Chapter 20: Transferring the Closely Held Business

Annual Exclusion

$15,000

Which of the following statements concerning the tax treatment of the liquidation of a deceased owner's interest in an LLC pursuant to a buy-sell agreement is correct? (A) The payment of the liquidation proceeds to the estate will be taxed solely as a capital gain. (B) The liquidation proceeds will carry out the deceased owner's distributive share of income as ordinary income to the estate. (C) The payment of the liquidation proceeds by the LLC will provide the surviving owners with income tax basis equal to the purchase price in proportion to their ownership interests. (D) The LLC receives an income tax deduction for the amount of the distribution that is a legal obligation of the LLC.

(B). (A) is incorrect because the decedent's share of ordinary income items of the LLC are carried out in the transaction and will not be given capital gains tax treatment. (C) is incorrect because the LLC is making the purchase and only the cross-purchase method will provide basis to the surviving owners equal to the purchase price. (D) is incorrect because the LLC is not a separate taxpayer and the distribution is for the liquidation of the interest and is not deductible in any event.

Which of the following statements concerning the use of the Sec. 6166 tax provision for the installment payment of estate tax for a family business is correct? (A) The provision is useful to defer taxes if the estate is to sell the business to successors outside of the deceased owner's family. (B) The closely held business interest included in the gross estate must be valued at greater than 50 percent of the adjusted gross estate if the provision is to be available. (C) The provision is particularly useful if the heirs who are responsible for the federal estate taxes will be employed by the business into the indefinite future. (D) The provision is unavailable unless the estate would be insolvent without the use of the estate tax deferral.

(C). (A) is incorrect because the deferred taxes are accelerated and payable immediately if the estate or heirs sell the business interest. (B) is incorrect because the business interest must be valued at greater than 35 percent of the adjusted gross estate. (D) is incorrect because the requirement that a closely held business interest valued at greater than 35 percent of the adjusted gross estate is an objective test and there is no lack of liquidity requirement.

An irrevocable life insurance trust can be a useful tool for the owner of a family business for which of the following reasons? I. The proceeds can assist in reducing the liquidity burden without adding to the estate taxes. II. The proceeds can provide income to the surviving spouse and an inheritance to heirs who will not inherit the business. (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(C). Both statements are correct.

Estate planning objectives for the closely held business owner include which of the following? I. Retention of sufficient wealth to provide for an adequate retirement lifestyle. II. Taking steps to improve the liquidity of the business owner's estate. (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(C). Both statements are correct.

Which of the following concerning the retirement of the owner of a closely held business is correct? (A) The owner of a closely held business can generally rely on passive income from the business as a source of retirement income. (B) The owner of a closely held business will be unable to participate in qualified retirement plans and must rely on personal savings for retirement income. (C) The owner of a closely held business will no longer be able to provide services for compensation at the time of retirement. (D) The owner of a closely held business who sells the business to a family member for an installment note may receive sale proceeds over time to supplement retirement income.

(D). (A) is incorrect because closely held businesses will rarely provide significant passive income distributions. (B) is incorrect because the owner of a closely held business can and should participate in retirement plans to provide deferred compensation. (C) is incorrect because the retired owner certainly could continue to provide services such as part-time employment, consulting, or serving on a board of directors.

Mrs. Smith is the 60-percent owner of an LLC that is an operating business. The remaining ownership of the business is held in equal shares by three children and one investor who provided some capital when she formed the LLC. She has been advised to begin to reduce her potential estate tax liability. One proposal is to transfer one-half of her current ownership (30 percent of the membership units) in the LLC to a grantor-retained annuity trust (GRAT). She will retain the right to receive 7 percent of her initial contribution to the GRAT annually for 10 years. At the termination of the GRAT, the remainder will be paid to her children in equal shares. Which of the following statements concerning this transaction is correct? (A) She can partially shelter the gift of the GRAT by using her gift tax annual exclusion. (B) The principal of the GRAT will be removed from her gross estate if she dies within 10 years. (C) The income earned by the trust will be taxable to the trustee of the GRAT. (D) The value of her initial contribution of the GRAT can be discounted due to the minority interest (lack of control) discount for value purposes.

(D). (A) is incorrect because the transfer to a GRAT is a future interest gift and ineligible for the federal gift tax annual exclusion. Statement (B) is incorrect because the principal of the GRAT will be brought back to the gross estate if the grantor dies before the trust terminates. Statement (C) is incorrect because a GRAT is typically a grantor defective trust and the grantor will be subject to the income taxes.

All the following statements concerning the role of professional advisors and planning a closely held business owner's business succession and estate plans are correct EXCEPT: (A) Professional advisors have a tendency to focus solely on their individual tasks and often fail to motivate the business owner to complete the process. (B) The process has a greater possibility of success if there is a team of necessary advisors centered by one key advisor who takes responsibility for completing the process. (C) An important role for the professional advisor is to assist a business owner in effectively communicating the plan to family members and business successors. (D) A business owner is generally highly motivated to complete the process and will generally drive the planning team members to complete the work.

(D). A business owner is often very busy running a successful business. He or she will have difficulty dealing with family issues and his or her own mortality and will often procrastinate with regard to the business succession and estate planning process.

Which of the following statements concerning the federal estate taxes facing the estate of a closely held business owner is (are) correct? I. The use of the lifetime exclusion amount (as indexed for inflation) against lifetime gifts precludes the use of the applicable exclusion amount against federal estate taxes. II. A business interest that is sold pursuant to a binding buy-sell agreement at death is excluded from the business owner's gross estate. (A) I only (B) II only (C) Both I and II (D) Neither I nor II

(D). Statement I is incorrect because lifetime adjusted taxable gifts are added back into the tentative tax base at the time of death and the estate is allowed to use all of the applicable credit amount against federal estate taxes. Statement II is incorrect because the business is owned at the time of death and is included in the gross estate even though it must be exchanged for the purchase price under a buy-sell agreement.

Private Annuity

-Private annuities are appropriate vehicles for a sale when the property owner is seeking an income stream, income tax deferral, and estate tax reduction -The property is transferred to the recipient for a promise (payments are not secured) -No value of the private annuity is included in the owner's estate (estate taxes are avoided)

Entity Agreement

A business buy-sell agreement for partnerships and corporations in which the business itself is the designated purchaser of the deceased's business interest.

Cross Purchase Agreement

A buy-sell agreement to which only the owners are party and under which surviving owners agree to purchase the business interest of a deceased, disabled, or retired owner

Split Gift

A gift tax technique allowing spouses to use two annual exclusions per donee by treating all gifts during a calendar year as coming from both spouses.

Blockage Discount

A reduction in the fair market value of a large block of publicly-traded stock because the transfer of a large block of stock is less marketable than other transfers of smaller amounts of stock

Martial Deduction

A type of tax law that allows a person to give assets to his or her spouse with reduced or no tax imposed upon the transfer. Some marital deduction laws even apply to transfers made postmortem.

The gift or sale of a controlling interest in a closely held business will not be discounted for lack of marketability because many buyers can be found to pay a control premium.

False. A closely held business interest is generally treated as having marketability problems because it has generally never been offered for sale to outsiders.

Successful business succession is the primary estate planning goal of a closely held business owner.

False. Adequate retirement income and providing appropriate inheritances to all heirs are more important.

An irrevocable life insurance trust (ILIT) provides the grantor with the flexibility to change beneficiaries at a later date when the successors to the family-owned business are identified.

False. An ILIT is irrevocable and will avoid federal estate taxes only if the grantor has given up the power to alter the future enjoyment by the trust beneficiaries and no longer holds incidents of ownership in the life insurance policy.

The choice for a buy-sell agreement for an unincorporated business is the cross-purchase agreement because the entity does not technically exist for tax purposes.

False. Both the cross-purchase and entity-purchase designs are viable for partnerships and LLCs.

It is likely that a closely held business owner will receive substantial passive income from the business during retirement.

False. Closely held businesses rarely provide substantial passive income due to tax disadvantages and the need to compensate service providers adequately.

The provisions of Sec. 6166 to defer the federal estate taxes caused by the inclusion of a closely held business is useful to an estate if the deceased owner's heirs will not continue to hold the business.

False. Sec. 6166 was enacted to assist in preserving the family business and the subsequent sale of the business by family heirs will accelerate remaining tax payments.

Business interests gifted to family members of the donor cannot be discounted for lack of control if the members of the family can combine their interests after the gift to exercise control.

False. The IRS issued a Revenue Ruling that treats every transaction separately for the purposes of gift or estate tax valuation. Hence, a gift of a minority interest in the business can be discounted for lack of control even if members of the family in combination will control the business.

It is likely that the closely held business owner will be extremely motivated to address the business succession and estate plan.

False. The business owner will probably have resistance in dealing with issues such as mortality and addressing his or her family members. This generally leads to procrastination that must be overcome by the advisory group.

The receipt of life insurance proceeds by a corporation will subject to the corporate AMT tax.

False. The corporate AMT tax was eliminated by the Tax Cuts and Jobs Act of 2017.

The corporation should not hold the life insurance on a shareholder's life to fund a stock-redemption agreement because tax rules prohibit the corporation from holding life insurance on the life of a shareholder.

False. The corporation is the "purchaser" in the stock redemption agreement and the purchaser should always be the policyowner and beneficiary of life insurance used to fund a buy-sell agreement. There is no prohibition for the corporation to own life insurance on the life of a shareholder whose equity interest must be bought out at death.

The receipt of life insurance proceeds by a partnership or LLC from life insurance used to fund an entity-purchase agreement will increase the tax liability of its owners.

False. The death benefits of life insurance are received by the entity free of federal income taxes.

The transfer of a business interest to a grantor-retained annuity trust (GRAT) in which the grantor retains the right to a fixed annuity for life will be an effective estate-freezing technique.

False. The retained life estate or life enjoyment rule of the federal estate tax inclusion provisions will cause all or much of the trust principal to be included in the grantor's gross estate at death. The GRAT will be most effective for federal estate tax purposes if the grantor survives the term and no longer holds the right to an annuity at death.

A business owner should retain all appreciation rights in the closely held business interest until death to satisfy estate planning objectives.

False. The transfer of the future appreciation in the business or other assets to family successors is an important part of the estate reduction process.

The $11.18 million (as indexed for inflation) applicable exclusion amount is used to shelter gifts to the business owner's surviving spouse from federal estate taxes.

False. The transfers to a surviving spouse are sheltered from the taxable estate by the federal estate tax marital deduction.

One disadvantage of the sale of the business interest for an installment note is that the buyer must pay interest at a rate equal to prime plus two percent.

False. There are several possibilities for selecting an interest rate, including the applicable federal rates and there is no discussion of any interest rate related to the prime rate.

The $11.18 million (as indexed for inflation) applicable exclusion amount can be applied as a tax credit to offset federal estate tax due even if the exemption was used to shelter lifetime taxable gifts.

False. There is a total exclusion amount of $11.8 million applicable to either gift taxes or federal estate taxes or both.

Gross Estate

For federal estate tax purposes is the total of the items included in the estate's tax base.

Taxable Gift

Gift not excluded or deducted as a result of a special exclusion or deduction provided by the gift tax rules.

Adjusted Gross Estate

Gross Estate - Funeral Expenses, Administration Expenses, Debts, Taxes, and Casualty Losses

Minority Discount

Minority interest is reported on the consolidated income statement as a share of profit belonging to minority shareholder

Administrative Expenses

Most planners estimate the administrative expense as 2 to 5 percent of the estate

Marketability Discount

Ownership interest in a business that is readily marketable (like a publicly traded company) is worth more than an ownership interest that is not readily marketable (like a privately held company) .

Self Cancelling Installment Notes (SCINs)

Promissory note that is cancelled upon the death of the payee. The unpaid balance of a SCIN is not normally included in the payee's estate for tax purposes.

Present Interest Gifts

The donee has all immediate rights to the use, possession, and enjoyment of the property and income from the property. The annual exclusion does not apply to a future interest gift.

Statue of Limitations

The gift tax return will have the 3-year statutory protection only if it is substantiated with enough information to give the IRS sufficient details of the nature of the transaction

6166 Installment Payment of Estate

To qualify to defer estate tax payments under Sec. 6166, the estate must hold a closely held business interest valued at greater than 35 percent of the adjusted gross estate

An irrevocable life insurance trust (ILIT) can be used as a business succession trust if the trustee takes the insurance proceeds at the death of the business owner and purchases the business interest from the deceased business owner's estate.

True

It is critical for a closely held business owner to identify the appropriate successor when contemplating retirement.

True

One advantage of the sale of a business interest or other property to junior generation family members is that all appreciation subsequent to the sale will escape taxation in the seller's federal estate tax return.

True

One function of the advisor to the business owner is the effective communication of the succession plan to interested parties.

True

One problem with transferring a closely held business interest at death is that the estate of the business owner may suffer from lack of liquidity.

True

Premiums on life insurance used to fund a buy-sell agreement for a pass-through entity will effectively cause the owners to bear the burden of the federal income tax caused by the nondeductibility of the premiums.

True

The business interest held at death by a closely held business owner will be included in his or her gross estate for federal estate tax purposes even if the business ownership was shared with other owners.

True

The cross-purchase arrangement for a buy-sell agreement provides the advantage that the purchasers receive full federal income tax basis for the business interest they acquire.

True

The liquidation of the interest in an LLC held by the estate under an entity-purchase buy-sell agreement will generally result in the recognition of some ordinary income by the estate.

True

The proceeds from the sale of a closely held business can be structured in a manner to provide some continuing retirement income to a closely held business owner.

True

The redemption of stock from the estate of a deceased shareholder in a family corporation will often result in the redemption proceeds being taxable as a dividend.

True

The sale of a business interest or other property in exchange for a private annuity or a self-cancelling installment note (SCIN) provides the advantage that the annuity or SCIN will not be included in the seller's gross estate.

True

The use of the provisions of Sec. 6166 to defer the estate taxes caused by the inclusion of a closely held business in the gross estate was provided by Congress to assist a business owner's estate with liquidity issues.

True

false. There is a total exclusion amount of $11.8 million applicable to either gift taxes or federal estate taxes or both.

True

Installment Sales

When a firm finances a sale and payments are expected to be received over an extended period of time; If collection is certain, revenue is recorded at the time of sale; If not certain, either the installment method or cost recovery method can be used; In the installment method, profit is recognized as cash is collected and equals the cash collected multiplied by the total expected profit as a percentage of sales; The cost recovery method only recognizes profit when cash collected exceeds costs incurred