon payment due on

July 1, 2019. The IRS audited the transaction and attacked

it on several grounds, including that the partnership was a

sham, that Section 2703 dealing with buy/sell agreements

applied, and that the promissory note should be treated as

equity and not debt. If the debt were recharacterized as

equity, then Section 2701 and/or Section 2702 would apply.

Alternatively, the Service argued that if the sale were

recognized and the note constituted valid debt, the discount

should be limited to 3 percent.

(2) On October 15, 2003, a settlement was reached. Under the

settlement, the sale of partnership units to the grantor trust

was respected as a bona fide sale. It was found that none of

Sections 2701, 2702 or 2703 applied to the transaction.

The Service did prevail in reducing the discount used on

the family limited partnership interests from 42 percent to

37 percent. While a settlement does not produce precedent

upon which taxpayers can rely, the settlement shows the

IRS backing off on the arguments that it had been using to

attack a sale to defective grantor trust. This settlement

should give individuals using the technique more comfort.

3. Private Annuities. A private annuity involves a transfer of property by the

individual to a related party in return for a promise to pay a fixed periodic

sum for the rest of the individual’s lifetime. As with the installment sale,

tax on the capital gain is deferred, in this case over the individual’s

lifetime. The value of the transferred property will be removed from the

individual’s estate because he has no interest in it at death. No part of the

uncollected annuity will be included in the estate either, since the

transferee’s payment obligation terminates at the individual’s death.

Moreover, unlike an installment note, the remaining capital gain is not

taxed at the annuitant’s death.

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a. Full Value. A private annuity transaction must be structured as an

exchange of equivalent value; otherwise the excess of the

property’s fair market value over the present value of the annuity

will be a taxable gift. An appraisal should be made of the

transferred interest, and the individual’s health should be examined

and, in some cases, should be taken into account in determining the

terms of the annuity.

b. Mortality/Longevity Issues. Other potential problems may occur

as well. First, if the individual dies prematurely, the purchaser

may have a very low income tax basis in the transferred property.

Second, if the individual outlives his expected lifespan, the amount

paid to him (and included in his estate) may exceed the value of

the property. Finally, the individual bears the risk of nonpayment,

which may be substantial when the transferee is a younger

generation member, such as a child.

c. Income Tax Issues. Private annuities have a built-in income tax

disadvantage. A portion of each annuity payment received by the

annuitant is taxed as ordinary income, but is not deductible by the

payor. (It is added to the payor’s basis.) This tends to make the

private annuity technique useful only when there is a predictable

foreshortened life expectancy.

d. Short Life Expectancy. Even if the actuarial value of the

transferee’s promise, as determined under the estate and gift tax

tables, equals the fair market value of the property, a gift may be

made if the transferor is in extremely poor health at the time of the

transaction because the regulations preclude the use of the standard

actuarial tables if the individual who is the measuring life is

terminally ill. Reg. §25.7520-3(b)(3). An individual who is

known to have an incurable illness or other deteriorating physical

condition is considered terminally ill if there is at least a 50%

probability that the individual will die within one year.

Reg. §25.7520-3(b)(3). However, if the individual survives for 18

months or longer after the date of the transaction, that individual is

presumed not to have been terminally ill at the date of the

transaction unless the contrary is established by clear and

convincing evidence. Reg. §25.7520-3(b)(3).

e. Proposed Treasury Regulations §§ 1.72-6 and 1.1001-1, 2006-44

IRS 947. Under proposed regulations, a transfer of appreciated

assets for a private annuity would result in the immediate

recognition of gain.

In Revenue Ruling 69-74, 1969-1 C.B. 43, a father transferred an

appreciated asset with a basis of $20,000 and a fair market value of

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$60,000 in exchange for the son’s promise to pay him an annuity

of $7,200 per year. This revenue ruling stated that the father’s gain

was to be reported by him on a pro rata basis over the father’s life

expectancy. In Lloyd v. Commissioner, 33 B.T.A. 903 (1936), the

court held that the gain on the sale of property for an annuity

contract was not required to be reported immediately. Instead, the

gain was to be reported when the annuity payments exceeded the

basis in the property. These proposed regulations would change

the results of both Revenue Ruling 69-74 and Lloyd v.

Commissioner. Consequently, a transfer of appreciated assets for a

private annuity would result in the immediate recognition of gain.

The IRS stated that neither the open transactional approach of

Lloyd nor the ratable recognition approach of Revenue Ruling 69-

74 clearly reflected the income of the transferor of property in

exchange for an annuity. It felt that an annuity contact, whether

secured or unsecured, could be valued at the time it was created.

The IRS stated that transferor should be taxed in a consistent

manner, regardless of whether the parties exchanged appreciated

property for an annuity or sold the property and used the proceeds

to purchase an annuity.

In general, the changes are to be effective with respect to annuity

contracts entered into after October 18, 2006. There are exceptions

for sales to charity and for sales before April 17, 2006 provided

that the purchaser does not sell the assets for at least two years.

4. Self-Canceling Installment Notes (SCINs). A SCIN – a note having a

fixed term but which terminates by its terms at the seller’s death – is a

hybrid using the installment approach to determine the maximum

payments to be made by the buyer (child) and using the private annuity

approach on cessation of payments if the seller (parent) dies before all

payments have been made. Like any other installment note, a SCIN issued

by one family member to another is not subject to Chapter 14, as the SCIN

does not represent an interest of any kind in the family business.

a. The income tax treatment of SCINs is discussed in General

Counsel Memorandum 39503 (June 28, 1985) and Frane v.

Comm’r, 98 T.C. 341 (1992) rev’d in part 998 F.2d 567 (8th Cir.

1993). SCINs offer a number of advantages that may make them

preferable to private annuities under appropriate circumstances.

First, if the transferred property is used in a trade or business or

held for investment, a SCIN generates deductible interest for the

buyer. For buyers in high income tax brackets, the SCIN’s risk

premium may generate larger interest deductions if the premium is

paid in the form of higher interest. Alternatively, the premium can

increase the buyer’s basis and depreciation deductions if it is paid

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in the form of a higher purchase price. Second, whereas a SCIN

limits the number of payments to the seller, payments under a life

annuity may continue long enough to defeat the estate reduction

purpose of the original transfer. Moreover, once the seller’s life

expectancy is reached, the capital gain portion of private annuity

payments is treated as ordinary income. Third, a SCIN allows the

seller to take a security interest without losing installment sale

treatment. If the seller were paid a private annuity, retention of a

security interest would cause acceleration of gain to the time of

transfer.

b. If the holder of the SCIN dies before receiving all of the note

payments, nothing is includible in the gross estate, but the IRC §

453B installment obligation disposition rules apply and accelerate

the balance of the gain by treating the cancellation as a transfer.

The transfer is deemed to be made by the decedent’s estate, and is

taxable to the estate under IRC § 691(a)(2), with the income being

includible on the decedent’s estate’s first fiduciary income tax

return (Rev. Rul. 86-72, 1986-1C.B. 253, and Frane).

c. To avoid a gift, the self-canceling feature should provide a

premium to the seller. See Moss v. Comm’r., 74 T.C. 1239 (1980).

(1) The premium may be reflected either in the interest rate or

in the purchase price and other terms.

(2) Using separate counsel helps substantiate the premium as a

bargained-for element of the transaction.

d. For a SCIN transaction to be effective, the sale must be a bona fide

transaction. In Costanza v. Comm’r., 320 F.3d 595 (5th Cir.

2003), the Court found that a SCIN would not bail since the estate

successfully rebutted the presumption for inclusion of an intra-

familial self-canceling installment note in the estate by

demonstrating a “real expectation of payment” and an “intent to

enforce collection of the indebtedness.

(1) At age 73, retired GM welder, restaurateur and developer,

Duilio Costanza, decided to return to his native Italy. On

the advice of his attorney, Mr. Costanza sold two parcels of

property to his son, Michael. In exchange, Michael

executed a self-canceling installment note (SCIN) for

$830,000 (the price at which the properties had been

appraised). Pursuant to standard SCIN agreements,

Michael was to pay for the property in monthly

installments. Both properties were secured by mortgages.

The term of the SCIN was eleven years. The initial interest

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rate was 6.25%, which would increase by one-half percent

at 2-year intervals.

(2) Before Mr. Costanza could return to Italy, he fell ill and

underwent coronary bypass surgery. He died almost

immediately thereafter. At the time of his death, Mr.

Costanza had received only one quarterly payment

(representing three monthly installments) from his son.

Under the SCIN’s “cancellation-upon-death provision,”

neither the SCIN nor the real estate was included in Mr.

Constanza’s estate for tax purposes. The IRS challenged

the exclusion of the SCIN and issued a notice of deficiency.

(3) The IRS sought to adjust the value of Mr. Costanza’s estate

based on the sale for the SCIN not being a bona fide

transaction, or, alternatively, sought to increase Mr.

Costanza’s adjusted taxable gifts on the grounds that the

transaction was a bargain sale.

(4) The Tax Court had found in favor of the IRS. The Sixth

Circuit overturned the Tax Court, holding that the SCIN

was a bona fide promissory note with a value equal to its

stated value. However, the Sixth Circuit remanded the case

for a determination of whether the SCIN equaled the

property’s fair market value. The court found that Michael

overcame the presumption against an inter-family note

transaction by demonstrating that his father held a “real

expectation of repayment” and”intent to enforce the

collection of the indebtedness.” The IRS had challenged

the “expectation of repayment” requirement, noting that

Michael made the first payment on a quarterly basis rather

than the monthly basis required by the agreement. The

court agreed with the estate that Michael’s quarterly

payment, consisting of three backdated checks, reflected

his father’s expectation of payment in a form requiring only

quarterly trips to the bank.

(5) The court rejected the IRS’ argument that the SCIN was

created with an expectation that Mr. Costanza would die

prematurely. Michael successfully persuaded the court that

no one anticipated Mr. Costanza’s premature death; his life

expectancy ranged from 5 to 13.9 years at the time the

SCIN was created and he had made clear that the SCIN was

intended to fund his remaining years in Italy. The court

also declined invalidate a SCIN on the presumption that the

parties expected one to die before the other—and therefore

executed a SCIN rather than an unconditional promissory

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note—as this would “question the validity of an SCIN, an

argument that the Tax Court has long since rejected.” A

final factor contributing to the court’s finding of a bona fide

SCIN was that the SCIN was secured by a mortgage on the

real estate.

5. Grantor Retained Annuity Trusts.

a. Structure. In a Grantor Retained Annuity Trust (“GRAT”), the

grantor retains the right to receive fixed annuity payments (payable

at least annually) for a term of years or the prior death of the

grantor (an annuity interest). At the end of the term, the grantor

receives no additional benefits from the trust. The remaining trust

principal is either distributed to beneficiaries (such as the grantor’s

descendants) or held in further trust for their benefit. If the grantor

survives the term, that trust principal is excluded from the

grantor’s estate for federal estate tax purposes.

b. Section 2702. The grantor’s annuity interest in the trust is a

qualified interest under Section 2702. This means that the IRS

tables apply to value the gift made when a GRAT is created,

regardless of the type of assets used to fund the GRAT or the

identity of the remaindermen. Therefore, a GRAT can be funded

with cash, marketable securities, real estate, closely held stock or

other assets.

c. Gift Computation. The transfer of property to a GRAT constitutes

a gift equal to the total value of the property transferred to the trust,

less the value of the retained annuity interest. The value of the

annuity interest is determined using the valuation tables under

Section 7520 and the applicable interest rate for the month of the

transfer. The grantor of a GRAT is treated as making an

immediate gift when the trust is funded, but the value of the gift is

discounted because it represents a future benefit. Therefore, if the

grantor survives the annuity term, the property will pass to the

designated remaindermen at a reduced transfer tax value.

EXAMPLE: Mother, age 55, transfers $500,000 of assets to a

GRAT and retains the right to receive an annuity of $50,000 per

year, payable annually, for 15 years or her prior death. Assume

that under the IRS tables, the value of Mother’s retained annuity

interest is $390,000, so the amount of the gift upon creating the

GRAT is $110,000. If the trust assets provide an average return of

at least 10% annually, there will be at least $500,000 in the GRAT

at the end of the term. If the individual is still living at the end of

the term, the remainder men receive $500,000 plus all

appreciation, if any.

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d. Mortality Risk. The grantor must survive the annuity term under a

GRAT to achieve the full transfer tax benefits of the trust. In

Letter Ruling 9345035 (August 13, 1993), the IRS indicated that if

a grantor dies during the annuity term, the Service would include

the entire value of the GRAT in the grantor’s estate under Section

2039.

e. Grantor Trust Status. Most GRATs provide that the annuity

payout amount must be satisfied from trust principal to the extent

trust income in a given year is insufficient. The IRS has ruled

privately that Section 677 applies where the annuity may be

satisfied out of trust income or principal. See e.g., Ltr. Rul.

9415012 (January 13, 1994). Therefore, virtually every GRAT

should be treated as a grantor trust with respect to all trust income.

f. Choice of Assets. A GRAT will be most effective when funded

with rapidly appreciating assets or high-yield assets that can

support a large annuity that will minimize the gift. It is not

necessary that the assets used to fund the GRAT produce current

income sufficient to pay the annuity. Because the GRAT will be a

grantor trust, the trustee can satisfy the annuity payments with

distributions of trust principal in kind without income tax

consequences. See Ltr. Ruls. 9415012 (January 13, 1994);

9345035 (August 13, 1993).

EXAMPLE: The GRAT created by Mother in the previous

example is funded with 10,000 shares of closely held stock (worth

$500,000). The annual dividend from the stock will be about

$10,000 and the stock has been appreciating at about 10% per year.

Assume the stock has appreciated in value from $50 per share

when the trust was funded to $55 per share at the end of year 1. To

satisfy the annuity, the trustee could pay Mother $9,960 in

dividends plus 728 shares of the stock (value of $40,040). That

leaves 9,272 shares in the GRAT, with a value of $509,960.

g. S Corporations. Stock in an S corporation is an ideal asset for a

GRAT. Individuals who own S corporation stock are not able to

take advantage of the corporate preferred stock recapitalization or

partnership freeze to freeze the value of their interests for estate tax

purposes, due to restrictions on the type of stock such an S

corporation may issue and the rules regarding permissible

shareholders. A GRAT is a viable alternative for freezing the

value of such an interest. The retained annuity in a GRAT is

similar to a preferred dividend or partnership income preference

right. Because the gift is fixed in value at the time the trust is

established, all future appreciation in the trust property will be

excluded from the grantor’s estate, if he survives the term. Thus,

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the grantor is effectively freezing his interest in the trust property.

Indeed, a GRAT might be better than a freeze in some cases,

because of the gift tax leverage it provides.

(1) An electing S corporation may only have certain types of

trusts as shareholders. However, a grantor trust will qualify

as a shareholder of S corporation stock. Most of the private

letter rulings that have examined the treatment of a GRAT

as a grantor trust have involved transfers of stock in an S

corporation. See, e.g., Ltr. Rul 9415012 (January 13,

1994).

(2) The GRAT can be a particularly advantageous way to

transfer stock in an S corporation if the corporation makes

annual distributions to its shareholders to cover the

shareholders’ income tax obligations arising from the

corporation. Because the S corporation is a flow-through

entity for income tax purposes, the trustee of a GRAT is

able to satisfy annuity payments with pre-tax dollars from

the corporation.

EXAMPLE: Client transfers $2,000,000 of S Corporation

stock to a GRAT and retains an annuity of $225,000

(11.25%) per year for 15 years or until the prior deaths of

Client and his spouse. The $2,000,000 value is determined

after applying appropriate valuation discounts to the stock.

The value of Client’s retained annuity interest is

$1,975,000, so Client makes a taxable gift of only $25,000

when he creates the GRAT. The S Corporation distributes

cash of about $240,000 per year (i.e., 12% of the

$2,000,000 value) to provide funds for income taxes and

some additional amounts for discretionary use by the

shareholders. Thus, the GRAT can pay Client the annuity

out of part of the $240,000 that the GRAT receives each

year, and Client uses a portion of the annuity distribution to

pay his income taxes related to S corporation income.

h. Voting Stock. If voting stock in a closely held corporation (one in

which the grantor and related parties own 20 percent or more of the

voting stock) is transferred to the GRAT, the grantor should not

retain the right to vote that stock beyond the date that is three years

before the end of the annuity term. The right to vote the stock will

cause the stock to be included in the grantor’s estate under Section

2036(b), and the relinquishment of that right within three years of

death will cause inclusion under Section 2035(d). If the grantor

retains the right to vote the stock until the end of the annuity term,

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he must survive an additional three years to ensure that the

property will be excluded from his estate.

i. End of Term. At the end of the annuity term, the property in the

GRAT can be distributed outright to the grantor’s children or other

beneficiaries, or retained in trust. One advantage of retaining the

property in trust is that the grantor’s spouse can be a beneficiary,

thereby permitting the couple to have some access to the property

during the spouse’s life and causing the trust to continue to be a

defective grantor trust.

j. Gift Tax Risk. GRATs have a significant advantage over other

gifting techniques because of the ability to define the retained

interest in terms of the initial value of the gifted property “as

finally determined for federal gift tax purposes”. Thus, if the gift

value is doubled, so is the retained annuity, and the net gift

increase is thereby muted.

k. Zero-Out GRATs

(1) Section 2702 provides that an interest in a trust retained by

the grantor will be valued at zero for purposes of

determining the value of the gift to the trust, unless the

retained interest is a qualified annuity interest, a qualified

unitrust interest or a qualified remainder interest. The

regulations under Section 2702 provide that the term of the

annuity or unitrust interest “must be for the life of the term

holder, for a specified term of years, or for the shorter (but

not the longer) of those periods.” Treas. Reg. § 25.2702-

3(d)(3).

(2) Despite the apparent statement in its own regulations

granting three options for the term of a GRAT, the IRS

took the position when issuing final regulations that an

annuity payable for a term of years (with annuity payments

continuing to the grantor’s estate if he or she died during

the term) always had to be valued as an annuity for a term

of years or the prior death of the grantor. The position was

not stated in the text of the final regulations; rather it was

illustrated in one of the regulation’s examples. See Treas.

Reg. § 25.2702-3(e), Example 5. The requirement that one

always must take into account the possibility of the

grantor’s death before the end of the term in valuing the

annuity had the effect of reducing the value of the annuity,

and increasing the value of the remainder interest and,

therefore, the value of the gift for a transfer to a GRAT.

Because of this and other requirements for valuing

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annuities, the IRS made it impossible to create an annuity

in a GRAT with a value equal to the value of the property

transferred (a “zero-out GRAT”).

(3) In Walton v. Commissioner, 115 T.C. 589 (2000), the

taxpayer challenged the position in the IRS regulations.

The Tax Court agreed that Example 5 in the regulations is

inconsistent with the purposes of the statute and declared

the Example invalid.

(A) The case involved Audrey Walton, the widow of

Sam Walton. In 1993, she transferred 7 million

shares of Wal-Mart stock to two GRATs in which

she retained an annuity of 59.22% for two years. If

she died during the term, the annuity payments

would continue to her estate. The GRATs failed to

produce the desired benefits. The price of Wal-

Mart stock remained essentially flat for two years,

and all the stock was paid back to Mrs. Walton to

satisfy the annuities.

(B) Mrs. Walton brought the suit to avoid a large gift

tax liability for the failed transfer. Her annuity

interests valued for the full two-year term resulted

in a gift to the GRATs of about $6,195. If her

annuity interest was valued as a right to receive

payments for two years or her prior death, as the

IRS asserted, the gift would be $3,821,522.

(C) The Tax Court first recognized that the IRS’s

regulations are entitled to considerable deference,

but, as interpretative regulations, they still could be

ruled invalid if they do not implement the

congressional mandate in some reasonable manner.

Based on the purpose of the statute and its

legislative history, the court concluded that there

was no rationale for requiring that the annuity be

valued as a two-year or prior death annuity. In

particular, the court noted that Congress referred to

the charitable remainder trust rules as a basis for the

Section 2702 provisions, and the regulations clearly

allowed a two-year term to be valued without prior

death contingencies in a charitable remainder

annuity trust.

(4) The ruling in Walton gives taxpayers the unique

opportunity to implement a technique that has no tax cost if

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it fails. By structuring the GRAT so the value of the

annuity equals the value of the property transferred, the

taxpayer can avoid using applicable exclusion or paying

gift tax. If the transferred assets increase significantly in

value during the term of the GRAT, some of that

appreciation is transferred out of the taxpayer’s estate tax

free.

(5) A zero-out GRAT often works best when the annuity term

is short (such as two years) and the GRAT is funded with

one stock. A single stock that performs well during a two-

year period easily can grow at an annual rate of 20% or

more over that time frame.

EXAMPLE: In June 2013 when the Section 7520 rate is

1.2%, an individual creates a two-year GRAT and funds it

with $500,000 of stock that has a current price of $25 per

share. He retains the right to receive an annuity of 53.18%

each year for the two years. The value of the annuity is

$500,000, and the gift when the individual creates the trust

is zero. If the stock increases to $30 per share after one

year, and $36 per share at the end of two years (a 20%

increase each year), there will be $135,020 left in the

GRAT at the end of the two years to pass to children tax-

free:

Initial Value of Stock: $500,000

End Year 1 Value 600,000

Annuity to Grantor: (265,900)

Beginning Year 2 Value $334,100

End Year 2 Value: $400,920

Annuity to Grantor: (265,900)

Property Remaining for Children: $135,020

(6) The property transferred to a two-year GRAT needs to

sustain a high growth rate for only a short period of time

for the GRAT to be successful. If the property does not

appreciate as anticipated, it all is returned to the grantor in

the annuity payments. The grantor then can create a new

GRAT.

(7) If a short term GRAT is used, it is better to isolate separate

stocks in separate trusts so that the losers do not pull down

the winners.

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(8) One issue in a straight-term-of-years, or Walton, GRAT is

how to minimize the estate tax consequences if the grantor

dies during the annuity term.

(9) In a GRAT with annuity payable for a term of years or the

grantor’s prior death, if the grantor is married, the trust

simply can provide that all the trust property will pass to a

marital trust for the surviving spouse, or will pour back into

the grantor’s estate plan and be allocated between the

marital and nonmarital trusts.

(10) If the grantor dies during the term of a term-of-years

GRAT, the annuity payments do not stop at the grantor’s

death; they are paid to the grantor’s estate (or revocable

trust if so designated in the GRAT). It is not entirely clear

whether the annuity payments and the GRAT corpus both

can be given to the surviving spouse and merged back

together to qualify all the property for the marital

deduction.

(11) In Notice 2003-72, 2003-44 I.R.B. 964 (November 3,

2003), the IRS acquiesced in Walton. On July 26, 2004,

the IRS issued proposed changes to Treas. Reg. § 25.2702

in which taxpayers would be allowed to structure the

annuity in a GRAT using a fixed term of years. However,

revocable spousal annuities could not be considered when

valuing the annuity interest. The IRS has now issued final

regulations on this.

F. Redemptions of Stock — §§ 302 and 303.

1. A redemption of a shareholder’s stock by the business is a very effective

way to terminate or reduce the shareholder’s interest in the business and

provide him or her with liquidity. The business itself is often in the best

position to fund a buy-out of a shareholder. Provisions for redemption of

stock are often found in buy-sell agreements, and are frequently privately

negotiated when a shareholder wishes to liquidate his or her investment.

2. A major problem in planning for redemptions (at least with respect to C

corporations) is that the corporation purchases the stock of a shareholder,

pursuant to a buy-sell agreement or otherwise, the proceeds paid to the

shareholder will be treated as dividend income, rather than proceeds from

a sale, unless the redemption qualifies as an exchange under Section 302

or 303 of the Code.

3. A redemption will only qualify for exchange treatment only if the

redemption: (a) is “substantially disproportionate,” (b) results in a

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“complete termination of the shareholder’s interest, (c) is not “essentially

equivalent to a dividend” in light of all relevant facts and circumstances,

or (d) is necessary to pay estate taxes resulting from inclusion of the

closely held stock in the shareholder’s estate.

4. Substantially Disproportionate Redemptions. A redemption will be

considered substantially disproportionate if:

the individual has reduced his percentage ownership

of the voting stock of the corporation by more than

20 percent;

the individual has reduced his percentage ownership

of the common stock of the corporation by more

than 20 percent; and

the individual owns less than 50 percent of the

voting power of the corporation after the

redemption.

EXAMPLE: Unrelated individuals A and B each own 50 of the 100

outstanding shares of XYZ common stock, and no other stock is

outstanding. The corporation distributes $30,000 to A in exchange for 20

of his shares. This redemption would qualify as an exchange because A

reduced his ownership in the common (and voting) stock by more than 20

percent. He owned 50 percent of the stock before the redemption (50

shares out of 100 shares) and 37.5 percent of the stock after the

redemption (30 shares out of 80 shares). Since his 37.5 percent ownership

is only 75 percent of his previous 50 percent ownership, he has had a

reduction of over 20 percent, as is required. Since after the redemption he

owns less than 50 percent of the stock, the redemption is substantially

disproportionate.

a. These required reductions in ownership would often be easy to

meet, were it not for the attribution rules that are applied in

determining ownership of a corporation. IRC § 318.

(1) The attribution rules provide that an individual is

considered to own not only the stock he owns outright but

also the stock owned by certain related parties.

Specifically, the following stock will be attributed to the

individual:

stock owned by members of his immediate family

(spouse, children, grandchildren, and parents);

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stock owned by certain entities (estates or trusts in

which he is a beneficiary, partnerships in which he

is a partner, and corporations in which he is a 50

percent shareholder); and

stock that he has an option to acquire.

(2) In addition, entities are considered to own stock owned by

their beneficiaries, partners, and shareholders (if the

shareholder is a 50 percent owner of the corporation).

b. These attribution rules can be applied more than once and become

very complicated. Redemptions in family-owned corporations

therefore often do not qualify under the substantially

disproportionate rules. In the example above, were the two

shareholders father and son the redemption would not have been

substantially disproportionate since, after the attribution rules were

applied, A would have been considered to own 100 percent of the

stock both before and after the redemption.

c. Special S Corporation Opportunities. Because of the unique ways

that the taxation rules of S Corporations interact with redemptions,

special opportunities may arise in connection with the redemptions

of S Corporation stock. In particular, it may be desirable to do

redemptions of stock, which are not “substantially

disproportionate” and therefore are treated as a dividend, but only

in cases where the S Corporation has sufficient “AAA” account so

that the “dividend” is treated as a distribution of previously taxed

income to the redeeming shareholder. This would allow, for

example, the redemption of a parent’s stock in an S Corporation to

the extent that the corporation has AAA accounts that can be used

to purchase the stock even though, if the corporation were a C

Corporation, the redemption would be taxed as a dividend. When

redemptions of S Corporation stock are being accomplished under

this technique, caution still has to be taken that the aggregate basis

of the redeeming shareholder in his S Corporation stock is equal to

or more than the redemption proceeds. In this regard, once again,

there is a special opportunity with S Corporations because all of

the basis attributable to all of the redeeming shareholder’s stock

can be used for these purposes.

5. Complete Terminations. To enable redemptions in family-held

corporations to qualify for exchange treatment, Code Section 302(b)(3)

was enacted. Section 302(b)(3) extends exchange treatment to a

redemption in which the entire interest of a shareholder in the corporation

(as shareholder, employee, director, or any other relationship except that

of creditor) is terminated after the redemption. (Since the individual is

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entitled to retain his interest in the corporation as a creditor, the

corporation is able to pay part of the redemption proceeds in the form of a

note).

a. The individual must not only terminate his entire interest in the

corporation, but must also sign an agreement whereby he

recognizes that exchange treatment will subsequently be denied if

he reacquires any interest in a prohibited capacity within ten years.

In addition, special problems arise if the redeeming party received

stock from or transferred stock to a related party during the ten-

year period immediately before the redemption.

b. If the requirements of Section 302(b)(3) are met, the family

attribution rules are waived. IRC § 302(c)(2). Thus, the individual

whose stock is redeemed will not be considered to own stock that

is owned by his spouse, children, grandchildren, or parents.

c. This type of redemption is useful in providing liquidity to an

individual; however, it is much less useful if an estate or trust is to

be the redeeming entity. This is because only family attribution is

waived, not the attribution to the estate or trust of stock owned by a

beneficiary. Thus, if any beneficiary of the estate continues to own

stock in the closely held corporation (as would normally be the

case in a family situation), the redemption will not qualify for

exchange treatment under this provision.

d. On the other hand, a complete termination of an estate or trust may

be effective if a family member of a beneficiary (rather than the

beneficiary himself) continues to own stock in the corporation.

Under applicable law, an estate or trust may waive family

attribution from a family member of a beneficiary to the

beneficiary if certain requirements are met. Specifically, both the

estate or trust and the beneficiary must meet all the requirements

for waiver, discussed previously. The beneficiary must also agree

to be jointly and severally liable for any additional tax assessed in

the event he acquires any interest in the company in a prohibited

capacity within ten years.

e. The applicable legislative history emphasizes that this provision

does not apply to waiver of attribution from a beneficiary to the

estate or trust. Thus, in planning for the estate, one should assume

that no complete termination of interest could be effected by an

estate or trust if any of its beneficiaries continues to own stock in

the corporation.

EXAMPLE: XYZ Corporation redeems all the stock held in a

trust of which an individual and his descendants are exclusive

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beneficiaries. The individual’s father owns all the remaining stock

of XYZ Corp. All the father’s shares are attributed to the

individual under the family attribution rules, and all the shares

deemed constructively owned by the individual are, in turn,

attributed to the trust under the entity attribution rules. If both the

trustee and the individual sign the required waiver agreement and

the individual agrees to be personally liable for any tax deficiency

resulting from a prohibited reacquisition, then the family

attribution rules may be waived and XYZ Corp.’s redemption from

the trust will be a complete termination of the trust’s stock interest.

On the other hand, if the individual or any of his descendants also

directly own shares of stock in XYZ Corp., those shares will be

attributed to the trust under the entity attribution rules for which no

waiver is permitted, and the trustee’s interest in XYZ Corp. cannot

be considered completely terminated.

6. Redemption Not Essentially Equivalent to a Dividend.

a. This determination must be made in light of all relevant facts and

circumstances.

b. The case law and IRS pronouncements can be difficult to

reconcile.

c. This provision will not apply if the redeemed shareholder, directly

or by attribution, is deemed to own all of the shares of the

corporation.

d. This provision is more readily available if the redeemed

shareholder does not control the corporation.

7. Redemptions To Pay Death Taxes. Code Section 303 provides special

statutory relief from the normal redemption rules in cases where the

redemption proceeds could be used to pay death taxes attributable to

inclusion of closely held stock in an individual’s estate.

a. Section 303 permits exchange (rather than dividend) treatment for

a redemption if more than 35 percent of the decedent’s gross

estate, as adjusted (gross estate less total allowable deductions for

funeral and administration expenses, debts, and losses), consists of

the stock of a corporation. If a decedent owned stock in more than

one corporation, and if he owned at least 20 percent of the

aggregate value of all of the outstanding shares (of all classes) of

each such corporation, the stock interests can be aggregated to

reach the 35 percent level. Stock deemed to be owned by

attribution cannot be included to reach the necessary 20 percent

level.

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b. Under Section 303, any stock included in determining the value of

the decedent’s gross estate is eligible for exchange treatment,

regardless of whether the estate actually owns the stock. Thus,

stock acquired from the decedent’s estate by an heir or legatee, or

by a surviving joint tenant, can be redeemed and exchange

treatment accorded if certain conditions are met. One such

condition is that the person redeeming the stock must be

responsible by operation of law or by operation of the provisions

of the decedent’s will for the payment of federal estate taxes.

c. Section 303 limits the amount of stock that is redeemable to the

aggregate of (a) all federal and state death taxes imposed because

of the decedent’s death and (b) the amount of funeral and

administration expenses allowable as deductions to the estate.

d. It is not necessary to actually use the money from the redemption

to pay the taxes and expenses. In fact, the corporation may

distribute property other than cash when it redeems the shares.

(Note, however, that the corporation will recognize gain if it

distributes appreciated property. IRC § 311.) A note may be used

if the corporation is short of cash and other property is not

available, as long as the note is a true debt instrument. Any

amount redeemed in excess of the taxes and expenses will

generally be considered a dividend to the estate, unless it qualifies

for exchange treatment under one of the other provisions discussed

previously.

e. A redemption under Section 303 must normally occur within 3

years and 90 days from the date when the federal estate tax return

is filed. If deferral of estate taxes is elected under Section 6166, a

redemption will qualify if it is made on or before the due date of

the last installment. However, any redemptions made later than 4

years after the decedent’s death are limited to whichever is less, (a)

aggregate death taxes and administration expenses remaining

unpaid just before the redemption, or (b) the total of the taxes and

administration expenses actually paid during the 1-year period

beginning on the date of the redemption.

f. Fairness Issues and Timing – Determining the price to be used for

a 303 redemption can be very ticklish.

(1) Obviously the price should not exceed the Federal Estate

Tax Value

(2) But that value is not finally known until the estate tax audit

is complete

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(3) Even the finally determined estate tax value can be

problematic if the shares sold are owned by individuals or

trusts whose interests aren’t exactly the same (example, a

second spouse)

(4) A note or contract of sale with a price adjustment with final

estate tax value is often used.

G. Deferral of Estate Tax — § 6166. One of the primary liquidity needs of an estate

stems from its liability to pay federal estate taxes. These taxes are normally due

nine months after the decedent’s death. Recognizing that serious liquidity

problems can exist in estates that consist primarily of closely held business

interests and attempting to make it unnecessary to sell such interests to pay death

taxes, Congress enacted another statutory relief provision to provide for a deferral

of the estate tax in certain situations (IRC § 6166).

1. Qualification

a. Citizen. This deferral can be taken advantage of only if the

decedent was a citizen or resident of the United States at his death.

b. 35 Percent Requirement. The value of his interest in a closely held

business exceeds 35 percent of the value of his adjusted gross

estate (defined in the same manner as under Section 303). In

determining whether the value of the decedent’s closely held

business interest meets the 35 percent test, the value of passive

assets of the business is not counted (IRC § 6166(b)(9)). Passive

assets are those assets not used in carrying on the trade or business.

Congress determined that the benefits of deferral should not be

available to estates holding closely held business interests that

consist largely of investment-type assets that can be liquidated to

pay estate taxes without hardship.

c. 14-Year Deferral and Payment. If the decedent was a U.S. citizen

or resident and the 35 percent test is met, the executor can elect to

defer for five years payment of the portion of the estate taxes

attributable to the closely held business interest (the total estate tax

multiplied by the ratio of the value of the closely held business

interest to the value of the adjusted gross estate) and thereafter pay

the deferred portion in up to ten annual installments. The final

installment would thus be due 14 years after the date the entire tax

would otherwise be due

EXAMPLE: A decedent’s adjusted gross estate is valued at $1

million. Of this amount, $700,000 is composed of a closely held

business, none of the assets of which are passive assets. The

decedent was a U.S. citizen at the time of death. In this example,

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since 70 percent (which is greater than 35 percent) of the adjusted

gross estate consists of a qualifying closely held business, 70

percent of the total estate taxes can be paid in installments.

Furthermore, the first installment may be deferred for up to five

years after the date the tax would otherwise be due.

d. Definition of “Closely Held Business”. For purposes of Section

6166, an active trade or business being operated as a

proprietorship, a partnership (if 20 percent or more of its total

capital is included in the decedent’s gross estate or if the

partnership had fewer than 45 partners), or a corporation (if 20

percent or more of the value of the voting stock is included in the

decedent’s gross estate or if the corporation had fewer than 45

shareholders) can each qualify as a closely held business interest

(IRC § 6166(b)(1)).

e. Attribution Rules. In determining the percentage owner-ship of the

business interests for purposes of the 20 percent test, an executor

may also elect to count interests not actually owned by the

decedent for estate tax purposes but attributable to the decedent

from members of the decedent’s family under IRC §267(c)(4); but

the price paid for that election is loss of both the five-year deferral

on the initial installment payment of the estate tax and the

favorable 2 percent interest rate on the deferred taxes (see 2.e.

below) (IRC § 6166(b)(7)).

f. Qualified Lending and Finance Business. The Economic Growth

and Tax Relief Reconciliation Act of 2001 (“2001 Tax Act”)

expanded the availability of deferral under IRC §6166 to

qualifying lending and finance businesses that otherwise might be

categorized as passive investments, effective for estates of

decedents dying after December 31, 2001 (IRC § 6166(b)(10)).

2. Passive Assets and Holding Companies. Because passive assets are

excluded for the purpose of valuing a business interest under Section

6166, a decedent’s closely held business probably will have to be

appraised twice for estate tax purposes if Section 6166 is to be used, once

as one entity and then a second time without including any passive assets

that the business may own. In determining the amount of tax that can be

deferred, passive assets will again be excluded from the calculation.

a. Stock in another business. Ordinarily, stock that the business owns

in another corporation will be treated as a passive asset for these

purposes, however, if the corporation is engaged in an active trade

or business and owns stock of a second closely held corporation

engaged in an active trade or business, an exception may apply. In

this case, if

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(1) at least 80 percent of the value of each corporation (without

regard to the stock of the subsidiary held by the parent

corporation) is attributed to assets used in a trade or

business, and

(2) either the parent corporation owns 20 percent or more in

value of the subsidiary’s stock, or the subsidiary has 45 or

fewer shareholders, then the two corporations will be

treated as one (IRC § 6166(b)(9)(B)(iii)). For estates of

individuals dying before January 1, 2002, the number of

shareholders of the subsidiary may not exceed 15 for the

parent and subsidiary to be treated as one corporation for

this purpose.

b. Holding Companies. In the alternative, the executor may make a

special holding company election, which permits the executor to

look through the parent (holding) company (or successive layers of

holding companies) for purposes of determining whether the

decedent owned a qualifying interest in a closely held business.

The stock of the holding company must not be readily tradable,

and shall be treated as voting stock of the underlying corporation

for purposes of the 20 percent ownership test if it is voting stock

and the holding company, in turn owns directly (or through the

voting stock of other holding companies) the voting stock of the

underlying company (IRC § 6166(b)(8)).

EXAMPLE: A decedent owned 50 percent of the common stock

of ABC Holding Company. ABC Holding Company owns 42

percent of the common stock of DEF Corp., which is a closely held

company engaged in an active trade or business. The date of death

value of ABC Holding Company is $500,000, and the total value

of the decedent’s adjusted gross estate is $1 million. Under

Section 6166, the decedent’s executor can elect to look through the

holding company and treat the decedent’s ABC stock as if it were a

21% percent interest in DEF Corp. The value of the closely held

interest exceeds 35 percent of the decedent’s adjusted gross estate,

and the estate will be deemed to own in excess of 20 percent of the

value of the voting stock of DEF Corp. since it is owned by the

holding company. Thus, the decedent’s ABC stock will qualify

under Section 6166.

Although this election permits holding company stock to qualify

for estate tax deferral, Section 6166 is not as beneficial to estates

owning holding company stock as to those owning stock in active

companies. The special 2 percent interest rate and the initial five-

year deferral are lost. The first principal payment will be due nine

80

months after the date of death, with the remaining payments due

annually over the following nine years.

In addition, a holding company can qualify for Section 6166

deferral even if it owns marketable securities in addition to the

interest in the active closely held business. However, in that case,

payments must be made in five installments, not ten.

c. Aggregation of Two or More Businesses. Interests in two or more

closely held businesses owned by the decedent, none of which

satisfy the 35 percent threshold test alone, can be aggregated for

purposes of that test if 20 percent or more of the value of each is

included in the decedent’s gross estate (IRC § 6166(c)). Stock or a

partnership interest held by a husband or wife as community

property or as joint tenants, tenants in common, or tenants by the

entirety, and stock or partnership interests held by the decedent’s

immediate family, are treated as owned by the decedent for

purposes of the tests already described (IRC § 6166(b)(2)).

d. Procedures. Notice of the election to defer estate tax must be filed

on or before the due date for filing the estate tax return (after

taking into account any extensions of time granted for such filing).

If there is some question as to the values to be assigned to the

decedent’s assets, especially the closely held business interests, a

protective election may be made. Notice of a protective election

must be filed on or before the due date for filing the return. If the

final values for the estate make the deferral provisions applicable,

the executor must then file a final notice of election within 60 days

after the values are finally determined, and include payment of any

taxes due that are not attributable to the closely held business. If

no election (protective or otherwise) is made and a deficiency is

later assessed, the executor may still elect, within 60 days after the

demand for payment of the deficiency, to pay the portion of the

deficiency attributable to the closely held business in installments

(see Treas. Reg. § 20.6166-1).

e. Interest. The deferral of tax liability under Section 6166 can be

viewed, in effect, as a loan from the federal government to the

estate. Accordingly, the government charges interest on the

amount “loaned.” A certain portion of the deferred tax qualifies

for a special 2 percent interest rate. This portion is equal to the

estate tax on the sum of $1 million (adjusted for inflation annually

beginning in 1999) plus the applicable exclusion amount, reduced

by the applicable credit amount. IRC § 6601(j). The “2 percent

portion” in 2016 is $1,480,000. The remainder of the deferred tax

bears interest at 45 percent of the rate set for tax deficiencies

(which is currently at 6 percent). Under TRA 1997, interest paid

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under § 6166 is no longer deductible for estate or income tax

purposes.

Before payment of the first installment of tax, the amount of

interest due is payable annually. Beginning with the first

installment, the interest thereafter is payable with each annual

installment. Interest paid is deductible as an administration

expense, but only as it accrues. When the interest becomes

deductible and the estate claims the deduction, the estate tax is

recomputed (Rev. Rul. 80-250, 1980-2 C.B. 278; Rev. Proc. 81-27,

1981-2 C.B. 548).

f. Acceleration.

(1) 50 Percent. Acceleration of the installment payments will

occur if 50 percent or more of the decedent’s interest in the

closely held business is disposed of or withdrawn from the

business (in the case of a holding company election, this

rule applies both to the holding company and the

underlying business) (IRC § 6166(g)). For this purpose,

transfers to beneficiaries, to the trustee named in a will, or

to an heir will not be considered dispositions. Moreover,

any subsequent transfer made because of the death of a

beneficiary who receives stock under the original

shareholder’s instrument will not be an accelerating event if

the transfer is made to a member of the beneficiary’s

family. A change in the form of operation of the business

(e.g., from a corporation to a proprietorship) or a mere

change in corporate form will not be considered a

disposition (although more substantive reorganizations are

considered dispositions).

(2) Delinquent Payment. Acceleration may also occur if the

payment of tax or interest is delinquent more than six

months beyond the due date for such payment. If the full

amount of a delinquent payment is paid within six months

of its original due date, acceleration will be avoided.

However, the delinquent payment loses eligibility for the 2

percent interest rate, and a penalty of 5 percent is imposed

for each month that the payment is late.

(3) Undistributed Income. If an estate that has elected to use

the deferral provisions has undistributed net income for any

taxable year ending on or after the due date of the first

installment, the executor must use that income to pay any

remaining unpaid estate tax (IRC § 6166(g)(2)). Further,

any dividend payments to a holding company from the

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underlying business will be treated as paid to the estate for

these purposes to the extent of the holding company stock

included in the estate.

(4) Section 303 Redemptions. Redemptions to pay death taxes

do not trigger acceleration of the tax, but, for purposes of

determining whether other distributions or withdrawals

cause acceleration to occur, the value of the closely held

business interest is reduced by the value of the stock

redeemed. This provision applies, however, only if on or

before, whichever is earlier, (a) the date of the first

installment due after the distribution or (b) one year from

the date of the Section 303 distribution, the executor pays

an amount of estate tax not less than the amount of the

property distributed in the redemption (IRC §

6166(g)(1)(B)). The determination of whether the executor

has paid estate tax not less than the amount of property

distributed in the redemption may be made either on a

cumulative basis (comparing the cumulative amount of

estate tax paid to the cumulative amount of redemptions) or

on a redemption-by-redemption basis (comparing the

amount of estate tax paid following the redemption to the

particular redemption) (Rev. Rul. 86-54, 1986-1 C.B. 356).

g. Planning Considerations. Because qualification for deferral of

estate tax depends on whether the closely held business interest

equals or exceeds a certain percentage of the decedent’s estate, it is

apparent that certain actions will either enhance or reduce the

chances that this deferral provision will be available to the

executor. Techniques such as lifetime gifts more than three years

before death to reduce the size of the estate can be useful.

h. In Estate of Roski, 128 T. C. No. 10 (April 12, 2007). The Tax

Court held that the Internal Revenue Service has no authority to

require a bond or special lien in every situation in which an estate

elects to pay it tax in installments under Section 6166.

(1) A primary liquidity need of an estate stems from its liability

to pay federal estate taxes which are normally due nine

months after the date of the decedent’s death. Recognizing

that serious liquidity problems can exist in estates that

consist primarily of closely-held business interests, and

attempting to make it unnecessary to sell such interests to

pay death taxes, Congress enacted Section 6166 to provide

for the deferral of the estate tax in certain situations. If a

decedent was a citizen or resident of the United States at

his or her death and the value of his or her interest in a

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closely-held business exceeds 35% of the value of his or

her adjusted gross estate, the executor can elect to defer for

five years the payment of the portion of the estate tax

attributable to the closely-held interest and thereafter pay

the deferred portion in up to ten annual installments. The

final installment is due fourteen years after the date the

entire tax would otherwise be due.

(2) The deferral of tax liability under Section 6166 can be

viewed, in effect, as a loan from the federal government to

the estate. Accordingly, the government charges interest on

the amount “loaned.” A certain portion of the deferred tax

qualifies for a special 2% interest rate. The remainder of

the deferred tax bears interest at 45% of the interest rate set

for tax deficiencies (which is currently 8%). This interest

may not be deducted as an administration expense. In

addition, under Section 6166(k), the IRS may require a

special lien or a bond.

(3) Edward Roski died on October 6, 2000. On January 4,

2002, the executor filed the federal estate tax return

reporting a balance due of $32,778,372 and elected to defer

payment of the balance under Section 6166.

(4) In September 2003, the IRS notified the estate that it had

received the notice of Section 6166 election. Because of

the notice of election, the estate was required to either post

a bond or in lieu of a bond provide a special lien under

Section 6324A. The estate responded by requesting that

the IRS exercise its congressionally mandated discretion

and require neither the posting of a bond nor the imposition

of the special lien. The estate indicated that it was unable

to find a bonding company willing to underwrite the

amount in question. Even if the estate were to obtain a

bond, the estate’s adviser believed that the cost would be

prohibitive. The estate contended that the assets of the

estate were part of a well established family owned

business which should provide assurance of the availability

of adequate funds to pay the estate tax liability. It noted the

government already had security for the payment of the

estate’s deferred tax in the form of the statutory lien

provided under Section 6324. The imposition of a special

lien in lieu of a bond would adversely affect the estate’s

ability to carry on the closely-held business. Finally the

imposition of the special lien would violate covenants in

various partnership agreements of the closely held business.

The IRS responded by stating that the estate could not

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make the Section 6166 election because the estate failed to

provide a bond or special lien.

(5) The estate sought the relief under Section 7479 which

allows an estate making a Section 6166 election in which

there is a controversy with the IRS to avoid paying the tax

and seeking a refund in order to resolve dispute. Both the

IRS and the estate moved for summary judgment on this

issue.

(6) The Tax Court first noted that IRS has changed its position

regarding whether a bond is required for a Section 6166

election four times over the last fifteen years. The court

then found that the IRS has no authority to require a bond

or special lien in every case. By doing so, the Internal

Revenue Service was making the furnishing of security a

substantive requirement of Section 6166 and Congress did

not intend this. Further, the IRS’s adoption of a standard

that precluded the exercise of discretion was grounds to set

aside the determination made by the IRS. The court, in

somewhat harsh language, stated that by adopting a bright

line rule in every case, the IRS had shirked it administrative

duty to state findings of facts and reasons to support its

decisions that are sufficient to reflect a considered

response. The court indicated that it lacked the facts to

decide the merits of the estate’s assertion that furnishing

security was unnecessary in this case. Consequently,

neither the estate’s nor the IRS’s motion for summary

judgment was granted.

H. Relationship of Sections 303 and 6166.

1. There is no acceleration of unpaid estate taxes deferred under section 6166

if the estate pays an amount of tax on or before the date of the next

installment equal to or greater than the amount received from the section

303 redemption. If this is done, however, the closely held business

amount under section 6166 is reduced relating back to the date of the

decedent’s death. This means that an earlier disposal of a portion of the

closely held business that was within the 50 percent safety zone may no

longer be in the safety zone. Reg. Section 20.6166A-3(d)(2). Rev. Rul.

72-188, 1972-1 C.B. 383.

2. Generally, a series of redemptions will produce the optimum benefits of

sections 6166 and 303. To obtain the maximum dollar benefit from

section 6166, the deferral period must be maximized. But this creates

problems with a redemption under section 303 and the four-year time

limitation. In general, the maximum benefits under section 6166 can be

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obtained if there are a series of redemptions. The first redemption should

occur within four years of the decedent’s death and be in the amount of the

death taxes, interest, funeral expenses and costs of administration that

have been paid up to the time of the redemption. As each installment is

paid under section 6166, there would follow a redemption under section

303. Private Letter Ruling 8204129 involves a series of redemptions

under section 303 and the effect on a section 6166 election.

3. One pitfall that the practitioner must be cautious about concerns

acceleration of the unpaid federal estate taxes under section 6166 with a

redemption under section 303. As pointed out above, there is an

acceleration of the unpaid federal estate taxes deferred under section 6166

if more than 50 percent is withdrawn from the closely held business.

Section 6166(g)(1)(B) provides a safe harbor with a redemption under

section 303 if there is paid an amount of tax equal to the value of property

and cash withdrawn from the corporation. It should be noted, however,

that the value of the closely held business amount under section 6166 is

reduced relating back to the date of the decedent’s death. This means that

an earlier disposal of a portion of the corporation that was within the 50

percent safety zone may no longer be within the safety zone. See Reg.

section 20.6166 A-3 (d)(2); Rev. Rul. 86-54, I.R.B. 1986-15, 44, April 14,

1986; and Rev. Rul. 72-188, 1972-1 C.B. 383.

4. Revenue Ruling 86-54 provides an explanation of the application of

sections 303 and 6166 when shares of stock are redeemed and an election

to pay the estate tax in installments is made. This ruling modified

Revenue Ruling 72-188.

a. Deductibility of Interest Incurred to Pay Estate Tax.

(1) Section 2053(a)(2) allows a deduction for administration

expenses that are allowable by the law of the jurisdiction in

which the estate is being administered. Regulation section

20.2053-3(a) provides that expenses actually and

necessarily incurred are expenses “in the collection of

assets, payments of debts, and distribution of property to

the persons entitled to it.” If the loan is not necessary to the

proper administration of an estate, interest on the loan is

not deductible as an administration expense. In Ruper v.

United States, M.D. Pa., No. 1:CV-03-0421 (October 22,

2004), the Court held that an estate did not provide factual

details to support a finding that a loan incurred to pay the

estate taxes attributable to lottery winnings was necessary

to the administration of the estate.

(2) Regulation section 20.2053-1(b)(3) prohibits a deduction

taken upon the basis of a vague or uncertain estimate. That

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Regulation states: “If the amount of a liability was not

ascertainable at the time of final audit of the return by the

District Director and, as a consequence, it was not allowed

as a deduction in the audit, and subsequently the amount of

liabilities ascertained, relief may be sought by a petition to

the Tax Court or a claim for refund.”

(3) Interest on loans incurred by an estate to pay its estate tax

obligation in a single payment have been held to constitute

a deductible administration expense, even though the estate

could have elected to pay the tax in installments under

section 6166 pursuant to the terms of the stock restriction

agreement. See McKee, T.C., CCH P. 13,058. In Private

Letter Ruling 200020011, the Internal Revenue Service

ruled that interest attributable to a loan obtained from a

commercial lender to pay off federal estate taxes deferred

under section 6166 is deductible as an administration

expense under section 2053(a)(2).

(4) In Revenue Ruling 84-75, 1984-1 C.B. 193, the personal

representative had borrowed funds to pay the estate tax so

as to avoid a forced sale of estate assets. The Internal

Revenue Service found that the loan was reasonably and

necessarily incurred in administering the estate, therefore

the interest incurred on the loan was deductible as a cost of

administration under section 2053(a)(2). Because the

estate’s payments on the loan could be accelerated,

however, the amount of interest to be paid by the estate was

uncertain. The Service ruled that interest could only be

deducted after the interest accrued and any estimate of

future interest was not deductible.

(5) If the interest on the unpaid estate tax is taken as an estate

tax deduction, the Internal Revenue Service will only allow

the deduction as the interest is paid. Bailly Estate v.

Com’r, 81 T.C. 246 (1983); Rev. Rul. 80-250, 1980-2 C.B.

278. To deduct the interest on unpaid estate tax on the

estate tax return, the personal representative must file

amended returns claiming the interest as the interest was

paid. The amended returns must be filed within the

applicable statute of limitations, which is three years from

the date of filing or two years from the date of payment of

estate tax. Internal Revenue Code section 6511. If interest

is paid after the applicable statute of limitations, the estate

cannot obtain a refund of estate tax.

b. Nondeductibility of Section 6166 Interest Payments.

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(1) When the Taxpayer Relief Act of 1997 reduced the interest

rate to two percent and 45 percent of the general

underpayment rate, the Act also eliminated the deductibility

of the interest for both federal estate and income tax

purposes.

(2) For decedents dying before December 31, 1997, however,

the interest on the unpaid estate tax could have been used

as a deduction on the estate tax return or as a deduction on

the fiduciary income tax return. Thus, for decedents dying

before December 31, 1997, it was necessary to file an

amended estate tax return as each interest payment was

made.

I. Alternative Strategy: Third Party Borrowing With Estate Tax Deduction For

Interest Payments

1. General Description.

a. Electing the benefits of section 6166 is not the only long-term

borrowing options available to the personal representative of a

business owner’s estate. Another option available to the personal

representative is borrowing from a third party, including borrowing

from an entity controlled by the decedent’s estate or beneficiaries.

b. A personal representative of a business owner’s estate may prefer

not to elect the benefits of section 6166, but to borrow funds from

a third party to pay the federal estate tax. Borrowing from a third

party may allow the personal representative to deduct the interest

payment as a cost of administration under section 2053(a)(2). It

may be possible to structure the loan arrangement so that the entire

interest payment over the term of the loan can be deducted as a

cost of administration when the estate tax return is filed. This

technique is based on the Tax Court memorandum decision in

Estate of Graegin.

2. Estate of Graegin.

a. Estate of Graegin v. Commissioner, T.C. Memo. 1988-477,

involved the deductibility of a balloon payment of interest due

upon the maturity of a loan incurred to pay Federal estate taxes.

The issue was whether the interest was a deductible administration

expense under section 2053(a)(2). The assets in Mr. Graegin’s

estate consisted primarily of stock in a closely held corporation.

After payment of state inheritance taxes and other expenses, the

estate had $20,000 of liquid assets remaining. Rather than sell the

stock in the closely held corporation, the estate borrowed funds

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(approximately $200,000) from a wholly-owned subsidiary of the

closely held corporation to pay the estate taxes. The term of the

promissory note evidencing the loan was 15 years and the interest

rate was 15 percent simple interest (equal to the prime rate on the

date of the loan). All principal and interest of the loan was to be

repaid in a single balloon payment at the end of the term and the

loan agreement contained a prohibition against early repayment.

(The 15-year term was selected because it was the life expectancy

of the income beneficiary of the trust.) The estate requested and

obtained the approval of the local probate court for the personal

representatives to enter into the loan. The estate deducted the

amount of the single-interest payment due upon maturity of the

note ($459,491) on the federal estate tax return as a cost of

administration. The Internal Revenue Service disallowed the

interest expense on the basis that the expense was not actually

incurred and was unlikely to occur because the relationship of the

parties made the repayment of the loan uncertain. The estate

pursued the deduction in Tax Court.

b. The Tax Court found that the amount of interest on the promissory

note was not vague but was capable of calculation and that the

parties intended to pay the loan on a timely basis. For that reason,

the Tax Court held that the entire amount of the interest on the note

was deductible as a cost of administration under Section

2053(a)(2).

3. The Position of the Internal Revenue Service Post Graegin.

a. The Internal Revenue Service issued a Litigation Guideline

Memorandum dated March 14, 1989 in response to Graegin. In

the Memorandum, the Service repeated its position that interest on

indebtedness was deductible as an administration expense if the

indebtedness is incurred to enable the estate to pay taxes due

without selling non-liquid estate assets at a forced sales price. In

order to be deductible, the interest must be certain to be paid, and

the amount must be subject to reasonable estimation. Because the

loan in Graegin was found by the Tax Court not be uncertain, the

Internal Revenue Service stated that the result in Graegin was not

inconsistent with the arguments advanced by the Service.

b. In the Litigation Guideline Memorandum, the Internal Revenue

Service raised additional arguments to challenge a situation similar

to Graegin. First, the loan must be bona fide and financing

between related entities is subject to stricter scrutiny than arms’

length dealings. If the underlying loan arrangement is not bona

fide, there can be no deduction allowed for the interest on the debt.

In the Memorandum, the Service mentioned another factor to be

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examined, the treatment by the lender of the interest. The related

lender should accrue interest income so that the tax treatment is

consistent between the lender and the borrower. Also, the Service

stated that the transaction must have substance and unusual

financing techniques, such as unsecured loans, high rates of

interest, and loans with long terms should have close scrutiny

especially if less expensive lending alternatives are available from

third party sources.

4. Rulings by the Internal Revenue Service.

a. Private Letter Ruling 199903038 involved a request for a ruling

that a deduction may be claimed on a federal estate tax return for

the total amount of interest that would be paid over the term of an

installment loan. The loan was from a commercial bank and would

provide for annual payment of both interest and principal over a

specified term of years not to exceed seven years at a fixed rate of

interest. The note also provided that principal and interest may not

be prepaid. The Service ruled that the deduction may be claimed

on the estate tax return for the entire amount of post-death interest

provided the expenses were necessarily incurred in the

administration of the estate (which was a factual determination on

which the Service did not rule). The favorable ruling was

conditioned on the estate obtaining approval for the proposed

transaction from the appropriate local court.

b. Private Letter Ruling 199952039 reached a similar result.

5. Recent Internal Revenue Service Technical Advice Memorandum.

a. In Technical Advice Memorandum 200513028, the Internal

Revenue Service disallowed interest on a Graegin-style note

executed by a partnership making a loan to the estate owning the

partnership interest. The facts in that Technical Advice

Memorandum are as follows. The decedent formed a limited

partnership and contributed assets to the partnership in exchange

for a two percent general partnership interest and a 97 percent

limited partnership interest. The decedent died 5 ½ years after

formation of the partnership. The decedent’s estate consisted

primarily of the decedent’s 97 percent interest in the limited

partnership. Approximately 57.6 percent of the partnership assets

consisted of publicly traded stocks, bonds, and cash. The

remaining partnership assets consisted primarily of real property

(17.5 percent) and installment sale notes (24.7 percent).

b. Under the decedent’s will, the residue of the decedent’s estate,

which included the decedent’s limited partnership interest, was to

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be distributed to separate trusts for the benefit of his two children.

One of the decedent’s children and a third party were personal

representatives of the decedent’s estate. Before the filing of the

estate tax returns, the personal representatives and one of his

children, as a general partner of the partnership, executed a

promissory note with the estate as the borrower and the partnership

as the lender. The promissory note matured 10 years from the date

of the note. Prepayment of principal and interest was prohibited by

the terms of the note. The Estate’s 97 percent limited partnership

interest was pledged as security pursuant to a separate security

agreement for the payment of the note. The interest rate was one

percent above the prime interest rate. The Technical Advice

Memorandum mentioned that the average interest rate for 15 year

mortgage loans was two percent less than the prime interest rate at

the time of the loan. On the federal estate tax return, the personal

representatives claimed a cost of administration deduction under

section 2053(a) for the amount of the interest payable over the 10-

year term of the loan.

c. In the Technical Advice Memorandum, the Internal Revenue

Service disallowed the interest deduction for the following reasons.

First, the Service did not believe that the loan was necessary to the

administration of the estate. Because the partnership held

substantial liquid assets, and the child was a co-executor of the

estate and a general partner of the partnership, the child could force

the partnership to distribute liquid assets to the estate with which to

pay the estate taxes. The Service stated there was clearly no

fiduciary restraint on the child’s ability to access the partnership

funds. Because the same parties stood on all sides of the

transaction, the partnership assets were readily available for the

purposes of paying the estate tax. In addition, the Service believed

it was questionable whether the estate would actually make the

payments in accordance with the terms of the promissory note. In

addition, if the estate did make the payments, there would be no

change in the economic position of the parties involved.

Accordingly, the Internal Revenue Service disallowed the interest

expense.

6. Many states which have a separate estate tax permit a decedent’s estate to

defer the payment of the state estate tax under Section 6166 and pay the

state estate tax in installments. However, the regulations to Section 2058

provide that the deduction for state estate tax can only be taken when paid.

a. If an estate makes a 6166 election to defer state estate tax as well,

this means that the Section 2058 deduction can only be taken in

part as each installment is paid. This causes a recalculation of the

amount of federal tax each time an installment is paid since an

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installment payment of state tax reduces the total amount of federal

tax. It also causes a recalculation of the amount for which the

Section 6166 election can be made and the need to request a refund

each time an installment is made.

b. To avoid this, an alternative is to use a Graegin note to provide the

funds to pay the state estate tax and take the Section 2058 state tax

deduction up front. In addition, the interest on the Graegin note

can be deducted.

J. Using discounts in valuing closely held business interests.

1. The valuation for estate and gift transfers of interests in a closely held

business or partnership offers significant opportunities for tax savings.

The courts have held that a majority interest has more value than a

proportionate share of a business’s total value, while a minority interest

has less value than a proportionate share. A business owner, therefore,

should look to fractionalization and dispersal of such interests, both as a

defensive measure to eliminate the control premium which the IRS will try

to attribute to a majority holding, and as an offensive measure to obtain a

minority discount on a minority holding. The business owner also should

be sure to take advantage of discounts for lack of marketability, which

should apply to all closely held assets, whether the person holds a majority

interest or a minority interest.

EXAMPLE: Paul owns 100% of Acme Corp. and fears that at his death

or the death of his wife, the IRS will impose ruinous estate taxes on the

value of the business. To reduce this threat, he starts a gift program. He

gives 50% of the stock to his wife, Mary. Since this is a marital gift, it is

not subject to gift tax. Each spouse then makes annual gifts to each of

their three children of 1% of the company stock, using their $10,000

annual gift tax exclusions and some of their lifetime applicable credit

amount exemptions. Annual gift tax returns are filed and a 40% discount

is claimed against each gift for a minority holding and lack of

marketability. At the end of 8 years, 48% of the stock has been removed

from the estates of Paul and Mary at a very low gift tax cost. At Paul’s

death, his 26% of the stock is reported for estate tax purposes at a

discounted value since it is also a minority holding. Paul’s will leaves

some of the stock to his children and some to his wife, but not enough to

give her majority control. Thus, none of the transfers will be of a majority

holding. The control premium is avoided and minority discounts should

be allowed.

a. A lack of marketability discount is available for closely held stock

because there is no ready market for the stock. It is not traded on

an exchange. This illiquidity renders the stock less attractive than

publicly traded stock and justifies a reduction in value. The

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discount for lack of marketability in reported cases and rulings

ranges from 15% to as high as 50 or 60% in exceptional situations.

b. A discount for lack of control, commonly called a “minority

interest discount,” is appropriate when the stock being valued does

not carry control of the company and the owner of the stock is

unable to dictate the company’s management or distribution

decisions. A discount is applicable because the buyer is unable to

influence his return on investment. A willing buyer would take this

lack of control into account in making an offer to purchase a

minority block of stock. The “control premium” is the flip side of

the minority discount. It is the value added to a block of stock to

reflect the fact that the owner controls the company. Market

studies and cases indicate that the minority interest discount (or

control premium) often is in the range of 15% to 40%. Thus, the

combined effect of marketability and minority interest discounts in

valuing closely held stock could be very significant.

2. Although market studies, case law, and IRS rulings provide evidence of

the range of discounts generally available, it is very risky to use a discount

without the supporting opinion of a professional appraiser. If the IRS

challenges the value assigned to a company, or the discount used in

deriving that value, the taxpayer bears the burden of proving that his

valuation is correct. He will be in a difficult position if he selected a

discount informally and then must hire a professional appraiser after a

transfer of stock has taken place to confirm that he was correct. The IRS is

more likely to question a taxpayer’s valuation position if they see that it is

not already supported by an appraisal. The IRS recognizes that it is in a

better position to obtain additional tax dollars from the taxpayer in a

settlement because the taxpayer will be motivated to avoid the expense of

hiring an appraiser at the time of audit.

3. Taking advantage of these discounts for transfers of closely held stock is a

critical component in reducing future estate tax liability. A taxpayer can

take advantage of these valuation discounts when he gives away closely

held stock or partnership interests during his life. Lifetime gifts of small

interests in the asset may permit the donor to use minority interest

discounts, or, in the case of real estate, fractional interest discounts. These

discounts may not be available to the same degree when the stock is

subject to estate tax at death.

EXAMPLE: Assume that ABC Corp. is worth $50 million on an

undiscounted basis, and that Parents make lifetime gifts of a 5% interest in

ABC Corp. to their children. That interest has an undiscounted value of

$2.5 million. If it is discounted 35% for lack of marketability and

minority interest, they can gift the interest for a tax value of about $1.63

million. If they retain the interest until the death of the survivor, the

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discount for lack of marketability is still available. However, if the

survivor has more than 50% of the stock, a control premium might apply

that entirely offsets the lack of marketability discount. Stock that is given

away for $1.63 million during life may have a value of $2.5 million, or

even more, if retained at death.

4. Gifts of closely held stock are often made easier by creating a class of

nonvoting stock in the family business. This has several advantages:

a. A parent can transfer stock to children without reducing his or her

voting interest in the company.

b. The issuance of nonvoting stock can be used to dilute the per share

value of stock, making it less costly to transfer interests in order to

eliminate a control premium. For example, the transfer of a 5%

interest in ABC Corp. in the illustration above required a gift of

$1.63 million even after valuation discounts. If ABC Corp. issued

9 shares of nonvoting stock for each share of voting stock, then

90% of the equity value of the company would be isolated in the

nonvoting stock. A 5% interest in the voting stock would be worth

only $250,000, or $163,000 after discounts.

c. If in the future one child assumes a primary management role in

the company, the parent can transfer voting control to that child

while treating other children equally from an economic standpoint

by transferring nonvoting stock to them.

5. The use of discounts is effective because valuation for transfer tax

purposes is based upon the value which hypothetical willing buyers and

willing sellers would negotiate for that particular transfer. Therefore,

taxpayers can create complicated structures of ownership of business

interests or investments, which would make such instruments of

ownership less attractive (and therefore less valuable) to the hypothetical

buyer or seller, even though the family members would be comfortable

with such instruments.

K. Limited Partnerships and Limited Liability Companies.

1. Over the past 15 years, many individuals have been using a family-owned

partnership or limited liability company as a vehicle for managing and

controlling family assets. A typical family partnership is a limited

partnership with one or more general partners and limited partners.

Usually, the parents act as general partners of the partnership or own a

controlling interest in a corporate general partner. As general partners, the

parents manage the partnership and make all investment and business

decisions relating to the partnership assets. The general partnership

interest usually is given nominal value, with the bulk of the partnership

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equity being limited partnership interests. Initially, the parents receive

both general partnership interests and limited partnership interests.

Thereafter, the parents can transfer their limited partnership interests to the

children.

EXAMPLE: Parent transfers $10,000 of his $1,000,000 of real estate,

cash and securities to his children. Parent contributes the remaining

$990,000 of investments to a newly formed partnership, to which the

children contribute their $10,000. Parent receives a general partnership

(GP) interest worth $10,000 and limited partnership (LP) interests with a

net asset value of $980,000. The children receive $10,000 of LP interests.

Parent make gifts of the $980,000 of LP interests to children.

2. A limited liability company (“LLC”) can be structured in much the same

way as a limited partnership. The parents or one of them, often act as

Manager and thereby control the decision-making. Initially, the parents

receive the bulk of the LLC member interests. Over time, they can

transfer most or all of those interests to their children. The LLC can

provide an attractive alternative to the use of a partnership, especially

where there is a desire to limit the personal liability of all the participants

in the entity without having to create a separate entity for the general

partner.

3. Non-Tax Estate Planning Benefits

a. The limited partnership or LLC addresses the problems faced by

many individuals who may be in a financial position that would

permit them to gift property to children, but who are reluctant to do

so because they are unwilling to give up management and control

of the property, or do not want children to own the property

directly.

b. The limited partnership or LLC interests represent a right to a

share in the entity income and capital, but grant no voice in

management of the entity. This structure permits an individual to

make gifts of limited partnership or LLC interests to his spouse,

children, and (eventually) more remote descendants, without

transferring the underlying assets. As general partner of the

partnership or manager of the LLC, the individual can continue to

exercise control over the transferred interests. Thus, the individual

can transfer interests in the entity to reduce the value of his estate,

and retain authority to manage the property. This combination is

difficult to achieve in most circumstances. Normally, if a person

gives away property, he can no longer exercise control over it.

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c. The partnership or LLC agreement also can restrict the ability of

any recipient of interests to make further transfers of those

interests, by limiting the persons to whom any transfer could be

made during life or at death, and the amount that the entity would

be willing to pay a partner upon liquidation of his or her interest.

These restrictions will help ensure that the interests are kept in the

family and will help protect the underlying assets from potential

creditors of a child, or from a spouse of a child in a failed

marriage.

d. Many of the benefits that a partnership or LLC provides also can

be achieved by making gifts to an irrevocable trust for children or

more remote descendants. In a number of respects, though, a

partnership or LLC provides flexibility not available in a trust.

(1) Unlike an irrevocable trust, the terms of the partnership or

LLC can be amended to address changing circumstances.

(2) A partnership or LLC gives the managing partner or the

manager greater latitude with respect to management

decisions than a trustee of a trust may have. A managing

partner’s or manager’s actions will be judged under the

“business judgment rule” rather than the more restrictive

“prudent man rule” applicable to a trustee.

(3) Although an individual who creates an irrevocable trust

often can retain management control over trust assets by

naming himself as investment adviser, the individual

generally cannot retain the trustee’s discretionary authority

to make distributions without causing Code Sections 2036

or 2038 to apply.

(4) The long-standing law with respect to business entities has

been that the individual can retain this control as general

partner of a limited partnership or manager of the LLC

without Section 2036 or 2038 applying. See United States

v. Byrum, 408 U.S. 125 (1972). The IRS has ruled that the

general partner’s powers do not cause transferred limited

partnership interests to be included in his estate under

Section 2036 or 2038 because the partner’s authority is

considered to be limited by his fiduciary obligations to

other partners. Letter Rulings 9415007 (August 26, 1994);

9332006 (August 20, 1993); 9131006 (April 30, 1991). In

Estate of Strangi v. Commissioner, T.C. Memo 2003-145,

this principle became subject to question for the first time,

and the IRS now is aggressively attacking it.

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4. Family partnerships also can be used in many cases to obtain additional

valuation discounts. It should be possible to discount the value of the

limited partnership interests for gift and estate tax purposes below the

value of the underlying partnership assets because the interests lack

marketability and control. As with interests in a closely held corporation,

there is no ready market for closely held limited partnership interests. By

their very nature, limited partnership interests do not participate in

management of the partnership and therefore lack control. These

characteristics of a limited partnership interest make it less valuable than

the assets transferred upon formation of the partnership. In effect, one can

transfer assets to a partnership in order to create a closely held business

and take advantage of discounts where they otherwise would not be

available. The benefit of these discounts, of course, is that they enable an

individual to give away more property.

EXAMPLE: After creating a partnership with $1,000,000 of real estate,

cash and securities, Parent gifts $980,000 of LP interests to his children.

He discounts those interests by 35% to reflect their lack of marketability

and control. This enables Parent to transfer the LP interests for $637,000,

and possibly shelter the entire gift with applicable credit amount and

annual exclusions.

5. A family partnership can be particularly beneficial with assets such as real

estate (held directly or through other partnerships) and business assets,

because it permits ownership to remain consolidated while economic

interests in the assets are given away in the form of partnership interests.

The partnership also can hold other investment assets, such as marketable

securities. (A family partnership cannot hold stock in a Subchapter S

corporation because a partnership cannot qualify as a Subchapter S

shareholder.)

6. A family partnership also may be used to shift future growth in the value

of assets to younger generations, permitting that growth to escape transfer

tax, while at the same time permitting an individual to retain the income

from those assets. This is done by creating a partnership with two basic

types of interests, (i) those that have a fixed value but a preferred cash

flow (“frozen interests”), and (ii) those that share in all future appreciation

(“growth interests”). This technique is called a partnership “freeze.” In a

family partnership structured as a freeze, Parents retain the frozen

partnership interests and give the growth interests to their children or

grandchildren, either immediately or over time. The goal is to transfer all

or substantially all of the growth interests, because as the underlying

partnership assets appreciate, that appreciation is allocated only to the

growth interests. If descendants hold all of the growth interests, they will

benefit from all appreciation of partnership assets, without any transfer tax

cost. Parents also would retain small general partnership interests if they

wanted to maintain control of the partnership.

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7. Current law requires that the preferred “dividend” on a frozen partnership

interest be cumulative and fixed at a market rate in order to avoid gift tax

consequences when the frozen partnership interest is created. However,

any income from the partnership in excess of the required return, as well

as all growth of partnership assets, would pass to the Parents’ children as

holders of the growth partnership interests. Because a partnership is a

flow-through entity for income tax purposes, pretax earnings can be used

to support the preferred payments on the frozen interest.

EXAMPLE: Parents form a family partnership with $20 million of real

estate and marketable securities. The partnership assets produce a current,

pretax yield of 5% annually and appreciation of 6% annually. The frozen

interests will receive a preferred right to partnership income (the

“preferred yield”) equal to 8% of their initial fair market value. If the

partnership is formed with assets that provide a 5% cash return, then the

partnership will produce $1 million of cash flow initially ($20 million x

5%). If the frozen interests must pay an 8% preferred yield, then up to

$12.5 million of frozen partnership interests can be created (because $12.5

million x 8% = $1 million). Therefore, in this example, the partnership

would issue up to $12.5 million of frozen interests, and $7.5 million of

growth interests. Parents would then make a gift of all or part of the

growth interests to their descendants or trusts for their benefit.

Each year, the partnership would make a preferred distribution of $1

million to Parents. The growth on the partnership assets and any income

earned by those assets in excess of the preferred distribution will accrue to

the benefit of the growth partners, without estate tax in either Parent’s

estate. If the partnership continues to invest in assets that yield a 5%

pretax income and with appreciation of 6% annually, and assuming that all

income over the preferred yield is reinvested, then at the death of the

surviving spouse 25 years after formation of the partnership, the

partnership assets will have increased in value by about $65 million, all of

which will have accrued to the benefit of the owners of the growth

partnership interests without transfer tax. If Parents’ descendants own all

of the growth interests, this will save over $35 million in estate taxes.

8. Partially offsetting the benefit of this shift in appreciation is the fact that

Parents are receiving annual preferred income payments, which will

increase their estates. In addition, the growth partners are giving up most

of the current return on their investment in the partnership, at least in the

initial years, in order to satisfy the preferred income payments to the

frozen partners. These facts have to be taken into account in determining

the overall economic benefits from a partnership freeze. However, as long

as the benefits that the growth partners receive from the partnership, in the

form of appreciation and excess income, exceed the income lost to the

frozen interests, the growth partners generally will benefit overall from the

arrangement.

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9. It may be desirable to create frozen interests even if the family is not

interested in a freeze per se. Frozen interests can be used to maintain a

stream of income for the senior family members even after they give away

most of the equity in the partnership.

EXAMPLE: Assume that the assets in a $1 million partnership produce

net income of about $40,000 per year. Parent is willing to give away a

substantial portion of his growth interests but wants to maintain an income

stream of about $30,000 per year. Instead of creating $980,000 of growth

LP interests, Parent can retain $300,000 of frozen LP interests that give

him a preferred return of 10% annually and $680,000 of growth LP

interests. He can gift the growth interests to his children and retain

$30,000 of cash flow.

L. S Corporations.

1. Definition of S Corporation. Subchapter S of Chapter 1 of the Internal

Revenue Code permits an electing corporation to be taxed in a manner

similar to a partnership and thereby avoid double taxation on corporate

earnings. Generally speaking, an S corporation is not taxable as a separate

entity. Instead, the corporation’s income, loss, deductions, and credits are

passed through pro rata to its shareholders, who must include these items

in the computation of their separate income taxes (Section 1366). Section

1361(b)(1) sets out the requirements that must be satisfied in order for a

corporation to elect and maintain S corporation status.

2. Requirements for S Corporation Status.

a. No more than 100 shareholders;

b. No shareholders other than individuals, estates, certain trusts, and,

as of January 1, 1998, certain tax-exempt organizations. The only

tax-exempt organizations that qualify are charitable organizations

described in Section 501(c)(3) and qualified retirement plans

described in Section 401(a);

c. No nonresident alien shareholders;

d. No more than one class of stock (for these purposes, differences in

voting rights among the shares of common stock are disregarded);

and

e. No membership in an affiliated group determined under Section

1504.

3. Shareholder Consent to S Election. If the foregoing requirements are met,

all shareholders must consent to making the S election before the election

can be validly made (Section 1362(a)). Once the election has been made, it

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applies for all succeeding taxable years, so long as the corporation

continues to meet the qualifying requirements. The election can also be

voluntarily revoked in certain cases.

4. Trusts That Can Hold S Corporation Stock. Section 1361(c)(2) specifies

six types of trusts that will qualify as S corporation shareholders:

a. A voting trust;

b. A trust, all of which is treated as owned by an individual who is a

citizen or resident of the United States under the grantor trust rules

of Sections 671-678;

c. A trust that was a grantor-type trust (including a Qualified

Subchapter S Trust (“QSST”) for which a qualified election was

made) immediately before the death of the deemed owner and that

continues in existence after that person’s death, but only for a

period of two years;

d. An otherwise nonqualifying trust to which stock was transferred

pursuant to a shareholder’s will, but only for a period of two years

beginning on the date of transfer;

e. An Electing Small Business Trust (“ESBT”), defined under

Section 1361(e), for which a qualifying election is made; and

f. A QSST, defined under Section 1361(d)(3), for which a qualifying

election is made.

5. Deemed Owner of S Corporation Stock Held in Different Types of Trusts.

Generally, when a qualifying trust owns shares of S corporation stock, the

trust itself is not treated as the shareholder either for purposes of the 100

shareholder test or for income tax purposes.

a. This avoids interfacing the income taxation rules for S

corporations with those for trusts.

(1) The rules of Subchapter J of Chapter 1 of the Code relating

to taxable income, distributable net income, distributions,

throwback, and other trust income tax concepts normally

do not apply to S corporation income where the stock is

held in trust.

(2) Instead, all income, loss, deductions, and credits

attributable to the trust’s stock are treated as belonging to

the deemed shareholder. This has important tax and

fiduciary accounting ramifications, discussed later.

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b. In the case of a voting trust, each beneficiary of the trust is treated

as a shareholder of the corporation.

c. In the case of a grantor-type trust, the deemed owner of the trust is

treated as the shareholder.

d. In the case of a QSST, the current income beneficiary of the trust is

treated as the shareholder.

e. In the case of an ESBT, each current beneficiary of the trust is

treated as the shareholder for purposes of meeting the 100

shareholder requirement, but the ESBT, and not the beneficiary of

the ESBT, will be taxed on the ESBT’s share of S corporation

income.

f. In the case of a grantor-type trust after the death of the deemed

owner, the estate of the deemed owner is treated as the shareholder

until the earlier of the disposition of the stock or the expiration of

the two-year period during which the trust will be a qualifying

shareholder.

g. In the case of a trust to which stock is transferred pursuant to a

will, the estate of the testator again is treated as the shareholder

until the earlier of the disposition of the stock or the expiration of

the period during which the trust will be a qualifying shareholder.

In these cases, the regulations indicate that the estate is considered

the shareholder only for purposes of determining whether the

corporation qualifies for the S election, and the trust itself is treated

as the shareholder for income tax purposes (Treas. Reg. Section

1.1361-1(h)(3)(ii)(A)).

6. Grantor-Type Trusts. For S corporation purposes, a qualifying grantor-

type trust is a trust, all of which is treated under the grantor trust income

tax rules as owned by an individual who is a citizen or resident of the

United States (Section 671).

a. Various grantor-type trusts may qualify as S corporation

shareholders under this requirement, including:

(1) A trust in which the grantor has a reversionary interest

whose value exceeds 5 percent of the value of the trust as

of the date of creation;

(2) A trust in which the grantor has the power to control

beneficial enjoyment;

(3) A trust in which the grantor has certain borrowing or

administrative powers;

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(4) A trust in which the grantor has a power of revocation; and

(5) A trust in which the grantor or his spouse is entitled to

receive distributions of income or corpus.

b. Certain trusts in which a person other than the grantor has a power

to vest the income or corpus in himself may also constitute a

qualifying grantor trust, provided that the entire corpus is treated as

owned by the beneficiary (Treas. Reg. Section 1.1361-1(k)(1),

Example 2).

(1) A beneficiary with a general inter vivos power to appoint

the entire trust principal to himself or to withdraw it for

himself is treated as the grantor for income tax purposes

under Section 678(a), and that status also constitutes the

trust a qualifying grantor-type trust for S corporation

purposes.

(2) The power must exist as to the entire principal, not just the

S corporation stock; and no other person can have any

current interest in the trust.

(3) A trust with a Crummey power of withdrawal in one

beneficiary could qualify, if the power extends to all trust

principal (see Letter Ruling 9140047 (July 2, 1991)). If the

power might not extend over all contributions to the trust, it

might still qualify as a QSST.

c. If the trust ceases to be a grantor-type trust upon the deemed

owner’s death, his estate is thereafter treated as the shareholder if

the trust continues in existence. As stated earlier, the trust will

continue to qualify to hold the stock for at least two years after the

deemed owner’s death.

7. Electing Small Business Trusts. An ESBT may have multiple

beneficiaries and may accumulate income for future distribution. The

ESBT, and not the beneficiaries of the ESBT, will be taxed on the trust’s

share of the S corporation’s income.

a. Section 641(c) provides special rules for the taxation of the portion

of an ESBT that contains S corporation stock.

(1) The portion of the trust containing S corporation stock is

treated as a separate trust for income tax purposes. The S

corporation income will be taxed in all cases at the highest

rate applicable to trusts (currently 35% and 15% for capital

gains).

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(2) In addition, the deemed separate trust is not allowed to take

a personal exemption, and only items of income, loss,

deduction and credit that are required to be taken into

account by an S corporation or that result from the sale or

other disposition of S corporation stock, or in some cases

from the payment of state or local taxes or administration

expenses, may be taken into account

(3) The S corporation’s income will not be included in the

trust’s distributable net income. Thus, no deduction will be

allowed to the trust for distributions to its beneficiaries, and

the beneficiaries will not be taxed on any S corporation

income distributed to them.

b. Definition of ESBT.

(1) All of the beneficiaries of the trust must be individuals,

estates, or (after December 31, 1997) charitable

organizations as current beneficiaries.

(2) The trust must not be a QSST or a trust exempt from

taxation.

(3) No beneficiary may have acquired an interest in the ESBT

by purchase (only interests that are the result of gift,

inheritance, or other nonpurchase transactions are

permitted).

(4) The trustee of the trust must elect ESBT treatment. IRS

Notice 97-12 (1997-1 C.B. 385) lists the information that is

required to be included in an ESBT election.

c. Immediately after enactment of the ESBT provisions, many

practitioners expressed the concern that a trust could not qualify as

an ESBT if it might distribute property by its terms to another

trust, either upon termination of the ESBT or in a discretionary

distribution pursuant to a facility of payment clause.

(1) In either situation, practitioners noted that the recipient

trust could be treated as a beneficiary of the proposed

ESBT, thereby disqualifying the trust for the ESBT

election. IRS Notice 97-49 (1997-2 C.B. 304) eliminated

this concern.

(2) The Notice defines the term “distributee trust” as any trust

that receives or may receive distributions from an intended

ESBT, whether the rights to receive such distributions are

fixed or contingent, or immediate or deferred, and then

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provides that a distributee trust (other than a charitable

trust) will not itself be treated as a beneficiary of an ESBT.

(3) Instead, the IRS will look through the distributee trust and

treat any person who has a beneficial interest in it as a

beneficiary of the ESBT. Thus, a trust that provides for the

discretionary distribution of principal and interest to A for

life, then for the division of the trust corpus into separate

trusts for A’s children, will meet the requirements for an

ESBT because A’s children will be treated as beneficiaries,

not the separate trusts for A’s children.

d. Notice 97-49 also states that a person in whose favor a power of

appointment could be exercised is not a beneficiary of an ESBT

until the power is actually exercised in such person’s favor.

Furthermore, a person whose contingent interest in the trust is so

remote as to be negligible is not a beneficiary of an ESBT for

purposes of Section 1361(e)(1)(A)(i).

e. Under Notice 97-49, any person who, during any period, is entitled

to, or at the discretion of any person may receive, a current

distribution from the principal or income of an ESBT (referred to

as a “potential current beneficiary”) is treated as a shareholder of

an S corporation during that period for purposes of determining

whether the S corporation meets the 100 shareholder requirement.

(1) Thus, although a person who may receive trust property

pursuant to a lifetime power of appointment is not a

beneficiary until the power is exercised, such person is

treated as a potential current beneficiary, even though the

power has not been exercised.

(A) This rule applies only to a lifetime power. Person

who may receive property only pursuant to a

testamentary power of appointment will not be

treated as potential current beneficiaries until the

power is exercised.

(B) A broad, special power of appointment, pursuant to

which property can be appointed among unlimited

appointees (other than the holder of the power, his

or her estate, and the creditors of either) will result

in an unlimited number of potential current

beneficiaries, each of which will be treated as S

corporation shareholders. Since this will clearly

cause the 100-shareholder limit to be exceeded, any

ESBT holding S corporation stock and granting a

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broad special power of appointment will cause the

immediate termination of the S election. It is

critical, therefore, that any trust that is intended to

qualify as an ESBT not contain a broad special

power of appointment.

(2) Section 1362(a) provides that all shareholders must consent

to a corporation’s initial S election. This consent is made

on a Form 2553. IRS Notice 97-12 provides, however, that

if an ESBT is among a corporation’s shareholders at the

time of its S election, only the trustee, and not each

potential current beneficiary, needs to sign the Form 2553

on behalf of the trust.

f. On December 29, 2000, the Internal Revenue Service issued

proposed regulations under Section 641(c) and 1361(e) relating to

ESBTs (65 Fed. Reg. 82963). The proposed regulations modified

some of the provisions in Notices 97-12 and 97-49. Final ESBT

regulations were issued on May 14, 2002. No substantive changes

were made to the proposed regulations, but several clarifications

were made. The following summarizes the principal provisions of

the final regulations:

(1) For purposes of the 100 shareholder limitation, the final

regulations continue the definition of potential current

beneficiary given by Notice 97-49, but add that during any

period that there is no potential current beneficiary of an

ESBT, the trust shall be treated as the shareholder.

(A) In the case of an ESBT that is a grantor trust, the

deemed owner of the grantor trust is also treated as

a potential current beneficiary.

(B) A person is treated as a shareholder of the S

corporation at any moment in time when that person

is entitled to, or in the discretion of any person may,

receive a distribution of principal or income of the

trust. A person who, after the exercise of a power

of appointment, receives only a future interest in the

trust is not a potential current beneficiary.

(C) An attempt to temporarily waive, release or limit a

power of appointment would not be effective to

limit the number of potential current beneficiaries.

However, a permanent release of a power of

appointment that is effective under local law may

reduce the number of potential current beneficiaries.

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(D) The potential recipients of current distributions

pursuant to an exercise of a power of appointment

are considered, not whether the power is a special or

a general power of appointment.

(2) If current distributions can be made to a distributee trust,

and the trust does not qualify to be a shareholder of an S

corporation, then the distributee trust will be considered to

be a potential current beneficiary, and therefore a

shareholder. In that case, the corporation’s S election

would terminate. For this purpose, a distributee trust is

deemed to qualify to be a shareholder if it would be eligible

to make a QSST or ESBT election if it held S corporation

stock. If the distributee trust does qualify to be a

shareholder of an S corporation, then the potential current

beneficiaries of the distributing ESBT will include the

potential current beneficiaries of the distributee trust.

However, if the distributee trust is a former grantor trust

prior to the owner’s death, or is a trust receiving a

distribution of S corporation stock from a decedent’s estate,

the estate of the decedent is treated as the only potential

current beneficiary. In no case will the same person be

counted twice.

(3) Previously, the trustee of an ESBT had to make a separate

election with respect to each subchapter S corporation

whose stock is owned by the trust, in each case filed where

the corporation files its income tax returns. Under the final

regulations, the trustee will make a single election, to be

filed with the service center where the ESBT files its

income tax return.

(4) The prohibition on acquiring an interest in an ESBT by

purchase applies if any portion of a beneficiary’s basis in

the beneficiary’s interest is determined under Section 1012

(which states the basic rule that, in general, a taxpayer’s

basis in property is that taxpayer’s cost in acquiring the

property). Thus, a part gift, part sale of a beneficial interest

will terminate the trust’s status as an ESBT. Although

beneficiaries may not purchase an interest in the trust, the

ESBT itself may purchase S corporation stock.

(5) Revenue Procedure 98-23 (1998-1 C.B. 662) provides

procedures for the conversion of a QSST to an ESBT, and

vice versa. Under the final regulations, a consistent filing

location for QSST and ESBT elections and conversions is

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established, in all cases the service center where the S

corporation files its income tax returns.

(6) A trust that is wholly or partially a grantor trust may elect

to be an ESBT. Currently, for purposes of an ESBT’s

consent to an S corporation election, only the trustee need

consent. However, under the final regulations, if the ESBT

is also a grantor trust, the deemed owner must also consent

to the S corporation election.

(7) For federal income tax purposes, an ESBT will consist of

an S portion, a non-S portion, and in some instances a

grantor portion. The items of income, deduction, and credit

attributable to any portion of the trust treated as owned by a

person under the grantor trust rules, including S

corporation stock and other property, are taken into account

on that individual’s income tax return under the normal

rules applicable to grantor trusts. The S portion is subject

to the special rules of Section 641(c) described above,

while the non-S portion is subject to the normal rules

applicable to trusts.

(8) If an otherwise allowable deduction of the S portion is

attributable to a charitable contribution by the S

corporation, the contribution will be deemed to be paid by

the S portion pursuant to the terms of the trust’s governing

instrument within the meaning of Section 641(c). If the

other requirements of Section 641(c) are met, the

contribution will be deductible by the S portion, limited to

the gross income of the S portion.

(9) If a payment is made to a charitable organization by the

ESBT pursuant to the terms of its governing instrument, the

payment is deductible to the extent it is paid from the gross

income of the non-S portion (thus, if an ESBT contributes

S corporation stock to a charity, that contribution will not

be deductible).

EXAMPLE: A trust contains $1,000,000 of stock in S

Corp, an S corporation, and $2,000,000 in cash and

marketable securities, has a provision permitting the trustee

to make distributions of income and principal to a named

charity. The trust elects to be treated as an ESBT. In 2013,

he trust receives $150,000 in income from the cash and

marketable securities in the non-S portion of the trust, and

reports $100,000 in S corporation income for the S portion

of the trust. In that year, the trustee distributes $10,000 in

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cash and $10,000 in S Corp. stock to the named charity.

The trust had $100,000 in deductible administrative

expenses and noncharitable distributions for 2013

permitting a charitable deduction of up to $50,000

($150,000 of income in the non-S portion minus $100,000).

The $10,000 cash distribution to charity is fully deductible.

Even though an additional $40,000 in deductible charitable

distributions may be made, the $10,000 distribution of S

Corp. stock to charity is not deductible, because, since the

S portion is treated as a separate trust for income tax

purposes, distributions from the S portion cannot be

deducted against the distributable net income (“DNI”) of

the non-S portion and the income of the S portion is not

included in the trust’s DNI.

(10) If an ESBT sells S corporation stock on the installment

method, the income with respect to the installment

proceeds is taken into account by the S portion, and the

interest on the installment obligation is taken into account

by the non-S portion. Interest expenses paid on loans used

to purchase S corporation stock must be allocated to the S

portion, but are not deductible by the S portion.

(11) A grantor trust may elect to be an ESBT. However, since

the qualification and taxation of ESBTs are separate issues,

making an ESBT election does not alter the treatment of tax

items attributable to the portion of the trust treated as

owned by grantor or another person. The special taxation

rules applicable to ESBTs apply to any portion of the trust

that is not treated as owned by the grantor or another

person.

(12) Generally, a trustee who wishes to revoke an ESBT

election must obtain the consent of the Commissioner by

means of a private letter ruling. Such consent is deemed to

be given, however, for revocations that occur upon the

conversion of an ESBT to a QSST. If an ESBT fails to

meet the definitional requirements of an ESBT under

Section 1361(e), the trust’s ESBT status terminates

immediately. However, if the trust acquires an ineligible

potential current beneficiary, it has 60 days in which to

dispose of its S corporation stock. If the stock is not so

disposed, the S corporation election will terminate as of the

date the ineligible person became a potential current

beneficiary. In addition, an ESBT election is terminated if

the ESBT fails to hold any S corporation stock, except that

it will continue to be treated as an ESBT as long as it is

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reporting income from the sale of S corporation stock under

the installment method.

g. Most of the new regulations took effect upon the date the final

regulations were published in the Federal Register (May 14, 2002).

However, because of potentially abusive transactions involving

ESBTs that assume the applicability of Section 641(c) to the

taxation of the grantor portion of such trusts, the regulations

regarding taxation of ESBTs under Section 641(c) are applicable

for taxable years of ESBTs that end on and after the date the

proposed regulations were published (December 29, 2000).

8. Qualified Subchapter S Trusts.

a. To qualify as a QSST, a trust must meet four basic requirements

(Section 1361(d)(3)).

(1) The trust may have only one current income beneficiary,

who must be a citizen or resident of the United States.

(2) All of the trust income (not just that generated by S

corporation stock) as defined in Treasury Regulation

Section 1.643(b)-1 (i.e., trust accounting income), must be

distributed currently to that beneficiary.

(3) Any corpus distributed during the current income

beneficiary’s life must be distributed to that beneficiary.

(4) Each income interest in the trust must terminate upon

whichever event occurs earlier, the death of the current

income beneficiary or the termination of the trust.

b. If the trust meets the foregoing requirements and if the current

income beneficiary or his legal representative elects to have

Section 1361(d) apply, the trust will be treated as a grantor-type

trust for purposes of Section 1361(d) and will be a qualified holder

of S corporation stock. If the beneficiary is a minor and has no

court-appointed legal representative, a natural or adoptive parent

can make the election (Treas. Reg. Section 1.1361-1(j)(6)).

Thereafter, all of the trust accounting income will be taxable to the

current income beneficiary. Capitals gains realized by the trust will

be taxable to the trust (Treas. Reg. Section 1.1361-1(j)(7)).

c. Since only one income beneficiary is permitted, and the income

beneficiary must receive any corpus distributions, a provision

under which income or principal may be distributed among a class

of beneficiaries is prohibited. Note, however, that the QSST may

provide for successive income beneficiaries, after the death of the

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initial beneficiary (but each present interest segment of the trust

must meet the same exclusive life interest rules in order to remain

a QSST).

d. The requirement that all income must be distributed focuses on

trust accounting income, not taxable income. Trust accounting

income will be defined by local law. In this regard, the regulations

indicate that the trust instrument need not mandate that all income

be distributed currently so long as the trust in fact distributes all of

its income annually (Treas. Reg. Section 1.1361-1(k)(1) Example

4). The 65-day rule of Section 663(b) will apply to a QSST, so that

the trustee may elect to treat any amount of income that is properly

paid to a beneficiary within the first 65 days following the end of

the taxable year as if properly paid on the last day of that taxable

year (Treas. Reg. Section 1.1361-1(j)(1)(i)).

e. The trust must also be drafted to preclude the possibility that it will

not meet the qualification requirements. Thus, for example, the

trust may not provide that corpus can be invaded or distributed

upon termination in favor of someone other than the current

income beneficiary, if the trust does not hold S corporation stock

(Treas. Reg. Section 1.1361-1(j)(1)(iii)). Separate shares in a single

trust may qualify if they would be treated as separate shares under

Section 663(c) (Treas. Reg. Section 1.1361-1(j)(3)).

f. If the trust ceases to qualify because of the death of the income

beneficiary and there is no successor, the estate of the deceased

beneficiary is treated as the shareholder, and the two-year rule that

applies to grantor-type trusts at the death of the deemed owner will

apply (Treas. Reg. Section 1.1361-1(j)(7)(ii)). If there is a

successor income beneficiary, that beneficiary is bound by the

election of the predecessor unless he or she affirmatively refuses to

consent (Section 1361(d)(2)(B)(ii)). However, this does not

include the income beneficiary of a trust created at the death of the

income beneficiary that receives a pour-over distribution of S

corporation stock from the qualified trust (Treas. Reg. Section

1.1361-1(j)(9)(i)). The affirmative refusal to consent must be filed

within 2 months and 15 days after the date on which the successor

income beneficiary became the income beneficiary, and is

effective as of the latter date.

g. A number of different types of trusts may meet the requirements

for a valid QSST. These include:

(1) A general power of appointment or testamentary QTIP

marital deduction trust;

110

(2) A unified credit shelter trust, so long as there is only one

current income beneficiary, such as the surviving spouse,

and income is distributed at least annually (however, the

trust may not contain a provision permitting principal to be

invaded for anyone other than the income beneficiary);

(3) A minor’s annual exclusion trust meeting the requirements

of Section 2503(c), so long as all of the trust income is

distributed at least annually;

(4) A trust which provides that all income be distributed

annually to a single beneficiary until the trust no longer

holds S corporation stock, after which the income can be

accumulated or, alternatively, the trust will be terminated

(note, however, that the trust cannot be terminated in favor

of a beneficiary other than the designated income

beneficiary) (see Revenue Ruling 89-55, 1989-1 C.B. 268);

(5) A trust which provides that the income will be paid to three

living beneficiaries in equal shares (see Letter Ruling

8737038 (June 15, 1987)); and

(6) A variety of trusts in which the trustee can pay or

accumulate income, so long as there is only one income

beneficiary, and the trustee in fact pays out all of the

income each year.

h. Final QSST regulations were published on July 17, 2003,

incorporating the changes made in the Small Business Job

Protection Act of 1996 and the Taxpayer Relief Act of 1997, which

extended the time that a grantor trust or a testamentary trust may

be permissible shareholders of S corporation stock from 60 days

(the rule prior to the Small Business Act) to two years after the

death of the decedent. The final regulations clarify that a

testamentary trust is (i) a trust to which S corporation stock is

transferred pursuant to the terms of a will, but only for the 2-year

period beginning on the day the stock is transferred to the trust, (ii)

a qualified revocable trust electing to be treated as part of an estate

for income tax purposes under Section 645 that is funded with S

corporation stock, for the duration of the Section 645 election

period, or (iii) a trust to which the shares held by the electing

Section 645 trust during the election period, but only for the 2 year

period beginning with the transfer.

9. Estates as Shareholders. An individual shareholder’s estate remains an

eligible shareholder during the period of administration.

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a. In some cases, it may be desirable to keep the estate open for a

prolonged period so that the estate can remain a shareholder as

long as possible. This might be especially true if the ultimate

recipient of the stock is a nonqualifying S corporation shareholder

(for example, a partnership, a business corporation, or a

nonresident alien).

(1) The position of the IRS is that if the administration of the

estate is unreasonably prolonged, the estate will be deemed

to be terminated for federal income tax purposes.

(2) Under Treas. Reg. Section 1.641(b)-3(a), the permissible

period of administration for tax purposes is the period

actually required by the personal representative to perform

the ordinary duties of administration, such as the collection

of assets and the payment of debts, taxes, and bequests,

whether the period is longer or shorter than the period

specified under applicable state law for the settlement of

the estate. This in effect is a facts and circumstances test.

(3) Typically, an estate will remain open until an estate tax

closing letter is received and all outstanding debts of the

decedent are paid. In this regard, the IRS recognizes that an

election under Section 6166 to pay the estate tax in

installments is a valid reason to keep the estate open

(Section 6166(g); see Revenue Ruling 76-23, 1971-1 C.B.

264). Thus, if the estate qualifies, the executor might

consider making the election even though it might not be

attractive for other reasons.

b. In some instances it may be desirable for the executor to make or

join in an S election.

(1) This may occur either for a company that was a C

corporation during the decedent/shareholder’s life, or for a

business incorporated by the executor to insulate the other

estate assets from business liabilities.

(2) An election may be desirable, for example, to unlock an

income flow to the decedent’s family. The decedent may

have been receiving a substantial salary during life, which

was cut off by the decedent’s death. The S election permits

the income of the corporation to flow through to the estate

and ultimately its beneficiaries.

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(3) An election may also be useful in some circumstances in

permitting an estate to take advantage of the deferral of the

payment of estate taxes under Section 6166.

EXAMPLE: Under Section 6166, the payment of estate

taxes may be deferred if at least 35% of the adjusted gross

estate consists of interests in an active business. In one

case, an estate held the stock of a holding company, which

in turn had three wholly owned subsidiaries. Since the

stock in holding company held by the estate was considered

passive assets, however, the estate did not qualify for the

deferral under Section 6166. Section 1361(b)(3)(A)

provides that a qualified subchapter S subsidiary–that is, a

wholly owned subsidiary of an S corporation, with a few

exceptions–is treated for all purposes of the Code as not

separate from its parent. Thus, by making an election for

the parent, the executor transformed the passive holding

company into an active business (based on the activities of

the subsidiaries) and was able to qualify for the deferral

under Section 6166.

c. Where the executor has discretion to fund trusts with specific

assets of his choice, no funding with S corporation stock should be

made until the executor determines which trusts will be qualifying

shareholders.

(1) Where the executor has insufficient discretion in selecting

distributees for S corporation stock so as to maintain the

election, the executor may be able to delay distribution or

avoid the disqualifying distribution by selling the stock to a

qualified shareholder or in a redemption back to the

corporation itself.

EXAMPLE: Under the will of John Jones, his entire

estate, which contains John’s 50 percent interest is STU

Corp., an S corporation, is to be allocated to a trust for the

benefit of his surviving spouse, Julie Jones, and his

children. The trust contains a provision permitting Julie to

appoint trust property during her lifetime to any individual

(other than herself and her creditors) who is a U.S. citizen

or resident.. The trust does not qualify as a grantor trust. It

cannot qualify as a QSST, because there is more than one

income beneficiary. Finally, although the trust would

qualify as an ESBT, there would be an unlimited number of

potential current beneficiaries under Julie’s broad special

lifetime power of appointment, each of which would be

treated as an S corporation shareholder. Funding the trust

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with S corporation stock would therefore increase the

number of shareholders over the 100-shareholder limit,

thereby causing the loss of the S election. The trust

therefore cannot be funded with S corporation stock

without causing the S election to be lost. Prior to funding

the trust, the trustee enters in agreement with John’s

children, who collectively own the remaining 50% of STU

Corp., under which STU Corp. will redeem the shares held

by the estate. The cash proceeds of the redemption will

then be used to fund the trust.

(2) If the estate is, finally, compelled to distribute S

corporation stock to a nonqualifying trust, that trust has two

years after receipt to either pass the stock on to a qualified

shareholder (through sale or distribution) or transform itself

into a qualified shareholder through disclaimers or

reformation.

d. The executor is treated as the shareholder for federal income tax

purposes as to any S corporation stock owned by the estate. As a

result, all income allocable to S corporation stock held by the

estate is taxable to the estate.

(1) An S election does not change the basic corporate law

applicable to the declaration and payment of dividends,

only the tax treatment of corporate income.

(A) The election does not put the estate (or any

shareholder) in the position of being entitled to

receive the earnings of the corporation.

(B) The conduit nature of the S corporation means that

the estate will be taxed on its proportionate share of

the undistributed income of the corporation, but it

does not compel the corporation to distribute any of

the funds.

(2) One of the main concerns for the executor, therefore, will

be an assurance that the estate will not end up with the

responsibility for large amounts of income tax when it is

not receiving distributions from the corporation. This might

be provided by a predeath agreement between the

shareholders and the corporation, which can provide that

the corporation will distribute at least enough funds to

enable the shareholders to pay the incremental tax liability

caused from owning the corporation’s stock.

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e. Distributions from an estate are generally taxable to the recipient to

the extent of the estate’s distributable net income (DNI).

(1) DNI means for any taxable year the taxable income of the

estate (defined under Section 643), with certain

modifications set forth in Treas. Reg. Section 1.643(a)-1

through (a)-7.

(2) If the estate is an S corporation shareholder, its pro rata

share of the corporation’s undistributed income should be

part of DNI. This can cause distributions by the estate that

were thought to be nontaxable to create a tax to the

beneficiary.

EXAMPLE: An estate that otherwise consists largely of

non-income producing property and property producing

tax-exempt income, holds stock in an S corporation. Other

than the S corporation’s K-1 income, the only taxable

income reported by the estate for 2013 is offset by

deductions. The deductions, however, are not sufficient to

shield the estate’s S corporation K-1 income for that year.

The estate makes distributions to its beneficiaries only of

principal and tax-exempt income during 2013. However,

even though the S corporation makes no distribution to the

estate in 2013, the portion of the estate’s distributions to

each beneficiary that are equal to the beneficiary’s pro rata

share of the S corporation undistributed income must be

treated by the beneficiary as taxable income. If the S

corporation had instead been a C corporation, its

undistributed income would not be reported to the estate

and would not constitute any portion of the estate’s DNI.

In that case, the beneficiaries would not be taxed on their

distributions from the estate.

M. Sale to an ESOP.

1. If the family business has an Employee Stock Ownership Plan (“ESOP”)

the stock can be sold to the ESOP in a transaction, which would not need

to qualify as a redemption. This alternative can be beneficial where the

family is not concerned about retaining substantially all the equity in the

company in the family.

2. When an ESOP is created it provides the employees of a closely held

business with the opportunity to have an ownership interest in the

business.108

The business provides for the ownership interest by following

these general steps:109

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a. The business will set up a trust fund, into which it contributes new

shares of its own stock or cash to purchase new shares. The ESOP

also has the ability to borrow money to purchase new shares and

the company’s cash contribution can be used to pay back the loan.

b. The shares that are acquired by the trust are then allocated to the

individual employees’ accounts based on a formula previously

determined by the company. As the employee’s seniority

increases, his right to the shares in his account increases.

c. In a closely held company, when employees leave, they receive

their shares and the company must buy back the shares at fair

market value, which is based on the annual outside valuation.

3. An ESOP creates a market for otherwise privately held stock. Thus, a sale

to an ESOP can create substantial liquidity for the family, without losing

control of the business.

4. An ESOP is a defined contribution retirement plan designed to invest

primarily in employer securities. IRC §4975(e)(7). An ESOP is separate

from the family business so a sale to the ESOP is not a redemption, and

the rules for qualification of a redemption as an exchange (rather than a

dividend) do not apply.

5. Under Section 1042(a), if the owner sells his stock to an ESOP for the

employees of the company, capital gain tax will be deferred if the

proceeds of sale are reinvested, within the period beginning 3 months

before and ending 12 months after the sale, in securities issued by

domestic corporations which are not holding companies. The owner’s

basis in the stock carries over to the new securities, but upon the death of

the seller, all securities owned at that time would receive a step-up in basis

under Section 1014.

Note: Although ESOPs can now hold S Corporation stock, this Section

1042(a) deferred gains treatment of a sale to an ESOP is unavailable to an

S Corporation because the definition of “qualified securities” includes

only those securities issued by a domestic C Corporation. IRC §

1042(c)(1)(A).

6. The Internal Revenue Code requires the sale of securities to an ESOP to

meet additional requirements in order to defer the tax, which include:

a. The ESOP must own at least 30% of the total value of the

business’ stock after the transaction. IRC § 1042(b)(2).

b. Also, the purchased shares cannot be allocated to any employee

related to the seller (within the meaning of IRC § 267(c)(4)), or

who owns more than 25% of the stock.

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c. Finally, the seller must have held the stock for 3 years prior to the

sale. IRC § 1042(b)(4).

EXAMPLE: Owner, O, owns all of the stock of his $10 million

corporation, but he is ready to retire. O wants his daughter, A, to take

over control of the company and wants to preserve the jobs of many of his

key employees. A’s goals include securing her father’s retirement and

providing the employees with incentives to remain with the company. If

O sells at least 30% of his stock to an ESOP ($3 million), the sale will

result in tax deferral. O will save approximately $600,000 in federal taxes

and will be able to reinvest the $3 million. A will be able to take over the

business and provide incentives to the many key employees.

7. Benefits to the family business.

a. The family business is permitted to deduct the amount of cash

dividends paid on shares of stock held by the ESOP, provided

those dividends are passed through to the plan participants by the

plan. IRC. § 404(k).

b. The family business may also be permitted to deduct dividends

paid to the ESOP on shares the ESOP acquired with debt, if those

dividends are used to make payments of interest and principal on a

loan used by the Plan to acquire the employer securities. IRC

§ 404(k).

c. Until recently, the family business (or the ESOP) was able to

obtain a more favorable rate of interest, facilitating debt service.

Banks were allowed under IRC §133(a) to exclude from income

50% of the interest received from a loan to the family business or

to the ESOP for the acquisition of employer securities if certain

additional conditions were met. Those conditions were that the

ESOP own more than 50% of each class of stock, the loan be for

not more than 15 years, and the participants be entitled to vote the

shares. This section was repealed in 1996.

8. Although the ESOP would own the stock, it would generally be controlled

by the Plan administrative committee appointed by the Board of Directors.

In turn, the family typically would control the Board as the only outside

shareholder(s). Care must be taken, however; to be sure that all parties

understand the duties and fiduciary obligations inherent in the ESOP and

that those risks are acceptable.

9. The family must also be aware of any Section 2701 issues that may arise.

For example, if a shareholder transfers his common stock to an ESOP

while retaining a preferred stock interest, Section 2701 valuation rules

may apply if the shareholder’s family controls the corporation and a

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family member is a potential ESOP beneficiary. See PLR 9253018

(January 1, 1993).

N. Employee Stock Ownership Plans (ESOPs) As S Corporation Shareholders.

1. The S corporation rules permit certain tax-exempt organizations, including

qualified plans described in Section 401(a) and charitable organizations

described in Section 501(c)(3), to hold S corporation stock. Among

qualified plans, ESOPs provide especially advantageous opportunities for

planning with S corporation stock.

2. An ESOP has an advantage over all other forms of qualified plans, which,

like any other exempt organization, are required to treat distributions on S-

stock as unrelated business taxable income (UBTI). Section 512(e)(3),

enacted as part of the Taxpayer Relief Act of 1997, exempts ESOPs from

UBTI.

3. Using an ESOP as an S corporation shareholder creates the ability to defer

current income tax on corporate income. If an ESOP owns 100% of an S

corporation, no current federal income tax is payable at either the

corporate or personal level, since the ESOP is a tax-exempt employee

benefit trust. It is important to note that eventually taxes will be due by

ESOP participants when distributions are made by the ESOP to the

participants.

EXAMPLE: ESOP-C holds 100% of the stock of ABC Corp, a C

corporation, and ESOP-S holds 100% of the stock of STU Corp., an S

corporation. During 2013, both corporations had income of $100,000 and

distributed their entire net income as dividends. ABC Corp. paid

corporate-level taxes of $22,250 on its income, and distributed $77,750 in

dividends to ESOP-C. On the other hand, STU Corp. paid no corporate-

level tax, and distributed its entire $100,000 of income to ESOP-S. Even

though neither ESOP-C nor ESOP-S pays tax on its dividend income, a

participant in ESOP-S will eventually receive a greater distribution based

on the ESOP’s 2006 income than will a participant in ESOP-C (assuming

identical investments of the assets of the two ESOPs and identical timing

of distributions to, and percentage interests of, the two participants).

4. ESOPs holding S corporation stock have some disadvantages with respect

to ESOPs holding C-corporation stock.

a. Section 1042 rollovers are not available to S corporation ESOPs.

Under Section 1042, a taxpayer, other than an S corporation, may

sell securities to an ESOP and replace the securities with other

securities without recognition of gain. This is often important in

third party financing of ESOPs, in which a third party (typically a

commercial bank) makes a loan to the sponsoring corporation,

118

which in turn makes a loan to the ESOP. The proceeds of these

loans are then used to purchase the sponsoring corporation’s stock

to fund the ESOP. Third party lenders often prefer the seller to

pledge the Section 1042 rollover securities as collateral for the

loan, since such securities are usually publicly traded and easily

converted to cash. Such lenders may not be willing to participate

in the financing of S corporation ESOPs.

EXAMPLE: ABC Corp., a closely held C corporations, wishes to

establish an ESOP and fund it with $2 million worth of ABC stock.

In order to do so, it obtains a loan of $2 million from a third-party

lender, TPL Bank. ABC Corporation then lends $2 million to the

ESOP, which will be used by the ESOP to purchase the securities

from ABC Corp. TPL Bank could have made its loan directly to

the ESOP. However, a loan to an ESOP is subject to the exempt

loan rules, including (i) it must be without recourse against the

ESOP except to the extent of employer securities and certain

contributions, (ii) it must be a term loan rather than a demand loan,

(iii) plan assets pledged as collateral must be released in

installments according to certain regulatory requirements, among

other requirements (Treas. Reg. Section 54.4975-7(b)). TPL Bank

is therefore not willing to make the loan directly to the ESOP. In

addition, ABC Corp. can amortize its loan to the ESOP over a

shorter period than its own loan from TPL Bank, thus providing a

cash flow advantage to ABC Corp. ABC Corp. uses the proceeds

of its sale of ABC stock to the ESOP to purchase publicly traded

securities in a tax-free Section 1042 rollover transaction. These

Section 1042 rollover securities are then pledged to TPL Bank as

collateral for TPL Bank’s loan to ABC Corp. Because of the ease

of converting publicly traded securities to cash in the event of a

foreclosure, TPL Bank much prefers this arrangement to receiving

collateral in a less marketable form.

b. The annual addition exemption available to ESOPs holding C

corporation stock is not available to S corporation ESOPs.

(1) In general, an employer’s contributions to an ESOP are

deductible under Section 404(a), but not in excess of the

limitations set forth in Section 415(c). Under Section

415(c)(1), annual additions to a participant’s account in a

defined contribution plan (including an ESOP) generally

may not exceed the lesser of $40,000, adjusted for inflation,

and 100 percent of the participant’s compensation. Annual

additions are comprised of employer contributions,

employee contributions, and forfeitures (Section 415(c)(2)).

119

(2) Section 415(c)(6) provides that, in the case of an ESOP,

these limitations do not apply to employer contributions

that are deductible under Section 404(a)(9)(B), which

provides for the deduction by the employer of certain

contribution by the employer that are applied to interest

payments on the loan used to acquire the employer’s stock.

(3) This exemption is not applicable to S corporations (Section

404(a)(9)(C)).

(4) Furthermore, Section 404(k)(1) provides that, in the case of

a C corporation, a deduction is allowable, in addition to the

deductions under Section 404(a), for certain dividends

(generally, dividends paid to participants within 90 days

after the end of the plan year, reinvested in employer

securities, or applied to the repayment of the ESOP’s loan)

paid in cash with respect to employer securities.

(5) An S corporation ESOP is thus more limited in the income

deduction it can generate for contributions to the plan.

EXAMPLE: ABC Corp., a C corporation, and STU Corp.,

an S corporation, each have ESOPs covering 50 employees.

In each case, the limitations under Section 415(a) is equal

to $1,000,000. In addition, the stock held in the ESOP of

each corporation paid dividends in 2013 of $500,000,

which are applied to the repayment of the ESOP’s loan

used to purchase its employer securities. ABC Corp. and

STU Corp. each make a contribution to its ESOP during

2013 of $750,000, all of which is applied to participant

accounts. Since the participants in each case make

contributions of $250,000, ABC Corp. and STU Corp. can

each deduct the $750,000 in direct contributions to its

ESOP, but cannot make additional deductible contributions

during 2013. In addition, ABC Corp. makes $250,000 in

additional payments to the ESOP that are applied to the

repayment of the ESOP’s loan. ABC Corp. can deduct

these payments, but STU Corp. cannot make such

deductible interest payments. Furthermore, ABC Corp. can

deduct the $500,000 in dividends paid by the ESOP’s

employer securities. Thus, ABC Corp. makes a total direct

contribution of $1,000,000 and deducts $1,500,000. In

contrast, STU Corp. makes a total direct contribution of

$750,000 and deducts $750,000.

5. When S corporation ESOPs were first permitted in 1996, they were

marketed to companies with one or two employees to provide them with

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significant tax sheltering. Often there was no bona fide employee

ownership arrangement and the companies themselves often had no

substantial assets or business. Thus, the ESOPs for such companies were

often disguised forms of non-qualified deferred compensation plans for

executives.

a. Section 409(p) was enacted as part of the Economic Growth and

Tax Relief Reconciliation Act of 2001 to provide anti-abuse rules

to curb these abusive S corporation arrangement that were

endangering the legitimate S corporation ESOPs. Section 409(p)

prohibits any portion of the assets of an ESOP holding S

corporation stock to accrue for the benefit of a disqualified person

during any year in which disqualified persons own more than 50%

of the shares in the S corporation.

b. For S corporation ESOPs existing prior to March 14, 2001, the

provisions of Section 409(p) are effective only with respect to plan

years beginning after December 31, 2004. This delayed effective

date provided a loophole for many promotes of the type of abusive

ESOPs that Section 409(p) was intended to curb. Under Revenue

Ruling 2003-6, the delay in the effective date was eliminated for

those ESOPs for which do not provide broad-based employee

coverage and do not benefit rank-and-file employees as well as

highly compensated employees and historical owners.

X. Conclusion.

Counseling owners of family businesses, especially in succession matters, is one

of the most difficult tasks facing an estate planning professional. It requires tact

and diplomacy, especially if the owner’s desires are to meet with a minimum of

family conflict on the one side and a minimum of taxes on the other. Fortunately,

there are a wide variety of estate planning techniques available to owners of a

family business. Through the effective use of the techniques discussed herein,

attorneys can greatly benefit clients who own a family business.

ENDNOTES

73227783_1

1 Portions of this outline were presented at the 36th Annual Philip E. Heckerling Institute on

Estate Planning, sponsored by the University of Miami School of Law, in a presentation

entitled “Non-Tax Considerations in the Succession of Closely Held Businesses” (January

2002).

2Bernard Kliska, Planning for Business Succession, CHI. BAR ASS’N, Apr. 16, 1996, at 1.

3 Id. at 1.

121

4 MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

5 MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

6 CENTER FOR THE STUDY OF TAXATION, FAMILY BUSINESSES IN THE U.S. ECONOMY (1994).

7 Charles A. Redd, Peace in the Sandbox: How to Transfer a Closely Held Company to Some or

All of the Children, TR. & EST., Mar. 2008, at 42, 42.

8 Hannah Shaw Grove & Russ Alan Prince, What, No Succession Plan?, TR. & EST., Sept. 2004,

at 69, 69.

9 CENTER FOR THE STUDY OF TAXATION, FAMILY BUSINESSES IN THE U.S. ECONOMY (1994).

10

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1401.1, at 14-5 (1988).

11

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 17 (2009).

12

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 17 (2009).

13

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1401.1, at 14-6 (1988).

14

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1401.1, at 14-6 (1988).

15

Hannah Shaw Grove & Russ Alan Prince, What, No Succession Plan?, TR. & EST., , Sept.

2004, at 69, 69 (citing the estimate by Joseph Astrachan, editor of Family Business Review).

16

Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s Needs, EST.

PLAN. J., July 2006. Markstein summarizes that he has seen businesses sold because of family

disharmony or because of the ineptitude and/or lack of commitment of the succeeding

generation.

17

Scott C. Withrow, Integrating Family Business Systems in Succession Planning, PRAC. LAW.,

Apr. 1997, at 81.

18

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 19 (2009).

19

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 19 (2009).

20

MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

122

21

Margot Gibb-Clark, Family Firms Learn to Share Power, TORONTO GLOBE & MAIL, June 25,

1999. Aron Pervin, of Toronto-based Pervin and Co., uses this word “accidental partnerships.”

Id.

22

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 19 (2009).

23

Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s Needs, EST.

PLAN. J., July 2006.

24

Hannah Shaw Grove & Russ Alan Prince, What, No Succession Plan?, TR. & EST., Sept. 2004,

at 69, 69.

25

Glenn A. Ayres & Michael J. Jones, Face the Fear, TR. & EST., Feb. 2007, at 50, 51.

26

Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s Needs, EST.

PLAN. J., July 2006 (citing Doud, Challenges and Opportunities in Family Business Succession,

59 N.Y.U. INST. ON FED. TAX’N § 1401[2] (2001)).

27

Ernie Doud, Top Ten Excuses Why Founders Won’t Let Go—and Ten Rebuttals, TRANSITIONS,

Mar.–Apr. 1994, at 1.

28

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1402.1, at 14-8 to 14-9 (1988).

29

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1402.2, at 14-10 to 14-11 (1988).

30

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1402.6, at 14-12 to 14-13 (1988).

31

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1402.6, at 14-13 (1988).

32

John J. Fitzpatrick, Ph.D. & Anne E. Francis, Ph.D, How Families Work: A Guide to

Understanding Family Businesses, ACTEC (1993), at 11.

33

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

MIAMI HECKERLING INST. ON EST. PLAN. § 1402.8, at 14-14 (1988).

34

John J. Fitzpatrick, Ph.D. & Anne E. Francis, Ph.D, How Families Work: A Guide to

Understanding Family Businesses, ACTEC (1993), at 12.

35

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 20 (2009).

36

Gerald LeVan, Passing the Family Business to the Next Generation: Handling Conflict, 22 U.

123

MIAMI HECKERLING INST. ON EST. PLAN. § 1404.1, at 14-15 to 14-16 (1988).

37

Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s Needs, EST.

PLAN. J., July 2006.

38

IVAN LANSBERG, SUCCEEDING GENERATIONS (1999).

39

IVAN LANSBERG, SUCCEEDING GENERATIONS 29–32 (1999).

40

Charles E. Cohen, A Paladin of Publicity Bows Out in Grand Style, PEOPLE, Mar. 19, 1990, at 28.

41

See www.beretta.com and www.berettausa.com.

42

IVAN LANSBERG, SUCCEEDING GENERATIONS 32–33 (1999).

43

Margot Gibb-Clark, Family Firms Learn to Share Power, TORONTO GLOBE & MAIL, June 25,

1999.

44

IVAN LANSBERG, SUCCEEDING GENERATIONS 33–37 (1999).

45

IVAN LANSBERG, SUCCEEDING GENERATIONS 37–43 (1999).

46

Curt Hazlett, All in the Family: Portrait of Three Succession Plans, TR. & EST., Feb. 2004, at

54, 56.

47

Johan Lambrecht & Jozef Lievens. Pruning the Family Tree: An Unexplored Path to Family

Business Continuity and Family Harmony, 21 FAM. BUS. REV. 4 (2008).

48

IVAN LANSBERG, SUCCEEDING GENERATIONS 45 (1999).

49

IVAN LANSBERG, SUCCEEDING GENERATIONS 123 (1999).

50

Curt Hazlett, All in the Family: Portrait of Three Succession Plans, TR. & EST., Feb. 2004, at

54, 56.

51

See In re 75,629 Shares of Common Stock of Trapp Family Lodge, Inc., 725 A.2d 927 (Vt. 1999).

52

See, e.g., “Sound of Music” Family Ordered to Pay, HOLLAND SENTINEL, Jan. 18, 1999.

53

Seth Lubove, My Brother, My Rival, FORBES, Sept. 11, 1995, at 134.

54

Charles A. Redd, Peace in the Sandbox: How to Transfer a Closely Held Company to Some or

All of the Children, TR. & EST., Mar. 2008, at 42, 42.

55

Charles A. Redd, Peace in the Sandbox: How to Transfer a Closely Held Company to Some or

124

All of the Children, TR. & EST., Mar. 2008, at 42, 44–45.

56

Charles A. Redd, Peace in the Sandbox: How to Transfer a Closely Held Company to Some or

All of the Children, TR. & EST., Mar. 2008, at 42, 45–46.

57

Charles A. Redd, Peace in the Sandbox: How to Transfer a Closely Held Company to Some or

All of the Children, TR. & EST., Mar. 2008, at 42, 47–48.

58

ROGER FRITZ, WARS OF SUCCESSION 19 (1997) (quoting 1992 U.S. Census Bureau figure).

59

MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

60

MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

61

Making Siblings’ Spouses Part of the Team, FAM. BUS. ADVISOR, Feb. 1998.

62

Glenn A. Ayres & Michael J. Jones, Face the Fear, TR. & EST., Feb. 2007, at 50, 51.

63

Making Siblings’ Spouses Part of the Team, FAM. BUS. ADVISOR, Feb. 1998.

64

Evelyn M. Capassakis, Divorce and the Family Business, TR. & EST., July 2005, at 28, 29–30.

65

ROGER FRITZ, WARS OF SUCCESSION 231 (1997).

66

Margot Gibb-Clark, Family Firms Learn to Share Power, TORONTO GLOBE & MAIL, June 25,

1999. Aron Pervin, of Toronto-based Pervin and Co., uses this word “accidental partnerships.”

Id.

67

See James E. Hughes, Family Preservation, A Philosophy, TR. & EST., Aug. 2007.

68

Dennis T. Jaffer & Tim Habbershon, We’re Jammin’, FAMS. IN BUS., Jan./Feb. 2004, at 41, 43,

available at http://www.dennisjaffe.com/articles/Smuckers2.pdf.

69

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 4,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

70

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 5,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

71

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 3,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf..

125

72

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 5,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

73

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 6,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

74

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 16,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

75

MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

76

Curt Hazlett, All in the Family: Portrait of Three Succession Plans, TR. & EST., Feb. 2004, at

54, 56.

77

Curt Hazlett, All in the Family: Portrait of Three Succession Plans, TR. & EST., Feb. 2004, at

54, 56.

78

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 11–12,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.

79

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 18–19 (2009).

80

Mike Cohn, They Lived Happily Ever After and Other Family Business Fairy Tales: Non-Tax

Issues that Can Paralyze Succession and Estate Planning, 40 U. MIAMI HECKERLING INST. ON

EST. PLAN. § 11, at 11-12 to 11-16 (2006).

81

Johan Lambrecht & Jozef Lievens, Pruning the Family Tree: An Unexplored Path to Family

Business Continuity and Family Harmony, 21 FAM. BUS. REV. 4 (2008).

82

Margot Gibb-Clark, Family Firms Learn to Share Power, TORONTO GLOBE & MAIL, June 25,

1999.

83

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 11,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf.; see also

www.smuckers.com.

84

Bernard Kliska, Planning for Business Succession, CHI. BAR ASS’N, Apr. 16, 1996, at 1, 4–6.

85

Mike Cohn, They Lived Happily Ever After and Other Family Business Fairy Tales: Non-Tax

126

Issues that Can Paralyze Succession and Estate Planning, 40 U. MIAMI HECKERLING INST. ON

EST. PLAN. § 11, at 11-2 (2006).

86

Edward F. Koren, Preserving the Patriarch’s Patrimony for the Prodigal and Other

Paranormal (or Normal) Family Members: Non-Tax Considerations in Family Business

Succession Planning, 31 U. MIAMI HECKERLING INST. ON EST. PLAN. § 11, at 11-5 (1997).

87

Edward F. Koren, Preserving the Patriarch’s Patrimony for the Prodigal and Other

Paranormal (or Normal) Family Members: Non-Tax Considerations in Family Business

Succession Planning, 31 U. MIAMI HECKERLING INST. ON EST. PLAN. § 11, at 11–5 (1997).

88

U.S. Family Businesses in Strong Position to Survive Downturn, MARKET WIRE, Mar. 2009, at

26.

89

Bernard Kliska, Planning for Business Succession, CHI. BAR ASS’N, Apr. 16, 1996, at 1, 3.

90

Edward F. Koren, Preserving the Patriarch’s Patrimony for the Prodigal and Other

Paranormal (or Normal) Family Members: Non-Tax Considerations in Family Business

Succession Planning, 31 U. MIAMI HECKERLING INST. ON EST. PLAN. § 11, at 11-12 to 11-13

(1997).

91

Glenn A. Ayres & Michael J. Jones, Face the Fear, TR. & EST., Feb. 2007, at 50, 55.

92

MASSMUTUAL, AMERICAN FAMILY BUSINESS SURVEY 7 (2007).

93

Glenn A. Ayres & Michael J. Jones, Face the Fear, TR. & EST., Feb. 2007, at 50, 51.

94

Glenn A. Ayres & Michael J. Jones, Face the Fear, TR. & EST., Feb. 2007, at 50, 51.

95

Edward F. Koren, Preserving the Patriarch’s Patrimony for the Prodigal and Other

Paranormal (or Normal) Family Members: Non-Tax Considerations in Family Business

Succession Planning, 31 U. MIAMI HECKERLING INST. ON EST. PLAN. § 11, at 11-16 to 11-30

(1997).

96

Daniel Markstein suggests the inclusion of a psychologist and an actuary on his 9-member

team. See Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s

Needs, EST. PLAN. J., July 2006.

97

Daniel H. Markstein, III, Business Succession Planning that Meets the Owner’s Needs, EST.

PLAN. J., July 2006.

98

Hannah Shaw Grove & Russ Alan Prince, What, No Succession Plan?, TR. & EST., Sept. 2004,

at 69, 69.

99

Craig E. Aronoff & John L. Ward, How to Manage your Firm’s Biggest Threat, NATION’S

127

BUS., June 1995, at 50.

100

Craig E. Aronoff & John L. Ward, How to Manage your Firm’s Biggest Threat, NATION’S

BUS., June 1995, at 50.

101

Mark Green, Family Business and the Economic Downturn, FAM. BUS. ADVISOR, Sept. 2008.

102

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 6–7 (2009).

103

8 BARCLAYS WEALTH INSIGHTS, FAMILY BUSINESS: IN SAFE HANDS? 17–20 (2009).

104

Mark Green, Family Business and the Economic Downturn, FAM. BUS. ADVISOR, Sept. 2008.

105

Suzanne Mcgee, Succession Recession, FIN. PLAN., Apr. 1, 2009.

106

Dennis T. Jaffer & Tim Habbershon, We’re Jammin’, FAMS. IN BUS., Jan./Feb. 2004, at 41,

43, available at http://www.dennisjaffe.com/articles/Smuckers2.pdf.

107

DENNIS T. JAFFER & TIM HABBERSHON, LINKING STRONG ORGANIZATIONAL VALUES TO A

CENTURY OF COMPANY SUCCESS: HOW THE SMUCKERS STEER THEIR FAMILY COMPANY 11,

available at http://www.dennisjaffe.com/articles/SmuckersCase.pdf. 108

354 Tax Management Portfolio, ESOPs, p. A-1 (6th

Edition). 109

“How an Employee Stock Ownership Plan (ESOP) Works”, www.nceo.org

February 2016

THE ADVISOR’S GUIDE TO LIFE INSURANCE: OPENING THE “BLACK BOX” OF THE LIFE INSURANCE

WAYNE TONNING, FSA

R. MARSHALL JONES, JD, CLU, CHFC

This presentation is designed to provide introductory information in regard to the subject matter covered. It is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. Jones Lowry and M Financial, its distributors and their respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

Disclosure Notice

2

Wayne Tonning

FSA

M Financial

1125 NW Couch Street, Suite 900

Portland, OR 97209

Wayne.Tonning@mfin.com

503.414.7430

Contact Information

R. Marshall Jones

JD,CLU

Jones Lowry

470 Columbia Dr, Suite 100-E

West Palm Beach, FL 33409

RMJ@JonesLowry.com

561-712-9799

3

Wayne Tonning is a Director and Actuary–Insurance, Product Management at M Financial Group.

He brings more than two decades of experience with M Financial to components of M Financial’s client

advocacy strategy. Wayne’s product management responsibilities include due care initiatives, authoring

knowledge and marketing reports, bulletins, updates, and white papers for Member Firms to use with their

advisors (i.e., attorneys, CPAs, and family offices). Wayne conducts industry product competitive studies,

drives due care analysis of all M Partner Carrier product offerings and financial strength, leads in-force

policy management activities, and delivers key metrics and insights in support of the development of

new products.

In addition to his core leadership in Product Management, Wayne oversees M Financial’s Sales Support

and Advanced Markets teams. In this role, he has successfully led the team in the development and

delivery of new services and staffing realignments designed to enhance the level of marketing support for

M Financial’s growing number of Member Firms.

In 2011, Wayne co-authored The Advisor’s Guide To Life Insurance, a comprehensive resource that

provides insight on the purchase, fundamentals, applications, and maintenance of life insurance products.

The book was published by the American Bar Association’s Section of Real Property, Estate and Tax Law.

Wayne also speaks regularly at advisor events, covering topics related to product complexities and due

care, on which he has become a nationally recognized expert.

Prior to joining, and then assuming leadership of, M Financial’s Product Management team, he spent 12

years implementing and managing reinsurance arrangements for M Financial Re, M Financial’s producer-

owned reinsurance company.

Wayne received a BS in finance from Portland State University and is a Fellow of the Society of Actuaries.

Wayne Tonning - M Financial

4

R. Marshall Jones - Jones Lowry

R. Marshall Jones is a Principal of Jones Lowry, an M Financial Member Firm. Jones Lowry is

an independent firm that designs, implements and administers innovative life insurance solutions for

ultra-high net worth clients and their advisors. Jones Lowry has more than $2.0 billion of individual

life insurance inforce.

Mr. Jones graduated with honors from Harvard College. He received his Juris Doctorate from the

University of Akron Law School and served as a Senior Writer for the Law Review. He is a non-

practicing member of the Florida Bar and holds the professional designations of Accredited Estate

Planner (AEP®), Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC),

Chartered Advisor in Philanthropy (CAP) and Fellow, Life Management Institute (FLMI).

M Financial is a national insurance group owned by its Member Firms. With its 37+ year old,

independent data base of high net worth insureds and corporate executive insureds, M Financial and

its Member Firms partner with major insurance companies to develop and monitor M-Proprietary

policies that have the potential to perform better than illustrated.

Marshall has presented at numerous professional organizations, including national meetings of the

Association for Advanced Life Underwriting (AALU), Million Dollar Round Table (MDRT), the Society

of Financial Services Professionals (SFPS) and the New York University Summer Institute in

Taxation. He is the author of the book, Making Decisions about Life Insurance.

Marshall and his wife Irene have been married for more than 35 years. They enjoy golf, running,

bridge, and reading. Marshall finished 36th in the 1973 Boston Marathon and completed more than

twenty sub-3 hour marathons over the next 25 years.

5

WHAT’S INSIDE THE BLACK BOX?

6

The Perfect Investment Vehicle?

Broad Investment Diversification

Non-Correlated

Tax-Free Appreciation

Tax-Free Re-Allocation

Creditor Protected

FIFO Tax Accounting

Non-Taxable Distributions

Income Tax Free at Death

100% Estate Liquidity

7

Life Insurance as a Unique Investment Asset

20 Pay Tax-Free After Taxable Taxable

His/Her Planned Death Tax Estate Estate

Year Age Premium Benefit IRR Equivalent Equivalent IRR

1 59 60 403,592 40,000,000 9811.00% 66,666,667 16418.33%

5 63 64 403,592 40,000,000 123.50% 66,666,667 151.43%

10 68 69 403,592 40,000,000 40.25% 66,666,667 49.47%

15 73 74 403,592 40,000,000 21.48% 66,666,667 27.02%

20 78 79 403,592 40,000,000 13.64% 66,666,667 17.64%

25 83 84 0 40,000,000 9.86% 66,666,667 12.88%

30 88 89 0 40,000,000 7.65% 66,666,667 10.05%

32 90 91 0 40,000,000 7.01% 66,666,667 9.22%

35 93 94 0 40,000,000 6.23% 66,666,667 8.20%

40 98 99 0 40,000,000 5.24% 66,666,667 6.91%

8

Life Insurance as a Unique Investment Asset

9

LIFE INSURANCE PRICING:

THE BASICS

10

Life Insurance Pricing: The Basics

4 Key Actuarial Pricing Factors: mortality, investment

earnings, expenses & taxes, and persistency.

▬ Here’s how they apply to the design of any life insurance policy.

Carrier Perspective

Policyholder Perspective

(Pricing Factors) (Assumptions)

Mortality Experience + Mortality Margin === Mortality Charge

Investment Earnings - Interest Spread === Interest Credit

Expenses & Taxes + Expense Margin === Loading Charges

11

Basic Policy Mechanics: Cash Value

Beginning

Cash Value

(=) Surrender

Value

(+) Premium

(-) Loading

Charges

(-) Mortality

Charge

(+) Interest

Credit

(=) Ending

Cash Value

(-) Surrender

Charge

Universal Life: flexible premiums;

policy remains in force as long as

the cash value remains positive

(the policy lapses when the cash

value reduces to zero).

Whole Life has a fixed premium

schedule to ensure a positive cash

value to maturity.

12

1907: WHOLE LIFE

(WL)

Whole Life is a fixed premium, cash value solution

with projected performance based on low interest

rates and current mortality. WL provides upside

potential (crediting rates and mortality) with limited

flexibility. Carrier maintains investment control, but

investment risk is born by policyholder.

13

Whole Life Insurance

14

Fixed Premiums based on guarantees, usually

payable for life; limited liquidity; limited transparency

▬ Non-Guaranteed Dividends can pay premiums,

enhance cash value, or increase death benefit

Crediting rate: Supported by investment grade portfolio

bond and mortgage portfolio

▬ Book value accounting smooths portfolio yield and

Dividend Interest Rate (DIR)

Black Box: Divisible Surplus (Mortality Charges, Policy

Charges, Interest Credit)

Trends:

▬ Downward dividend interest rates (DIR)

▬ Carriers taking more investment risk to sustain DIRs

Whole Life: Attributes

15

Whole Life “Dividend Interest Rates”

Changes in DIRs over time have tended to align

with new money interest rate movements.

Black Box:

The application of the Dividend Formula varies

widely by insurer and policy.

Limited reliable conclusions can be drawn

from comparing the absolute DIRs of WL

carriers.

NOTE: DIRs in WL have a very different

application than UL crediting rates; they are not

comparable on an absolute basis. (White Paper)

16

Correlation Between WL DIRs and

Rolling Average Benchmark

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

01

/01

/99

07

/01

/99

01

/01

/00

07

/01

/00

01

/01

/01

07

/01

/01

01

/01

/02

07

/01

/02

01

/01

/03

07

/01

/03

01

/01

/04

07

/01

/04

01

/01

/05

07

/01

/05

01

/01

/06

07

/01

/06

01

/01

/07

07

/01

/07

01

/01

/08

07

/01

/08

01

/01

/09

07

/01

/09

01

/01

/10

07

/01

/10

01

/01

/11

07

/01

/11

01

/01

/12

07

/01

/12

01

/01

/13

07

/01

/13

01

/01

/14

07

/01

/14

01

/01

/15

07

/01

/15

Historical UL/WL Benchmark vs Sample Interest Rates

UL/WL Benchmark (Moody's BAA 7 Yr Rolling Average) Carrier A UL Crediting Rate Carrier B DIR

17

In-Force Policies

▬ Annual Reviews; Assess Policyholder Treatment

▬ In-force illustrations to assess impact of lower DIRs

▬ Note: Limited ability to fix a reducing dividend problem

New Policies

▬ Run downside scenarios; consider Paid Up Additions

riders

▬ Note: Term Riders will reduce Policy Guarantees

and may reduce ultimate death benefit

Whole Life: Practical Considerations

Whole Life is a fixed premium, cash value solution with projected performance

based on low interest rates and current mortality. WL provides upside potential

(crediting rates and mortality) with limited flexibility. Carrier maintains investment

control, but investment risk is born by policyholder.

18

Blended Whole Life Insurance

19

1978: UNIVERSAL LIFE

(UL)

Universal Life is a flexible premium, cash value

solution with projected performance based on low

interest rates and current mortality. UL provides

upside potential (crediting rates and mortality) with

significant flexibility. Carrier maintains investment

control, but investment risk is born by policyholder.

20

Universal Life Insurance

21

Flexible Premiums, liquidity, transparency of

product charges

Guaranteed and Current crediting rates and

cost of insurance charges (COIs)

Crediting Rate supported by investment grade

bond and mortgage portfolio

▬ Book value accounting smooths portfolio yield

and crediting rate

Black Box: Gross/Net Crediting Rate Spread

Trend: Downward crediting rate pressure

Universal Life: Attributes

22

UL Crediting Rate Portfolio

Source: Best Statement File, A.M. Best

23

Economic conditions, such as low interest rates

and equity market volatility, generally impact all

financial instruments, including life insurance.

Life Insurance, in general, has performed well

relative to other financial instruments.

▬ Superior portfolio yields and crediting rates

(3.5%–4.5%).

▬ High-quality assets with comparatively low

default rates.

▬ Tax-deferred inside build up of cash values.

UL Product Performance Considerations

24

Decline In Historical New Money Rates

Note 2015 rate

increase of

approximately

90 bps

25

Strong Correlation Between UL Crediting

Rates And Rolling Average Benchmarks

26

0 1 2 3 4 5 6 7

New Money 5.5 6.5 7.5 7.5 7.5 7.5 7.5 7.5

7 Yr RA 5.6 5.4 5.5 5.8 6.1 6.5 6.8 7.2

5.0

5.5

6.0

6.5

7.0

7.5

8.0

%

November 2015 Crediting Rate Benchmark

Hypothetical 7 Year Projection 7 Year Rolling Average of Moody's Baa

Portfolio Yields Will Continue to Drop

Due To Lag Factor (New Money Increase)

Rolling average

drops

approximately 10

bps over 2 years

before rebound

27

In-Force Policies

▬ Crediting rate reductions

● To or approaching guarantees

▬ Increased non-guaranteed charges (COI increases)

● Five carriers increased in-force COIs in 2015 (an uncommon industry practice that speaks to the severity of low interest rate environment)

● White Paper

New Policies

▬ Reductions in Crediting Rates (Current & Guaranteed)

▬ Premium Restrictions

▬ Additional Charges for large premiums

Universal Life: Recent Carrier Actions

28

In-Force Policies

▬ Annual Reviews; Assess Policyholder Treatment

▬ In-force illustrations to assess impact of lower crediting

rates (include scenario testing)

▬ Take appropriate action to keep the policy on track

● Additional premiums, reduced death benefit, 1035 exchange

New Policies

▬ Run downside scenarios

▬ Fund appropriately (i.e., with conservatism)

Universal Life: Practical Considerations

Universal Life is a flexible premium, cash value solution with projected performance based on low interest rates and current mortality. UL provides upside potential

(crediting rates and mortality) with significant flexibility. Carrier maintains investment control, but investment risk is born by policyholder.

29

VARIABLE UNIVERSAL LIFE

(VUL)

Variable UL is a flexible premium, cash value solution for sophisticated owners with maximum

control and flexibility. Policyholder maintains control and risk. Policyholder must commit to ongoing

management of policy to optimize results.

30

Flexible premiums, flexible investment options, liquidity,

very high transparency

▬ Investment Allocation and Re-Allocation by Client

▬ Guaranteed and Current product charges (COIs)

Variable Crediting Rate: 100% risk transfer with earnings, net

of charges, on Separate Account investment options (40+

choices)

Black Box: Insurance Charges at Fund Level

Trends:

▬ Increased Separate Account Investment Choices

▬ Addition of UL Fixed Accounts & Indexed UL Options

▬ Medium Duration No Lapse Guarantees (NLG)

Variable UL: Attributes

31

$10,000 Investment with No Withdrawals

32

$10,000 Investment with $600 Annual

Withdrawals

33

In-Force Policies

▬ Annual Reviews of Policy Charges and Investment Results

▬ In-Force Illustrations may expose overly optimistic

assumptions

▬ Take appropriate action to keep the policy on track

● Additional premiums, reduced death benefit, 1035

exchange

New Policies

▬ Plan for volatility

▬ Fund Appropriately (increasing cash values to maturity)

▬ Stress Test

Variable UL: Practical Considerations

Variable UL is a flexible premium, cash value solution for sophisticated owners with maximum control and flexibility. Policyholder maintains control and risk.

Policyholder must commit to ongoing management of policy to optimize results.

34

2003: No-Lapse Guarantee

Universal Life

(NLG-UL)

NLG Universal Life is a planned premium, illiquid contract with death benefit guarantees based on (1)

low interest rates, (2) high reserve requirements, and (3) current mortality with no upside potential

and limited flexibility. Investment risk and mortality risk are borne by the insurance carrier.

35

Fixed Guaranteed Premiums and Guaranteed Death Benefit for Specified Term of Years or for Life

Not Liquid:

▬ Little or no cash surrender value

▬ Withdrawals or Loans reduce guarantees

Timely Premium Receipt by Carrier

▬ Late or early payments may decrease the guarantees

▬ Often no “Grace Period” to prevent policy lapse

Trends: Upward price pressure; carriers exiting market; shorter maximum guarantee periods (i.e., medium duration NLG)

No-Lapse Guarantee UL: Attributes

36

Benefits:

▬ Scheduled Premiums and Contractual Death Benefit are fully guaranteed provided every premium payment is received on a timely basis

▬ Insurance Carrier assumes all investment risk

▬ Regulations require adequate reserves to honor guarantees

Concerns

▬ Limited premium flexibility

▬ Timing of premium payments is critical

▬ Little or no cash surrender value to maintain policy

NLG UL: Practical Considerations

NLG Universal Life is a planned premium, illiquid contract with death benefit guarantees based on (1) low interest rates, (2) high reserve requirements, and (3) current mortality with no upside potential and limited flexibility. Investment risk and mortality risk are

borne by the insurance carrier.

37

2005: INDEXED UNIVERSAL LIFE

(IUL)

Indexed UL is a flexible premium, cash value solution with projected performance based on hypothetical

crediting rates and current mortality. IUL can provide 100 – 200 bps increased yield over UL. Carrier maintains

significant control, but risk is born by policyholder.

38

Flexible Premiums, exposure to equity markets with

downside protection, liquidity, transparency of product

charges

Crediting Rate: % of index (e.g., S&P 500 without dividends)

with cap (e.g., 11%) and floor (e.g., 0%);

▬ Option to re-allocate to Fixed Account (UL Crediting Rate)

Black Box: Determination of Floor, Cap and Participation Rates

Trends:

▬ Declining caps & participation rates

(economics or “bait & switch”?)

▬ Increased Indexed Account Options

▬ Medium duration No Lapse Guarantees (NLG)

Indexed UL: Attributes

39

Segment Term: 12 Months

Underlying Index: S&P 500 (excluding dividends)

Participation Rate: 100%

Growth Cap: 11%

Guaranteed Floor: 0%

Hypothetical Returns:

▬ 6.23%: Worst 20-Year Average since 1970

with 12 monthly segments/year

▬ 6.45%: Maximum Illustration Rate allowed under Actuarial Guideline 49

▬ 7.03%: Average of all overlapping 20 year returns since 1970

▬ 7.21%: Average Annual Return over the last 65-year historical period

Note: Indexed Account Caps, Floors and Participation Rates are linked to

General Account portfolio yields and options market costs

1-Year S&P 500 Indexed Account Example

40

In-Force and New Policies:

1. Once a Year “Index Roulette”

2. Overly optimistic investment assumptions

3. Gimmick Indexed Options

4. Carriers that treat Policyholders like Stockholders

5. Think Very Long Term (Lifetime Investment)

6. Excellent Plan Management

Indexed UL: Practical Considerations

Indexed UL is a flexible premium, cash value solution with projected performance based on hypothetical crediting rates and current mortality.

IUL can provide 100 – 200 bps increased yield over UL. Carrier maintains significant control, but risk is born by policyholder.

41

WHAT A DIFFERENCE THE YEARS MAKE! UL vs Indexed UL vs Variable UL

42

Primary Crediting Rate Mechanisms:

UL vs IUL vs VUL

-40.00%

-35.00%

-30.00%

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

Historical UL Crediting Rates, S&P 500® Returns, and Hypothetical IUL Crediting Rates

S&P 500

IUL

UL

43

Post 2008 Look Back: S&P 500®

Double Digit Returns in 5 of Last 6 Years

Page 44 of 25

16.5%

9.9%

4.3%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

S&P 500 IUL UL

2009-2014

Cumulative Annual S&P 500® Return and Crediting

Rates

44

15 Year Look Back: S&P 500® Volatility

IUL Outperforms VUL

Page 45 of 25

3.7%

6.5%

5.1%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

S&P 500 IUL UL

2000-2014

Cumulative Annual S&P 500® Return and Crediting

Rates

45

25 Year Look Back: 190 to 300 bps VUL Enhanced Yield

Page 46 of 25

9.1%

7.2%

6.1%

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%5.5%6.0%6.5%7.0%7.5%8.0%8.5%9.0%9.5%

10.0%

S&P 500 IUL UL

1990-2014

Cumulative Annual S&P 500® Return and Crediting

Rates

46

CLOSING THOUGHTS

REVIEWS & DESIGNS

47

Product Matrix – Premium Risk Sufficiency

Guaranteed Universal Life

Participating Whole Life

Traditional Universal Life

Indexed Universal Life

Variable Universal Life

Conservative Conservative Balanced Moderate Flexible Styles: Conservative to

Aggressive

"Intolerant of volatility and seeks guarantees"

"Intolerant of volatility and seeks guarantees. Willing to pay higher premium for

upside potential"

"Tolerant of modest volatility and willing to

accept fewer guarantees in favor of premium

flexibility"

"Tolerant of higher volatility and willing to accept fewer

guarantees in favor of premium flexibility and

investment opportunity"

"Tolerant of volatility and may be willing to reduce guarantees to maximize

investment opportunity"

Premium Risk Sufficiency

Held by Insurance Company Held by Insurance

Company Transferred to Policyowner Transferred to Policyowner

1 Transferred to Policyowner

1

Premium / Death Benefit Guarantees

Fully Guaranteed (Full Death benefit) for term of years up

to lifetime

Fully Guaranteed for Life (Base Death Benefit Only)

Guaranteed Interest, Mortality Cost and Expense Loads are used to calculate guaranteed death benefit

and cash value

Same as Traditional UL except Interest is based on an

Index with a guaranteed "floor" rather than a declared rate, See Note 1, for No-Lapse

Rider alternative.

No Interest guarantees eliminates a death benefit guarantee for this product,

See Note 1, for No-Lapse Rider alternative.

Product Description Essentially "Lifetime Term"; low premium, bare bones

design with no flexibility or upside. In this low interest rate environment there is a risk of being locked in to

lower performance.

Fixed premium has highest initial cost for full

guarantees; dividends provide significant "upside" and may be used to reduce

premium now or in the future.

Flexible Premium allows for a wide range of design

possibilities that may be adjusted to match changing

future needs.

Same as Traditional UL except Index crediting creates greater upside potential but

with more volatility. No-Lapse Rider provides Full DB guarantees for a term of years

Same as Traditional UL except Separate Account

options create a true equity based product with both

upside and loss potential and higher volatility. Same No-

Lapse Rider as Index UL

Notes:… 1 No-Lapse Alternative - Many Index and Variable Universal Life contacts offer No-Lapse riders that, for a premium, keep the "Premium Risk Sufficiency" held by the Insurance Company. Normally the cost of these riders is prohibitive to provide "Lifetime" no-lapse guarantee. However, mid-term guarantees (e.g. - Age 90) are often reasonably priced, and do not create a drag on performance that causes a significant increase in premium.

Style Comparability

Lower Risk - Higher Guarantees Higher Risk - Lower Guarantees

Premium Risk Sufficiency

48

Insurance Product Selection: A Portfolio Approach Male 64, Female 58; Survivorship Benefit $80,000,000

Carrier A.M. Best S&P Moody’s Fitch Comdex Weighted Average Comdex

Company A A+ A+ A1 A+ 89

Company B A+ A+ A1 A 88

Company C A+ AA- Aa3 AA- 95

92 Company D A+ AA- A1 AA- 94

Company E A++ AA+ Aa1 AAA 99

Company

A

15%

Company

B

40% Company

C

15%

Company

D

15%

Company

E

15%

Products by Company

Indexed

UL

30%

GUL

40%

VUL

15%

Traditional

UL

15%

Products By Type

49

Variable Universal Life (VUL) insurance combines the death benefit protection and tax advantages of life insurance with the investment potential of a comprehensive selection of variable investment options. The insurance component provides death benefit coverage and the variable investment option component gives you the flexibility to potentially increase the policy's cash value.

Variable life insurance products are long-term investments and may not be suitable for all investors. An investment in variable life insurance is subject to fluctuating values of the underlying investment options and it entails risk, including the possible loss of principal.

Investors should consider the investment objectives, risks, charges and expenses of any variable insurance product and its variable investment options carefully before investing. This and other important information about the investment company is contained in the variable product and fund prospectuses, which can be obtained by calling your advisor. Please read them carefully before you invest.

This information has been taken from sources, which we believe to be reliable, but there is no guarantee as to its accuracy. It is not a replacement for any account statement or transaction confirmation issued by the provider. This material is not intended to present an opinion on legal or tax matters. Please consult with your attorney or tax advisor, as applicable.

Pursuant to IRS Circular 230, we notify you as follows: The information contained in this document is not intended to and cannot be used by anyone to avoid IRS penalties.

Securities referenced in this presentation are offered through various broker/dealers with which Member Firms of M Financial Group are associated, including M Holdings Securities, Inc., member FINRA SIPC.

Variable Universal, Indexed Universal and Universal Life Insurance generally require additional premium payments after the initial premium. If either no premiums are paid, or subsequent premiums are insufficient to continue coverage, it is possible that coverage will expire.

The indexed accounts do not directly participate in any stock or equity investments.

Important Disclosures

50

Wayne Tonning, FSA

M Financial

1125 NW Couch Street, Suite 900

Portland, OR 97209

Wayne.Tonning@mfin.com

503.414.7430

Contact Information

R. Marshall Jones, JD,CLU

Jones Lowry

470 Columbia Dr, Suite 100-E

West Palm Beach, FL 33409

RMJ@JonesLowry.com

561-712-9799

51

THE END!

THANK YOU!!

52

“Everything that can be invented

has been invented.”

Charles H. Duell,

Director of US Patent Office, 1899

“Sensible and responsible women

do not want to vote.”

Grover Cleveland, 1905

“Who the hell wants to hear actors

talk?”

Harry M. Warner, Warner Bros. Pictures,

1927

THE EVOLUTION OF AN

INVESTMENT

FIDUCIARY’S ROLE IN

ESTATE PLANNING + HAROLD EVENSKY, CFP

INVESTMENT

FIDUCIARY

HISTORY

GENERAL

HARVARD COLLEGE V. AMORY,

26 MASS. (9 PICK.) 446(1830)

"…how men of prudence, discretion and

intelligence manage their own affairs,

not in regard to speculation, but in

regard to the permanent disposition of

their funds, considering the probable

income, as well as the probable safety of

the capital to be invested."

1830 - HARVARD vs. AMORY

Where, however, the risk is not out of

proportion [to return], a man of

intelligence may make a disposition

which is speculative in character with a

view to increasing his property instead

of merely preserving it. Such a

disposition is not a proper trust

investment...”

1959 – RESTATEMENT 2ND

Unfortunately the old paradigm remained

“…all purchases of even high-grade

securities for the purpose of resale at a

profit...”

“...all programs not mandated by the

trust instrument that are undertaken to

increase the number of dollars to

compensate for loss of purchasing

power...”

OLD PARADIGM REMAINS

UNIFORM MANAGEMENT OF INSTITUTIONAL

FUNDS ACT (1972)

• The prudent use of appreciation (a

total return policy)

• Investment authority to invest in

stock

• The right to delegate investment

authority

1972 – INSTITUTIONAL FUNDS

EMPLOYEE RETIREMENT SECURITY ACT of 1974

...with the care, skill, prudence, … under the circumstances then

prevailing that a prudent man acting in a like capacity and familiar with such

matters would use in the conduct of an enterprise of a like character and with

like aims…. provide a procedure

1974 - ERISA

Howard v.Shay 100F. 3d 1484 (9th Cir.1998)

“ERISA fiduciaries are held to the standard not of a prudent person but rather of a prudent fiduciary with experience dealing with a similar enterprise …. If they do not have all of the knowledge and expertise necessary to make a prudent decision, they have a duty to obtain independent advice.”

ERISA

“… focuses on the trust’s portfolio as a

whole and the investment strategy on

which it is based, rather than viewing a

specific investment in isolation.”

1990 – RESTATEMENT 3RD

Reflects Modern Investment Concepts and Practices

• Recognizes that return on investment

is related to risk… risk includes deterioration of real return owing to inflation.

• No investments or techniques are imprudent per se

1990 – RESTATEMENT 3RD

• Sound diversification is fundamental

• The duty of impartiality requires a balancing between production of current income and the protection of purchasing power.

1990 – RESTATEMENT 3RD

• A duty to analyze and make

conscious decisions concerning the

levels of risk appropriate

• Trustees may have a duty as well

as having the authority to delegate

as prudent investors would

1990 – RESTATEMENT 3RD

UNIFORM PRUDENT INVESTOR ACT

National Conference of Commissioners on

Uniform State Laws (1994)

American Bar Association, Miami, (1995)

The primary objective of the act is to make

fundamental changes in five criteria for

prudent investing.

1994 - UPIA

1. The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments.

2. The tradeoff in all investing between risk and return is identified as the fiduciary’s central consideration.

3. All categorical restrictions on types of investments have been abrogated

1994 - UPIA

4. The requirement that fiduciaries diversify their investments has been integrated into the definition of prudent investing.

5. Delegation is now permitted, subject to safeguards.

1994 - UPIA

PRINCIPLES

• No investments or techniques are imprudent per se

• Sound diversification is fundamental

• A duty to analyze and make conscious decisions concerning the levels of risk appropriate

1994 - UPIA

• The duty of impartiality requires a balancing of the elements between production of current income and the protection of purchasing power.

• Trustees may have a duty as well as having the authority to delegate as prudent investors would.

1994 - UPIA

Florida Statutes 518.11 – Investments

by fiduciaries; prudent investor rule

Current as of: 2015 | Check for updates |

Other versions

(1) A fiduciary has a duty to invest and

manage investment assets as follows:

(a) The fiduciary has a duty to invest

and manage investment assets as a

prudent investor would considering the

purposes, terms, distribution

requirements, and other circumstances

of the trust. This standard requires the

exercise of reasonable care and caution

and is to be applied to investments not

in isolation, but in the context of the

investment portfolio as a whole and as

a part of an overall investment strategy

that should incorporate risk and return

objectives reasonably suitable to the

trust, guardianship, or probate estate. If

the fiduciary has special skills, or is

named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a duty

to use those skills.

Florida Statutes 518.11 –

Investments by fiduciaries;

prudent investor rule

518.11 - FLORIDA PIA

Florida Statutes 518.11 – Investments

by fiduciaries; prudent investor rule

Current as of: 2015 | Check for updates |

Other versions

(1) A fiduciary has a duty to invest and

manage investment assets as follows:

(a) The fiduciary has a duty to invest

and manage investment assets as a

prudent investor would considering the

purposes, terms, distribution

requirements, and other circumstances

of the trust. This standard requires the

exercise of reasonable care and caution

and is to be applied to investments not

in isolation, but in the context of the

investment portfolio as a whole and as

a part of an overall investment strategy

that should incorporate risk and return

objectives reasonably suitable to the

trust, guardianship, or probate estate. If

the fiduciary has special skills, or is

named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a duty

to use those skills.

• To be applied to investments not in

isolation, but in the context of the

investment portfolio as a whole…

that should incorporate risk and

return objectives reasonably

suitable to the trust, guardianship,

or probate estate.

FLORIDA PIA

Florida Statutes 518.11 – Investments

by fiduciaries; prudent investor rule

Current as of: 2015 | Check for updates |

Other versions

(1) A fiduciary has a duty to invest and

manage investment assets as follows:

(a) The fiduciary has a duty to invest

and manage investment assets as a

prudent investor would considering the

purposes, terms, distribution

requirements, and other circumstances

of the trust. This standard requires the

exercise of reasonable care and caution

and is to be applied to investments not

in isolation, but in the context of the

investment portfolio as a whole and as

a part of an overall investment strategy

that should incorporate risk and return

objectives reasonably suitable to the

trust, guardianship, or probate estate. If

the fiduciary has special skills, or is

named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a duty

to use those skills.

• No specific investment or course of

action is, taken alone, prudent or

imprudent.

• If the fiduciary has special skills, or

is named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a

duty to use those skills.

• The prudent investor rule is a test of

conduct and not of resulting

performance.

(c) The fiduciary has a duty to

diversify the investments unless,

under the circumstances, the fiduciary

believes reasonably it is in the

interests of the beneficiaries and

furthers the purposes of the trust,

guardianship, or estate not to diversify.

FLORIDA PIA

Florida Statutes 518.11 – Investments

by fiduciaries; prudent investor rule

Current as of: 2015 | Check for updates |

Other versions

(1) A fiduciary has a duty to invest and

manage investment assets as follows:

(a) The fiduciary has a duty to invest

and manage investment assets as a

prudent investor would considering the

purposes, terms, distribution

requirements, and other circumstances

of the trust. This standard requires the

exercise of reasonable care and caution

and is to be applied to investments not

in isolation, but in the context of the

investment portfolio as a whole and as

a part of an overall investment strategy

that should incorporate risk and return

objectives reasonably suitable to the

trust, guardianship, or probate estate. If

the fiduciary has special skills, or is

named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a duty

to use those skills.

• The prudent investor rule is a test of

conduct and not of resulting

performance.

• The fiduciary has a duty to diversify

the investments …

FLORIDA PIA

Robert B. Wolf, Defeating the Duty to

Disappoint Equally—The Total Return

Trust, 32 REAL PROP. PROB. & TR.

J. 46 (1997)

Total Return Trusts? Can Your Clients

Afford Anything Less, 33 REAL PROP.

PROB. & TR. J. 131 (1998)

1997 - TOTAL RETURN UNITRUST

Florida Statutes 518.11 – Investments

by fiduciaries; prudent investor rule

Current as of: 2015 | Check for updates |

Other versions

(1) A fiduciary has a duty to invest and

manage investment assets as follows:

(a) The fiduciary has a duty to invest

and manage investment assets as a

prudent investor would considering the

purposes, terms, distribution

requirements, and other circumstances

of the trust. This standard requires the

exercise of reasonable care and caution

and is to be applied to investments not

in isolation, but in the context of the

investment portfolio as a whole and as

a part of an overall investment strategy

that should incorporate risk and return

objectives reasonably suitable to the

trust, guardianship, or probate estate. If

the fiduciary has special skills, or is

named fiduciary on the basis of

representations of special skills or

expertise, the fiduciary is under a duty

to use those skills.

2002 - Florida Statutes 738.1041 – Total

Return Unitrust

A trustee may, without court approval,

convert an income trust to a total

return unitrust, reconvert a total return

unitrust to an income trust

2002 - TOTAL RETURN UNITRUST

A TRU can address the problems of the

classic trust design

• The interest of current beneficiaries are

harmonized with remainder

beneficiaries

• Since both key parties to the trust have

similar interests14, the mission of the

trustee and investment team can be

more focused

ADVANTAGES OF THE TRU

• Even though interest rates may

fluctuate widely in the marketplace,

the TRU can minimize or eliminate

the impact on the current beneficiary.

ADVANTAGES OF THE TRU

• TRU diminishes the potential that

trustees will be surcharged by

remainder beneficiaries who, with 20-20

hindsight, claim those trustees invested

too heavily in income producing assets

and the threat of lawsuit against a

trustee by income beneficiaries who

charge the trustee with investing too

much of the trust's assets for long-term

growth

.

ADVANTAGES OF THE TRU

UNFORM PRUDENT MANAGEMENT OF INSTITUTIONAL FUNDS ACT (UPMIA)

NATIONAL CONFERENCE OF COMMISSIONERS

ON UNIFORM STATE LAWS

July 7-4, 2006

2006 - UPMIFA

The Uniform Prudent Management of Institutional Funds Act (UPMIFA) replaces the Uniform Management of Institutional Funds Act (UMIFA - 1972).

2006 - UPMIFA

Comment

UPMIFA updates rules on investment decision making for trusts, including charitable trusts, and imposes additional duties on trustees for the protection of beneficiaries.

… follows modern portfolio theory for investment decision making. … applies to all funds held by an institution, regardless of whether the institution obtained the funds by gift or otherwise and regardless of whether the funds are restricted.

2006 - UPMIFA

UPMIFA applies these rules and duties to charities organized as nonprofit corporations.

UPMIFA does not apply to trusts managed by corporate and other fiduciaries that are not charities, because UPIA provides management and investment standards for those trusts.

2006 - UPMIFA

The changes UMIFA made to the law permitted charitable organizations to use modern investment techniques such as total-return investing and to determine endowment fund spending based on spending rates rather than on determinations of “income” and “principal.”

2006 - UPMIFA

FIDUCIARY

HISTORY

SECURITIES INDUSTRY

When the Securities Exchange Act of

1934 and the Investment Advisers Act

of 1940 passed, the financial markets

were barely active. The number of

advisers was quite small.

1940 – INVESTMENT ADVISOR ACT

Advisers were viewed and regulated

as fiduciaries. Brokers were viewed

and regulated as securities

salespersons … brokers were

excluded from the definition of an

investment adviser.

1940 – INVESTMENT ADVISOR ACT

BROKER/DEALER EXEMPTION

Any broker or dealer whose

performance of such services is

solely incidental to the conduct of his

business as a broker or dealer and

who receives no special compensation

therefor.

1940 – INVESTMENT ADVISOR ACT

U.S. Supreme Court

SEC

v.

Capital Gains Research

Bureau, Inc.,

375 U.S. 180 (1963)

1963 - CAPITAL GAINS

The Supreme Court decision

recognized that, as a matter of

law, investment advisers owe a

fiduciary duty

1963 - CAPITAL GAINS

Brokers’ regulation differed

Self-regulatory organizations of

brokers to be supervised by the

Securities and Exchange

Commission (SEC). One

organization emerged: the National

Association of the Securities Dealers

(now FINRA).

1963 - CAPITAL GAINS

SUMMARY

ACROSS ALL

REGS

PRUDENT INVESTMENT GUIDELINES

• FOLLOW THE INVESTMENT PLANNING

PROCESS

• DETERMINE THE RISK TOLERANCE OF

THE TRUST

• DEVELOP AN INVESTMENT POLICY

• DESIGN THE POLICY FOR TOTAL

RETURN

• MANAGE RISK

PRUDENT INVESTMENT GUIDELINES

• LIQUIDATE INAPPROPRIATE

INVESTMENTS

• MINIMIZE DIVERSIFIABLE RISK

• DIVERSIFY ACROSS POORLY

CORRELATED ASSET CLASSES

• CONSIDER THE USE OF BOTH PASSIVE

AND ACTIVE MANAGERS

• DELEGATE INVESTMENT MANAGEMENT

PRUDENT INVESTMENT GUIDELINES

IT’S ALL

ABOUT

TRUST

TODAY

FINANCIAL

SERVICES

REGULATION

TODAY

THINGS

CHANGED

• Merger of large financial institutions

• Banks offer advisory, investment

management, brokerage, investment

banking, and other financial services

• Brokers exercise new and different

functions.

• The variety of brokers fee-structures

has also multiplied and expanded

throughout the years.

THINGS CHANGED

CURRENT

REGULATION

PRINCIPAL-

DRIVEN

vs

RULES BASED

BROKER

SUITABILITY – RULES

“Arms-length”

In these relationships, the

doctrine of “caveat emptor”

generally applies.

RULES vs PRINCIPALS

INVESTMENT ADVISOR - PRINCIPAL

The law imposes duties of loyalty, care,

and full disclosure to carry on with their

dealings with the client at a level far

above ordinary, or even “high,”

commercial standards of conduct.

PRINCIPALS - FIDUCIARY

Conduct of the fiduciary cannot be

circumscribed by the client in

advance. The duty of loyalty

compels the fiduciary to act in the

best interests of the client, and not

out of the fiduciary’s self-interest.

PRINCIPALS - FIDUCIARY

ON ONE SIDE

THE

“HARMONIZERS”

RULES - HARMONIZERS

#AICPApfp

Wall Street LAWYER

The Madoff “Opportunity”

Harmonizing the Overarching Standard of

Care for Financial Professionals Who Give

Investment Advice

• Thomas P. Lemke is Managing Director and

General Counsel of Legg Mason

• Steven W. Stone a partner in the Washington,

DC office of Morgan, Lewis & Bockius

RULES - HARMONIZERS

Wall Street LAWYER

The RAND Report—found that, in

varying degrees, investors,

investment professionals, and

other affected parties either do not

understand, or are confused by,

the bifurcated approach.

RULES - HARMONIZERS

Wall Street LAWYER

This confusion is understandable

because broker-dealers and

investment advisers often do the

very same thing: they give advice

or recommendations

RULES - HARMONIZERS

Wall Street LAWYER

A question remains as to whether

long-standing competitive distrust,

jockeying over legalistic distinctions,

and focusing on “labels” could derail

the “opportunity” for reform that has

been fostered by the Madoff scandal

RULES - HARMONIZERS

Wall Street LAWYER

Current broker-dealer regulatory

scheme does not have traditional

fiduciary duty principles embedded

in it but it nevertheless clearly

reflects fiduciary principles

RULES - HARMONIZERS

Wall Street LAWYER

FINRA has issued a variety of

rules … Although this guidance is

rarely couched in “fiduciary duty”

nomenclature, there can be no

doubt that its “DNA” flows from

fiduciary principles .

RULES - HARMONIZERS

Wall Street LAWYER

• Just and Equitable Practices

A broker-dealer must observe high

standards of commercial honor.

• Suitability of Recommendations

A broker-dealer must have a

reasonable basis to believe that any

recommendation is “suitable,”

RULES - HARMONIZERS

Wall Street LAWYER

A Proposed Uniform Standard

The appropriate uniform standard of

care needs to be vigorously debated.

The final result must balance a

number of public policy, investor

protection, political, and competitive

considerations.

RULES - HARMONIZERS

Wall Street LAWYER

While fiduciary duty clearly should be

the overarching standard of care, that

standard must be defined and applied

in particular cases …in a way that

recognizes the different roles financial

professionals may play.

RULES - HARMONIZERS

Wall Street LAWYER

Given the relatively few concerns

historically associated with non-

discretionary advice, investors who

use financial professionals for non-

discretionary advice seem

adequately protected by the current

approach.

RULES - HARMONIZERS

Wall Street LAWYER

Broker-dealers are subject to a broad

array of detailed, reticulated rules.

The stacked volumes of statutes and SEC

and SRO rules to which a broker-dealer is

subject might span three feet in height,

investment advisors are subject to rules

that probably span less than three inches.

RULES - HARMONIZERS

SIFMA recommends the adoption of a

“universal standard of care” that …

express, in plain English, the

fundamental principles of fair dealing

that individual investors can expect

from all of their financial services

providers.

RULES – UNIVERSAL STANDARD

The new universal standard would

combine the suitability requirement

with the ideas of FINRA Standard of

Commercial Honor and Principals of

Trade which requires high

standards of commercial honor and

just and equitable principals of

trade.”

RULES – UNIVERSAL STANDARD

THE

LAW

1999 The S.E.C. proposed a rule allowing

brokers to offer fee-based accounts without

being subject to the Investment Advisers

Act. Though the rule was not formally

adopted, the S.E.C. said brokers could act

as if it were.

2004 The Financial Planning Association

sued the S.E.C. It said the S.E.C. had

violated federal procedures in failing to

adopt a rule that was pending for more than

four years.

RULES – HISTORY

2005 In response, the S.E.C. adopted the

Merrill rule, formally called “Certain Broker

Dealers Deemed Not to Be Investment

Advisers.” The rule allows brokers to offer

fee-based accounts and not act as

fiduciaries, as long as they make certain

disclosures. A few weeks after the rule was

adopted, the Financial Planning Association

filed a second lawsuit.

RULES – HISTORY

2007 The United States Court of Appeals for

the District of Columbia rules in the

Financial Planning Association’s favor, and

overturns the Merrill rule.

RULES – HISTORY

SEC 913 . AUTHORIZED (NOT REQUIRE)

THE SEC TO ESTABLISH A FIDUCIARY

DUTY FOR BROKERS, DEALERS, AND

INVESTMENT ADVISERS PROVIDING

PERSONALIZED ADVICE AT A LEVEL NO

LESS THAN THE ‘40 ACT

DODD-FRANK

July 2010

2010 – DODD FRANK

At the heart of that issue of harmonizing rules for broker/dealers and advisors is a fiduciary duty… our attention right now is focused on fighting for the legislative provision that would mandate a uniform fiduciary standard.

It is an important issue for us.

Mary Shapiro, SEC Chair

2010 – DODD FRANK - SEC

The central imperative of a fiduciary is

putting investors’ interests first. A

fiduciary should also act with good

professional judgment, and avoid

conflicts of interest, if possible, or

otherwise effectively manage conflicts

through clear disclosure and, as

appropriate, investor consent.

John Taft, CEO of RBC Wealth Management and Chair-Elect of SIFMA

2010 – DODD FRANK - RULES

SEC has not even said if it will propose a

rule.

Last year Daniel Gallagher, a Republican

commissioner has said he is not sure that a

majority of the Commission believes that a

stronger rule is necessary.

“The commission should slow down and get

all of the facts before adding to the long list

of rules resulting from these false

narratives.”

2010 – DODD FRANK - SEC

The DOL “conflict of Interest”

“fiduciary” rule was reproposed in

April 2015

2015 – DOL RULE

Assistant Secretary for Employee Benefits Security

Department of Labor

There are about 48,000 private sector

defined benefit plans that hold

approximately $2.6 trillion in assets. In

addition there are nearly 670,000 private-

sector 401(k) and other defined

contribution plans that hold about $3.9

trillion. IRAs hold an additional $4.7 trillion.

DOL – PHILLIS BORZI

Unlike plan participants, IRA holders do

not have the benefit of a plan fiduciary to

represent their interest in dealing with

advisors. Compared to those with plan

accounts, IRA holders are more likely to

be elderly. For all of these reasons,

combating conflicts among advisors to

IRAs is at least as important as

combating those among advisors to

plans.

DOL

Research focusing exclusively on the most

clear-cut forms of conflict estimate an

extreme lower bound on losses of roughly

$6-$8 billion per year for IRA investors.

More inclusive, but still quite conservative,

estimates of the cost of conflict suggests

losses of roughly $8-$17 billion per year.

WHITE HOUSE

MORNINGSTAR

The rule could drastically alter the profits

and business models of investment

product manufacturers.

Based on our proprietary estimates, we

believe that the rule will affect around $3

trillion of client assets and $19 billion of

revenue at full-service wealth

management firms.

TODAY

• CFP BOARD

• FPA

• NAPFA

• INVESTMENT ADVISOR ASSOCIATION

• NASAA

• FUND DEMOCRACY

• CONSUMER FEDERATION OF AMERICA

• AARP

• AFL-CIO

DOL - FOR

• Security Industry and Financial Markets

Association (SIFMA)

• Investment Company Institute

• Vanguard ; Fidelity; Blackrock

• National Association of Professional

Agents

• And Other Major Insurance

Organizations

DOL - AGAINST

We were all disappointed that the

Congressional leaders ultimately did

not include in the budget appropriations

bill either of the provisions that we

worked on and supported. Both our

provisions – one to de-fund and one to

delay – would have saved annuity

savers from the Rule's carnage to

retirement readiness.

DOL - AGAINST

U.S. Chamber of Commerce

President and CEO Tom Donohue

said a chamber legal challenge is “a

possibility” when the Department of

Labor’s proposed fiduciary rule for

retirement plan advisors is finalized.

DOL - AGAINST

Donohue attacked the rule as flawed

during his annual State of American

Business address, claiming it could

limit small businesses’ access to

retirement services or lock them out of

the retirement market altogether.

However, he acknowledged he hasn’t

read the proposal.

DOL - AGAINST

It’s expected that the rule will be

submitted to the OMB any day.

Typical OMB review periods last 90

days, but an expedited review is

possible resulting in an enactment

before April.

TODAY

THE YOU STANDARD

AND THE

FIDUCIARY OATH

THAT’S ALL

FOLKS !