Much attention is devoted to estate planning strategies that aim to reduce a family business’s exposure to federal estate taxes and similar state levies. These strategies include such mechanisms as grantor retained annuity trusts (GRATs), intentionally defective grantor trusts (IDGTs), family limited partnerships and limited liability companies. The focus of such discussions tends to center on the “transactional” aspects of the techniques and the associated financial projections.
Yet almost all estate planning for family business owners will, at some point, involve the ownership of some or all of the family business within a decedent’s estate or a trust. Lifetime estate planning techniques, such as outright gifts, GRATs and IDGTs, will involve some ongoing ownership of a family business interest in trust. In addition, many family business owners will continue to own at least some of the family business at the time of their death, such that an owner’s executor will hold a family business interest as part of the owner’s estate.
It is therefore important for family business owners to be aware of the issues that often arise in the context of administering family business interests within estates and trusts, and to work with their advisers to make that administration as effective as possible.
Fiduciary duties
The most pervasive issue relates to the role of the executor or trustee (collectively referred to here as “fiduciary”). The laws governing fiduciaries place a significant duty upon the fiduciary to hold an estate’s or trust’s assets in a manner that preserves and protects the assets. In the context of a decedent’s estate, this can mean the executor’s liquidation of assets into cash as soon as is practicable after death. In the context of a trust, it generally requires proper diversification of assets to minimize risk. These duties are frequently inconsistent with the holding of a family business interest in an estate or trust, since a family business interest is inherently risky, and a tension therefore exists.
That tension can be reduced by prudent drafting of the will and trust documents. Where it is expected that an estate or trust will own business interests, the will or trust document should make it clear that the fiduciary can continue to hold the family business interest without violating the executor’s or trustee’s fiduciary duties.
Wills and trusts should also contain provisions that allow fiduciaries to work effectively with a family business interest. State statutes governing the administration of estates and trusts are often restrictive or unclear in matters involving operating a closely held business. In some cases, such statutes necessitate judicial involvement in decision making with regard to such interests. The restrictions and limitations imposed by these statutes can be overcome by proper drafting of administration provisions that clearly delineate the powers of the fiduciary, and that obviate the need for court approval.
It is important for the family to know that the fiduciary will be the owner of the family business interest and may perhaps have control over fundamental decisions (appointing a board, selling the business, etc.). This can be a concern to most family business owners. The family business governing documents, such as shareholders’, partnership and operating agreements, should be established to ensure that the fiduciary is not in a position to wield more control than is desired over the ongoing affairs of the business.
Tax management is also a consideration that needs to be addressed. This is particularly an issue for businesses that operate as an S corporation, or intend to operate as such, since S corporation status is available only if all shareholders are “eligible” shareholders. Estates and trusts can be eligible shareholders, but wills and trusts must include certain provisions to help ensure that the estate or trust will qualify as an eligible shareholder.
Selection of executor or trustee
Generally, the universe of executor or trustee candidates includes family members, friends, professionals and trust companies. When closely held business interests are involved, that universe shrinks, because most professionals and trust companies are reluctant to oversee illiquid investments such as a family business interest.
The selection of the fiduciary will depend in part on the structure of the family business. If the family has been able to develop a management succession plan, the fiduciary will be less involved in day-to-day operations, and thus familiarity with the business is less of a prerequisite. Without a succession plan, the fiduciary may need to become very involved, in which case that person should have a strong understanding of the business.
Valuation and liquidity
One of the first tasks in administering a family business interest as an asset of a decedent’s estate or revocable trust is determining the business interest’s value for estate tax purposes. Although many buy-sell agreements provide that the value of a family business interest will be determined by agreement of the owners (using an agreed-upon formula), the Internal Revenue Service will generally not respect such agreements for federal estate tax purposes. It is quite conceivable that the value of a family business interest for federal estate tax purposes will be higher than the price to be paid in a family buy-sell agreement (“phantom value”).
This disconnect doesn’t mean that family buy-sell agreements should not determine the value for buy-out purposes. It does suggest that families may want to consider setting a purchase price under a family buy-sell agreement that more closely reflects the fair market value of the business interest. Further, the will and trust provisions of the deceased owner (i.e., the selling owner under a buy-sell) should direct who would be responsible for paying the estate taxes on the phantom value, in order to avoid inequities.
Another issue involves liquidity to pay estate taxes or other expenses. The will and trust administration provisions should provide clear authority to the fiduciary to borrow money and to pledge business assets as collateral. This would also include authority to make an Internal Revenue Code Section 6166 election, which essentially allows qualifying estates (i.e., those with significant closely held business interests) to borrow money from the IRS at discounted interest rates. With respect to trusts established and funded during the decedent’s lifetime, the provisions of those documents should be coordinated so that the trustee can work with an executor or similar fiduciary to provide liquidity via purchase of assets from, or lending of money to, a decedent’s estate.
Active and passive heirs
Many family businesses will have some heirs who are actively involved in the family business, and some heirs who are not. To address the passage of family business assets in an equitable fashion, many families will use life insurance, buy-sell agreements or lifetime intrafamily purchase mechanisms, such as GRATs or IDGTs.
Whatever planning is used to accomplish the appropriate distribution, care must be taken to ensure that the administration provisions of wills and trusts are consistent with the plan, thus allowing for the fiduciary to effectively implement the planning strategies. The tax payment clause of a will or revocable trust might direct that the active heirs pay any death taxes on phantom value. Similarly, if the deceased business owners still had a small but controlling interest in the family business, the documents should make it clear that the active heirs will be allocated that interest in distributing the assets of the estate or revocable trust, thus avoiding unnecessary conflict between the active and passive heirs. In the case of real estate leased to a family business, the real estate might be allocated to the active heirs’ share in order to avoid conflict.
Key factors
Planning for the efficient transfer of family business interests requires not only proper selection of transactional techniques, but also proper establishment of administration provisions within the wills and trusts that will eventually govern the management and disposition of those assets. Appropriate consideration of those factors can be essential to the proper management of the family business, and the implementation of a family’s overall estate plan.
Michael W. Mills is a partner in the law firm of Antheil Maslow & MacMinn LLP in Doylestown, Pa. (www.ammlaw.com).