Finance Tax Time

As Penn State professor William Rothwell ominously points out in the forward to Exit Right: A Guided Tour of Succession Planning for Families in Business Together, more than 40% of the people who run the closely held operations that comprise 80% of the North American economy will retire by 2007. Those businesses will either be sold to a third party or management team, closed down, or passed on to the next generation.

In this article I will focus on passing the business on to the next generation.

The government has also encouraged the passing of a business from one generation to the next with several favorable estate and gift tax rulings. Estate planning attorneys have utilized IRS ruling 5960 to minimize the estate and gift tax owed for a business either gifted to or inherited by the next generation.

The business is often placed in one or more LLC’s and divided up into minority pieces to take advantage of very substantial and legal minority discounts, often as high as 40%.

As is often the case, a business owner will have, for example, 4 children. Two sons will be actively involved in running the businesses and two daughters have built lives totally separate from the business. Because 85% of the value of the estate is tied up in the value of the business, to be “fair” the business is gifted and willed to the four siblings in almost equal proportion. Because the sons are running the business, they will get slightly more of the business and slightly less of the remaining estate.

This gives them majority interest in the business. After dad leaves the business, the two sons will continue to run and grow the business without any input or participation from their two sisters. Typically the business does not pay any dividends and the two sisters’ portions are non-liquid because there is not a good market for selling minority stakes in a privately held business.

Also, there is generally a very restrictive buy sell agreement that favors the majority holders. The sisters have no idea what the “fair value” of the business is and the only indication they have ever gotten is an official IRS gift tax or estate tax return with 40% discounts applied. If the enterprise value were, for example, $50 million and the two sisters owned a combined 40%, you would think that they had an asset worth $20 million.
The only document they have seen, however, is the gift or estate return, valuing their portion at only 60% of that number, or $12 million.

The brothers feel entitled to the lions share because Ann and Julie had nothing to do with building this business. The brothers pay themselves big salaries and benefits and pay out little of no dividends. They may approach the sisters with gift tax return and restrictive buy sell agreement in hand and offer to generously buy out the sisters for a combined 8 million, because that is “all the company can afford to pay.”

After this transaction takes place, let’s look at the result of how dad’s estate was fairly divided. Originally the brothers were left with 60% of the $50 million business, or $30 million and a minor portion of the remaining estate. The sisters were left with 40% of the business, or $20 million and the bulk of the remaining estate of $10 million.

That appears to be fair. However, the buyout of the sisters for a combined $8 million results in an effective estate distribution of $42 million to the brothers and $18 million to the sisters. This is not what dad intended, but it happens all the time.

This is a very complex and emotional issue and there are no simple answers. Generally, dad had his identity tied up in the business and wants it to live on through his sons after he is gone. This is a noble, yet impractical thought if all the siblings are not actively involved in the business. The children often inherit the restrictive buy sell agreements that favor the brothers running the business and scare off investors that may have been interested in a minority stake in the business.

Much of the value from a privately held business is derived from the benefits of working in the business. There is the very real concern that the integrity of the gift or estate tax business valuations will be compromised if the sisters are bought out at a price approaching a pro-rated division of total enterprise value.

Unfortunately, in most cases, nothing is done and as a result there are literally hundreds of billions of dollars of minority interests in privately held business that are providing little return or no return to their owners.

One of the keys to unlocking the liquidity in these minority interests is for the business owner to recognize this situation prior to building his estate plan. Unfortunately, we are often brought in after the fact and a fair outcome then is contingent upon the majority owners honoring dad’s original intent of fairness and working toward that end.

Dave Kauppi is a business broker and President of MidMarket Capital. We help business owners with all aspects of Mergers and Acquisitions.

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Overview

In the Pre-Budget Report of December 2003 the Chancellor Gordon Brown announced proposals to levy an Income Tax charge from 6th April 2005 in those circumstances where the transferor of an asset retains and interest or continues to benefit from that asset. In the instance of real property, the ‘benefit’ envisaged is the transferor continuing to reside in the property he/she has allegedly given away.

How the Charge Applies

The Government refer to such assets as ‘pre-owned assets’ and, broadly speaking, its intention is to tax the ‘annual value’ of such assets as a benefit-in-kind on the former owner still enjoying the use of the asset. The annual value on which the charge is based will be the open-market rental for a property or a fixed percentage of the capital value of most other assets to which the new charge applies. Any amounts which the transferor pays for the use of the asset - rent for example - will be deducted from the annual value in arriving at the taxable benefit.

The charge will also apply if a person provides the funds to purchase an asset which they go on to enjoy the benefit of after 5th April 2005.

Rationale Behind the Charge

The charge is intended to counter many Inheritance Tax planning schemes, but unfortunately, it will also impact many innocent and unintended victims. Thankfully, the legislation has included some exceptions to the application of the charge. The charge will not apply if;

The asset was gifted before 8th March 1986

The asset is owned by the transferor’s spouse

The asset is, in fact, still caught by the ‘Gifts with Reservation’ rules and as such Inheritance Tax applies instead (hence, the Income Tax charge will not be levied on top).

The asset was sold at an arm’s length price for cash (even if to a connected party).

The transferor of the asset had themselves inherited it and their ownership had ceased as a result of a Deed of Variation affecting that inheritance.

The transferor’s continued enjoyment of the asset is merely incidental or has arisen only as a result of an unforeseen change in family circumstances.

The annual taxable benefit (after deducting any contributions by the transferor, where necessary) does not exceed

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Question: My grandmother, recently deceased, left E, EE, & HH bonds to me, my sister, and mother. The total is approximately $600,000, under the limit to be taxed. However, there is substantial interest accrued on the bonds. What would be the best way to distribute these? Should we have them changed to our names to avoid the Capital Gains or do the taxes have to be paid before distributed? Will taxes be due when we eventually cash them in? Will any taxes be due on the HH bonds? Are the CGT over and above the income taxes? Please Advise. Thank You. R.

Answer: Dear R - First, you indicated that the bonds have a value of approximately $600,000 and you say that this is “under the limit to be taxed.” If you’re referring to the federal estate tax, I would agree - as long as the combined value of all your grandmother’s assets do not exceed $2 million, you don’t have to worry about federal estate taxes.

From an income tax standpoint, however, you are correct in thinking that the bonds may be subject to tax if they are cashed in. Let’s go over the tax rules on this and see where we stand with respect to these bonds.

Most of us are aware of the “step-up in basis” rules that apply upon death. Those rules, however, only apply to capital assets. For example, if you buy a house for $100,000 and you sell it for $250,000, you have a capital gain of $150,000, which you report on Schedule D of your Form 1040 in the year of sale. The gain is the difference between your sale price ($250,000) and your cost basis ($100,000). Your cost basis is what you paid for the house, plus any capital improvements you make during the time you own it. Keep in mind that you only pay a tax on the increase in the value of your capital (i.e., a capital gain) - and you only pay the tax when the capital asset is sold or otherwise disposed of.

The tax laws give you a break if you hold a capital asset until death. In that case your “cost basis” is increased to its date of death value. The practical effect of this rule is to eliminate any capital gains tax on the appreciation of your capital assets from the time you acquired them until the time you die. When your heirs take over your capital assets, they start off with a cost basis equal to the date of death value.

In the above example, if you own the house until you die and the date of death value is $250,000, then the $150,000 unrealized capital gain is forgiven entirely. Your heirs then take over the house with a cost basis of $250,000. If they later sell the house, their capital gain would be the difference between the selling price and their cost basis of $250,000.

The step-up in basis rule, as we’ve just discussed, only applies to the increase in value of your capital assets - it doesn’t apply to the income earned by your capital assets. In tax parlance, the increase in value of your capital assets is called a “capital gain.” The income earned by your capital assets is called “ordinary income.” The most common types of ordinary income are interest and dividends.

One way to distinguish a capital gain from ordinary income is through the use of the apple tree analogy. If you buy an apple tree and it increases in value over the years, that increase in value is treated as a capital gain. The gain is “unrealized” until you sell the tree. When you do sell or otherwise dispose of the tree, you then “realize” the gain and you pay a tax on the capital gain at that time.

If you hold the tree until you die, the unrealized gain is forgiven and your heirs take the apple tree at its value upon your death. This is the benefit of the step-up in basis rule.

Now let’s take a look at the apples growing on the tree. They represent the earnings on your investment, which are taxed as ordinary income. The apples are very much like dividends and interest that is earned on stocks and bonds; i.e., they all represent the earnings on your investment.

Most ordinary income is taxed in the year it is earned. However, with bonds, the interest earned each year is allowed to accrue untaxed until the bond is sold or cashed in - very much like the apples on our apple tree. When you eventually do liquidate a bond, the money you receive actually represents two things: a return of your capital investment (cost basis), plus accrued interest. In some cases, if you sell a bond rather than redeem it, you may receive a premium over the face value. In that case, the premium represents an appreciation in the value of your capital investment; i.e., a capital gain.

While the appreciation in the value of your capital investments (i.e., capital gain) is forgiven upon death by virtue of the step-up in basis, the same is not true for the earnings on your capital investments; i.e., ordinary income. This type of income is referred to as “income in respect of a decedent” or “IRD” for short.

Think of it this way - if you inherit an apple tree with the apples on it, you won’t pay a capital gain on the appreciation in value up to the time of the decedent’s death, but you’ll pay taxes on the apples when you sell them, the same as the decedent would have done if he had lived to sell them himself.

So, now let’s relate all this to your specific questions. First, if you cash in the bonds, you won’t have to pay any capital gains taxes because there won’t be any capital appreciation in the value of the bonds. Bonds are nothing more than an I.O.U. In this case, your grandmother loaned money to the federal government and the federal government agreed to pay her interest for the use of her money. When the I.O.U. (i.e., the bond) is redeemed, you’ll be paid back the amount your grandmother loaned to the federal government, plus the interest earned on the loan. The interest is ordinary income (IRD) and is taxable to whomever owns the bond at the time it is redeemed.

Because HH bonds pay interest semi-annually, there probably won’t be much accrued interest that you’ll receive when the bonds are redeemed. However, whatever interest is accrued at that time will be paid to the holder and it will be taxed to the holder as ordinary income in the year the bonds are redeemed.

One final point. Distributions from an estate (or trust) are deemed to carry out ordinary income first and principal second. For this reason, it is generally advisable to have the estate redeem the bonds and then distribute the money to the beneficiaries rather than distributing the bonds directly to the beneficiaries. If you distribute the bonds directly to the beneficiaries (which is generally done on the basis of face value), each beneficiary will pay income taxes on the interest accrued on their respective bonds. Since some bonds may have more accrued interest than others and, since each beneficiary may be in a different tax bracket, they will probably pay different amounts of taxes on the bonds they receive. So, even though they all receive the same face value, the actual cash remaining after taxes will be different for each beneficiary. For this reason, you may want to have the estate redeem the bonds and distribute the cash equally to each beneficiary.

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