Inheritance planning: a necessary part of estate and gift tax planning.

It has been said that more wealth will be passed on to the "baby boom generation" over the next 10 years than has been passed on during any other period in history. Perhaps that explains the increase in "estate planning" and marketing of related services by insurance companies, brokers, lawyers and accountants. Although estate and gift tax planning is definitely a necessity for any wealthy individual, estate and gift tax planners must be careful not to focus only on estate tax savings and ignore inheritance planning" for the beneficiaries.

The following situation is a classic example of what can happen if proper time is not spent with the beneficiaries of gifts and/ or inheritances of closely held corporations or family-owned farms.

Three brothers were given a coal mining company by their mother. The mining company had been established by their father in the 1950s. The company was never a large money maker, so C corporation status was maintained for liability purposes, and all profit was usually paid out as salary. The company acquired some large tracts of land over the years. However, the land was not valued highly because it was purchased as farm land, and it was not cost beneficial to mine all the coal. The father passed away and all assets were left to the mother. The company was somewhat inactive over the last several years, and its only income was a de minimis amount of royalty income received from another coal company doing some mining on its land.

As part of her estate planning, the mother gave the company to her sons while the value was still low, thereby removing the potential for appreciation from her estate. No special use valuation under Sec. 2032A was necessary, due to its low value and the need to reclaim part of the land.

Several years later one of the sons arranged to have an outside company strip mine the remaining coal from the land, and for another company to purchase the land, fill in the stripped area with refuse and reclaim the land. The two deals together will generate between $1 million and $2 million of revenue to the company over the next five years.

The problem is that the company will now be receiving income, the bulk of which will be royalties, thereby making the corporation a personal holding company (PHC). All earnings will be taxed twice, at the corporate level and then again at the shareholder level on the payment of dividends, and maybe even three times (corporate income tax, corporate level tax on undistributed PHC income and an eventual shareholder level tax when the net earnings are distributed or the corporation liquidated].

The moral of this scenario is that the planning should not have stopped when the mother's advisers recommended and implemented the gift of the company to her sons. The new owners were apparently unaware of the complex tax situation they were handed, and therefore took no steps to avoid an onerous tax burden.

What could have been done, had someone been advising the sons?

* Giving the stock to a wider range of relatives in an attempt to avoid PHC status by "failing" the stock ownership rules of Sec. 542[a][2]. This is not always feasible because of the stock attribution rules of Sec. 544.

* Determining if an S election would have been appropriate once the sons took over. In the example, this may or may not have helped, as the tax on "passive" income and potential for termination of S status might come into play.

* Outright liquidation of the corporation before any of the deals were consummated, with similar agreements entered into by the sons as individual co-owners of the property. * A joint venture type of agreement to work the land that would generate ordinary income to the corporation to avoid the PHC and Sec. 1375 problems caused by the royalties.

As many family-owned farms and/or businesses pass to the "baby boom generation" over the next few years, it is likely that many of these inheritances will be received with little estate or gift tax being paid because of good estate planning. However, these estate tax savings could quickly vanish as a result of the lack of planning on behalf of the children who have worked on the family farm or in their fathers' businesses. Although these beneficiaries may receive modest incomes now, many will soon inherit or be given million dollar investments. Some will choose to continue to operate the businesses or farms, while others will wish to "cashout" as quickly as possible. Without timely inheritance planning, this may prove costly. It is imperative that estate and gift tax planners or tax advisers address the question of whether the businesses or farms are going to continue after they are transferred to the next generation. An "inheritance plan" should be a major part of a family's estate plan. From Dennis Seamon, CPA, Pittsburgh, Penn.