Selecting the Business Entity for Succession Planning
One of the most important decisions a business owner must make in estate planning is selecting the appropriate business entity. That decision will affect the income and transfer tax consequences to the owner and the family and the ease with which the business can be shifted from one generation to the next. Generally, there are four choices: (1) C corporations; (2) S corporations; (3) limited partnerships; and (4) limited liability companies.
Gift Giving and the Business Entity
An immediate consequence of the choice of business entity is the ability of the owner to make lifetime gifts to the next generation. Making lifetime gifts of interests in the business is an essential part of the estate plan for three reasons: (1) the interest given away is removed from the owner's estate, thereby reducing the overall estate tax; (2) all appreciation in the value of the interest after the gift is removed from the owner's estate; and (3) all income earned by the interest after the gift is removed from the owner's estate.
A C corporation, unlike a sole proprietorship, is a separate legal entity. As such, a C corporation has the right to sue or be sued, enter into contracts, and hold and dispose of property in its own name. More importantly, a C corporation is a separate taxable entity. Therefore, the major disadvantage of a C-corporation is double taxation. In other words, a C corporation pays income tax at the corporate level on its earnings and then the shareholder pays income tax at the individual level on the after-tax earnings distributed as dividends.
Making gifts of stock of a C corporation is relatively simple. Usually, the business owner wants to maintain control over the business while making gifts to the younger generation. One way to accomplish this is to create two classes of stock‹ preferred stock and common stock. The only difference between the two classes is that the preferred stock has voting rights while the common stock does not. The owner can then make gifts of the nonvoting common stock to the younger generation and, by retaining the voting preferred stock, maintain control over the corporation.
Because the owner is giving away a minority interest, a discount from the value of the interest is available for gift tax purposes. The discount is based upon both the lack of control and the lack of marketability of the stock that the donee receives. A discount of 30% to 40% for both the minority interest and lack of marketability is generally considered reasonable.
An S corporation is a corporation which has made an election under the Internal Revenue Code to be treated as a pass-through entity for tax purposes. All income and losses are passed through to the shareholders, and there is no corporate level tax. The principal disadvantage of an S corporation is the strict requirements for making and maintaining the election.
One of those requirements is that an S corporation may have only one class of stock. However, differences in voting rights are disregarded so long as all of the outstanding shares have identical rights to distributions and liquidation proceeds. Therefore, an S corporation may be recapitalized to create preferred stock and common stock if the only difference is the voting rights of the shares.
Another requirement is that an S-corporation may have no more than 100 shareholders. More importantly for estate planning purposes, with certain limited exceptions, a trust is not an eligible S corporation shareholder. That restriction challenges S corporation owners who wish to make lifetime gifts of stock to the younger generation.
Generally, the same valuation discounts that are available for gifts of stock of a C corporation are also available for gifts of stock of an S corporation.
Use of family limited partnerships has become an increasingly popular means of transferring the family business to the younger generation. In a limited partnership, the general partners have unlimited liability for debts incurred in the business and complete control of the management of the business. The limited partners are not liable for the debts and liabilities of the limited partnership in excess of their capital contributions and generally have no control or management rights. Consequently, the business owner can transfer earnings and appreciation to the next generation by making lifetime gifts of limited partnership interests while maintaining complete control by retaining a small general partnership interest. Again, valuation discounts of 30% to 40% for gift tax purposes may be appropriate.
There are certain assets which should not be placed into a family limited partnership, including (1) the family home; (2) individual retirement accounts and other qualified plan interests; (3) stock in an S corporation; (4) stock in a professional corporation; (5) risky assets, such as cars, planes, and boats that are likely to attract liability in the form of large lawsuits; and (6) personal use assets, such as art, jewelry, antiques, or other collectibles.
Limited Liability Companies
A limited liability company (LLC) is a hybrid entity offering limited liability to its members, like a corporation, and pass-through income tax treatment to the owners, like a partnership. An LLC offers the best of both the corporation and the partnership to its members and avoids some of the disadvantages of the S corporation and the limited partnership. See the related article in this Bulletin regarding the uses and advantages of an LLC.
Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, unless specifically indicated otherwise, any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of avoiding tax related penalties or promoting, marketing or recommending to another party any tax related matter addressed herein.