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A passing fancy: transferring a family business at less cost.

With the dawn of the Clinton administration come proposals for increased taxes. Although some Americans are proclaiming their willingness to "pay their fair share" to rescue the country from a perceived financial disaster, few, if any of us, want to "contribute" more than we must. Much of our attention is directed toward the everincreasing income tax burden. Far less attention is given to the truly confiscatory gift and estate tax.

The intent of this article is to raise our readers' awareness regarding gift and estate taxes in general and, more particularly, the awareness of those who own closely held businesses. It is vital that owners of closely held businesses consult their accountants and attorneys to find out how they can minimize the potentially devastating effects of the gift and estate tax.

Americans are well aware of how much income and Social Security tax we pay every paycheck. Not surprisingly, many of us are concerned about the proposed income tax increase. The combined increase in income, Social Security, and Medicare taxes could bring the effective top marginal tax rate to 43 percent.

In contrast, the gift and estate tax system is relatively unknown. It comes into play when: (1) an individual transfers within one calendar year assets exceeding $10,000 in value to someone other than their spouse, and/ or (2) an individual dies with a gross estate of at least $600,000. Most Americans are not positioned to make annual gifts of $10,000 or more, so there is a lack of national attention to the gift tax. The estate tax, on the other hand, will apply to more of us than we might expect.

Many "middle-class" Americans have estates exceeding $600,000. An unmortgaged home, a bank account or two, a few investment securities, and life insurance proceeds can quickly push the "average" American's estate into the minimum applicable estate tax bracket of 37 percent. This is all the more frightening when you consider that the estate tax brackets continue upwards to 55 percent. In addition, some of us who followed sound advice and saved for our retirement will face an additional 15 percent excise tax on "excessive" retirement plan funds. This brings the marginal tax rate on part of some estates to 70 percent.

Owners of closely held companies and their families are particularly at risk from the estate tax. Many such companies are run by two, or possibly more, family generations, and much of the family wealth in the form of company stock is likely to be in the hands of the eldest shareholder, who most frequently is the company founder. The all-toooften unfortunate result is that the family business must be sold to satisfy the estate tax bill when the business owner passes away. A business is destroyed, and our economy loses a once-productive employer and provider of goods or services.

Many closely held businesses can be preserved beyond the death of a rounding shareholder if proper estate planning is in place. Attorneys, accountants, and financial advisers can work together to help construct an effective plan for transferring the family-owned company from one generation to the next. Estate taxes, possibly in the hundreds of thousands or even millions of dollars, can be avoided, a business saved, and the livelihood of succeeding family members preserved through the process of estate planning.

One method of transferring a family business from one generation to the next while minimizing gift and estate taxes involves the gifting of closely held company stock shares over a period of years. The greatest advantage of this strategy is the ability to "discount" the value of the company stock for gift tax purposes when less than a majority interest is transferred. Based upon the element of control, a minority interest is worth comparatively less than a controlling interest in the same company. By transferring minority interests in company stock each year, the transferor could, for example, reduce the value of his company's stock from $50 to $35 per share, based on a 30 percent discount.

There are countless examples of owners of closely held businesses taking advantage of the minority discount. In one instance a parent owned 100 percent of his family business. For business and tax-planning purposes, the parent transferred a 20 percent interest in the company to each of his five children. To reduce the gift tax consequences and to recognize the true value of a 20 percent minority interest in a company, the parent discounted the value of each share his children received.

Assuming the value of the entire enterprise was $2 million, the gift tax for a transfer to children without a minority discount would be about $267,000. By using a 35 percent discount, the annual exclusion, and the combined unified credit of both parents, the gift tax due could be reduced to $0, for a current tax savings of $267,000!

The long-term impact of a discounted stock value is a reduction of the transferor's taxable gifts, and, consequently, the gift and estate taxes he or she will owe ultimately. Naturally, this concept does not set well with the IRS. The service has for years fought, unsuccessfully, the taking of discounts for minority-interest transfers between family members.

The IRS long believed that transfers of family-controlled company stock among family members should be viewed in light of the family's overall controlling interest. From the IRS's perspective, the transfer was not of a distinguishable minority interest but rather part of a larger controlling interest. The IRS believes that family members are likely to act in unison regarding the family business. The underlying synergism of the family in the IRS's mind led to the reasoning that any family-held interest in a family-controlled company constituted a majority interest by association.

Many families across the United States serve as examples of how misguided this line of reasoning is. Countless family-controlled companies either have fallen apart, been sold, or instituted specific internal management controls because of the family's inability to reach a consensus about operating the business. There are no guarantees a family will act in unison when the family business is passed to the next generation. In many cases, family members negotiate with each other from a tougher position than they might with an unrelated party.

Not only was the IRS's position misguided, but it also discriminated against the institutions that comprise the American dream: the family business. Why should a parent be forced to transfer his or her company stock to a child at a higher value than he or she could obtain from a total stranger? An unrelated person would never pay more than a discount value for a minority interest in a closely held company. Why should the IRS arbitrarily expect more from a family member?

Fortunately, the IRS recently has come to accept a more rational position on the subject. In a recent ruling (Rev. Rul. 93-12), the IRS did not disallow a claimed minority discount when a parent transferred 20 percent of his stock to each of his five children. This represented the IRS's acceptance of the view argued by private tax professionals and maintained by most courts. What is important is the IRS's formal recognition of the minority discount for transfers of closely held stock among family members.

It is critically important that owners of closely held family businesses obtain appropriate counsel from their accountants, estate planning attorneys, and personal financial advisers. These professionals can offer advice on the appropriateness of a minority discount, the level of discount warranted under the particular facts and circumstances, and how the transfer ought to be structured. Through careful planning, high gift and estate taxes can be minimized for the owners of closely held companies.
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Title Annotation:estate planning
Author:Pettinga, Mark V.
Publication:Saturday Evening Post
Date:May 1, 1993
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