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September 17, 2003 7:55 AM CDT

Estate and Financial Planning for the Masonry Business Owner


Masonry business owners and their families are faced with a constantly moving set of IRS tax rules and regulations pertaining to estate planning and asset transfers. The objective of this article is to give readers an overview of applicable planning alternatives they may consider, help reduce the possible taxes, and preserve your wealth by transferring growing and appreciated assets to second- and third-generation family members. My philosophy is consistent with the attitudes of most small business owners I have as clients. None of them want the government to collect any estate tax or capital gains tax if they can legally prevent it. There are costs and benefits to alternative approaches to asset preservation and transfer. So let's take a look at some of the choices currently available to masonry business owners and suppliers.

First off, in order to consider these options we need to make a few assumptions: We assume your greatest financial asset is your business, followed by real estate, retirement plan assets and life insurance.

The 2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) introduced a few important issues to be aware of as we consider the merits of estate planning in different ways. Most importantly, the tax on selling your appreciated business or investment assets, a long-term capital gains tax, was reduced to 15 percent of the net gain (down from 20 percent under prior legislation). In addition, dividends payable from profits of "C" structure corporations (ordinary income) were also reduced to 15 percent on amounts received by shareholders. From an investment standpoint, relative to personal and corporate investment strategies, the principal impact of the change is likely to drive individuals to purchase dividend producing stocks and to hold them for periods long enough to qualify for long-term capital gains prior to selling them. This would tend to create a more stable market environment, move market assets from non-dividend paying stocks and interest-bearing bonds in favor of companies that are increasing their dividend pay-out rates. Tax policies are pushing investors to seek companies with improving profits and dividends that will simplify the challenges facing masonry business owners and their families as they attempt to reinvest cash proceeds from the sale of assets. Reinvesting in such dividend bearing securities will often provide a strong continuing source of growth and income for less experienced survivor beneficiaries. This also suggests that masonry owners who presently operate as sole proprietorships or LLC structures may want to amend the ownership of their own businesses to allow dividends to play a role in compensation and planning.

In order to do effective planning, taxpayers need to be aware of the applicable tax rates over the next few years until 2010, when the current estate tax rules are repealed. Readers should consider that legislation on estate taxes was set by Congress to sunset on December 31, 2010, and reverts to previous lower exemption rates enacted prior to 2001. Therefore, unless Congress amends the current sunset provisions prior to December 31, 2010, the current legislation will not apply after that time.

In considering each of the alternatives to follow, I recommend that the masonry business owner proceed cautiously given the fact that estate taxes are repealed in 2010 but spring back to life in 2011. In making gifts, the masonry business owner will lose the free step-up in basis to fair market value on assets that would otherwise be received if the property instead passed through the estate after death. However, the benefit lost in most cases would likely be offset by the cost of estate tax imposed, depending on the masonry owner's personal circumstances.

The Family Corporation

A long-time asset transfer strategy used by families with appreciated business assets founded by the parent generation was to sell the existing business to a "C" corporation set up by the children, second-generation beneficiaries who own the common stock. The parent generation receives, by way of an exchange, preferred dividend bearing, cumulative, redeemable and callable stock with a pre-determined dividend rate such as 6 percent. Using a net business value of $1,000,000 as an example, the corporation agrees to pay the dividend of 6 percent of the equity in the preferred, not every year, but accumulated for future years whenever the dividend cannot be paid in a given year, thus the term cumulative. This stock is also redeemable by the company at its cost, and over time a demand can be made to call the redemption of the stock, at the behest of the parent. Typically, the senior family member will retire at some point removing the salary expense attached to his or her position as Chairman or President and the savings in cash flow can be utilized to redeem the preferred stock which triggers long-term capital gains tax at 15 percent. Appreciation of the business assets remains with the second and/or third generations. This is generally referred to as an estate freeze, since the value of the preferred stock stays fixed at the market value when the business is sold to the corporation. Tax can be deferred on this gain until the death of the second parent at which point an insurance policy could be used to pay the taxes on the gain in value of the original preferred.

Such a policy could be purchased on the life of the parent mother, who will typically outlive the parent father. The dividends paid by the business corporation to the parent mother will provide an attractive low-tax method of assuring economic certainty for the surviving parent through the balance of her life. In the meantime, tax planning within the corporation can be undertaken to minimize corporate tax which is 15 percent on the first $50,000, thus providing the family with the ability to deliver most of the 15 percent preferred dividend at a lower total tax rate. Providing continuing healthcare benefits and possibly long-term care insurance for elderly owners at the expense of the corporation may be a contingency masonry owners want to build into their sale of assets to a family corporation.

Medical Savings Plans are also of interest as they may position masonry owners to receive compensation and cost coverage, tax-free, for long-term coverage of out-of-pocket expenses that are not covered by Medicare benefits. The rules applicable to such plans need to be studied by your accountants and insurance advisors to see if there is a benefit to this strategy for you.

In particular, IRC Section 2701 may be of concern to planners. The section provides that certain priority rights in a partnership or corporation, "applicable retained interests," held by a senior generation be disregarded or valued at zero for purposes of valuing a gift of subordinate interests to certain younger generation members. The possible impact of this could result in assessment of tax on the gift of common stock to younger family members unless the strategy is carefully constructed. IRC sections 311(b) and 338 should be reviewed in connection with any transfer of assets to a corporation. Appreciated assets cannot be transferred out of corporation without recognition of a taxable gain. Any distribution of appreciated property to a shareholder is treated, under those Internal Revenue Code sections, as though assets were transferred in a taxable sale for fair market value. In addition, the owners may face double taxes in the event the corporation recipient later sells the business.

Let's look at another organizational strategy used by older owners to distribute assets to second- and third-generation owners.

The Family Limited Partnership

The Family Limited Partnership (FLP) may offer masonry owners a series of advantages over a corporation as a planning strategy. Appreciated assets are contributed to the partnership by the senior generation and limited partnership interests are gifted to second- and third-generation family members. By placing restrictions on the limited partners the "gift value" of the limited partnership units is reduced. Such values are determined by qualified appraisers and may result in valuation discounts of 25 percent to 45 percent from present fair market value of the actual holdings of the partnership. Careful design of the partnership is necessary to achieve the possible benefits of this discount. Thus, masonry business owners considering this method of planning will want the very best planning assistance and experienced legal firms to work with them.

Often, a limited liability entity designated by the donor becomes the managing general partner, and the current business owner will be President of that entity while he or she survives. Children and grandchildren are protected from any debts of the business by being "limited partners." Day-to-day management of contributed business or real assets usually continues with the present owner generation, but management can be transferred by agreement to include or add members of the second generation. Often state laws pertaining to property valuations are defeated by properly structured limited partnerships, deferring increased assessments until more than 50 percent of partnership interests are sold. Gift trusts can also be created to minimize taxes to beneficiary children and their heirs, putting another level of creditor protection in place at the same time.

Obviously such structures will typically cost $5,000 to $10,000 to organize and there are tax returns and distribution rules built into the structure that need to be adhered to on an ongoing basis. Taxation is at the level of the general partner and limited partners each of whom will get a K-1 allocating them their share of annual profit or loss. Usually the objective of the partnership is to transfer the ownership of the assets to a vehicle, which survives the death of the elder family owner. Again, life insurance may be a practical method of paying future taxes on the death of the second parent, if she is insurable at a reasonable number. Either capital gains taxes or estate taxes may result where original appreciated assets are transferred to the second generation on death of the second parent. The amount of insurance can be easily determined by estimating the worst case scenario on these taxes.

In our prior example, the appreciated fair market value of $1,000,000 in business value with a zero cost basis, could generate $150,000 in capital gains taxes. But there could also be estate taxes depending on what year the second death occurs. Residence values, retirement plan assets and appreciated art or investment portfolios will have to be considered. Taxes up to 49 percent can apply to estate taxes after the exemption, which increases to $3,500,000 in 2009, but still may not eliminate tax on many masonry owner family estates. Therefore, masonry families may want to look at some other strategies that also involve costs, which may not be acceptable to all.

Charitable Remainder Unit Trusts (CRUTs)

We are going to mention the possible use of a Charitable Remainder Unit Trust, but will not explore its applications, as we feel it is unattractive for most donors to consider in the light of the other alternatives.

The Private Foundation

A private foundation is often structured as a non-profit public benefit corporation to allow flexibility in operation. Upon formation, an application as status as a 501(c)(3) corporation can create a long-term family charitable legacy. Unfortunately, a private foundation can own no more than 20 percent of an active business and the deduction for contributions will be limited to 30 percent of the donor's "contribution base" — the contributor's adjusted gross income — without regard to net operating losses. Non-cash contributions are limited to 20 percent of the contributor's contribution base. IRS regulations prevent self-dealing, regulate distribution strategy, and may apply tax to investment income. Since the foundation strategy has limited application for most masonry business owners, we suggest readers speak with their personal tax advisors to cover the extensive IRS rules that apply to this type of charitable organization.

Qualified Personal Residence Trust (QPRT)

This trust may be applicable to the surviving parent who wants to transfer the value of a significant home to benefit grandchildren and avoid tax on the transfer. Such a trust may allow the grandmother use for her lifetime, transferring the property at today's value to a trust that benefits the grandchildren.

For the following, we will assume the residence is worth $1,000,000 and the value of the use of the property is 4 percent per year. If the subject property is appreciating at, for instance, 3 percent per year, in 15 years the $1,450,000 value would transfer to second generation beneficiaries at the original transfer price less the actuarial value of the retained income, say $400,000. If the $1,000,000 transfer exemption is not repealed at the end of 2010 (unknown) this would be a tax-free gift to the children. At very worst it will reduce the amount of estate tax payable if the estate is taxable based on other assets.

However, like everything there are some rules detracting from the use of this vehicle. If the grandmother doesn't live for 15 years, the value of the home can be included in her estate for tax purposes at fair market value. The strategy can be enhanced by providing for a reversion, the right to recover the property from the trust if she dies within the term of the trust. On the other hand, she could be forced out if she lives beyond the 15 years. By providing the right to lease the subject property after that time, continued occupancy can be assured and additional transfers of assets to second- and third-generation beneficiaries can be deployed in the form of rent payments. While these payments may be taxable in the hands of beneficiaries, with education expenses being tax deductible to students under new legislation, such income may be a way to generate gross revenue to finance the grandchildren's education tax-free while reducing later estate taxes.

Summing Up

Masonry owners are sometimes likely to build businesses that have accumulated values in excess of estate gift exemptions and that have accumulated long-term capital gains. One relatively cost-effective way to deal with the unexpected transfer of assets to second- and third-generation beneficiaries is to have life insurance plans on key owners in place in your business today. If yours is a growing business, use of products such as the Hartford Stag Term Insurance policy — which offers literally free 10- or 20-year term insurance, providing a full premium refund on large amounts of term insurance premiums ($100,000 to $2,000,000) upon conversion of such policies from term to permanent insurance plans within a five to 10 year period from original purchase (premiums are refundable subject to certain restrictions and conversion can be made without further medical evidence) — may be attractive.

Premium rates for insured persons in their forties are very reasonable. Purchasing key man or woman insurance, or both covering husband and wife, is a small but clever planning move for successful business owners who are likely to create significant estate values. Insurance owned by and paid for by a corporation can deliver tax-free benefits to a second-generation beneficiary to cover the out-of-pocket costs of capital gains taxes and possibly estate taxes.

Another possible asset transfer strategy applies to accumulated retirement plan assets that may be deployed as older generation members retire. Transferring assets in a 401(k) defined benefit pension plan to a new IRA or annuity offers the opportunity to bring a second family member in as a co-owner or co-annuitant. Some annuity companies will allow the retained value of the annuity to continue for the life of the second-owner beneficiary resulting in a long-term asset transfer that in some cases may be significant. Generally there is not enough money in the retirement plan assets or reserves to exceed the exemptions, but since investments are tax sheltered within the IRA or annuity products, keeping the assets there may be a significant long-term benefit to second- and third-generation beneficiaries where the assets are not needed to support the donor generation.

Discussing with your advisors an estate freezing tactic or a family limited partnership may be the additional step you want to take now if you are in your fifties or sixties, when grown children are involved in the business and plans for orderly transition of management and appreciated estate values are appropriate. In the meantime, use of the corporate "C" structure may be worth study as a means of creating balance sheet values for net worth and bonding purposes, persuading you to move from a proprietorship to a corporate business structure. The new lower rates on dividend income may save you approximately 10 percent on some portion of your taxable total income by paying corporate tax on up to $50,000 and issuing dividends to yourself for $42,500 if you are already making more than $80,000 taxable and paying 35 percent federal tax plus state tax if applicable on your next dollar of earned income.

Be aware that the above material is a summary and not intended to be a legal opinion or a guide applicable to any one situation. In putting forward these ideas in this format, my intention is to share some concepts. Hopefully, this summary prepares readers to take their unique situations to professional counsel, to obtain the highest quality legal and tax advice you can afford, to make sure your plan meets the changing regulatory requirements and also meets your own goals and objectives.

About the Author

Wayne F. Currie is Chairman and CEO of Incentive Capital Management, Inc. He has been a financial planner and investment advisor since 1970.


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