Succession and Liquidity: Two Key Considerations for Closely Held Businesses

I N S I D E T H E M I N D S

Family and Business Succession Planning Leading Lawyers on Evaluating Recent Trends,

Navigating Uncertain Tax Laws, and Developing Creative Strategies for Families and Businesses

2010 EDITION

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Succession and Liquidity: Two Key Considerations

for Closely Held Businesses

Joseph C. Vitek Partner

Arnstein & Lehr LLP

Inside the Minds – Published by Aspatore Books

Introduction As a partner in the Trusts and Estates Practice Group at Arnstein & Lehr LLP, my practice focuses on estate and business continuation and succession planning, asset protection, and income tax planning. I assist high net worth individuals and owners of closely held businesses and their families design and implement sophisticated estate planning strategies. I am also actively involved in the administration and settlement of trusts and decedents’ estates. My practice is challenging and rewarding. My practice constantly enables me to wear different hats—business adviser, counselor, document draftsman, and therapist. Business continuation and succession planning is not an isolated transaction, but a dynamic process. With regard to client matters, I firmly believe in the team concept. I often work closely with the client’s accountant, financial adviser, insurance adviser, trust officer, and other professional advisers to ensure that the client’s legal service needs and legal representation needs are being fully satisfied. By taking this proactive approach, I find that I can better assist the client in achieving his or her planning goals and objectives. An Overview of Succession Planning Most of us spend a significant part of our lives trying to accumulate enough property and investments so that we can enjoy our own lives (before and after retirement) and, at death, provide for our spouse, loved ones, and/or preferred charities. Some start with an idea and turn that idea into a viable family enterprise that provides goods or services for others to buy. The idea may be as simple as a delicious pastry that tantalizes our taste buds, or as complicated as a turbine engine used in the manufacture of automobiles. Throughout America, there is always a plethora of ideas, and those ideas continuously help drive our national economy. To help any idea thrive and prosper, however, takes careful planning and foresight. Because my practice focuses on broad-based strategic wealth planning matters, I frequently have the opportunity to assist entrepreneurs and closely held business owners and their families design and implement comprehensive plans that fulfill their desired financial and personal goals

Succession and Liquidity – by Joseph C. Vitek

and business objectives. After all, an effective plan should give what you own to whom you want the way you want, all at the least possible tax, administrative, and emotional cost to yourself and your loved ones. As I often tell my planning clients, strategic wealth planning is not about documents, it is about results—building your wealth inside and outside of your business, minimizing administrative expenses and taxes to the extent possible, limiting your exposure to certain liabilities to the extent possible, and ensuring that your spouse, loved ones and others are adequately provided for after your passing. Key Planning Issues for Closely Held Business Owners To fulfill these goals and objectives, all closely held business owners must focus their planning attention on at least two key issues: relinquishing control of the business and planning for their liquidity needs. Relinquishing Control of the Business A closely held business owner must envision the day when he or she is no longer in charge of the enterprise. That may occur due to a sudden disability or death, or it may occur due to a planned (and well-deserved) retirement. Regardless of how the separation occurs, there are issues and concerns common to all three situations. The owner leaves his or her family and business extremely vulnerable without being proactive in his or her planning. A solid business continuation plan is critical if the majority owner becomes disabled, retires, or dies. Business succession can be a smooth and orderly process or a tangled mess. The plan may contemplate succession to a family member or to unrelated key employees; alternatively, the owner may decide to sell and walk away. Due to the recent economic downturn and credit crisis, many business owners who were contemplating retirement within the next two years or less seem to be favoring family succession, believing that offers the family the best way to capture the future increase in business value that is likely to result as our economic recovery expands. Others who were contemplating selling their business as part of their exit strategy have delayed their retirement plans due to the recent economic recession.


Planning for Liquidity Although a closely held business owner should focus on whom he or she wishes to leave his or her valuable assets (including the business), any plan is incomplete if that business owner fails to consider his or her estate’s liquidity needs. For many closely held business owners, problems may arise if their wealth is largely illiquid. The family enterprise may generate income, but such income may be insufficient to pay any resulting estate tax (assuming there is one). In addition, a business owner’s estate may require liquid funds to guarantee that children not involved in the business receive an equal inheritance. There are also other liquidity needs common to closely held business owners. Overcoming Resistance to Succession Planning

I encourage my closely held business owner clients to address business succession issues early rather than waiting until retirement age. Rather than simply succumb to the client’s resistance, an attorney must learn to work through it. Often, the client’s resistance masks emotional baggage, fears of his or her own mortality, or family tensions. For example, the client may cite cost as the reason for not proceeding with proper planning, but he in truth may be reluctant to face the day the business he spent years building will go on without him. Many family business owners are type “A” personalities who have difficulty envisioning that anyone could manage and grow the business as they can. So, they tend to focus on what they do best and ignore any succession planning. In addition, due to the recent economic downturn, many closely held business owners have decided to hold off retiring, believing that they can obtain a better price and thus secure a more comfortable retirement once the economy rebounds. But even if they take that position, they should be proactive in their planning. Unfortunately, most attorneys are often ill-trained to manage these non-legal obstacles. To assist the client, many attorneys (myself included) often recommend holding a family meeting where all the family tensions can be aired. Sometimes, a professional counselor will assist in conducting that family meeting to help ensure the discussions stay productive.


In many ways, this process is similar to the game of golf. Like some golf greens, some clients may be hard to read. In golf, unless you are a PGA professional player, you cannot expect to drive every green from over 300 yards away; you need to make well-designed approach shots and stay out of the rough. Business succession planning is no different. By making those kinds of shots, you give your client the best chance to succeed. Ten Steps in the Succession Planning Process

In family business succession planning, there are generally ten steps for the attorney to follow:

1. Gather and analyze all pertinent financial, legal, and other business data. The attorney must understand the client’s business, its operational structure, and its key players. The debt, capital, and cash flows of the business must be analyzed. An attorney should solicit the client’s thoughts and perceptions about what has helped make the business successful. Odds are it was not simply “dumb luck.”

2. Identify the client’s financial and dispositive goals. If the client plans to

retire and walk away from the business during his or her life, two common goals are to minimize the potential income tax liability and provide for his or her own retirement. Sometimes, a client may mistakenly believe that if he or she received $X from the business he or she could afford a comfortable retirement. These financial projections should be reviewed by the client’s financial adviser based upon the client’s age and spending habits. If the client plans to die owning the business, common planning goals include: minimizing income and estate taxes, maximizing the wealth that passes onto the next generation, providing for a surviving spouse and dependents, and protecting certain key and loyal employees. As the process unfolds, these goals and objectives may need to be reviewed and reassessed.

3. Coordinate and review the data and goals with the client’s other advisers.

Succession planning is a team concept, and the key advisers must work together.


4. Appraise the value of the business. The client’s perception or estimation of that business value at the beginning of the process may be surprisingly different from what the appraiser reports. Our recent economic troubles have affected business valuations, but the effects vary among industries and geographic areas. In valuing the business, the advisers should analyze the possible use of favorable valuation discounts for lack of marketability, a minority discount for a lack of control, or a discount for the loss of a key person. Optimally, the business valuation should be completed by a valuation specialist whose methodology is solid and whose reports have previously withstood scrutiny from the Internal Revenue Service.

5. Analyze the needs of the client’s family. Are any family members poised

to succeed the client in managing the business? Potential candidates may be groomed and developed over time if the planning timetable permits. Or does the family expect the business to be sold whenever the client retires or dies. Of course, the client may be trying to coax one or more family members into the business. If those family members are resisting, thorough discussions with everyone involved may be warranted so that each person’s expectations may be voiced. Sometimes, due to family dynamics, a professional family adviser or consultant may need to be involved.

6. Identify potential ownership and management successors. Potential future

owners may come from within the family or the enterprise or from the outside. Similarly, potential managers may come from existing personnel or from the outside. Future owners and future managers need not be identical.

7. Identify the client’s options and make planning recommendations. To best

serve the needs of the client, the attorney and accountant should present joint planning recommendations. In my experience, the client is more likely to resist implementing any recommendations if he perceives his or her key advisers disagree on what ought to be done.


8. Discuss ramifications and modify goals accordingly. Once the client decides what he or she wishes to do, the advisers must discuss with the client all of the tax and non-tax ramifications of that course of action. In some cases, the client may need to review and reassess his or her earlier planning goals. Along those same lines, the client also must be schooled in the ramifications of non-action. Sometimes, clients do not fully comprehend the cost of not implementing the plan.

9. Establish a realistic timetable to implement the plan. In many business

succession cases, plan implementation will need to occur over time in stages. For instance, in cases where a successor manager must still be groomed and developed, a timetable to undertake that step must be established. In cases where multiple successors are anticipated, some corporate restructuring steps may be needed in order to reduce or eliminate potential family tension and conflict later. Legal documents, including a buy-sell agreement, employment agreements, and non-compete agreements for key employees, may need to be drafted. In many cases where the client has identified his or her time horizon to eventually retire from the business and sell it, steps to improve the business’ balance sheets may be necessary or desirable. In those cases, certain expenses may need to be trimmed in order to make the business more attractive to a potential third party purchaser; however, a third party purchaser may be skeptical if drastic cost-cutting measures are all done immediately before marketing the business for sale. A purchaser would prefer to see a financial history of at least three years with those changes being implemented. In cases where wealth shifting to the next generation is possible, those steps should be done well in advance of the client executing his or her exit strategy.

10. Follow through on plan implementation. The advisers should be

proactive in assisting the client with plan implementation. This helps to avoid breakdowns in implementation from occurring. The plan’s timetable may span multiple tax years. A periodic gifting plan or program may also need to be monitored. The advisers should also review the plan’s status periodically to verify that no changes have occurred in the desired goals, family dynamics or in the tax laws that could adversely affect the plan.


A Growing Trend: Use of Series LLCs Following Delaware’s lead, numerous states (including Iowa, Illinois, Nevada, Oklahoma, Tennessee, Texas, Utah, and Wisconsin) enacted an amendment to their LLC Act that permits the formation of series LLCs. Essentially, each series in a series LLC is a separate “cell” or “mini-LLC” within the LLC itself, which may have separate members, managers, assets and liabilities, and business interests. The LLC and not the series will be treated as a legal entity under that state’s law. Specifically, an LLC’s operating agreement may establish a designated series of members, managers, or LLC interests having separate rights, powers, or duties with respect to specified property or obligations of the LLC or profits and losses associated with specific property or obligations. To the extent provided in the operating agreement, any such series may have a separate business purpose or investment objective. The LLC operating agreement may also establish the procedures for management, operation, and dissolution of a series. With respect to business succession and continuation planning, the features of a series LLC may offer numerous planning benefits. For example, use of a series LLC may:

• Enable the client to achieve his or her planning objectives within a single entity. For example, a typical real estate client owns each property in a separate LLC in order to isolate liabilities, and another LLC handles the property management/development duties and functions. This numerous LLC structure may greatly complicate the client’s business succession planning goals, as all of the necessary buy-sell provisions must be contained in multiple agreements. With the series LLC structure, however, those buy-sell provisions can be consolidated in the master LLC operating agreement.

• Reduce or eliminate potential family tension or conflict. If several family members will succeed the client but family tensions and conflicts are likely to result, a solution may be to divide the business if that is possible without destroying it. The business may be divided by


product, operations, or geography. A series LLC may be used to accomplish some or part of this restructuring.

• Enhance voting, management and distribution flexibility. The series LLC operating agreement may provide that with respect to a series, certain members may vote separately or with any class or group of the members or managers associated with the series, and such voting may be on a per capita, number, financial interest, class, group, or other basis. A series may have more than one manager. The LLC may make a distribution with respect to a member of a series, provided that the amount distributed is determined based on the fair value of the property of the series that is subject to liability for which the recourse of creditors is limited.

• Facilitate equity compensation plans. A series LLC may facilitate an equity compensation plan for a company with multiple divisions. By segregating each division into a separate series, the LLC may grant key employees of each series some sort of equity interest tied to that series only (rather than an equity interest in the entity as a whole). This plan would reward employees of productive divisions and shield them from the downside risk of the other divisions.

Accordingly, a series LLC offers great tax and non-tax planning flexibility in implementing a client’s desired business succession plan. Despite these advantages, there are still potential risks—and uncertainty—with respect to such issues as tort-liability protection, fiduciary duties, avoidance of sales taxes and documentary transfer taxes, and property reassessments. In addition, the federal tax standards for a series LLC with multiple members remain unclear. Based on separate allocations of sharing ratios and economic benefits and risks by two or more individuals or entities among separate series, the Internal Revenue Service may argue that there are two or more tax partnerships rather than a single tax partnership. In Private Letter Ruling 200803004 (January 18, 2008), the Internal Revenue Service ruled that the federal tax classification (i.e., a disregarded entity, partnership, or taxable association) for a series LLC is determined for each series independently.


Popular Lifetime Exit Strategies in the Current Low Interest Rate Environment Today’s economic climate has created a perfect environment for several business succession planning tools. Depressed values and near historically low interest rates present several planning opportunities for closely held business owners who want to shift the business to the next generation on an income, gift, and estate tax favored basis. The planning opportunities include: The Intentionally Defective Grantor Trust (IDGT) An IDGT is not only an effective estate planning tool, it is also a succession planning tool for closely held family businesses where the owners expect their businesses to become significantly more valuable. An IDGT is an irrevocable trust for the benefit of the owner’s child or children who will succeed him or her in the business. Typically, the trust is made “intentionally defective” in one of two ways: either the grantor has the power to re-acquire trust assets by substituting other property of equal value, or the grantor can give a non-adverse party the power to add beneficiaries or to add a class of beneficiaries (including charitable organizations). Frequently, to provide maximum planning flexibility, the trust instrument will specify that these powers may be released or renounced if grantor trust status is no longer desired. An IDGT essentially freezes the family enterprise’s value (for which certain valuation discounts may apply) as of the day the business interests are sold or given away for gift and estate tax purposes. In exchange for his or her sale of the business interests to the IDGT, the business owner receives a promissory note. In effect, the owner has exchanged an appreciating asset (the business) for a non-appreciating asset (the note). The payment terms of the note may be quite flexible, provided interest is charged at the applicable federal rate. If the term of the note is less than three years, the short-term applicable federal rate may be used; if the term is between three and nine years, the mid-term applicable federal rate applies; and, if the term is greater than nine years, the long-term applicable federal rate applies. If inadequate interest is charged, adverse federal gift tax consequences may result.


However, the cash flow to the IDGT attributable to that interest sold must be sufficient to service the obligations under the note. The selling owner is deemed the owner of the IDGT for federal income tax purposes. Because the selling owner, for income tax purposes, is treated as being on both sides of the sale transaction, there are no adverse income tax consequences. See Rev. Rul. 85-13, 1985-1 C.B. 184, and Private Letter Rulings 9010065 and 9211026. The selling owner does not recognize any capital gain on the sale of the business interests to the IDGT. Although the selling owner will owe income tax on the earnings of the IDGT during his or her lifetime, he or she will not be subject to tax on the installment payments received. Nor will the selling owner be subject to tax on the interest payments.

Because the selling owner sold the business interests at fair market value (as discounted), federal gift taxes are minimized. In order to provide economic substance to the transaction, it is generally recommended that the owner contribute at least 10 percent of the value of the business interest to be sold to the IDGT as “seed money” for the IDGT. Oftentimes, the owner will utilize part or all of his or her lifetime gift tax exemption amount (which is currently $1 million) in making this initial gift to the IDGT. This strategy also gives the selling parent great flexibility in maintaining control of the management of the business until he or she is ready to retire. For example, the business interests may be bifurcated into two classes. If the business is organized as a corporation (including a subchapter “S” corporation), the stock may be recapitalized into voting and non-voting shares. If the business is a limited liability company, the membership interests may be classified as either management units or non-management units. If the business is a limited partnership, the partnership interests will consist of general partnership units and limited partnership units. If the owner wishes to control the management of the business for a projected period after the sale transaction, he or she may sell all of the non-voting shares, the non-management units or limited partnership units to the IDGT and retain the voting shares, the management units or general partnership units. At retirement, the voting interests (which may represent only a small percentage of the total business value) may be separately sold or given away.


Although there are planning variations, Appendix L diagrams how a typical sale to an IDGT works.

Private Annuity Essentially, a private annuity is a method by which a transfer of the business interest is made in return for an unsecured promise by the transferee to make fixed, periodic payments to the selling owner for the remainder of the owner’s lifetime. This strategy allows a parent to receive lifetime income while management, control, and future appreciation of the business inures to the benefit of the child who is succeeding him or her. For this strategy to work, however, the selling parent must relinquish all control over the business. Any retained interest will trigger adverse tax consequences. As a result, the parent cannot retain any voting rights with respect to the interests transferred, either directly or through a proxy. The authority for taxing private annuities is found in Rev. Rul. 69-74, 1969-1 C.B. 43, pertaining to the transferor or seller, and in Rev. Rul. 55-119, 1955-1 C.B. 352, pertaining to the transferee or buyer. For income tax purposes, the selling owner’s income from the annuity is payroll tax-free, partially a tax-free return of basis and partially a long-term capital gain. The capital gain and recovery of stock basis is spread ratably by the transferor over his or her life expectancy. The ordinary income component will equal the total annuity payment less the capital gain and recovery of basis components. Unfortunately, the child/transferee must make the annuity payments with after-tax dollars, meaning that he or she receives no interest deduction for them like in an installment sale. Unlike a self-canceling installment note, any deferred gain attributable to the transaction at the parent’s death is not treated as income in respect to a decedent (IRD) in the parent’s estate. To avoid triggering adverse income tax consequences, it is critical that the private annuity be an unsecured promise to pay. The child/transferee will be personally liable for the annuity payments, but the business interest sold cannot be used as collateral for the payments. Otherwise, any gain must be recognized immediately. To avoid triggering adverse gift tax consequences, proper valuation of the business interest is important. Any excess of the property’s value over the present


value of the annuity will generally trigger federal gift tax for the amount of such excess. Although there are planning variations, Appendix M diagrams how a typical private annuity transaction is structured.

Employee Stock Ownership Plan as a Lifetime Exit Strategy For many closely held business owners who decide to succeed their business to a non-family member, an employee stock ownership plan (ESOP) may be an attractive solution. ESOPs were first created under the Employee Retirement Income Security Act of 1974 (ERISA). In general terms, an ESOP is an extremely versatile financial planning tool designed to provide employees with an ownership interest in the company for which they work by investing primarily in employer stock. Because the “S” in ESOP stands for stock, an ESOP is only available to corporations; it is not available to other business entities, such as limited liability companies. Beginning in 1998, it became advantageous for an ESOP to be a shareholder of a Subchapter S corporation under the federal tax laws. Essentially, an ESOP provides a ready market for some or all of the shares owned by the shareholders in a closely held company. The ideal closely held business company candidate for an ESOP would meet most of the following criteria:

• Has strong cash flow and a history of increasing sales and profits • Has consistently been in a high federal income tax bracket • The company has substantial shareholder equity • The company already has a capable second-line management team

ESOP Planning Steps Creating and funding an ESOP involves numerous planning steps:

1. Obtain a business valuation. A value for the company must be determined. The ESOP is prohibited from paying more than fair market value for the stock it purchases. This valuation must be made by an independent appraiser. Both the Department of Labor


and the Internal Revenue Service have issued guidance on who should perform the valuation.

2. Conduct a feasibility study. A feasibility study must analyze the

proposed transaction. Essentially, the study must analyze how the transaction will be structured and how it will be financed. In this analysis, the amount that the company can afford to contribute to the ESOP each year must be calculated, and its effect on company earnings and profits must be examined.

3. Obtain a loan. If a leveraged ESOP is to be established, a loan

must be secured to finance the stock purchase. Given our recent financial and credit market crises, financing an ESOP transaction can be difficult, particularly if the lending institution is unfamiliar with ESOPs. Interestingly, because many leveraged ESOPs are largely seller financed, they have been less affected throughout our recent financial and credit market crises.

4. Select a fiduciary. The company’s board of directors must appoint a

fiduciary who will oversee the management and administration of the ESOP, including the approval of all purchases and sales of ESOP stock. This fiduciary may be an officer of the company, an independent bank or trust company, or disinterested individuals. It is generally advisable for the board to interview several candidates before selecting the fiduciary. The selected fiduciary should have vast experience in undertaking its duties and responsibilities.

5. Draft ESOP documents. Once financing has been arranged, the

ESOP documents must be drafted, reviewed, and executed. Counsel for the ESOP fiduciary will need to review all ESOP plan documents.

6. Obtain a valuation opinion. Obtain an opinion from the

independent appraiser who valued the company to provide assurance to the ESOP fiduciary that the ESOP is not paying more than the fair market value of the stock it is purchasing. This opinion is required under the Department of Labor’s proposed regulations. In many cases, the appraiser will be asked to render an


opinion as to the overall fairness of the proposed ESOP transaction from a financial perspective.

7. Negotiate and execute the stock purchase agreement. The stock

purchase agreement between the ESOP fiduciary and the selling shareholder(s) must be negotiated and executed. As with other stock purchase agreements, the agreement will set forth the price and other terms and conditions under which the ESOP will purchase the stock from the selling shareholder(s). In my experience, part of the purchase price is typically financed by the seller, meaning that the selling shareholder(s) will receive a promissory note and be repaid over installments. This may leave the seller vulnerable if the company does not perform as projected and the ESOP ultimately defaults on its obligation.

Although there are planning variations, Appendix N diagrams how a typical leveraged ESOP transaction is structured. ESOP Benefits for the Shareholder Use of the ESOP permits the selling shareholder to sell his or her stock and defer capital gains attributable to the sale. To defer such capital gains, the selling shareholder must reinvest the sale proceeds in qualified replacement property within a fifteen-month period, beginning three months prior to the date of the sale. Qualified replacement property includes stocks and bonds of most domestic operating companies that qualify under Internal Revenue Code Section 1042. This rollover option is not available to a Subchapter S corporation shareholder who sold his or her stock to an ESOP. If the selling shareholder receives a note as part of the ESOP transaction, the seller may still qualify for the tax-free rollover. However, if the note has not been fully paid by the time the qualified replacement property must be purchased, the seller will be required to use other funds to purchase enough qualified replacement property to roll over the entire sale proceeds. Interestingly, within the last few years, many selling shareholders have elected to forego the capital gain tax deferral under Internal Revenue Code Section 1042, noting that capital gain tax rates most likely will only increase. As a result, they recognize the gain in the year of sale. If Code Section 1042 rollover treatment is elected and the seller holds such qualified replacement property upon his or her death, his or her estate may be


eligible for a basis adjustment up to the fair market value of those securities as of the date of his or her death, assuming that the federal estate tax regime is reinstated in 2010 by Congress or in 2011 pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001. ESOP Benefits for the Company For the company, an ESOP provides numerous tax benefits. Since contributions to the ESOP are fully tax deductible, the company can fund both the principal and interest payments on the ESOP’s debt service with pre-tax dollars. In addition, dividends on ESOP stock are tax deductible if they are applied to repay ESOP loan principal the proceeds of which were used to acquire the company stock with respect to which the dividends were paid. The ability to reduce loan principal with pre-tax dollars and dividends can generate significant tax savings, thereby increasing the company’s cash flow. ESOP Benefits for the Employees For the employees, company contributions to the ESOP are allocated to the participating employee accounts in the trust established as part of the ESOP. The accumulated balance in a participant’s account is distributed to the participant upon his or her retirement or other termination of employment from the company. So long as the participant’s account remains in the ESOP trust, the value of the account is not taxable to the participant. Planning For Liquidity If a closely held business owner’s estate is not sufficiently liquid, his or her heirs may be forced to sell assets prematurely at below market prices to raise the necessary cash to meet the estate’s financial obligations and pay any resulting estate taxes. Typically, the heirs will need sufficient liquid funds to satisfy the following financial obligations that arise shortly after the owner’s death:

• Funeral expenses • Outstanding debts and liabilities


• The family’s continued living expenses to the extent that they were dependent upon the owner as the principal breadwinner

• Estate and inheritance taxes • Estate administration and settlement expenses

A proper buy-sell agreement will guarantee that the deceased business owner’s loved ones receive fair value for his or her business interests and set forth the terms at which the decedent’s estate is required to sell the business interest to the remaining owners or at which the enterprise must redeem that interest. A trusted buy-sell arrangement may also be used. Typically, buy-sell agreements are funded, at least in part, with life insurance to provide the liquidity to effectuate the buyout. All such insurance policies should be audited periodically to help ensure that the policies are performing well and the face amount of the policies is still sufficient. Planning for Installment Payments of Estate Tax Although federal estate taxes were repealed for 2010, closely held business owners should still plan for imposition of an estate tax upon their deaths. If the business value exceeds 35 percent of the decedent’s gross estate, the estate’s executor may elect to defer payment of the estate tax attributable to that business interest. The election to defer payment of the estate tax is made on the decedent’s estate tax return and attaching the notice of election to that return. Under Internal Revenue Code Section 6166, payment of the estate tax generally may be deferred for up to five years, and then the tax may be paid in up to ten annual installments. A 2 percent interest rate applies to that portion of the estate tax deferred on the first $1.34 million (as indexed for inflation) in taxable value of the business interest. All tax in excess of that subject to the 2 percent interest rate is subject to interest at 45 percent of the rate of the annual interest charged by the Internal Revenue Service for underpayment of tax (i.e., the short-term applicable federal rate plus 3 percent adjusted quarterly). There is a growing trend for the Internal Revenue Service to require collateral or a surety bond to secure the obligation of the decedent’s estate to make the required installment payments.


If the heirs dispose of the business interest during the fifteen-year deferral period, the unpaid estate taxes immediately become due. Such tax recapture provision survived estate tax repeal under the Economic Growth and Tax Relief Reconciliation Act of 2001. Interestingly, due to the recent economic downturn, many estate plans for closely held business owners ought to be reviewed and financial calculations made in order to assess whether they qualify for the deferred payment of the estate tax. During the economic crisis, the value of their business interests may have declined at a greater or lesser rate than their non-business assets, thereby requiring a new computation of the 35 percent threshold. Planning for Stock Redemption Internal Revenue Code Section 303 provides that a closely held corporation may redeem stock from a decedent’s estate or from its beneficiaries to pay estate taxes and administrative expenses if the stock comprises 35 percent of the decedent’s gross estate. This redemption of stock is not treated as a disqualifying disposition for purposes of the installment payment of estate taxes. This redemption is not considered a dividend as long as it is limited to taxes and administrative costs. Using a Graegin-Type Loan Another option is for the decedent’s estate to borrow funds to pay estate taxes from a wholly owned subsidiary of the closely held corporation. This technique was approved by the Tax Court in Graegin v. Commissioner, 56 T.C.M. 387 (1988). The note used in Graegin provided that all principal and accrued interest was due in a single balloon payment at the end of the note’s term, and neither principal nor interest could be prepaid. In Graegin, the Tax Court allowed the decedent’s estate to deduct as an administrative expense on the estate tax return the entire balloon interest payment, finding it to be a reasonable and necessary administrative expense. Under Internal Revenue Code Section 2053 and its accompanying regulations, an estate is generally entitled to deduct all reasonable and necessary administrative expenses. The Tax Court reasoned that the amount of the interest payable was certain


because the note prohibited prepayment. The estate also demonstrated that it had no alternative to pay estate taxes other than the forced sale of the illiquid business interest. Last year, however, the Tax Court disallowed the interest expense deduction where the decedent’s estate entered into a Graegin-type loan with a family limited partnership. In Estate of Black v. Commissioner, 133 T.C. No. 15 (December 18, 2009), the Tax Court ruled that the entire balloon payment interest expense of $20,296,274 was not necessarily “incurred” within the meaning of Internal Revenue Code Section 2053 and the regulations promulgated therein. The Tax Court reasoned that the partnership could have redeemed the estate’s partnership interest shortly after the decedent’s death in order to provide the necessary liquidity to pay the projected estate tax liability, thereby rendering the Graegin-type loan unnecessary. In its ruling, the Black court emphasized that the decedent’s son was both general partner of the partnership and the executor, thereby putting him on both sides of the Graegin-type loan. It is unclear from the Tax Court’s ruling in Black whether the interest expense would have been entirely deductible if an independent third party had acted as the estate’s executor. Following the court’s decision in Black, executors and their attorneys are seemingly caught in a catch-22. If the decedent’s family partnership redeems the decedent’s partnership interests in an amount sufficient to pay the projected estate tax liability, as the Black court recommended, they subject the estate to attack from the Internal Revenue Service under Internal Revenue Code Section 2036(a)(1). In general, Code Section 2036(a)(1) provides that the decedent’s gross estate includes the full value of the partnership interests transferred by gift during the decedent’s lifetime if the decedent retained the possession or the enjoyment of the transferred property. In Estate of Erickson v. Commissioner, T.C.M. 2007-107 (2007), a family partnership provided funds for the decedent’s estate to pay its projected estate tax liability. The Erickson court ruled that tantamount to making such funds available to the decedent, thereby causing estate tax inclusion under Code Section 2036(a)(1). If, instead of risking estate tax inclusion under Code Section 2036, the executor obtains a Graegin-type


loan, the interest expense may not be fully deductible under the rationale given in Black. Irrevocable Life Insurance Trusts To avoid the limitations, complexities, and potential challenges of using Code Section 6166 installment payments, Code Section 303 redemptions, and Graegin-type loans in light of the Black decision, many advisers may find themselves returning to the relative simple and straightforward irrevocable life insurance trust to provide liquidity following a closely held business owner’s death. The insurance proceeds payable to the insurance trust may be used to purchase assets from the decedent’s estate or to loan funds to the estate or to the business directly. Of course, the insurance trust may be used in conjunction with the other three liquidity strategies: Code Section 6166 installment payments, Section 303 redemptions, and Graegin-type loans. For example, the insurance trust may loan the estate funds if it would otherwise default in its Code Section 6166 installment obligation. Alternatively, the insurance trust may loan the family corporation the funds needed for it to redeem the decedent’s stock. Moreover, the insurance trust may structure its loan to the estate as a Graegin-type loan, in order for the estate to fully deduct the interest expense. However, to avoid a potential challenge to the Graegin-type loan similar to the one upheld in Black, the trustee of the insurance trust should be an independent third party. Conclusion It is critical that the business owner decide as early as possible whether he or she will be positioning the business for succession or sale. Regardless whether he or she decides to succeed the business to a designated successor or sell the business at retirement or death, each owner is confronted with business, family, financial, income tax, and estate and gift tax considerations that may prove difficult to balance. If the decision is to opt for succession, there are several strategies available to shift wealth on a tax-favored basis. Within the family context, there are sales to intentionally defective grantor trusts and private annuity transactions. With


the recent economic downturn and near historical low interest rates, these two strategies are enhanced. Within the non-family context, the business owner may use a leveraged employee stock ownership plan. If the decision is to opt for sale, the business owner must begin early positioning the business for its eventual sale. This typically involves maximizing profits, enacting cost-cutting measures, and positioning a capable second-line of management. Closely held business owners also face unique liquidity needs, because much of their estate is typically illiquid. Assuming that the federal estate tax regime will be reinstated, business owners should plan to take advantage of the deferral of the payment of estate taxes. Joseph C. Vitek is a partner in Arnstein & Lehr LLP’s Chicago office. His practice focuses on trusts and estates. He is a member of the Society of Trust and Estate Practitioners (STEP) and the Chicago Estate Planning Council’s membership committee. Mr. Vitek writes and lectures extensively on the subject of taxation, wealth transfer planning techniques, and probate and trust administration. Mr. Vitek received his LL.M. in taxation from the University of Missouri-Kansas City College of Law in 1992, his J.D. from the University of Nebraska College of Law in 1989, and his B.A. from the University of Nebraska in 1986. He is admitted to practice in Illinois and Nebraska and before the U.S. Tax Court.

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Succession and Liquidity: Two Key Considerations for Closely Held Businesses

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