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When Worlds Collide: The Intersection of Business Succession and Estate Taxation

Perhaps the most important aspect for successful business succession planning is to understand the client’s family dynamics, so an advisor needs a great deal of insight and understanding of the various personalities, goals, needs, and abilities surrounding the project. Many financial and estate considerations may impact any plan, depending upon the steps that are to be employed. The following is a discussion of the tax considerations for different approaches, based upon recent cases and rulings, and provides guidance in structuring a succession plan.

Installment Sale

A client may choose an installment sale for her business succession plan in order to maintain the desired cash flow, and to defer tax on the installment gain as the proceeds are received. The sale will shift appreciation and future growth to the next generation. The installment sale provisions of IRC section 453 affect the timing of gain reporting, but do not alter the amount or character of the gain realized. The seller’s gain is recognized over the period during which the sale proceeds are received. IRC sections 453 and 1239, however, provide an exception applied to sales of depreciable property between related parties—but remember that depreciation recapture rules may result in gain acceleration to the year of sale.

The installment sale technique may create several adverse estate tax consequences; for example, the deferral allowance under IRC section 6166 may become unavailable. IRC section 6166 provides a five-year deferral and a 10-year installment payment of estate taxes at a reduced interest rate. The decedent is there-after holding an installment note—not an interest in a business entity—which makes the requirements of section 6166 more difficult to meet.

In addition, the unpaid note balance will be income in respect of a decedent (IRD) under IRC section 691. IRD is taxed to the estate or to the beneficiaries without receiving a step-up in basis. This loss of an estate tax step-up in basis will result in significant income taxes that might have been avoided had the decedent died while owning the business. An installment sale for less than full and adequate consideration may also be characterized as a retained interest under IRC section 2036. In order to avoid the assets being brought back into the transferor’s estate under section 2036, the documentation should provide for fixed payments, at the applicable federal rate, equal to the fair market value of the property. It is important to avoid any upfront gift as well as to obtain a qualified appraisal. A self-cancelling installment note (SCIN) should also be avoided until future guidance is clarified. For more information, see the IRS’s Chief Counsel Advice (CCA) Memorandum 201330033 (Estate of William M. Davidson), which attacked the valuation and use of the section 7520 tables. (The issue of whether the SCIN may be valued based strictly on the section 7520 actuarial tables has not been resolved, as the estate settled with the IRS.)

Grantor Trusts

A sale to a grantor trust is a popular tax strategy for business succession planners. The benefit of a sale to the grantor trust is that the settlor does not need to report any capital gain on the sale transaction (Revenue Ruling 85-13, 1985-1 C.B. 184). In a grantor trust, generally the settlor is taxed on the income of the trust (IRC sections 671-679). Proper structuring and careful selection of grantor trust powers are essential in order for the transferred interest to be excluded from the settlor’s estate. For purposes of succession planning, only certain grantor trust powers are used in order to avoid inclusion in the settlor’s estate. Based upon Revenue Ruling 2008-22, the non-fiduciary power to reacquire assets by substituting assets of equal value is frequently used to create a grantor trust, as both the value of the asset at the time of the sale and the post-asset appreciation would be included in the settlor’s estate. Care must be taken to ensure that the debt is bona fide and that the special valuation rules under IRC sections 2701 and 2702 do not apply. Failure to properly structure the transaction may result in a present gift of the entire value, or in IRC section 2036 estate tax inclusion of the transferred interest. Under IRC section 2036, estate inclusion effectively eliminates any benefit of the initial estate freeze resulting from the sale to the grantor trust.

A client may choose an installment sale for her business succession plan in order to maintain the desired cash flow, and to defer tax on the installment gain as the proceeds are received.

The basic structure and form of the transaction includes an installment sale to a grantor trust at fair market value based upon a qualified appraisal. The settlor receives an installment note bearing interest at not less than the applicable federal rate (IRC section 7872). In order to avoid IRC section 2036 estate inclusion, many commentators have recommended that a “seed gift” of not less than 10% of the debt be included in the trust. Private Letter Ruling (PLR) 9535026 is frequently cited as a support for the 10% amount; however, there is no statutory provision regarding the necessary percentage. The purpose of the seed gift is to provide other assets from which the note can be paid, in order to better insulate the trust from an IRC section 2036 attack.

Additionally, it is recommended that the trust beneficiaries (customarily the settlor’s children) guarantee the notes. In Estate of Donald Woelbing v. Comm’r, Docket No. 030261-13, minimal guarantees were issued, and the IRS asserted that they were insufficient. balance. A relevant U.S. Tax Court case is Estate of Trombetta v. Comm’r (T.C. Memo 2013-234), in which the court’s focus on the actual operation of the guarantee made this alternative risky, considering that guarantors were rarely called upon to make payment. It is important that interest be paid at least annually to show that the installment note is bona fide debt. Furthermore, it is recommended that available principal be used to reduce the note balance.


Corporate redemptions are frequently used to implement business succession. PLR 201228012 provides helpful guidance on how to properly structure a corporate purchase of stock. If properly structured, the redemption will result in capital gains, which may be reported on the installment basis [IRC section 302(b)(3)]. Moreover, the note interest will be deductible by the corporation. In order to achieve capital gain treatment, the redemption must meet the requirements under IRC section 302(b). A complete redemption or termination of the shareholder’s interest will qualify.

In a family context, however, careful consideration must be given to the constructive stock ownership rules [IRC section 302(c)]. It is imperative that, immediately after the distribution, the redeemed family member have no interest in the corporation, and no longer serve as an officer, director, or employee of the business. The interest of the redeemed family member must be solely that of a creditor. In a family succession plan, the redeemed member must enter into an agreement to notify the IRS if such shareholder acquires an interest (other than by bequest or inheritance) within 10 years from the date of the redemption. Treasury Regulations section 1.302-4 describes the time and manner of such an agreement.

Fair Market Value

Fair market value is the price agreed by a willing buyer and a willing seller, both having knowledge of the relevant facts and neither under any compulsion [Treasury Regulations section 20.2031-1(b) and 25.2512-1]. Valuing stock in a closely held corporation is determined under Revenue Rulings 59-60, taking into account all facts and circumstances, considering market, income, and asset valuations.

An indirect gift may result when stock is redeemed at a price below fair market value [U.S. v. Marshall, 771 F. 3d 854 (5th Cir. 2014)]. In Marshall, the Fifth Circuit held that the remaining corporate share-holders were liable for substantial gift taxes and interest resulting from an indirect gift. In the case, Elaine T. Marshall sold stock in Marshall Petroleum Inc. back to the company at a price below its fair market value. The shareholders, as transferees, were found to be personally liable for both the unpaid gift taxes and accrued interest. Although the donor who made the gift had primary responsibility for paying the gift tax, the donee became personally liable to the extent of the value of the gift [IRC section 6324(b)], including interest and penalties for which the donor is liable. The liability is joint and several, regardless of the percentage the donee received. This is subject to the ceiling in IRC section 6324(b), which states “ … the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.”

Private Annuity

A private annuity may be used to transfer a family business to the next generation. In a typical private annuity, the parent will exchange the business interest for the right to receive periodic payments for life. Estate taxes are reduced if the parent receives annuity payments that are worth less than the property received by the child. Recent cases, such as Estate of Trombetta v. Comm’r, (T.C. Memo, 2013-234), highlight the need for proper valuation and structure. The parent should not retain control and, if a trust is used, great care should be taken to avoid IRC section 2036 inclusion and its implied agreements. In Estate of Trombetta, the Tax Court applied IRC section 2036 and included trust assets in the decedent’s gross estate. It is recommended that an annuity provide adequate and full consideration and based upon a qualified appraisal to fall under the execution of IRC section 2036(a)(1) for bona fide exchanges made for “adequate and full consideration in money or money’s worth.” Annuity payments should be made as scheduled to support the underlying computations, and to help avoid any challenge that an implied agreement was present. Additionally, the parent should not be trustee or participate in management of the assets, and a physician’s letter should also be obtained stating that the parent has no terminal illness. The use of IRS valuation tables will be unavailable if there is at least a 50% chance of death within one year (e.g., Treasury Regulations section 1.7520-3(b)(3), andEstate of Kite v. Comm’r, T.C. Memo, 2013-43). The failure to properly value and structure the annuity will result in adverse estate tax inclusion.

A grantor trust is often utilized for income tax purposes. Under proposed Treasury Regulation sections 1.1001-1(j) and 1.72-6(e), gain must be recognized at the time of the exchange. For example, if a property is worth $10, and its adjusted basis is $1, gain of $9 is recognized unless the annuity is exchanged with a grantor trust. Revenue Ruling 85-13, 1985-1 CB 184 provides that no gain is recognized.

Buy-Sell Agreements

It is essential to meet the requirements of IRC section 2703 in order to ensure that family buy-sell agreements are respected. The agreement must be bona fide, not a “device” to pass wealth for less than adequate and full consideration, and be comparable to an arm’s length agreement entered into by unrelated persons. In Estate of True v. Comm’r. [390 F.3d 1210 (10th Cir. 2004)], a family buy-sell agreement was not respected as a bona fide business arrangement due to overriding testamentary considerations. Qualified appraisals were not obtained, and thus substantial penalties were imposed.

Personal Goodwill

Goodwill is the value of customer loyalty and continued patronage (e.g., Newark Morning Ledger Co. v. U.S., 507 U.S. 546, 572-573, 1993). More recent cases have recognized that an employee may develop personal relationships independent of the business (e.g., Martin Ice Cream Co. v. Comm’r., 110 T.C. 189, 207-208, 1998). Last year, Estate of Adell v. Comm’r., T.C. Memo. 2014-155, applied the concept of personal goodwill to minimize estate tax valuation. The case involved business succession from a father to his son, who, through his education and efforts, transformed a cable up-linking business. The Tax Court approved the initial estate valuation, which included substantial discounts for the personal goodwill and business contacts generated by the son. Many business succession plans present an opportunity to creatively apply these principles.

Valuation Discounts

The utilization of minority and lack of marketability discounts deserve special consideration. Lack of marketability discounts reflect the liquidity issues surrounding closely held entities. Minority discounts take into consideration a lack of control. Revenue Ruling 93-12 revoked a prior ruling and allowed a minority discount for stock transferred to five children—specifically, 20% to each child.

The IRS retracted from its prior position of considering family status in disallowing such discounts. IRC section 2704, which was added in 1990 in order to curb abuses, disregards any “applicable restriction” when transferring business interests to a family member. Applicable restrictions do not include any restriction imposed or required by federal or state law, and the section further provides that regulations may require other restrictions to be disregarded in determining the value of family transfers. The Treasury Department is expected to issue regulations to further limit the ability of utilizing minority discounts in a family context.

Other Techniques

Succession planners must consider many other tax techniques: grantor retained annuity trusts (GRAT) and other “freeze techniques” are frequently utilized in the current low-interest-rate environment. Care must be taken to address the complex requirements of IRC Chapter 14. In CCA 20144253, a recapitalization of a family LLC resulted in a larger taxable gift. IRC section 2701 applied special valuation rules that did not recognize the rights and cash flow retained by the parent.

Similarly, IRC section 2702 is designed to prevent a transferor from reducing the value of a gift. If the transferor transfers a business interest and retains an income interest, the gift is the value of the entire business interest unless a “qualified interest” is retained. It is important to observe the formalities to show that any debt is bona fide debt, rather than equity; this is essential to avoid the special valuation rules of Chapter 14 and the application of IRC section 2036. (Sales or exchanges for a private annuity appear to be outside the scope of IRC section 2702; see Jonathan G. Blattmachr and Mitchell M. Gans, “Private Annuities and Installment Sales: Trombetta and Section 2036,” 120, The Journal of Taxation, May 5, 2014, pp. 227–238. The authors still recommend designing any trust to be compliant with IRC section 2702 regulations.)

The utilization of minority and lack of marketability discounts deserve special consideration.

The GRAT is a popular tool because it has statutory authority under IRC section 2702. The transfer can be made tax-free to a designated remainder beneficiary, while enabling the parent to retain a qualified annuity interest. The IRS presently allows a GRAT to be structured in a manner that results in no present gift, which is attractive to parents because they maintain cash flow equal to the fair market value of the property transferred in accordance with the applicable tables. In situations where cash flow is not sufficient, the retained annuity interest may be valued at less than the fair market value, and a taxable gift will result. The gift can be structured to avoid exceeding the exemption available to the settlor. IRC section 7520 prescribes the discount rates utilized in computing the present value of the grantor’s annual annuity payments. Due to current low interest rates, the required annuity payment is minimized, resulting in a larger benefit to the remainder beneficiaries.

The retained annuity stream continues for the designated period selected by the transferor. The settlor has great flexibility in determining the annuity amount and duration. Provided the settlor survives the selected GRAT period, business interests will have been successfully passed to the next generation at a value determined under the IRS tables. The future growth and expansion of the business thereby avoids the settlor’s estate tax burden, but care must be taken to ensure that the selected GRAT term does not exceed the life of the transferor; otherwise, the estate inclusion of IRC section 2036 will apply. Coordinating the GRAT with minority and marketability discounts can achieve enhanced results. LLCs and S corporations present the most appropriate vehicles, as C corporation distributions are generally taxable as dividends.

A Creative Endeavour

The above presents a brief analysis of recent cases and rulings as a guide to business succession planners. Success in estate succession planning is predicated on the advisor’s knowledge, intuition, creativity, and communication. The related traditional considerations of tax deferral (under IRC section 6166), step-up in basis, life insurance, and exemption utilization should be included in whatever plan is selected by CPAs and their clients.