As if it weren't tough enough keeping a family owned waste business afloat, parents and children now are seeking better ways to fuse ownership and kinship.
If the generations are bent on making it happen, it can be done, say the experts. But it takes resourceful planning and an awareness of the legal pitfalls.
Some approaches will succeed, and some won't. A recent decision by the U.S. Tax Court in Washington, D.C., demonstrates a strategy that flopped.
The aging owners of a 95-year-old funeral home business wanted their offspring to inherit and operate the firm. Their lawyer advised them to give company stock as gifts to their sons and a grandson, thereby reducing the size of the owners' taxable estates. The children and the grandchild were licensed funeral directors, and they worked in the several funeral homes operated by the company.
Under federal tax law, donors and their recipients can avoid being taxed for a gift, so long as the total value of all gifts between any two individuals does not exceed $10,000 per year.
The grandson and each of the sons began to receive annual gifts of stock valued at $10,000. Still, the owners believed that their respective estates were not being depleted quickly enough. Accordingly, they began making $10,000 stock gifts to their daughters-in-law, and eventually to the granddaughter-in-law.
Although the additional gifts had the immediate and intended benefit of accelerating the tax-free transfer of company stock out of the owners' estates, the tactic had an unfortunate downside. If any of the sons or the grandson died or divorced, their widow might remarry and have children with her new husband, thereby opening the possibility of someone outside the family gaining control of the stock.
As a countermeasure, the lawyer advised a mechanism for moving the stock from the wives back to the husbands. Besides preparing stock transfer certificates from the owners to the children, grandchild and their spouses each year, the lawyer also prepared papers by which the wives would make a purportedly tax-free $10,000 gift of stock to their husbands.
The company founder who, for years, endorsed all of the stock certificates for all the offspring and their spouses, set the procedure in motion. When he died in 1990, his widow continued the practice until she passed away in 1995. When the Internal Revenue Service (IRS) examined her federal estate tax return, it promptly challenged some 27 transfers she had made to the wives. The IRS claimed that these transfers were, in fact, a roundabout way of giving to the men in excess of the $10,000 annual exemption. The estate got slapped with a tax bill for nearly $130,000.
The widow's estate challenged the assessment in U.S. Tax Court, but the court ruled in favor of IRS. "Viewed as a whole, the evidence shows the daughters-in-law were merely intermediate recipients, and that [the mother] intended to transfer the stock to her lineal descendants who were committed to continuing the operations of the funeral home business," the opinion stated. Although the gifts superficially met the requirements for making a tax-free gift, the court applied the substance-over-form principle "to determine the real donee and value of the transferred property."
Tax experts suggest better, safer ways to maximize the benefits of the $10,000 annual exclusion: for starters, transferring the business into a family limited partnership. Notably, the transfer does not require the corporation to be dissolved. The company founder usually holds the general partnership interest, while the offspring receive periodic "gifts" of limited partnership interests. These interests are valued favorably for gift tax purposes because they involve no control of the company and have virtually no cash value. Thus, it's possible for a parent to make a gift of a business interest worth between $15,000 and $20,000, but valued for gift tax purposes at $10,000. By comparison, a corporate shareholder has more rights and prerogatives than a limited partner, so his stock would have a higher value.
Some taxpayers who take advantage of the $10,000 annual exclusion nevertheless file a gift tax return showing no tax due. By filing a return, the three-year statute of limitations begins to run on IRS's right to challenge the gift. This maneuver is particularly successful when excludable gifts are made over many years. Of course, if a taxpayer substantially understates the tax, IRS gets a six-year window for reassessment.
Estate tax strategies and loopholes tend to be used by small-business owners and others who can afford a complicated and expensive process. Any wonder that owners of family businesses strongly favor a prompt phaseout or, better still, an outright repeal of the estate tax?