Implications of the Transfers of Business Interests

April 13, 2006

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When executing estate planning strategies, the result of transfers to children will often be income-splitting that lowers the family's income taxes. Traditionally, income in a limited liability company (LLC) is divided according to the relative balance in the owners' capital accounts. Because the children will own much, or nearly all, of the business, according to the capital accounts, most of the income would be attributable to the children, if this traditional allocation scheme is used.

The children's share of income would be "passive" income in this instance. In 2006, the first $1,700 of this passive income will be taxed to the children at their lower tax rates, while the parents' top rate could approach 40 percent.

In addition, if the children actually provide services to the business, any payments to them would not be passive income. Accordingly, all of this non-passive income would be taxed to the children at their lower rates. For 2006, the first $5,150 (the amount of the child's current standard deduction) would be tax-free. Moreover, it should be noted that parents could provide the cash necessary to pay the taxes incurred by the children.

Further, when children actually work in the business, this will mean retirement plan contributions can be made on their behalf. It also will allow the retirement plan to qualify under the Employee Retirement Income Security Act (ERISA), where, otherwise, with only the two parents participating in the plan, it would not qualify. This will mean the retirement plan benefits will be protected as exempt assets in a bankruptcy or state court proceeding (see our discussion of asset exemption planning).

Use of this allocation scheme also will mean that the wealth represented by the business's earnings will not be subject to the estate tax. Nearly all of the income drawn out from the business would be attributable to the children and, thus, not taxable in the parents' estate.

Transfers to the children also offer flexibility with respect to income taxes. Because the parent retains control, and provides all of the labor and planning for the business, all (or most) of the business's earnings can be drawn out by the parent as salary, if that is desired. This obviously is an advantage to the parents in terms of control of the cash flow.

Moreover, transferring ownership interests to the children serves a useful asset exemption purpose. The value of the business is divided among the parent and the children, leaving the parent with complete control of the business, but with a lower-valued ownership interest. This makes it easier to exempt the parent's ownership interest.

Finally, when transfers are made into a trust with a spendthrift clause, the interests transferred are protected from the children's creditors.

Ultimately, asset protection strategies should be designed to work together, as part of a comprehensive asset protection plan.

If you are going to use this estate planning strategy of transferring ownership interests to family members, several caveats are in order:

While the parents retain control of the management of the business, and control over withdrawals during the life of the business, the children in fact will own a significant portion of the business. They will receive this share on liquidation of the business. Some parents would not want this result or would want the ability to revoke the transfers, which is not possible.
Parents still must plan for the transfer of control of the business (i.e., the manager interest) to the next generation. This decision involves many other factors, such as the children's desire, or competence, to operate the business, etc.
The IRS has approved the transfer of interests both to children directly and to trusts that hold the interests for the children. Accordingly, the children or the trust will be recognized as partners for federal tax purposes. However, in both cases, the IRS will recognize the children, or the trusts holding their interests, as partners, only if capital is a material income-producing factor. This rule exists to prevent parents from shifting what really is income from their personal services to the children. If the profits are generated principally by services provided by the parents, the children (or their trust) will not be recognized for federal tax purposes and the income will be taxed to the parents. Note that the IRS cannot control who is a partner under state law, or for any other purpose, except for purposes of federal taxation and, in this case, for purposes of deciding who will be taxed on the business's income.

Work Smart

This IRS rule on which partners are taxed may not present a problem for the small business owner, even in a personal service business, because the children will be gifted interests in the holding entity. The holding entity will produce income primarily from the provision of capital to the operating entity (providing leased equipment, purchasing receivables, etc.). This is yet another reason to use a holding entity and an operating entity.

Finally, where capital is not a material factor in producing income, there is another option. The IRS will recognize the children, or their trust, as partners if the children provide significant services to the business, and income is allocated according to the relative services provided, rather than on the basis of relative capital interests.

In addition, where trusts hold the interests of the children, the trustee, especially if this is the parent, must manage the interests solely for the benefit of the beneficiaries of the trusts--the children. This prevents parents from using the principal or income in the trust for their own personal benefit.

Warning

This strategy has recently come under IRS scrutiny, precisely because of its effectiveness in significantly reducing estate taxes. Basically, the IRS has scored successes when individuals have created an entity and transferred interests to their children on their death-bed, as a tax-avoidance tool, and when entities have been formed and funded solely with marketable securities and, thus, had no business purpose. Neither of these situations will be likely to apply to the small business owner.

This type of planning is really only appropriate for the family-owned business.
Most importantly, estate planning is an especially complex and ever-evolving area of law. It is wise to consult an estate planning practitioner before undertaking any planning measures.