Estate Planning for Owners of Closely Held Business Interests (Portfolio 809)

Tax Management Portfolio, Estate Planning for Owners of Closely Held Business Interests, No. 809-3rd, is designed as a guide to the lifetime and post-mortem estate planning techniques primarily applicable to the owners of interests in closely held businesses.

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Tax Management Portfolio, Estate Planning for Owners of Closely Held Business Interests, No. 809-3rd, is designed as a guide to the lifetime and post-mortem estate planning techniques primarily applicable to the owners of interests in closely held businesses.
Detailed consideration is given to various kinds of buy-sell agreements, including cross-purchase and stock redemption agreements; the gift and estate tax rules governing the lifetime disposition of closely held business interests, with special emphasis on §§2701-2704; the use of recapitalizations, charitable bail-outs, and private annuities to accomplish retirement, gift, and estate planning goals; §§303 and 6166 “relief” provisions concerning the payment of estate tax where the estate consists in significant measure of an interest in a closely held business; the rules which apply to subchapter S corporations; and special considerations when using a limited liability company.
This Portfolio may be cited as Mezzullo, 809-3rd T.M., Estate Planning for Owners of Closely Held Business Interests.


Louis A. Mezzullo, Esq.

Louis A. Mezzullo, University of Maryland (B.A. 1967, M.A. 1976), University of Richmond (J.D. 1976); member, Luce, Forward, Hamilton & Scripps LLP (2006-present); member, McGuireWoods LLP (2004-2006); founding member, Mezzullo & Guare, PLC, Richmond, Virginia (2000-2003); founding member, Mezzullo & McCandlish, Richmond, Virginia (1982-2000); former Adjunct Professor, University of Richmond Law School; author, 812 T.M., Family Limited Partnerships and Limited Liability Companies; 814 T.M., Estate and Gift Tax Issues for Employee Benefit Plans; 831 T.M., Valuation of Corporate Stock; 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703 and 2704; An Estate Planner's Guide to Buy-Sell Agreements (ABA); An Estate Planner's Guide to Life Insurance (ABA); An Estate Planner's Guide to Qualified Retirement Plan Benefits (ABA); An Estate Planner's Guide to Family Business Entities (ABA); Valuation Rules Under Chapter 14 (ABA); Limited Liability Companies in Virginia (Virginia Law Foundation); co-author, 803 T.M., The Migrant Client: Tax, Community Property, and Other Considerations; Advising the Elderly Client (Clark, Boardman, Callaghan); fellow and former Chair, American College of Tax Counsel; fellow and former Regent, American College of Trust and Estate Counsel; charter fellow, American College of Employee Benefits Counsel; Chair, ABA Section of Real Property, Probate and Trust Law (2000-2001); Vice Chair of Publications and Chair of the Business Planning Subcommittee of the Estate and Gift Taxes Committee of the ABA Section of Taxation; and Academician, Vice President, International Academy of Trust and Estate Law, and member of the Advisory Council of the Heckerling Estate Planning Institute.

Table of Contents

Detailed Analysis

I. Introduction

II. Transfer of Closely Held Business Interest

A. Buy-Sell Arrangements

1. Introduction

2. Types of Buy-Sell Agreements

a. In General

b. Cross-Purchase Agreements

c. Redemption Agreements

d. Hybrid (Combination Cross-Purchase and Redemption) Agreements

e. Sale to a Successor

f. Sale to ESOP

3. Funding and Pricing Mechanics of the Buy-Sell Agreement

a. Funding

(1) Self-Funding

(2) Insurance Proceeds

(a) In General

(b) Types of Insurance

(i) Term Life Insurance

(ii) Cash-Value Life Insurance

(A) Whole-Life Insurance

(B) Universal Life Insurance

(C) Survivor Joint-Life Insurance

(D) Split-Dollar Insurance Arrangements

(iii) Disability Insurance

(iv) Life Insurance Due Diligence

(c) Deductibility of Life Insurance Premiums

(i) Cross-Purchase Agreement

(ii) Redemption Agreement

(d) Taxation of Life Insurance Proceeds

(i) Proceeds Paid or Value Built Up While Insured Is Alive

(ii) Proceeds Paid at Death of Owner

(e) Tax Treatment of Disability Insurance

b. Pricing Approaches

(1) Fixed Price

(2) Formula Price

(3) Appraisal

(4) Section 2703

4. State Law Restrictions on Redemptions

5. Income Tax Consequences

a. C Corporations with Unrelated Shareholders

(1) Cross-Purchase Agreements

(a) Tax Consequences to the Withdrawing Shareholder

(b) Tax Consequences to the Purchasing Shareholders

(i) Shareholders Act Alone

(ii) Corporation Participates in Purchase

(iii) Shareholders Cause Another Corporation to Make Purchase

(2) Redemption Agreement

(a) Tax Consequences to the Withdrawing Shareholder

(b) Tax Consequences to the Continuing Shareholders

(c) Tax Consequences to the Corporation

(i) Recognition of Gain

(ii) Earnings and Profits

(iii) Sections 531–537

(3) Sale to Successor - Tax Consequences to the Purchaser and the Corporation

(a) Section 83

(b) Section 7872

(4) Sale to ESOP - Tax Consequences to the Selling Shareholder

b. Family Corporations

(1) Cross-Purchase Agreement

(2) Redemption Agreement

(3) Sale to a Successor

(4) Sale to ESOP

c. S Corporations

(1) Cross-Purchase Agreement

(a) Withdrawing Shareholders

(b) Continuing Shareholders

(2) Redemption Agreement

(3) Sale to Successor

(4) Sale to ESOP

d. Partnerships and Limited Liability Companies

(1) Cross-Purchase Agreement

(a) Tax Consequences to the Withdrawing Owner

(b) Tax Consequences to the Purchasing Owners

(2) Redemption Agreement

6. Effect of Buy-Sell Agreement and Other Restrictions upon Gift, Estate, and Generation-Skipping Transfer Tax Values

a. Buy-Sell Agreements

(1) Pre-October 9, 1990 Agreements, Etc. Not Substantially Modified

(a) In General

(b) Binding During Life and Death

(c) Bona Fide Business Reasons for Arrangement

(d) Not a Device to Pass Property to Objects of Decedent's Bounty

(2) Post-October 8, 1990 Agreements, Etc. (Including Pre-October 9, 1990 Agreements, Etc. Substantially Modified on or After That Date)

(a) In General

(b) Section 2703 Analyzed

(i) “For Purposes of This Subtitle”

(ii) Source of Rights and Restrictions

(iii) The Statutory Exception

(iv) Amplification of Regs. § 25.2703-1(b)(1)

(v) The Regulatory Exception

(c) “Substantial” Modification to an Existing Buy-Sell Agreement

(i) General Rule

(ii) Exceptions

b. Other Restrictions

(1) The Old Rule

(2) Section 2703

(3) Marital Deduction

B. Corporate Recapitalizations

1. Introduction

2. Tax Implications

a. Tax-Free If Statutory and Common Law Requirements Are Met

b. Recognition of Gain

(1) When Cash and/or Other Property Is Received

(2) When Amount of Securities Received Exceeds Amount of Securities Surrendered

3. Recapitalization as an Estate Planning Tool

4. Inter Vivos Recapitalizations

a. The Estate Freeze

b. The Enactment of § 2036(c)

c. The Repeal of § 2036(c)

d. Overview of Chapter 14

(1) Section 2701

(a) Scope

(b) Valuation of Transferred Interest Through Subtraction of Retained Qualified Payment Right

(c) Valuation of Qualified Payment Right; Recapture Rules when Qualified Payments in Arrears

(d) Excluded Transactions

(e) Conclusion

(2) Section 2702

(a) Background

(b) Valuation Method

(c) Excluded Transfers

(3) Section 2703

(4) Section 2704

5. Post-Mortem Recapitalizations

C. Charitable Stock Bail-Outs and Charitable Alternatives

1. Introduction

2. Structuring the Charitable Stock Bail-Out

a. Gift of Stock to Charity

b. Redemption of Stock

c. Risk That Redemption from Charity Will Be Recharacterized as Redemption from Shareholder

d. Sale of Stock to ESOP and Contribution of Qualified Replacement Property to Charity

3. Contribution of Stock to Split-Interest Trust

a. Charitable Remainder Trust

(1) Charitable Remainder Annuity Trust

(2) Charitable Remainder Unitrust

(3) Governing Instrument Requirements

b. Charitable Lead Trust

4. Pooled Income Fund

5. Tax Implications of Charitable Contributions - Charitable Deductions

6. Other Considerations

a. Descendents' Needs

b. Cost of Charitable Giving

c. Corporation May Be Unable to Redeem

D. Private Annuities

1. Introduction

2. Estate Tax Planning Objectives

3. Other Tax Consequences

a. Gift Tax

b. Deferral of Gain

c. Income Tax

4. Disadvantages of Private Annuities

a. Lack of Security

b. Potential Loss of Step-Up in Basis

c. Early Death of Annuitant

d. Late Death of Annuitant

e. No Interest Deduction

5. Private Annuity and Chapter 14

E. Gifts

III. Payment of Estate Taxes

A. Introduction

B. Section 303

1. Purpose and General Rule Summarized

2. Detailed Analysis

a. Is There a Distribution of Property to a Shareholder in Redemption of Stock Included in the Decedent's Gross Estate?

(1) Is There a Distribution of “Property”?

(2) What Is § 303 “Stock”?

(a) Any Class of Stock

(b) Stock with Substituted Basis

(c) Subchapter S Stock

(d) Stock That Was Included in a Decedent's Gross Estate but Is Now in Other Hands

(i) Stock Received Directly from the Decedent

(ii) Stock Received in Satisfaction of Monetary Bequest

(iii) Stock Received from Someone Other Than the Decedent

(iv) Stock Included by Reason of § 2035

(e) Holding Company Stock

(f) Stock with Substituted Basis

(i) In General

(ii) Section 306 Stock

(iii) Stock Received on Post-Mortem Liquidation

(iv) Identification of Redeemed Stock

(v) Aggregation of Directly Owned and Indirectly Owned Stock

b. To What Extent Do the Benefits of § 303(a) Apply?

(1) Taxes

(2) Funeral and Administration Expenses

c. Is the Percentage Requirement of § 303(b)(2) Satisfied?

(1) In General

(2) Special Rule for Stock in Two or More Corporations

(a) Limited Attribution Rule

(b) Is § 303(b)(2)(B) Elective?

d. Serial Redemptions

e. Does the Shareholder Have the Requisite Relationship to the Estate Tax?

f. Have the Time Requirements Been Met?

(1) Section 6501 Limitation Period

(2) Tax Court Decision

(3) Redemption with Notes Payable Outside Permitted Time Period

g. Section 303(d) - Generation-Skipping Transfers

h. Section 537 - § 303 Redemption Needs of the Business

C. Section 6166

1. Background

a. Section 6161

b. Section 6163

c. Old § 6166A

2. The Basic Scheme of § 6166

3. Detailed Analysis of § 6166

a. Estates Eligible for § 6166 Relief

b. Required Size of the Closely Held Business Interest

(1) “Adjusted Gross Estate” Defined

(2) “Allowable” as a Deduction Under § 2053 or § 2054

c. The Nature of § 6166 Relief

(1) Limitation on Amount of Estate Tax That May Be Paid in Installments

(2) Number of and Due Dates for Installments

(3) Rate of and Due Date for Interest

(4) Making the § 6166(a)(1) Election

(a) At Time when Estate Tax Return Is Filed

(b) Later

(c) Protective Election

d. “Interest in a Closely Held Business”

(1) “Business” Defined

(a) Section 6166(b)(9) Denial of Deferral for Passive Assets

(b) Timing of § 6166(a)(1) Determination

(c) Stock Acquired in a Reorganization

(2) An “Interest in a Closely Held Business”

(a) Proprietorship

(b) Partnership Interest

(c) Stock in a Corporation

(3) Special Rules

(a) Husband and Wife

(b) Indirect Ownership

(c) Decedent's Family

(d) Farmhouses and Certain Other Structures

(e) Partnership Interests and Stock That Is Not Readily Tradable

(f) Certain Holding Company Stock

(g) Certain Corporations in Existence on June 22, 1984

(h) Qualifying Lending and Finance Business Stock

e. Proration of Deficiency to Installments

f. Election in Case of Certain Deficiencies

g. Acceleration of Payment

(1) Disposition of Interest; Withdrawal of Funds from Business

(a) General Rule

(i) Provisions in the Code

(ii) Private Letter Rulings

(b) Section 303 Redemption Exception

(i) In General

(ii) Interrelationship of § § 6166 and 303

(c) Certain “Reorganization” Exchanges Excepted

(d) Certain Transfers to Beneficiaries Excepted

(2) Undistributed Income of an Estate

(3) Failure to Pay Principal or Interest

h. Special Rule for Certain Direct Skips

i. Cross-References

(1) Authority to Require Security

(2) Special Lien

(3) Statute of Limitations Extended

(4) Stock Transferred Within Three Years of Death

D. Section 2057

1. Purpose and General Rule

2. Detailed Analysis

a. Amount of Deduction

b. Requirements for Qualification

c. Recapture

d. Noncitizen Qualified Heirs

IV. Estate Planning for S Corporations

A. Introduction

B. S Corporation Eligibility Requirements

1. Qualified Subchapter S Trust (“QSST”)

a. QSST Requirements

b. QSST Election

c. Termination of QSST Status

d. Trusts That Qualify as QSSTs

(1) General Power of Appointment Marital Deduction Trust

(2) QTIP Trust

(3) Section 2503(c) Trust

(4) Charitable Remainder Trust

(5) Unified Credit “Sprinkle” Trust

2. Electing Small Business Trust (“ESBT”)

a. Beneficiaries and Potential Current Beneficiaries

(1) Beneficiaries

(2) Potential Current Beneficiaries

b. No Interest Acquired by Purchase

c. ESBT Election by Trustee

d. Taxation of ESBTs

3. One Class of Stock Requirement

C. Election of S Corporation Treatment

D. Overview of S Corporation Tax Rules

1. Income Tax Liability of S Corporation

2. Pass-Through of Income and Loss

3. Transfers Between Spouses or Incident to Divorce

4. Tax Treatment of Distributions

E. Transfer of S Corporation Stock

1. Shareholders' Agreement

2. Gifts of Subchapter S Stock During Life

a. Estate Tax Planning

(1) Outright

(2) In Trust

b. Shifting of Income

(1) Can the family transferees exercise ownership rights of the shares they received?

(2) Did the transferor continue to exercise complete dominion and control over the transferred stock?

(3) Did the transferor continue to enjoy economic benefits of ownership after the conveyance of the stock?

(4) Did the transferor deal at arm's length with the corporation?

3. Transfer of Subchapter S Stock Upon Death

a. Income in Respect of a Decedent

b. Transfer by Will

(1) Executor's Discretion to Make Non-Pro Rata Distributions

(2) Executor's Authority to Make Allocations to Permitted S Corporation Shareholders

c. Estate Administration Considerations

(1) S Election

(a) Existing S Corporation

(b) Existing C Corporation

(i) The Shareholders' Income Needs

(ii) The Effect on Net Operating Loss Carryovers

(iii) Loss of Fiscal Year

(iv) Employee Fringe Benefits

(c) Existing Partnership or Sole Proprietorship

(2) Income Tax Considerations

(3) Section 303 Redemption

(4) Section 6166 Installment Payment

(5) Election of Fiscal Year for Estate

V. Estate Planning for Partnerships and LLCs Taxed as Partnerships

Introductory Material

A. Overview of Partnership Tax Rules

B. Special Considerations

1. Valuation Discounts

2. Death of a Partner

3. Withdrawal of a Partner

4. Anti-Abuse Regulations

5. Family Partnership Rules

a. Introduction

b. Bona Fide Transaction

c. Capital as a Material Income-Producing Factor

d. Capital Interest

e. Basic Tests as to Ownership

f. Conclusion

6. Self-Employment Income

C. Drafting Issues

1. Introduction

2. Important Provisions in the Operative Agreement

a. Business Purpose

b. The Economic Arrangement Among the Partners or Members

c. Restrictions on Transferability

d. The Management Structure

e. Dissolution and Liquidation

f. Withdrawal

(1) Voluntary

(2) Involuntary

3. Estate Planning Issues

a. Special Valuation Rules

b. Other Gift and Estate Tax Issues

c. Family Partnership Rules

d. Constructive Termination of the Entity

e. Basis Adjustments

Working Papers

Working Papers

Table of Worksheets


Worksheet 1 Sample Buy-Sell Agreement for C Corporation

Worksheet 2 Sample Buy-Sell Agreement for S Corporation

Worksheet 3 Sample Buy-Sell Agreement for Family-Owned Corporation (with S Corporation Provisions)

Worksheet 4 Sample Limited Partnership Agreement

Worksheet 5 Sample Certificate of Limited Partnership

Worksheet 6 Sample Deed of Gift for Limited Partnership Interest

Worksheet 7 Sample Letter to Client Explaining Provisions of Limited Partnership Agreement

Worksheet 8 Sample LLC Operating Agreement (Manager-Managed)

Worksheet 9 Sample LLC Articles of Organization

Worksheet 10 Sample Consent of LLC Organizer

Worksheet 11 Sample Deed of Gift for LLC Interest

Worksheet 12 Sample Letter to Client Explaining Provisions of LLC Operating Agreement

Worksheet 13 Sample Memo Describing Best Practices in Operating an LLC

Worksheet 14 Sample Statement by Beneficiary of QSST Election

Worksheet 15 Sample Statement by Trustee of ESBT Election

Worksheet 16 Sample Consent of Directors in Lieu of Special Meeting

Worksheet 17 Sample Plan of Recapitalization




Treasury Rulings: