National Association of Estate Planners and Councils

March, 2012 Newsletter
Provided by Leimberg Information Services

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Jeff Scroggin & the Seven Realities of Family Business Succession

“...but in this world nothing can be said to be certain, except death and taxes.” Ben Franklin

Jeff Scroggin believes that there are seven important realities that need to be understood when it comes to considering the passage of a family business. According to Jeff, clients who realize the existence of these seven realities will reduce future heartaches and avoid the potential loss of the family business to family conflicts and taxes.

John J. (“Jeff”) Scroggin has practiced as a business, tax and estate planning attorney (and as a CPA with Arthur Andersen) in Atlanta for 34 years. He is a member of the Board of Trustees of the University of Florida College Of Law. He holds a BSBA in accounting, J.D., and LL.M (Tax) from the University of Florida. Jeff served as Founding Editor of the NAEPC Journal of Estate and Tax Planning and was Co-Editor of Commerce Clearing House’s Journal of Practical Estate Planning. He was a member of the Board of the National Association of Estate Planners and Councils from 2002 to 2010. Jeff is the author of over 230 published articles and columns. He has been named as a 2012, 2011, 2010 and 20009 Georgia Super-Lawyer and as a 2011, 2010 and 2009 Five Star Wealth Advisor. Jeff is a nationally recognized speaker on estate, business and tax planning issues and has been quoted extensively, including in the Wall Street Journal, CNN Headline News, MSNBC, National Public Radio, Fortune Magazine, Forbes Magazine, Kiplinger’s, Money Magazine, Worth Magazine, Financial Advisor, National Underwriter, Bloomberg Wealth Management, Smart Money Magazine, Journal of Financial Services Professionals, Wall Street Magazine, BNA Estates Gifts & Trusts Journal, Financial Planning, the New York Times, the International Herald Tribune, the Chicago Tribune, the South China Post, the LA Times, the Miami Herald, the Atlanta Journal/Constitution and Newsday. Jeff owns one of the largest private collections of tax memorabilia in the US.

Here is his commentary:


Many entrepreneurs intend to pass the family business to future generations. Unfortunately, most family businesses fail to survive into the third generation. When considering the passage of a family business, there are seven important realities that need to be understood.


Death and Disability Will Occur, but the Legacy Will Continue

We will all die. However, Paul Simon may have gotten the perspective of many of us correctly: [I will]A...continue to continue to pretend that my life will never end...” Death will happen to all of us – and most of us will suffer at least one period of disability before passing.

But estate planning for family businesses is not most fundamentally about death and the taxes that occur at death. It is about planning for the Legacy you will leave behind.

This perspective starts with understanding that estate planning does not start with THINGS or the taxes imposed upon them. It starts with PEOPLE: Who you were and are and who your family is and might become. In the last two decades I have observed a significant re-orientation of both clients and advisors from acting as though the preservation of family assets (e.g., minimizing taxes) is the most important goal of estate planning. Increasingly, clients and planners recognize there is often a misplaced emphasis which focuses on assets rather than family, on structure and complex techniques over perspective, on tax savings in place of family need. When Aprotecting and preserving the family@ becomes the beginning point of planning, clients first focus on how to leave a positive impact on their family. Both the client and the planner may be forced to deal with difficult family issues (e.g., treating the children as individuals with their own personalities and problems, not as equals), which the client may have preferred to avoid - to the ultimate detriment of the client=s family.

When you deal with the inevitable reality of death and disability, you can leave a positive LEGACY for family – instead of the bitter legacy of conflict, taxes and legal expenses which so often occurs when an inadequate plan (or no plan) is in place.

Does this mean that taxes can be ignored in the planning process? Absolutely not. But the cost of taxes pales in significance to the damage to family of poor or non-existent planning. If the business fails to survive because of family conflict, what does it matter what the taxes were on the business?

So what does this mean in the context of a family business? If the Legacy that is being passed includes a family business, the client needs to spend time before death or disability assuring that the Legacy leaves the family better off, not ridden by conflicts and costs from poor or non-existent planning. Successor managers need to be designated and trained. Honest conversations need to be held and plans need to be implemented, rather then letting things erratically evolve when the business owner passes. Structures need to be developed, designed to reduce conflict among family members and to minimize the cost of passing the business.

The Estate Tax Is Not Going Away

Despite all of the political discussions over the last decade, there is virtually no chance that the federal estate tax will be permanently eliminated. While Congress has provided for higher estate, GST and gift exemptions through 2012, there is no reasonable expectation of an elimination of estate taxes any time in the future. Moreover, a growing number of states are considering an increase in death taxes to shore up their budgets.

Moreover, unless Congress passes new legislation, on January 1, 2013 the transfer tax rules of 2001 automatically return – restoring an estate exemption of $1.0 million and a top estate tax bracket of 60% (i.e., a 5% 5% surtax is imposed on transfers from $10.0 million to $17,184,000, designed to eliminate the benefit of the lower marginal tax rates and raise the effective transfer tax rate on larger wealth transfers to a 55% rate). Moreover, the states which have remained coupled to the federal estate tax will automatically have their state death taxes restored.

This increase in estate tax could place a substantial burden on family businesses. Look at the issue in its most simplistic format. Assume an unmarried client has a $5.0 million business which is the only asset that will pass to family. Dying in 2012 incurs no federal estate tax. But if the business owner dies in 2013, current law makes $4.0 million more of the estate taxable, with the top effective estate tax rate increasing by 20% (i.e., from 35% in 2012 to 55% in 2013), The automatic 2013 tax changes create a total estate tax in 2013 of over $2.0 million.

Will Congress pass legislation to continue the large transfer tax exemptions adopted in December 2010? Because new legislation is necessary and each of the political parties has their own agendas, it’s impossible to know what will happen after 2012. However, given the current politics, it is highly possible that we will end 2012 without knowing what the transfer tax rules will be for those who die or gift assets in 2013.

Given that the estate tax is not going to be eliminated and given the automatic increase in transfer taxes in 2013, a family business owner who intends to pass the business to family members is forced to address the state and federal transfer tax cost of transfer this year. Because of unique transfer tax opportunities in 2012 and the potential substantial increases in transfer taxes in 2013, the owner should start that planning as soon as possible.

Income Taxes Are Going Up

On January 1, 2013, the top federal income tax rate of 35% will automatically increase to 36% and 39.6%. On that same date, the special 15% federal tax rate on dividends will be gone (i.e., they will be taxed at rates of up to 39.6%+) and federal capital gain tax rates will go up by 5%. Congress could raise these rates even higher. The social security tax burden may also increase in coming years to fund the shortfalls in the entitlement programs. The 2010 Healthcare Bill includes two significant tax increases on high income earners:

· A 0.9% Medicare payroll surtax on wages over $200,000 ($250,000 for joint filers)

· A 3.8% tax on investment income, including capital gains, dividends, interest, rents, royalties and other “unearned” income over certain limits.

Will Washington extend all or some of the Bush income tax cuts? As with the transfer tax changes, no one knows what legislation may be passed. Will any legislation be another temporary measure like the December 2010 tax bill which provided new rules for two years and rampant uncertainty after the temporary rules expire?

Even though the Obama administration has promised not to raise income taxes on married taxpayers below an adjusted gross income of $250,000, any informed observer understands that income taxes will probably have to be raised on more Americans to have any hope of reducing the deficit. Both the Washington Post and New York Times have conceded that higher income taxes are coming for Americans at levels of income below $250,000.

If income taxes are going up, start planning now to reduce that future tax burden.

There Is No Equity Value to A Family Business

When an entrepreneur wants to pass his or her business to family members, there is no true equity value to the business. Because the equity will not be reduced to cash (i.e., by a sale of the business), it provides no current benefit to the business owner. While the business owner may decide to sell the business to family members, the cumulative tax cost of such a sale normally makes it a poor planning choice.

In fact, the equity value of the business is a liability waiting to happen because of the potential state and federal transfer tax liabilities on the passage of the business and the potential need to “buy-out” family members who are not in the business.

When the issue is properly addressed, the owner is interested in control of the business and the income and benefits which are derived from that control. Using readily available planning approaches (e.g., deferred compensation, voting rights, partnerships and trusts), the income of the business can be separated from equity, and the equity can be passed at a reduced tax cost to family members using various techniques (e.g., minority and lack of marketability adjustments, charitable lead trusts).

The retention of the equity value of the business may create a transfer tax liability which could have been reduced or even eliminated. By retaining controlling ownership, the entrepreneur loses the ability to not only discount the present value of the business, but also causes the family to pay estate taxes on the appreciation in the business. For example, assume in 2012 (when the gift tax exemption is $5.0 million), a married taxpayer has a $10.0 million company and transfers all of the business to a three separate family trusts for his three children and their descendants. The client dies 15 years later. Such a gift has a number of benefits:

· If the minority interest which was transferred to each trust was discounted at 40% and the donor’s spouse agreed to gift splitting, the couple’s combined gift tax unified credit would cover the entire gift (i.e., $10.0 million discounted at 40% is worth $6.0 million – less than the couple’s combined gift exemptions).

· Because of valuation adjustments, even if the business did not grow, the immediate estate tax savings would be as much as $2.2 million (i.e., the $4.0 million valuation adjustment times a 55% estate tax rate after 2012).

· But what if the business grew at a 10% annual rate until the parents died 15 years later? At the end of 15 years, the prior transfer will have moved $42 million out of the donor’s estate, saving the family an additional $17.6 million in estate taxes (i.e., $32 million in appreciation at a 55% estate tax rate in 15 years).

· Trustees selected by the entrepreneur may control the gifted business interest and decide how trust distributions will be made to family members. With proper drafting, the business owner and/or heirs may retain the ability to remove the trustees, without the trust assets being included in his taxable estate.

With top estate tax brackets of up to 60% in 2013 and the estate tax potentially due nine months after death, the tax burden could make it financially impossible for an entrepreneur to pass the business to family members. The tax payment of 55-60% of the value of the business (even when electing estate tax deferral under IRC section 6166) can result in such significant cash drains that the business cannot survive.

Essentially, federal and state transfer taxes are a voluntary confiscation tax. With proper planning the confiscation can be minimized or eliminated. The thoughtful business owner recognizes this issue and realizes that transferring current equity (and its future appreciation) can reduce the future tax burden on the business, without adversely impacting the owner’s income. Contrary to the owner’s intent, the emotional retention of all of the equity ownership or absolute control can actually destroy the business.

The Inevitable Conflict

Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur’s death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business. This is almost always a mistake.

During the owner’s lifetime, the owner may have been able to maintain peace in the family and serve as the "benevolent dictator" of the family business. Unfortunately, this powerful role disappears with the entrepreneur's death or incapacity. Sibling rivalry, in-law problems and other issues often begin to come forward, particularly between those who are operate the business and those who are outside the business.

In many cases, the outsiders feel that the compensation and perks provided to the insiders are "excessive." Outsiders question the business decisions (e.g., capital expenditures, hiring and firing of employees, expansion plans) of the insiders even when they know little about the business’s needs, operations or competition. Outsiders often believe that the income paid to them should match the compensation paid to the insiders.

Meanwhile, the insiders (who often feel they are working too hard) resent that their sweat is increasing the equity value of the outside family members who are continually asking for more and more income to which they are “not justly entitled.” The insiders may fail to see that the outsiders have a right to a return on their “investment” in the family business. Many family businesses and owners have paid huge legal fees because of these conflicts and/or have been forced to sell the family business to alleviate the problem.

This conflict is an inevitable reality as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not necessarily a matter of "good" and "bad" family members. It is a matter of increasingly different life goals - a normal part of life. Those differing life goals can create such significant conflict and stress that it damages or destroys the business.

The solution lies in setting up a structure in the estate plan that assures that those in the business own and control as much of the business as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this “equalization planning.” This planning process is best done during the business owner’s life so the entrepreneur can dictate the terms to family members – particularly if the passage of assets is perceived to be disproportionate. Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.

Heirs May Increase Their Own Burdens

A son works in the family business. Over 20-30 years the son helps grow the value of the father’s business - only to equally share it with his siblings and a not-so-appreciative stepmother. Not only does the development of the parent’s business increase the potential federal and state death taxes, but the son’s contribution to the growth of the business must be shared with siblings and other family members. By not addressing the issue before the father’s passing, the son will have increased his own burden.

Even if a business owner is unwilling to address the value of the child’s long term contribution, children in the business should raise the issue.

Divorces Will Happen

Almost 50 percent of all marriages end in divorce. If divorce is such a prevalent issue, why do we so often ignore the possibility in estate planning? Planning should include reducing the divorce-driven exposure of a parent and an heir’s. Buy-sell agreements should be drafted to allow the family to repurchase ownership interests which pass to non-blood family members by divorce or death. Trusts may be created which provide long term benefits to family members, but deny such benefits to divorcing spouses or non-blood heirs Although they are not particularly romantic, clients and their heirs should be strongly encouraged to sign pre-nuptial agreements before marriage.

Divorces will also happen between business owners. When emotions are not running high and/or when transfers of the family business are being made to family members, clients should carefully consider restricting the manner in which future transfers of the family business can occur. Often the restrictions placed on the donee/younger generation will not be equally applied to the donor/older generation. Business owners may dictate the use of buy-sell agreements among their children to protect the family business. S corporation elections need to be protected from inadvertent terminations or purposeful terminations by disgruntled family members.

Buy-Sell Agreements can be viewed as business pre-nuptial among the owners. Like most pre-nuptials, no one pays much attention to them during the marriage – until conflicts erupt.


Clients who realize the existence of these seven realities will reduce future heartaches and avoid the potential loss of the family business to family conflicts and taxes.


Jeff Scroggin


LISI Estate Planning Newsletter #1931, (February 29, 2012) at Copyright 2012 John J. Scroggin. Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

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