Monday, November 4, 2019
Estate, business and succession planning changed dramatically with the enactment of the American Taxpayer Relief Act (ATRA) enacted in early 2013. The federal estate tax exemption was indexed for inflation and stood at $5.25 million for deaths in 2013. It adjusted upward for the next few years until the Tax Cuts and Jobs Act (TCJA) was enacted in late 2017 and increased it to $11.18 million for deaths in 2018. With an adjustment for inflation it presently stands at $11.4 million for deaths (and taxable gifts made) in 2019. Consequently, very few estates have any concern about the federal estate tax. The TCJA also made significant changes to the federal income tax. One significant new provision is the 20 percent pass-through deduction for individuals and entities other than C corporations.
For those farming and ranching operations that plan to continue in the family from generation to generation, entity planning is often part of the overall business plan. What are the major points to consider? There are numerous tax and non-tax considerations.
Some thoughts on estate and business planning – it’s the topic of today’s post.
Basics. The goal of most individuals and families is to minimize the impact of the federal estate tax at death. But, as noted above, with the exemption at $11.4 million for 2019 and “portability” of the amount of any unused exclusion at the death of the first spouse for use by the surviving spouse, the estate tax is not an issue except for very few estates. That means that, for most families, it is an acceptable strategy to cause assets to be included in the decedent’s estate at death to get a basis “step-up.” Thus, succession plans that have been in existence for a while should be re-examined to ensure consistency with current law.
Buy-out agreement. For family businesses involving an S corporation, some sort of shareholder buy-out agreement is a practical necessity. Over time, however, if that agreement is not revisited and modified, the value stated may no longer reflect reality. In fact, it may have been established when the estate tax was projected to be more of a potential burden than it is now. The changes to the federal estate tax in recent years may be one reason, by themselves, to reexamine existing buy-sell agreements.
Consider Not Making Gifts of Business Interests. Historically, transition planning has, at least in part, involved the parents’ generation gifting business interests to the next generation of the family interested in operating the business. However, there might be a better option to consider. It may be a more beneficial strategy to have the next generation of operators start their own businesses and ultimately blend the parents’ business into that of the next generation. Not only does this approach eliminate potential legal liabilities that might be associated with the parents’ business, it also avoids gift tax complications.
A couple of recent cases provide guidance on this approach and illustrate how goodwill is treated when a business transitions from one generation to the next. Goodwill is the value of the business beyond the value of the identifiable business assets. It’s an intangible asset that is often tied to an individual. Goodwill can be an important aspect of farm and ranch businesses.
In Bross Trucking, Inc. v. Comr., T.C. Memo. 2014-107, a father owned and operated a trucking company as a C corporation. He was the sole shareholder. The company got embroiled in some safety issues and ceased operations. Consequently, the father’s three sons started their own trucking business. The sons used some of the equipment that had been leased to their father’s business. The sons had used the same business model and the business had the same suppliers and customers. Importantly, the father was not involved in the son’s business. However, the IRS claimed that the father’s corporation should be taxed on a distribution of intangible assets (i.e., goodwill) under I.R.C. §311. That goodwill, the IRS also maintained, had been gifted to the sons. The Tax Court disagreed, holding that the goodwill was personal to the father and did not belong to the corporation. Key to this holding was that the father did not have an employment agreement with the corporation and there was no non-compete agreement. Thus, there was nothing that tied the father’s conduct to the corporation. The lack of an employment contract or a non-compete agreement avoided the transfer of goodwill that might have been attributable to customer relationships or other corporate rights. That had the effect of reducing the corporate value, and also reduced its value on liquidation (an important point for C corporations).
In Estate of Adell v. Comr., T.C. Memo 2014-155, a similar strategy was involved with a favorable result. In this case, the Tax Court allowed a reduction in value for estate tax purposes by the amount of the executive’s personal goodwill. The point is that the value of a business is dependent on the contacts and reputation of a key executive. Thus, a business owner can sell their goodwill separate from the other business assets. In the case, the decedent owned all of the stock of a satellite uplink company at the time of his death. Its only customer was a non-profit company operated by the decedent’s son. The estate and the IRS battled over valuation with the primary contention being operating expenses that included a charge for the son’s personal goodwill – the success of the decedent’s business depended on his son’s personal relationships with the non-profit’s board and the son did not have a non-compete agreement with the father’s business. Thus, the argument was, that a potential buyer only if the son was retained. The Tax Court determined that the son’s goodwill was personally owned independent of the father’s company, and the father’s company’s success was tied to the relationship with the son’s business. In addition, the Tax Court found it important that the son’s goodwill had not been transferred to his father’s business either via a non-compete agreement or any other type of contract. The ultimate outcome was that the decedent’s estate was valued at about one-tenth of what the IRS initially argued for.
These cases indicate that customer (and vendor) relationships can be an asset that belongs to the persons that run the businesses rather than belonging to the businesses. Thus, those relationships (personal goodwill) can be sold (and valued) separately from corporate assets. That’s a key point in a present estate landscape. With the general plan to include assets in the estate to get a basis increase rather than gifting those assets away pre-death to the next generation, an entirely separate entity for the next generation of operators can also provide valuation benefits. Planning via wills and trusts at the death of the parent can then merge the parent’s business with the next generation’s business.
Another case on the issue, involving an S corporation, resulted in an IRS win. However, the case is instructive in showing the missteps to avoid. In Cavallaro v. Comr., T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that no technology transfer had occurred, and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid. The Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million. On appeal, the appellate court held that the valuation methodology of the expert witness for the IRS contained an error and remanded the case to the Tax Court. Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016). On remand, after correcting for the methodological flaw, the Tax Court decreased the gift value by $6.9 million. Cavallaro v. Comr., T.C. Memo. 2019-144.
The Cavallaro case represents a succession plan gone wrong. The taxpayers in the case were attempting to transfer the value in their company (which had been very successful) to their children via another family business in a way that minimized tax liability. As noted above, what was structured was a merger that was based on a fictitious earlier value transfer between the entities. The IRS claimed that the taxpayers had accepted an unduly low interest in the merged company and their sons had received an unduly high interest. The Tax Court agreed.
Estate and business planning is a complex process. There are many considerations that are part of a successful plan. Today’s post addressed only a few.