Estate and Succession Planning for Small Business...

April 2002 EB 2002-05

Estate and Succession Planningfor Small Business Owners

Loren W. Tauer

Dale A. Grossman

Department of Applied Economics and ManagementCollege of Agriculture and Life Sciences

Cornell UniversityIthaca, NY 14853-7801

It is the Policy of Cornell University actively to support equality of educational

and employment opportunity. No person shall be denied admission to any

educational program or activity or be denied employment on the basis of any

legally prohibited discrimination involving, but not limited to, such factors as

race, color, creed, religion, national or ethnic origin, sex, age or handicap.

The University is committed to the maintenance of affirmative action

programs which will assure the continuation of such equality of opportunity.

Table of Contents

Page

OBJECTIVES IN ESTATE AND SUCCESSION PLANNING .................................................... 1

PROPERTY OWNERSHIP ......................................................................................................... 2

FEDERAL ESTATE AND GIFT TAX .......................................................................................... 3Federal Estate Tax ................................................................................................................ 4Property Valuation for Estate Tax ........................................................................................ 5Family Farm and Business Exclusion .................................................................................. 6Exclusion for Conservation Easements ................................................................................ 6Installment Payment of Federal Estate Taxes....................................................................... 6Federal Gift Tax ................................................................................................................... 6

WILLS ......................................................................................................................................... 7

TRUSTS ...................................................................................................................................... 8

GIFTS ......................................................................................................................................... 9

INCOME TAX CONSIDERATIONS IN ESTATE AND SUCCESSION PLANNING .................. 11Income Tax Basis ................................................................................................................. 11Property Sales ....................................................................................................................... 12Income Tax Effects of Partnership Formation ..................................................................... 13The Final Income Tax Returns ............................................................................................. 13Sale of Residence ................................................................................................................. 14

LIFE INSURANCE FOR SMALL BUSINESS OWNERS ............................................................ 14Types of Life Insurance ........................................................................................................ 14Life Insurance and Taxes ...................................................................................................... 14Life Insurance in a Parntership, Corporation or Limited Liability Company ...................... 15How Much Life Insurance? .................................................................................................. 15Life Insurance for the Spouse ............................................................................................... 16

BUSINESS ORGANIZATION IN ESTATE PLANNING ............................................................. 16Who is to Succeed? .............................................................................................................. 17Dividing Business Income ................................................................................................... 18Buy-Sell Arrangements ........................................................................................................ 18

PROBATE AND POSTMORTEM ESTATE ADMINISTRATION ............................................... 19

NEW YORK STATE ESTATE AND GIFT TAX............................................................................ 20

GLOSSARY ................................................................................................................................. 21

L. Tauer and D. Grossman 1

Estate planning to many people consists ofdeciding how property should be distributed atdeath, but it also includes plans and techniquesto build the estate during life. It involvesdecisions about the types of property to own,the form of ownership, and, for small businessowners, the organization and operation of thebusiness, including succession, or passing thatbusiness on to the next generation.

This bulletin discusses the fundamentals ofestate and succession planning to help familieswith small businesses assess their goals andconsider the economic, legal, and tax implica-tions of various plans. The bulletin is by nomeans an exhaustive source on estate or suc-cession planning. Nor is it intended to substi-tute for legal or tax advice that should beobtained from your lawyer or accountant.More detailed publications are available else-where and trained professionals should beconsulted as a plan is formulated.

Estate and succession planning decisionsinvolve complex questions of law, tax, andbusiness planning. The only way to find theplan that is best for you is to work closely withyour lawyer and other specialists who canadvise you properly. Tax accountants, apprais-ers, life insurance agents, bank trust officers,

and financial planners provide other importantsources of information that you might considerin the planning process. Because you mustmake the final decision about the organizationand disposition of your business, it is essentialthat you be well informed about the choicesavailable so that you can make the best decisionfor you and your family.

Objectives in Estateand Succession Planning

Most young families start with a modestestate but have major commitments to depen-dents. It is often said that these families are theones most in need of estate planning. Theirmodest estate must provide for dependentsshould either or both parents die. Estate taxesare not yet a concern for these families becausetheir estates have not reached the size whereestate taxes would be due. Rather, their con-cerns should be determining who receives theproperty in the estate, the administration of theestate, and providing for the care of children.Younger persons also are concerned aboutincreasing their estates to provide for depen-dents and seeing that property generates incomeduring their lifetimes to supplement the incomefrom their labor.

ESTATE AND SUCCESSION PLANNINGfor

SMALL BUSINESS OWNERS

Loren W. Tauer*

Dale A. Grossman

*Loren W. Tauer is a professor and Dale A. Grossman is a senior lecturer, Department of Applied Economics andManagement, Cornell University. This material is for educational purposes and is not legal advice. It is a revision of our1998 extension bulletin (E.B. 98-04).

2 Estate and Succession Planning

As the family and the business grow, manyof these same concerns remain, but this familynow becomes concerned about structuring theestate and business as it grows. It needs to bealert to and aware of the potential consequencesof business organization and ownership pat-terns. During this growth phase, many familiesshow little concern for planning, and the conse-quences of many business decisions are notanalyzed completely. Sometimes, irrevocabledamage is done.

The third stage of family life is often re-ferred to as the exit stage. The business coupleis interested in reducing its participation in thefamily business, usually as a child is broughtinto the business. The parents generally willfirst reduce their labor involvement in thebusiness. They are usually eager to do this, andthe transition should create few problems aslong as the business can generate sufficientincome for the parents and children. Parentsnext reduce management involvement. Thiscan create conflicts. It is often difficult forparents to relinquish control of an operationthat they built. Finally, and often not untildeath, they will reduce or eliminate their own-ership involvement in the business. Smallbusiness owners can be extremely reluctant totransfer ownership during their lifetimes. Notonly are they emotionally attached to thebusiness, but they may be financially attachedas well. Small business owners do not gener-ally have major sources of retirement incomeother than social security and ownership in-come from the business. This financial depen-dency hinders giving the business to theirchildren, but it still may be possible to sell thebusiness to the children. After selling, theparents still own property but rather thanbusiness property it is cash (converted intoother investments) or a mortgage or a contract.

Property Ownership

Property can be owned solely by one personor organization, or ownership can be shared bymore than one party. Sole ownership is obvi-ously the simplest, most straightforward type ofpossession. The sole owner has the rights tothe property within limitations of the laws(such as vehicle registration or zoning), andthere is rarely any question raised when theserights are exercised.

Co-ownership occurs when two or moreparties hold title to property together. Muchproperty that is co-owned is owned by hus-bands and wives, but it is also possible for twounrelated people, or members of more than onegeneration (like a mother and daughter) to co-own property. A number of forms of co-ownership are defined by law, and the rightsand tax consequences of each type of co-ownership are different. No one form of co-ownership always will be preferred, but onemay be more advantageous than another de-pending on the people and the property in-volved.

One form of co-ownership is tenancy incommon where each party or tenant has sepa-rate and distinct property interests. Each co-owner has a fractional interest in the property.The amount of the fractional interest is thepercentage of the total value of the property thatthe individual paid, or received as an inherit-ance or gift, when the tenancy was created. Forexample, if property was purchased for $50,000and one of two tenants in common paid$20,000 in cash and mortgage payments, thenhis or her fractional interest is 40 percent. Eachtenant in common is entitled to the income thathis or her fraction of the property generates.Tenants may dispose of their interest as theywish. When one tenant dies, the interest passesaccording to the will (or the law of intestatesuccession if there is no will). The property


does not automatically revert to the survivors.Only that tenant’s interest is taxable in his orher estate. That portion of the property fallsunder the jurisdiction of the Surrogate’s Court(probate). When a partnership owns property, itowns it as a form of tenancy in common calledtenancy in partnership.

Another form of co-ownership is jointtenancy with right of survivorship. This iscreated by a deed if the property is land. Thejoint tenants own the same interests arisingfrom the same conveyance of title such thateach has an undivided or undesignated interestin the jointly owned property. Each has a rightto use the property and a right to any incomegenerated by the property as well. When onejoint tenant dies, the survivor automaticallyacquires full ownership of the property. If morethan two people are joint tenants with right ofsurvivorship, the remaining individuals sharethe propertyno third party will take thedecedent’s share. This ownership arrangementacts like a will substitute because the propertywill automatically belong to the survivors,avoiding probate. Federal or state estate taxesare not avoided, however. Each joint tenant’sinterest in the property will be included in hisor her taxable estate.

A joint tenancy that can be used only by ahusband and wife and only with real estate is atenancy by the entirety with right of survivor-ship. Like other joint tenancy property, upondeath of the first spouse, property in tenancy bythe entirety is passed on to the survivingspouse. Tenancy by the entirety propertycannot be severed without consent of both thehusband and wife. Divorce severs the tenancy,however.

Only one-half of the jointly held propertybetween husband and wife will be included inthe estate of the first to die regardless of whocontributed to the purchase of the property.

This one-half interest will qualify for the estatetax marital deduction, and although included inthe decedent’s estate, the interest will not besubject to federal estate tax. The survivingspouse will be the complete owner of theproperty.

Ownership of property can be determinedby the wording on the deed to the property ifthe property is real estate. Personal propertyownership might be determined by the name onthe bill of sale. Property that is registered willhave an owner listed on the registration docu-ment. Sole ownership of property exists whenthere is only one name on the document. Co-ownership exists when more than one nameappears. The term with right of survivorshipimplies joint tenancy. If the names of twospouses appear followed by the words husbandand wife, it is a tenancy by the entirety. If onlynames are listed, then ownership would be astenants in common. This is often the casewhere a partnership purchases a piece of equip-ment and the names of the partners are placedon the bill of sale. When determining owner-ship, it is advisable to collect the necessarypapers and documents and consult an attorney.

Federal Estate and Gift Tax

Changes were made in the calculation offederal gift and estate taxes in 1997 and againin 2001 by the Economic Growth and TaxRelief Reconcilliation Act of 2001. Throughthe year 2009 the estate tax credit will continu-ally increase and tax rates will fall. The result isthat over time larger estates will be exemptfrom estate tax, so that by the year 2009 onlyestates worth more than 3.5 million dollars willbe subject to estate taxes. In the year 2010 theestate tax but not the gift tax will be repealed.However, unless legislation is passed to perma-nently eliminate the estate tax, beginning againin 2011 the estate tax will be back, based upon


the law before the 2001 act. Most believeCongress will act before 2011. Both the uncer-tainty surrounding the future of the federalestate tax and the current phase-in of new taxrates and tax credits make it very important toregularly review the status of the law and itsimpact on property ownership and transferdecisions.

Federal Estate Tax

The gross estate includes all property inwhich the decedent had an ownership interest atthe time of death. This includes real estate,equipment, inventory, cash, and other assets.To determine the tax, property is valued at itsfair market value as of the date of death, or asan alternative, six months after death. Farm-land, if qualifying conditions are met, can bevalued at its use value for farming, which maybe lower than its market value. Family busi-ness property up to $1.3 million may also beexempted from the gross estate until the year2004. In 2004, the unified credit reaches $1.5million, exceeding this exemption, and the $1.3million exemption becomes redundant.

Just as with income tax returns wheredeductions are subtracted from gross income,deductions are allowed against the gross estate.One such deduction is a mortgage or otherdebts against the deceased. Other deductionsinclude funeral expenses, fees of the executorand attorney, charitable bequests, and lossesfrom fire, theft, and storm during settlement ofthe estate not compensated by insurance.

Another deduction is the marital deduction.This deduction is allowed for the amount ofproperty that is transferred to a living spouseeither by will, intestate, or through joint ten-ancy. Unlimited amounts of property can passto a spouse free of federal estate tax if it passesoutright or in a qualified trust to the living

spouse. A husband can leave all of his propertyto his wife and his estate will not pay a singledollar of federal estate tax. The same applies towives who die before their husbands. Butwhen the surviving spouse dies, he or she willnot have the use of a marital deduction unlessthat spouse remarries and leaves property to thenew spouse. Some people remarry, but fewleave everything to the new spouse. Theunlimited marital deduction may be appealingbecause it can prevent the payment of taxes atthe death of the first spouse. But tax planningshould be done to determine if there will beexcessive estate taxes due at the death of thesurviving spouse. Often, these could be mini-mized or eliminated by the use of trusts orbequests to loved ones other than the spouse inboth wills.

The taxable estate is derived by subtracting alldeductions from the gross estate. Then, as withincome taxes, a rate schedule is used to obtainthe tentative tax. There is a credit that reducesthe tax payable. The credit amount dependsupon the year of the death. Since both tax ratesand the credit will change through the year2009 these rates and credits are not printed inthis publication, but can be obtained from taxpublications. The applicable and maximum taxrates over the period range from 41% to 50%.Of interest to most small businesses would bethe size of the estate before estate taxes are due.Those amounts by year are shown in Table 1.For a death in 2007, for instance, estatessmaller than $2 million are exempt from tax.For planning purposes, you can use a tax rate of45% on the amount over the exemption amountlisted in Table 1, although the exact rate de-pends upon the size of the estate and the year ofdeath. An estate of $3 million in 2007 wouldpay about $450,000 in estate taxes, since the $3million estate exceeds the exemption amount of$2 million by $1 million. A credit also isavailable if property in the estate previouslyhad been taxed in another estate during the past


10 years. Another credit can be appliedagainst the federal estate tax for some or all ofthe state tax paid by the estate, although thiscredit will be reduced each year and will begone by the year 2005.

Any tax is due 9 months after death. Thetax may be paid in installments, however, if theestate qualifies.

To illustrate the computation of the federalestate tax, assume that an individual has$5,500,000 in assets and $475,000 in liabilitieswhen he or she dies in 2007, leaving$2,000,000 of the property to a spouse.

The federal credit for any state estate taxpaid or other miscellaneous credits were notcomputed for this example and may be avail-able.

Property Valuation for Estate Tax

Property owned by a decedent usually isvalued for estate tax purposes at its marketvalue at the date of the decedent’s death. If adecedent owned 100 shares of common stockthat was trading at $50 a share on the date ofhis or her death, then the value of the stock forthe decedent’s estate tax return is $50 times100, or $5,000.

There are a number of alternatives to thisestate property valuation rule. First, it ispossible to select a date other than the date ofdeath to value property for the estate tax return.This alternative date is 6 months after death. Ifthis alternative date is selected, then all prop-erty must be valued as of that date. It is notpossible to use the date of death to value someproperty and 6 months after death to valueother property. For businesses where salescontinue, and other assets are liquidated in the6-month period after death, then these assetsare valued as of the date of disposition if thealternative valuation date is selected.

Gifts made during the decedent’s life thatmust be included in the gross estate are valuedat the date the gift was made. This is true evenif the gifts have appreciated in value for therecipient.

An alternative estate valuation procedure isavailable for closely held family businesses,including farms. The procedure allows valua-tion at use value rather than market value. Usevalue may be lower than market value becausemarket value is the value of the property at itshighest and best useincluding use as high-rise office buildings or housing developments.

Table 1. Federal Estate Exemption Value

Year of death Taxable estate exemption value

$

2002 $1,000,000

2003 1,000,000

2004 1,500,000

2005 1,500,000

2006 2,000,000

2007 2,000,000

2008 2,000,000

2009 3,500,000

2010 Estate tax repealed

2011 and later 1,000,000

Gross estate (assets) $5,500,000 - Minus liabilities 475,000 - Minus estimated funeral and estate settlement costs 225,000Adjusted gross estate $4,800,000Marital deduction 2,000,000Taxable estate $2,800,000Tentative tax (45%) $1,260,000Unified tax credit 780,000Federal tax payable $ 480,000


Family Farm and BusinessExclusion

Beginning with deaths in 1998 and until2005, family owned businesses and farms maybe eligible for an additional estate tax exclu-sion. This exclusion is coordinated with theunified credit so that a combined $1.3 millionof the business can be excluded from estatetaxes. To qualify, the business or farm mustexceed 50 percent of the adjusted gross estate.In addition, in five out of the eight years beforedeath of the owner, the business must havebeen owned by the family with material partici-pation by the family.

Exclusion for ConservationEasements

Beginning with deaths in 1998, an estate taxexclusion is available for land subject to aconservation easement. The exclusion is$100,000 for 1998 but increases $100,000 eachyear to $500,000 in 2002 and later years.

Installment Paymentof Federal Estate Taxes

The federal estate tax return for a decedentis due 9 months after the decedent’s death andthe estate tax is due at that time. It is possibleto obtain a l-year extension to pay the tax if anacceptable reason can be given to the IRS. Itmay be possible to renew the extension eachyear for up to 10 years. Interest is assessed onthe unpaid tax. In addition to this extension, itis possible to pay the estate tax in installmentpayments if the estate qualifies.

A 15-year estate tax installment paymentplan is available if an estate consists of aclosely held family business. To qualify, thebusiness property value of the estate must

exceed 35 percent of the value of the adjustedgross estate. The interest rate is 2 percent onthe first $337,200 of tax (adjusted inflation).Only that portion of the estate tax attributed tothe business may be paid in installments.Because it currently costs more than 2 percentto borrow money, and it is also possible to earnmore than 2 percent on investments, it wouldseem foolish for the executor of an estate not totake advantage of the 15-year option. But thereare qualifying conditions that restrict or dis-courage an executor from using the 15-yearpayment option. The business must be oper-ated as a family business and not held as aninvestment only. A tax lien is placed againstthe property to ensure tax payment. There isalso an acceleration of the tax payments if morethan one-half of the business is disposed ofbefore the tax payments are completed. Finally,the interest payments are not deductible forincome tax.

Federal Gift Tax

Gifts made during life also may be subjectto tax. For 1998, the law provides a $10,000annual exclusion, which enables a donor togive any person during a calendar year tax-exempt gifts of $10,000. After 1998, the$10,000 annual exemption will be increased forinflation as measured by the Consumer PriceIndex (CPI). However, the annual exclusionwill only be increased in increments of $1,000so the CPI must first increase 10 percent froml997. For 2001 the annual exclusion remains at$10,000.

A husband and wife can give $20,000together in 2001 without tax even if the$20,000 is the property of only one spouse. Butif the amount of the gift exceeds $10,000, a taxreturn must be filed even if no tax is due. Theyearly exclusion can be used for any number ofgifts. A husband and wife, for example, may


give their four children total gifts of $80,000 in2001 without taxes. In 10 years they can give atleast $800,000, more if inflation occurs.

Gifts larger than the annual exclusion willbe subject to tax, and a gift tax form must befiled. The amount of the gift greater than theexclusion is subject to the same tax as an estateuntil the year 2004 when the gift tax will be de-coupled from the estate tax provisions. It ispossible to make gifts over time without anytax liability by using the annual exclusion, or tomake substantial gifts with some potential taxliability but still pay no tax by using the federalgift tax credit. Additionally, gifts to a spouseare not taxable, no matter how large.

Because the gift and estate tax is a unifiedtax until 2004, adjustments in computing theestate tax are made if a deceased individualmade taxable gifts during his or her lifetime.Added to the estate is the value of taxable giftsbeyond the annual exclusion. The tax is thencomputed. Any gift tax that previously hadbeen paid is subtracted from the tax. Finally,the appropriate tax credit is applied against thetax liability, as well as other available estate taxreturn credits.

After the year 2004 gift taxes are computedseparately. The maximum total of gifts whichcan be made after the year 2002 with no gift taxdue is $1 million. Gifts over $1 million will betaxed at the rates from 41% to 50% dependingupon the year and size of the gift.

Wills

For people who are responsible for thefinancial well-being of others, or who careabout what happens to their property when theydie, a will is one of the most important docu-ments they will ever sign. Contemplating one’sdeath is not an exhilarating prospect, but an

unexpected tragedy could strike even a youngperson and it is a good idea to be prepared. Ifyou do not have a will, the state will designatewho gets your property even if it may be con-trary to your wishes or those of your heirs.

There are very rigid rules in every state thatdetermine whether a will is valid, so consultinga lawyer to help you prepare a will makes goodsense. Unless you have a very complicatedestate, the fee charged by most lawyers to writea will should be among the lowest charged forany legal service. It is important to provideyour attorney with a complete financial pictureof your current assets and liabilities and theanticipated future status of these, as well asyour decisions about the distribution of yourproperty at your death. Your personal feelingsare important to the estate planningprocessafter all, your property and family areinvolved. Drawing a will and formulating anestate plan to save taxes should be compatiblewith your wishes, but not a higher priority thanyour nonfinancial goals.

Regarding the general requirements of thewill itself, a few formalities must be observed.A will must be in writing and must be signed atthe end by the testator (the person making thewill). There must be at least two witnesses tothe signing. They do not have to read the willitself, but they must be able to swear that theyknew that the testator was signing a will. Youmust be mentally competent to make a will;that is, have sufficient mental capacity to beaware of the property you own and the peoplewho would be the reasonable recipients of it atyour death. It also must be obvious that thewill was executed (signed) voluntarily and freefrom undue influence by those who will inherit.

Once a will is drawn and executed, thesame rigid legal requirements apply to anyattempt to change or amend it. If you changeyour mind and want to nullify or revoke your


will, you must physically destroy every copy orindicate in a subsequent will or will amendment(known as a codicil) that you intend to revokethe former will or part of the former will.Merely crossing out a few lines or destroying apage will not accomplish what you wish. It isequally important, therefore, to consult anattorney when you want to change your will.

Besides designating who receives whatproperty when the testator dies, the will is usedto name an executor to administer the estateand to delineate the executor’s powers. Thewill also can be used to designate a guardianfor minor children and to spell out preferredfuneral arrangements. If part of the property isto be placed in trust at death, the provisions ofthe testamentary trust are included in the will.

When the will is executed it is importantthat there be only one original. This should bekept in a safe place. The attorney who preparedthe document should keep a copy, but usuallydoes not hold the original. It is often recom-mended that an original of the will be kept in asafe deposit box held in the spouse’s name, ifpossible, so that it will be easily accessible andnot sealed in the decedent’s box until the IRScan inventory the contents. Wherever theoriginal will is placed, it is wise to have one ortwo other family members aware of its location.

Trusts

A trust is a legal tool that can be used totransfer and manage property. It is an ingeniousdevice because the person who creates the trust(known as the settlor) does not necessarily haveto give up all control over that property, normust he or she relinquish the income or ben-efits derived from it. It all depends on the formof trust used and the needs of the people it iscreated to serve.

To establish a trust, property is transferredfrom the settlor to another person (known as thetrustee) with the understanding that the recipi-ent will hold the property or use it in some wayas directed by the settlor. Anyone who benefitsfrom the use of that property, for example, byreceiving any income it generates is known as abeneficiary. A trust does not last forever.When it terminates, either at a given time orwhen a given event (like the death of thebeneficiary) occurs, those who get the propertyare known as the remainder interest holder.The settlor, beneficiary, and remainder interestholder need not all be different people. Anindividual can set up a trust naming himself orherself as beneficiary if the desire is to havesomeone else manage the assets in the trust.

There are several types of trusts, differ-entiated by when they are established and bythe rights retained by the settler. A trust may berevocable, meaning that the creator may chooseto end the trust at any time. Alternatively, atrust may be irrevocable, ending only upon thehappening of some event like the death of thebeneficiary. To have a favorable tax effect, atrust must be irrevocable. A trust set up duringthe settlor’s life is called an inter vivos trust. Atrust set up by someone’s will to take effectwhen that person dies is a testamentary trust.Both inter vivos and testamentary trusts areexcellent methods of providing financialsecurity for infants or family members whoshould not or cannot manage their own affairs,as well as being important devices in any planto minimize income and estate taxes.

Choosing a trustee is an important step insetting up a trust. No one is required to acceptsuch a position unwillingly, but once someoneagrees to serve, he or she cannot relinquish theresponsibility without permission of the court.It is important, therefore, that a person under-stands a trustee’s general duties and responsi-bilities, as well as the terms of the particular


trust. If there is a large amount of property inthe trust (known as the trust corpus or princi-pal), or if managing the trust corpus is a com-plicated undertaking, it may be wise to appointa corporate trustee like a bank to serve alone oras cotrustee with an individual. Any trustee isentitled to a fee for services. The maximumamount of the fee is established by state lawand relates to the value of the trust corpus.

The trustee’s powers are those assigned bythe trust document and those specified by statestatute. The trustee manages the assets, andthis generally includes buying and sellingproperty, investing in stocks and bonds, andpaying out income to beneficiaries consistentwith the trust terms.

Although trustees may have broad powers,they also have clear duties and high standardsagainst which their performance is measured.The trustee is a fiduciary and, as such, mustavoid any personal gain at the trust’s expenseand must exercise care in making decisions.The trustee may not be rash and speculative ininvesting, and special pains must be taken topreserve the trust principal from loss. A trusteemust account for all the assets that pass throughhis or her hands and respect the wishes of thesettlor in distributing income and/or principal.

Typically, beneficiaries receive income, andperhaps a portion of the principal, during theirlifetimes. Once income is distributed, benefi-ciaries can do with it what they please. But thetrust can include a spendthrift provision thatwould prevent a beneficiary from spending orassigning income to another before it is re-ceived, an important limitation where thebeneficiary tends to be careless in financialplanning.

A trust can provide to pay an amount out ofincome sufficient to provide support for thebeneficiaries at the discretion of the trustee.

This is a common way to provide for lovedones, particularly minor children, in a testamen-tary trust. A trust also can be used to assist inthe management of your property when you areolder or when you wish to do things other thanmanage property.

A trust is sometimes used to save estate taxon the estate of the second spouse to die. Forexample, a husband leaves a life estate in trustto his wife with the property to pass to theirchildren at her death. The wife receives in-come from the property during her lifetime butcannot sell or will the property. The property isincluded in his estate but not hers because herinterest in the property terminates at her death.A common problem for families using thisprocedure is that property in joint tenancybetween a married couple cannot be used by thehusband or wife to set up these marital trusts.Another problem is that very few corporatetrustees are able or willing to manage busi-nesses.

A trust is an extremely helpful tool in estateand financial planning. It provides flexibilityand a greater degree of funds management thanmight be possible with an outright gifteitherduring life or at death.

Gifts

A gift is a lifetime transfer of propertywithout receiving payment for the property.There must be an intent by the donor to makethe gift, accompanied by acceptance of the giftby the recipient (donee). In addition, thetransfer does not occur until the gift is deliveredto the donee. Putting a letter in your safedeposit box that says that you intend to giveyour daughter your heirloom pocketwatch is nota gift if the watch stays in your pocket.

The gift tax is a tax on the transfer of


property. No tax is incurred until the transferoccurs. A promise to transfer property as a giftin the future may be legally binding, but itwould not incur a tax at the time of the prom-ise. A tax is imposed on gifts placed in a trustat the time the transfer is made to the trust,even though the trust beneficiary may notactually receive the income or trust principaluntil some future date.

It is possible that the IRS will consider thata gift is made even where the donor argues thatthere was no intent to make a gift, so care mustbe taken. If you discharge a debt, it will beconsidered a taxable gift. If you make aninterest-free loan, particularly to a familymember, you may be deemed to have made agift equal to a reasonable rate of interest,although some courts have ruled that this is nota gift. If you make a habit of forgiving loanpayments on debt owed you by a family mem-ber, the IRS will maintain that the gift occurswhen the debt was incurred rather than whenforgiven, unless you have a demand note asevidence of your intent to collect the entire debtat some reasonable point in time. If you forgivepayments on debt incurred as the result of aninstallment sale, that forgiveness is taxableincome to the donor as well as being a gift.

One of the fastest and easiest ways toreduce the size of an estateand therefore theamount of estate tax to be paidis to make agift of property. But many people hesitate tojust give away what they have worked hard toacquire, so it is important to weigh the factorsinvolved in making such a gift.

Making lifetime gifts to family membersproduces nontax benefits as well as estate (andpossibly income) tax savings. Giving youngpeople ownership of business property providesthem with a stake in the business and is oftenan incentive to involve themselves fully in thebusiness’s operation. Additionally, giving

income-producing property to a family memberin a lower tax bracket might lessen the overalltax bite for the family.

It is possible to make gifts of money orvaluable property to minors without setting upa somewhat cumbersome trust or worrying thatchildren will have control of property beforethey are old enough to use it wisely. TheUniform Gifts to Minors Act provides a mecha-nism for making a gift to an adult as custodianfor the minor child. In most states, the childwill receive outright control of the property atage 18 or sooner if the donor so designates. Inthe meantime, the custodian has managementand investment powers. The donor, an adultrelative, parent or guardian of the child, or abank trust officer, may be the custodian. Thegift must be to only one child and only onecustodian should be designated per gift. Inother words, you may not open a savingsaccount in the name of “John and Mary Smithas custodians for their children, Patty andSteve.”

Many people benefit from making gifts totheir spouses. The tax advantages areclearall lifetime gifts to a spouse can betransferred federal gift-tax free. The keyobjective of transferring property to a spouse isto balance the size of each estate. Then, regard-less of who dies first, the estate tax is lowerthan if the property were in the estate of thatperson. For this technique to work the propertymust be willed to someone other than thesurviving spouse. Otherwise, all of the prop-erty will be taxed when the second spouse dies.And the tax may be tremendous because theestate tax marital deduction cannot be used ifthere is no surviving spouse.

Before making gifts to a spouse, take thetime to think about the circumstances surround-ing the gift, particularly if your primary reasonfor making the gift is to reduce estate taxes.


Obviously the first consideration should be thevalue of property currently owned by yourspouse. Remember, too, that the situation maychange. Make allowances if, for example, yourhusband or wife is likely to inherit property oracquire an interest in another business.

Although it is an unpleasant thought todwell on, a spouse’s health and life expectancyare factors influencing the decision to make agift. While statistics indicate that womengenerally outlive men, this rule of thumb maynot hold true in a specific instance where a wifeis a number of years older than her husband orin poor health. If this is the case, a gift fromhusband to wife may be pointless for, upon herdeath, her property would go back to herhusband to be taxed again in his estate unlessspecific provisions in her will provide fordistribution to other people.

Income Tax Considerations inEstate and Succession Planning

Because they face the grim situation ofpaying income taxes every year, small businessowners are generally more knowledgeableabout income taxes than estate taxes. Muchestate planning involves income tax conse-quences that are unfamiliar to owners, includ-ing techniques that may require the payment ofsubstantial income taxes. Additional incometaxes can discourage a business from usingthese techniques, but they must be consideredin spite of the income tax consequences be-cause such mechanisms allow the family tofulfill many of its estate planning objectives.

Income Tax Basis

The adjusted income tax basis of property iswhat you have invested in that property andhave not recovered through income tax deduc-

tions such as depreciation or losses. Knowingthe tax basis of property is extremely importantbecause the tax basis is used in computing anygain or loss on the sale or other disposition ofproperty.

The rules concerning tax basis are compli-cated and involved for many types of transac-tions. Your professional tax preparer is familiarwith these rules and is able to determine the taxbasis of property that you own. But it is neces-sary that you supply your tax preparer withsatisfactory records so that he or she can com-pute any changes in the tax basis of property.Keeping all your income tax returns is helpfulbut not completely adequate. Many actions thataffect the tax basis of property never show upon an income tax return. For example, if youadd a fireplace to your home, that expenditureincreases the tax basis of your home but itwould not be recorded on any of your incometax returns. If you sell your home, however,you need to know the cost of the fireplacebecause that cost is part of the tax basis of thehouse.

The income tax basis of purchased propertyis its purchase price or cost. If you pay $30,000for a delivery van, the tax basis of that van is$30,000. If a trade-in is involved, the tax basisof the new property is the adjusted tax basis ofthe property traded plus the cash boot. If youpay $20,000 cash and trade your old deliveryvan that has a market value of $10,000 and anadjusted tax basis of $8,000 for a new van witha market value of $30,000, the tax basis of thenew van is $28,000.

Adjusted tax basis occurs whenever anadjustment to the original tax basis is made. Asyou depreciate your new delivery van, its taxbasis will be adjusted downward each year bythe amount of depreciation claimed on your taxreturn. Adding equipment to the van willincrease the adjusted tax basis of the van.


Other tax basis adjustments can occur.

If you build or construct property, such as astore addition, then the tax basis of the addi-tion, which will be added to the adjusted taxbasis of the store, is the total cost of construc-tion. This includes not only the cost of materi-als but also any hired labor. Raised propertysuch as cows or feed has a zero tax basis,except for farmers who report income on theaccrual basis, which very few farmers do.

Before the Economic Growth and TaxRelief Reconcilliation Act of 2001, the taxbasis of inherited property was generally itsvalue oin the decedent’s tax return regardless ofthe size of the taxable return. That rule has beenaltered. For estates in the year 2010 (and yearsafter if Congress makes this permanent) inher-ited property will not receive a stepped-up taxbasis. The tax basis of the inherited propertywill be the same as the tax basis of the dece-dent. This means that accurate records areessential to determine the tax basis whenproperty is eventually sold.

For property going through an estate beforethe year 2010, property valued at up to $1.3million ($4.3 million with a surviving spouse)will receive a stepped-up tax basis based uponthe value of the property at the date of death (oralternative valuation date). If the estate isvalued at more than $1.3 million (or $4.3million with a surviving spouse) it is the execu-tor of the estate who determines which propertywill receive the stepped-up basis. It would seemlogical under most circumstances that propertywith the lowest tax basis would be chosen forstepped-up basis, especially if that propertymight be sold soon after the recipient receivesthe property.

Because only one-half of jointly heldproperty between spouses is included in theestate of the first spouse to die, only one-half of

the property will receive a new tax basis, if it isselected for stepped-up treatment, subject to thedollar limitation. The other one-half of theproperty will retain its original tax basis.

The tax basis of property received as a giftis generally the same as the tax basis which theproperty had in the donor’s hands. A majorexception occurs when the market value of theproperty is less than its adjusted tax basis, arare occurrence with inflation. If your fathergives you a computer that he had purchased andits adjusted tax basis to your father is $800, younot only get the computer but also the $800 taxbasis. You can immediately depreciate $800worth of computer on your tax return if you useit in your business.

Property Sales

Income taxes must be considered whenestate and business planning decisions involvethe sale of property. If property is sold for morethan its depreciated value (adjusted tax basis),the difference is subject to taxation the year theitem is sold. How the item is taxed dependsupon the type of property sold. For real estate(land and buildings), the difference between thesales price and the adjusted tax basis is usuallycapital gain. If property sold is personal prop-erty, such as livestock or machinery, any gainwill be ordinary income rather than capital gainincome, unless the item is sold for more than itsoriginal cost (tax basis). Only the amount ofthe sales price over the original cost will becapital gain.

The gain from property sales can be re-ported over more than 1 year if payment isreceived over more than 1 year. This relieves ataxpayer from paying tax on income that hasnot yet been collected and allows spreadingincome over more than 1 year to reduce taxes.These installment sales can be made to chil-


dren, other relatives, or unrelated individuals.Because payments are delayed, it is necessaryto charge a buyer a minimum interest rate set bythe IRS. Installment sales also have nontaxbenefits to both buyer and seller. The sellerreceives income payments over time, which canbe ideal during retirement. The buyer benefitsby not having to seek debt financing to pur-chase the property.

Income Tax Effectsof Partnership Formation

It is possible to form a partnership withoutany income tax having to be paid because of theformation. Some partnership formations,however, can create substantial income taxliabilities. There are two major income taxconcerns in forming partnerships which will bebriefly mentioned here. First, almost all busi-nesses have debt as well as property. If youtransfer property to a partnership for a partner-ship interest, you may also transfer the propertydebt to the partnership. This is perfectly legal.But if the amount of debt that you transfer isgreater than the adjusted tax basis of the prop-erty that you transfer, the difference is taxableincome when the transfer occurs. Many typesof property have a high market value but littleor no tax basis (raised livestock for example)and has debt against it.

A second partnership formation transactionwhich can trigger income tax is when a poten-tial partner has little or no property to transferbut will provide labor and so is given a partner-ship interest. The value of the partnershipinterest (minus any contribution of property) istaxable income to the labor-providing partner.A remedy is to sell the labor-contributingpartner an interest in the partnership. Becausethat partner probably has little money to makethe purchase, the purchase can be financed with100 percent debt by another partner. Beware,

however, of the possible tax on the gain real-ized by the selling partners in such a transac-tion.

The Final Income Tax Returns

A common statement that is credited toBenjamin Franklin is that the only two thingscertain in life are death and taxes. A corollarystatement to Franklin’s is that taxes are certaineven after death. And not just estate taxes! Adeceased taxpayer must have an income taxreturn filed on his or her behalf to pay incometax on any income earned before death that hadnot been reported on a previous tax return. Fora business that reports income on a cash basis,and many do, the last tax return would includecash receipts and expenses actually received orpaid. Other receipts or expenses that a businessmay have earned or incurred, but that had notyet been received or paid at the time of death,are not included. Examples include a check notreceived or purchases for which the deceasedhad not yet paid. Rather, these receipts andexpenses result in income or expenses whichare referred to as income (expenses) in respectof the decedent. Do not think for one momentthat this net income is not taxed. It is. Eitherthe estate must file a fiduciary income taxreturn and pay income tax on the income, or theincome can be passed on to an heir who mustreport the income on an individual tax return.

Farm income that results from livestock orcrops growing at the time of a farmer’s death isnot income in respect of the decedent and is notsubject to income taxes, except to the extentthat the final sales price of the livestock orgrowing crops is greater than their value at thefarmer’s death. Finally, property that generatesincome in respect of the decedent is included inthe gross estate. But the taxpayer reporting thisincome on a tax return receives an income taxcredit for the estate tax paid that is attributed to


that property.

Sale of Residence

A taxpayer is allowed to exclude fromincome taxes the first $250,000 in capital gainsfrom the sale of his home. For couples, theexclusion is $500,000. The exclusion is avail-able every two years and the taxpayer must livein the home for periods aggregating two yearsduring the five years preceding the sale. Thisprovision replaces the former option thatallowed you to rollover any gain into a newhome. That rollover of gain option is no longeravailable.

Life Insurance for Small BusinessOwners

Life insurance serves three basic purposes.The first, and typically the primary purpose, isto provide funds for dependents should a parentdie. A secondary use of life insurance is toprovide funds to meet the cash needs to settlean estate. A tertiary use, and in most instancesa poor use, is as a form of savings for retire-ment. Other uses of life insurance are oftencited but these uses fall under the above threecategories.

Types of Life Insurance

Life insurance policies come in manyforms. The two most common types of policiesare term insurance and whole life (or ordinaryinsurance). There are variations in these twobasic types. Other types of policies also areavailable to meet the special needs of businessowners.

Term insurance insures for the death of theinsured for a limited time period or term. It has

no cash value or savings account feature. Itcannot be borrowed against, cashed in, or usedto provide income during retirement. Becauseterm insurance only provides death benefits fora stated period of time, a new term policy canbe purchased at a lower cost than a new wholelife insurance policy and provide the sameamount of death benefits. Because of this, terminsurance is often recommended to youngfamilies who need a large amount of incomeprotection for their dependents but who do nothave a large amount of money to purchase lifeinsurance.

The other common type of life insurancepurchased by individuals is whole life. Wholelife is insurance for the remaining life of theinsured. The premiums paid in the early periodof a whole life policy are greater than what isnecessary to provide for the stated death ben-efits. The excess amount accumulates and isknown as the cash value of the policy. In thelater periods of the insured’s life, when thepremiums paid are less than what is necessaryto provide for the stated death benefits, theaccumulated cash value is used to help pay thecost. Whole life can be purchased with variouspayment plans. Many are paid up by age 65.

The cash value of a whole life policy can beborrowed against. The interest rate is stated inthe policy. Policies that have been in existencefor a long time may have extremely low interestrates. New policies currently being writtenhave higher interest rates. If you borrowagainst your policy, the death benefit is reducedwhile you have the loan. The cash value of thepolicy also may be received as cash if youterminate your policy.

Life Insurance and Taxes

Life insurance premium payments aregenerally not deductible as a business or


personal expense for income taxes except whena corporation provides life insurance for itsemployees. Life insurance death benefits alsoare not normally subject to income tax.

Death benefits paid to a beneficiary usuallyare exempt from income tax. If the benefits arepaid in a lump sum at the time of death, theamount of the payment to the beneficiary is freefrom income tax. If the benefits are paid ininstallments, only the additional interest earnedon the death benefits is subject to income tax.The spouse of the insured, however, has a$1,000 annual exclusion for interest earnedfrom installment payments. If only interest ispaid from the proceeds, then the $1,000 annualexclusion is not available.

Life insurance proceeds are subject to estatetax if the deceased had owned the policy. Butinsurance proceeds paid to the surviving spousequalify for the marital deduction and thuswould not be taxed. If someone other than theperson insured owns the policy, and the benefitsare not paid to the estate, then the proceeds arenot subject to estate tax.

Life Insurance in a Partnership,Corporation, or Limited LiabilityCompany

Life insurance can be used in a partnershipto help transfer one partner’s interest to theother partners if that partner dies. Variousarrangements can be used. In a cross-purchaseagreement, each partner owns a policy on eachof the other partners, pays the premiums, andnames himself or herself as beneficiary. Whena partner dies, the remaining partners will havesufficient funds to purchase the deceasedpartner’s share of the business. With a buy-outagreement, the partnership itself owns thepolicy, pays the premium, and names itself asthe beneficiary. In either case the premiums are

not tax-deductible and the proceeds are freefrom income tax. If the partnership owns thepolicy, part of the proceeds may be included inthe taxable estate of the deceased.

The cross-purchase and buy-out approachesdiscussed for a partnership can also be usedwith a corporation or limited liability companywith the same results. These entities can alsoprovide life insurance for their employees.Then the premiums paid by the entity may be abusiness expense. There are limitations to theamount of coverage when the premiums aredeductible expenses.

How Much Life Insurance?

Rules of thumb often are used to recom-mend the amount of life insurance a familyshould carry. A common rule is that the deathbenefits should be at least six to ten times theyearly income of the family. This rule is prima-rily designed for wage earners and not forbusiness owners where property ownershipcontributes to income. Rather than use rules ofthumb, a more systematic approach is recom-mended for all families, but especially forbusiness persons. An income requirement andincome source budget should be prepared. Theincome requirements of the family without thebreadwinner should be estimated. Theserequirements depend on the number of depen-dents and their ages, as well as the age of thesurviving spouse. Various factors need to beconsidered. If a post high school education isdesired for the children, then some allowancemust be included in the income needs to com-plete that goal.

Sources of income without the breadwinneralso must be determined and estimated. For afarm family, a major source of income is therental income of the family farm. If sufficientinsurance is used to retire all farm debts and


pay estate settlement costs and taxes, sufficientincome often can be obtained from proceedsfrom the sale of livestock and equipment, andrental income of the farm. Some additionalincome may be necessary to maintain the samelevel of living. Other income sources includesocial security, retirement plans, and otherproperty ownership. In some cases the surviv-ing spouse might be able and desire to return toor continue working. When estimating income,be sure to consider income tax.

Life Insurance for the Spouse

Life insurance cannot replace a lost hus-band or wife. It can, however, help replace theincome or other economic value that is lostwith the death of a spouse. It is usually mucheasier to measure the expected economic lossthat will occur when the wage earner or head ofhousehold dies than if the death is that of anonsalaried participant in a family business.

Determining how much life insurance isenough for the wife of a business owner de-pends on her survivor’s needs and the degree towhich she participates in operating the busi-ness. If she is active in the business, buyingenough life insurance to guarantee that therewill be no expense incurred when it is neces-sary to hire someone to perform her dutiesmight be wise. If she is employed outside thebusiness, her life might be insured to reflect theloss of income to the family at her death.

Insuring a wife and mother who is notemployed outside the home is a more subjec-tive process because there are fewer standardmeasures of the economic value of a woman inthis role. There should be enough life insur-ance to pay for the care of young children andfor the housekeeping services provided by ahomemaker if there is no one else in the familywho can step in to take over these important

functions.

Business Organizationin Estate Planning

A business family’s estate consists prima-rily of business property. Thus estate andbusiness planning are closely tied together. Adecision to purchase additional business prop-erty, for instance, has tremendous estate plan-ning implications. Not only might the purchaseincrease the value of the gross estate, but thetype of ownership will dictate how the propertycan be transferred at death. The manner inwhich a business is organizedsole proprietor-ship, partnership, corporation, or limited liabil-ity companyaffects estate planning. Forexample, if a business is incorporated, at thedeath of an owner, ownership is passed to heirsas corporate stock rather than as businessproperty. Transferring stock permits the use ofestate planning techniques different from thoseused in transferring business property. Muchconsideration needs to be given to questions ofbusiness organization as an estate plan ismapped out and modified over the years.

The vast majority of small businesses inNew York State are organized as soleproprietorships. That does not mean that theseoperations are not family businesses. In mostinstances the spouse and children are involvedin the operation. The business may be orga-nized so that the family receives wages for itslabor contributions to the business. Wageincentive plans can be used in addition to abase salary. In some instances the sole propri-etor may rent property from family members,often from a spouse. Complex business ar-rangements also might be used. For example, achild can operate an ancillary operation, pay theparents rent for the use of their property, andfile his or her own tax return. All of thesearrangements require careful business planning.


In addition, good communication between theparties involved is essential.

Beyond these business arrangements arepartnership, corporate, and limited liabilitycompany (llc) organization structures. Theseare often used when more than one generationor more than one family of the same generationis involved in the same business. A multiplefamily situation is not always a requirement; asingle man or woman may incorporate his orher business for management, tax, or estateplanning purposes. A detailed discussion of thepros and cons of various business entities isbeyond the scope of this publication, but we dohave a few comments.

A partnership, and especially a corporationand llc, is more complexlegally, operation-ally, and for tax purposesthan a sole propri-etorship. Before you leap into a partnership,corporation, or llc, be sure you adequatelyunderstand the requirements, limitations, andpossible results of a change in business form.Often the same business or estate objectivescan be fulfilled within the framework of a soleproprietorship.

A corporation may save income taxes orallow more flexibility in transferring estateproperty, but it probably will not substantiallychange the way a business is operated. If younow have a partnership and one son is respon-sible for sales, a daughter is responsible pur-chasing, another son is responsible for finance,and you coordinate all activities, incorporatingwill permit you to assume the position ofchairperson of the board and president of thecompany, and your children can be vice-presi-dents in charge of marketing, etc., but the day-to-day operating and management decisionswill probably not be altered. If the business isnot already operating efficiently, or familymembers are not working together, do notexpect a corporation to change that.

The newest form of business entity, thelimited liability company, is increasingly beingrecognized under state law as an alternative tothe partnership or corporation. New York lawallows for the organization of llcs, which aredesigned to combine the best features of thetraditional forms of business organization. Afamily interested in considering the formationof an llc should consult an experienced lawyerabout whether an llc is the best alternative,considering the family’s, and the business’sneeds.

Who is to Succeed?

Many families state that the most difficultdecision they ever make is deciding who is tosucceed the parent(s), and how ownership andthus management should be passed on. Withownership comes management, because if asucceeding child or children do not have amajority or controlling ownership interest in abusiness, they do not have management control.

When you own a business you normallythink that you have the right to decide who is tosucceed you in the business, and in fact you dohave that right. But a family business is morethan a business. All family members feel thatthey have a “stakeholder” interest in thatbusiness. Each may have spent afterschoolhours working in the business, or had specialevents missed because of demands of thebusiness. Most would like some participationor involvement in the business, even if it is notactive.

The challenge, then, is to select the child,children, or other relatives who will ensure thecontinuation of the business as a family busi-ness, and provide participating roles for theremainder of the family, and to accomplish thiswhile maintaining family harmony. Manyentrepreneurs find succession planning more


difficult than managing the business.

Dividing Business Income

If deciding who should succeed is the mostdifficult decision in succession planning, thesecond most difficult decision must be howbusiness income should be allocated to thefamily participants in the business. Dividingincome is simple when each participant pro-vides equal amounts of ownership, labor, andmanagement to the business. However, equalcontributions are rare in family businesses. Theparent(s) generally provides more ownershipand sometimes less labor than the offspring.The management contribution is difficult tomeasure, but is probably unequally supplied.With unequal input contributions, arriving at anequitable or fair division of business incomecan be a complex decision.

Federal and state income tax laws allow apartnership to allocate its income to the part-ners based upon sound economic principles. Inpractice, when unequal contributions are made,the common procedure is to reimburse familylabor, subtract those payments from businessincome, and allocate the residual to ownership.The major difficulty with this procedure is thatownership may receive a windfall gain or lossquite different from its economic contributionto business income. Much of any windfall gainor loss is due to good or poor management, andin a business, management can originate fromlabor as well as ownership. A young familymember, with little ownership interest, may bean excellent sales person, contributing signifi-cantly to business income. As a reward, and tobe equitable and maintain harmony, thatindividual’s contributions to the profitability ofthe business needs to be financially recognized.

Buy-Sell Arrangements

Before a business partnership (or corpora-tion or llc) begins, the parties involved shouldagree upon how the partnership will be formed,how it will be operated, and how it will bedissolved. Agreement as to the formation ofthe partnership is always reached because it isimminent in order to establish the partnership.Operation is also often agreed upon althoughmany times it is unclear how the partnershipwill operate after a few years when conditionshave changed. Usually, however, the dissolu-tion of the business partnership is never evendiscussed.

The failure to arrive at agreeable provisionsfor dissolution of the partnership can lead tofrustration, disappointment, and strained rela-tionships when it becomes necessary to dis-solve the partnership. And dissolution willoccur someday, either by death, disability,retirement, or by the desire of one or morepartners.

When done correctly, the future dissolutionis entirely planned before the partnership evenbegins, so that when an event that triggersdissolution occurs, such as a death, the dissolu-tion process will be almost mechanical. At thetime the partnership is formed, no partnerknows whether they or their successors will bethe seller or potential buyer in a dissolution, sothey all protect their interests. If the partiescannot come to an acceptable agreement beforethe partnership begins, the partnership probablyshould not be formed. This is generally a betteroutcome than having major disagreements atdissolution.

The reason a partner leaves the business isimportant because it determines the procedureused to transfer ownership, how the interest isvalued, and how the transfer is financed. Thus,it is recommended that separate provisions be


written in the buy-sell arrangement for eachtype of exit. At retirement a partner may bewilling to receive payments for his or her shareover a number of years. At death, it might bemore desirable to settle payment promptly.There are a number of procedures which can beutilized to value a partnership interest. In manycases the best procedure is an appraised valueby an outside expert(s). However, since themarket value of closely held family businessescan be difficult to determine, alternative valua-tion techniques are sometimes used.

There are three general ways to finance thetransfer of a partner’s interest. One is for theselling partners to finance the sale by taking theproceeds in installments. The second is for athird party lender to finance the transfer, andthe third, which is only relevant at a death, is touse life insurance. A combination of thesemethods is often used.

Probate and PostmortemEstate Administration

Although someone’s death automaticallytriggers a number of events, settling the estateand distributing property are not among them.There are laws and procedures that governadministration, but the effective operation ofthis process depends on the initiative of theindividuals who have an interest in the out-come. That interest is twofoldto completethe necessary legal steps to transfer ownershipof property under a valid will or by state law,from the name of the decedent to those whoinherit, and to pay any income or estate taxesdue so that ownership of property from theestate is not encumbered by tax liens andjudgments.

If the decedent left no will, the heirs or nextof kin, or perhaps a creditor, should petition theSurrogate’s Court to grant letters of administra-

tion to an administrator. If a will is located, thenamed executor or other interested personshould petition the court to probate, or prove,the will and grant letters testamentary to theexecutor. These documents are evidence thatthe representative of the estate is acting withcourt approval and gives that person the author-ity to buy and sell property and conduct otherbusiness on behalf of the estate.

The function of the personal representativegenerally is to collect the assets and preservethem by wise investment and good moneymanagement. The representative pays the debtsof the decedent and the expenses incurred inadministration, as well as income taxes for thedecedent in the year of death, income taxes forthe estate each year it remains open, and thefinal estate tax bill. He or she also has respon-sibility for distributing any assets remainingafter these obligations have been satisfied to thedivisees and legatees named in the will or thedistributees designated by law when one diesintestate (without a will).

Generally speaking, admitting a will toprobate is a routine matter, as is estate adminis-tration. Notice must be given to individualswho would inherit if the decedent died intestateand others somehow adversely affected to givethem an opportunity to object to probate. It ispossible that this might result in a lawsuit tocontest the will. Those named in the will areinformed that the will is being offered forprobate. If probate is not contested, the courtwill issue a decree and grant letters testamen-tary so the process of settling the estate can getunder way. If the will is contested, a hearing isheld to determine if all or part of the will isvalid. Those contesting the will have theburden of proving that there are grounds forbelieving that the testator was incompetent orunder duress when the will was executed, orthat there is some other reason to disregard its


provisions. Only in the most extreme casesdoes a will contest succeed.

Management of a deceased’s estate, orpostmortem estate management, receives muchless public attention than pre-death estateplanning but it is an extremely importantprocess. It is essential that the size of thedecedent’s estate be preserved, and enlarged ifpossible, and attorneys and corporate executorsskilled in estate tax planning should be con-sulted to accomplish this result. Tax savings isthe other primary goal of postmortem planning.

There are three tax returns involved inestate settlement: an estate tax return, a per-sonal income tax return for the decedent’sincome earned during the portion of the yearpreceding death, and estate income tax returnsfiled each year the estate remains open, oftencalled the fiduciary’s or executor’s return.Many of the techniques used in postmortemplanning are fairly straightforwardfor ex-ample, deciding on which tax return to takedeductions so as to pay the minimum tax. Anexample of a deduction that can be taken oneither of the income tax forms or on the estatetax form (but not on all three) is the medicalexpenses incurred during the last illness.

The income tax considerations of thebeneficiaries who are to receive property arealso factors in postmortem estate planning.Although the bequest itself is not taxed to therecipient, it may be that the sudden appearanceof income producing property in a given yearwill push the beneficiary into a higher taxbracket. If it is possible to postpone distribu-tion of estate assets, or spread it out over timeso that the recipient gets income in more thanone tax year, it will allow the beneficiary to dosome income tax planning to minimize futuretax payments. There are provisions in theInternal Revenue Code which allow deferral ofestate tax payments for up to 15 years for

qualified taxpayers. This is important in estateand postmortem planning, particularly wherethe principal asset in the estate is a closely heldbusiness.

New York State Estate and Gift Tax

The New York State death tax system ispatterned after the federal in that it is an estatetax rather than an inheritance tax paid by thosewho receive property from the decedent. Butunlike many of New York’s income tax provi-sions, which automatically amend to conformto changes in the federal income tax laws, anychanges in either the state estate or gift taxmust be made specifically by the state legisla-ture. The Federal Economic Growth and TaxRelief Reconcilliation Act of 2001 will havesignificant implications for the taxes collectedby New York and it is quite possible thatchanges in New York tax laws will be made inreaction to the Federal tax law changes. Spe-cifically, for estates of decedents on or afterFebruary 1, 2000, the New York estate tax isthe amount that is allowed as a credit againstthe federal estate tax. As a result, the combinedfederal and state estate tax will equal the exactsame amount as the federal tax would havebeen if there had been no state level estate tax.However, with the Economic Growth and TaxRelief Reconcilliation Act of 2001, this federalcredit is being reduced each year and will nolonger be available after the year 2004. Thatmeans that after the year 2004 New York willnot receive any estate tax unless the law ischanged.


codicil: an amendment to a will

gift: a lifetime transfer of property withoutreceiving payment for the property

gross estate: the value of all property in anestate before any estate tax deductions

intestate: to die without a will

joint tenancy: ownership of property by two ormore people where there is the right of survi-vorship; the surviving tenants receive theproperty at the death of a tenant

marital deduction: an estate or gift tax deduc-tion allowed for property transferred to a livingspouse

probate: the legal process of transferringownership of property from the deceased tothose who inherit

settlor: the person who creates a trust with hisor her property

taxable estate: the gross estate minus alldeductions; this determines the estate tax

tenancy in common: property ownership bytwo or more people where surviving tenants donot automatically receive the property

tenancy by the entirety: a type of joint tenancybetween husband and wife but only with realestate

testator: the person making a will

trust: a legal device which transfers propertyto another for management for the benefit of abeneficiary, often a third party

unified credit: a federal tax credit used toreduce the federal gift and estate tax to be paid

will: a legal document to distribute yourproperty as you wish after your death

Glossary

EB No Title Author(s)

OTHER A.E.M. EXTENSION BULLETINS

Fee(if applicable)

Projecting Cash Flows on Dairy Farms LaDue, E. L.2002-04

New York Greenhouse Business Summary andFinancial Analysis - 2000

Uva, W. and S. Richards2002-03 ($7.00)

The Organic Decision: Transitioning to OrganicDairy Production

Richards, S., S. Bulkley,C. Alexander, J. Degni,W. Knoblauch and D. Demaine

2002-02 ($12.00)

Cost of Establishment and Production of ViniferaGrapes in the Finger Lakes Region of NewYork–2001

White, G.B. and M.E. Pisoni2002-01 ($10.00)

Why Conduct Research and Extension Programsfor Small Farms

LaDue, E., and R. D. Smith2001-20

Market Enhancement Programs Operated in NewYork's Key Competitor States and Provinces

Bills, N. L. and J. M. Scherer2001-19

Agriculture-based Economic Development: Trendsand Prospects for New York

Bills, N. L.2001-18

A Compilation of Smart Marketing Articles,November 1999 – September 2001

Uva, W.2001-17 ($5.00)

New York Economic Handbook 2002 Extension Staff2001-16 ($7.00)

Income Tax Management and Reporting for SmallBusinesses and Farms

Cuykendall, C. H. andG. J. Bouchard

2001-15

Dairy Farm Business Summary: Eastern New YorkRenter Summary, 2000

Knoblauch, W. and L. D. Putnam2001-14 ($12.00)

Intensive Grazing Farms, New York, 2000Dairy Farm Business Summary

Conneman, G., J. Grace,J. Karszes, S. Richards,E. Staehr, D. Demaine,L. D. Putnam, S. Bulkley,J. Degni, P. Murray, and J. Petzen

2001-13 ($12.00)

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Estate and Succession Planning for Small Business...

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