A family-owned business is often far more than just the engine that drives the family's economic well-being. It is an entity to which family members may have an attachment that is nearly as much emotional as commercial. For that reason, a key concern of shareholders in a family-owned business is assuring that full ownership of the corporation remains within the family in the event of the death of a stockholder or upon the decision by a family member to liquidate his or her holdings.

Shareholders in a closely held family business can utilize a variety of estate planning strategies in order to assure continued ownership of the business by members of the family. The most common strategy is a buy-sell agreement, under which all the stockholders agree that, upon the death of one of them, or upon the decision by one of them to sell his or her shares, the remaining stockholders will have the right to purchase the shares from the decedent's estate or from the selling shareholder. The purchase need not be obligatory, and thus any remaining shareholder would be free to opt out. Those stockholders who elect to participate in the buyout acquire the deceased or selling stockholder's shares pro rata, based upon their respective holdings.

Alternatively, an agreement may be structured whereby the corporation itself, rather than the remaining shareholders, has the right (or perhaps the obligation) to purchase the shares of the deceased or selling shareholder. Many jurisdictions, seeking to protect creditors, place restrictions on the power of corporations to purchase their own shares. For example, reacquisition of its own shares by a corporation may be subject to a statutory requirement that the corporation's purchase of its own stock can be made only to the extent of accumulated surplus, or that after the purchase the corporation must be solvent.

A hybrid of these approaches is possible as well. The shareholders' agreement may provide that the corporation can buy its own shares to the extent of its accumulated surplus (or to the extent permitted under other statutory constraints), and any unpurchased shares would then be subject to a purchase option in favor of the remaining shareholders.

Whether shares of a family corporation's stock are to be purchased by the corporation or by the remaining stockholders, it is possible that neither will have sufficient, readily available funds to make the purchase. The problem of funding the purchase of deceased shareholders' stock may be addressed by purchasing life insurance policies on the lives of shareholders. This is particularly important in the case of older and/or controlling shareholders.

Whatever approach is taken, a critical issue is valuation: At what price are the deceased or selling stockholder's shares to be bought? Market value would be a legitimate valuation, but it is often difficult to calculate. Family businesses are, by definition, closely held, with little or no liquidity in their stock. Thus, market value may be difficult or impossible to determine accurately.

Book value has the advantages of relative ease of determination and apparent objectivity. However, care must be taken in situations where book value may differ significantly from actual economic value. This is true of companies with substantially appreciated assets that are carried on their books at acquisition cost. A court may refuse to enforce a transfer restriction providing for a buyout at book value when the evidence shows that the shareholder had received an offer to purchase the shares for much more than their book value.

Additionally, situations may arise where the business's accounting methodology is questionable. Under a buy-sell agreement, an understated book value may cause a substantial hardship upon the estate of a deceased shareholder, while an overstated book value may unfairly hinder the efforts of the remaining shareholders to keep the business within the family.

As with any estate planning issue, always seek qualified legal counsel before pursuing a business buy-sell agreement.

<< Back

As part of the passage of the Taxpayer Relief Act of 1997, Congress established a new type of individual retirement account, the Roth IRA. The traditional IRA has long been a popular way for an individual to save for retirement by contributing up to $2,000 of compensation per year to the IRA and deducting that amount from income. The contributions are taxed upon later distribution. The primary differences between a Roth IRA and the traditional IRA are that contributions to a Roth IRA are not deducted from income, but qualified distributions from a Roth IRA are not taxed as income. Unlike the case with a traditional IRA, contributions to a Roth IRA can be made after the owner has reached age 70 1/2. As is true with a traditional IRA, the assets of a Roth IRA grow tax free while they are held in the trust.

A recent IRS advisory, known as an "interim guidance," has placed a limit on a maneuver that had provided taxpayers with flexibility in regard to converting a traditional IRA into a Roth IRA. Such a conversion, known as a rollover contribution to the Roth IRA, results in the tax liability that must normally be faced upon a distribution from a traditional IRA. The IRS, however, has allowed taxpayers to "unconvert" to the traditional IRA in order to lessen the tax impact where the value of the fund declined after the initial conversion to a Roth IRA.

For instance, if the fund were worth $100,000 at the time of conversion to the Roth IRA, the tax would be paid on that amount. If the fund decreased in value to $80,000 following the conversion, however, the unconversion to a traditional IRA would erase the tax liability on the $100,000, and such liability would be on the lesser value, $80,000, upon a subsequent reconversion to a Roth IRA. No limit was placed on the number of unconversions/reconversions.

Under the new guideline, however, a taxpayer will be allowed only one unconversion/reconversion to a Roth IRA in 1999. If the taxpayer's initial conversion to a Roth IRA occurred in 1999, he will still be allowed an unconversion/reconversion this year. The problem is that, with only one more opportunity for an unconversion/reconversion, it becomes difficult for the taxpayer to know when such action would be most beneficial. The luxury of unlimited unconversions/reconversions thus becomes a guessing game.

<< Back

A very common but often overlooked aspect of income taxation concerns the tax consequences of an individual's sale of an asset received either by inheritance or as a gift. When such property is sold, the question arises as to whether the seller has realized a taxable gain. The determination of gain depends on a key factor known as "basis," which is essentially the figure against which the selling price is measured to show whether there was a gain or loss.

Where an individual sells an asset that he purchased, his basis for determining gain or loss on his subsequent sale of the asset is normally his cost. Where the property was received by inheritance or as a gift, there is, of course, no cost to the recipient. Federal tax law provides a series of rules for establishing basis in such situations.


Calculating the Basis of Inherited Property

The general rule, which is usually favorable to taxpayers, is that the recipient's basis for inherited property is stepped up (or stepped down) from the decedent's cost to the asset's fair market value at the decedent's date of death. The advantage of a step-up in basis is demonstrated by the example of a decedent who bought shares of stock for $500 and held onto the investment until his death, at which time the stock had appreciated to a value of $1 million. The person who receives the stock upon the decedent's death will take a stepped-up basis of $1 million, the stock's fair market value at the decedent's death. Therefore, upon the recipient's subsequent sale of the stock, the appreciation in value between $500 and $1 million will not be recognized for income tax purposes, and the recipient of the stock will be taxed only on the gain represented by any appreciation of the stock beyond $1 million.


Calculating the Basis of Gifted Property

The rules as to basis in the case of a gift do not allow for a stepped-up calculation and they depend upon whether the basis is being calculated for purposes of gain or loss. For determining gain, the basis is the same as it would have been in the hands of the donor and is called a "carryover" basis. In the above example, if the individual who had acquired the shares of stock for $500 chooses to give them to the recipient as a gift and does not hold them until his death, the recipient takes the same $500 basis as the donor. Therefore, if the recipient sells the shares when they reach $1 million in value, the tax liability would be based on the gain of $999,500. The choice between transferring an appreciating asset by gift and holding it until death can be crucial for purposes of the recipient's income tax liability on a later sale.

Where an asset transferred by gift depreciates to a value below the donor's original cost, the recipient's basis is the fair market value of the asset at the time of the gift. Thus, in the stock example, if the shares that had cost the donor $500 were worth $250 at the time of the gift and had depreciated in value to $150 at the time of the recipient's subsequent sale, the recipient's basis for measuring his loss would be $250, and his loss would be $100. If, however, the stock had been worth $600 at the time of the gift but had declined to $300 by the time of the recipient's subsequent sale, the basis for loss would be the donor's basis of $500 (because that figure is lower than the $600 at the value date of the gift), and the recipient's loss would be $500 less $300.


Neither Gain Nor Loss

In the unusual situation where the recipient's selling price is higher than the asset's value on the date of the gift but lower than the donor's cost basis, the recipient will have neither a gain nor a loss. For instance, once again using the stock example and the donor's $500 cost basis, if the value of the shares at the time of the gift was $300 and the recipient sells the shares for $400, (1) there would be no gain because, for purposes of gain, the recipient would have a $500 carryover basis, which would be greater than the selling price, and (2) there would be no loss because the $400 selling price would be measured against a basis of $300, the lower of the asset's value at the time of the gift or the donor's cost basis.

The gift recipient's carryover basis can be increased where the donor has paid a federal gift tax on the transfer. The amount of the gift tax that is attributable to the appreciation in value of the asset as of the date of the gift can be added by the recipient to his carryover basis. For instance, if the donor's cost basis in an asset is $50,000, he transfers the asset as a gift when it is worth $100,000, and he pays a gift tax of $20,000, the appreciation in value ($50,000) accounts for one-half of the asset's value at the time of the gift. Therefore, the recipient is entitled to add one-half of the gift tax liability ($10,000) to his carryover basis, resulting in a carryover basis of $60,000.

Even with such breaks, from the standpoint of the recipient's income tax liability on later sale the disadvantages of making lifetime gifts are clear. Of course, there are situations where the immediate transfer of property is so strongly desired and the consideration of the recipient's later income tax liability is not a priority. Tax savings should not be allowed to overwhelm the basic reasons for the transfer itself.

This article introduces the tax consequences of selling an asset that is inherited or received as a gift. Estate planning and tax laws are complex. You should always consult with a qualified professional to assist you in such matters.

<< Back

The costs of nursing home care for the elderly are such that over one-half of all nursing home residents at some point exhaust their assets and require the assistance of Medicaid coverage. Medicaid patients are generally less profitable for the homes than "private-pay" patients, who can afford to pay more for the cost of their care.

In some cases, nursing homes have been prompted by concerns over the bottom line to evict residents whose bills are being paid by Medicaid. Congress responded with the Nursing Home Resident Protection Amendments of 1999. The new law seeks to provide elderly residents some security against eviction, while recognizing that nursing homes need some flexibility in order to remain financially sound.

The legislation may be a small modification, but it has big consequences for many nursing home residents. It prevents nursing homes that voluntarily decide to withdraw from Medicaid, as is their prerogative, from evicting current residents who are receiving Medicaid assistance or who subsequently qualify for Medicaid.

As for residents who arrive after a home's withdrawal from Medicaid, a facility must give oral and written notice to the new residents that they could be forced to move if they eventually run out of money and are unable to pay for their care, even though they have become eligible for Medicaid benefits. The facility also must obtain from the new residents a signed acknowledgement of receipt of such information.

<< Back

In many cases, it makes sense for a parent/taxpayer to start transferring his wealth to his children well before the end of his own life expectancy and even before his children have reached their majority. There are two primary advantages to making such transfers. The first advantage is that of estate tax savings. When assets are transferred by the taxpayer and he retains no control over their ultimate disposition, they will not be included in the taxpayer's estate for federal estate tax purposes upon his death. Also, any appreciation in the value of the assets following their transfer would not be included in the taxpayer's estate.

The second advantage to making transfers of assets to the next generation at a relatively early point in the taxpayer's life is the nontax advantage of securing the inheritance of the taxpayer's descendants and safeguarding resources that can be used for their present needs, such as education. The taxpayer can retain control as to the amounts to be distributed and as to the purposes for which the distributions can be used.

One means of transferring property to a minor without giving the minor immediate control of it is to establish a custodianship for the minor. Such a transfer is an outright gift that resembles a trust because it is held and administered by a third person (the "custodian") who has the power to expend the custodial property for the use and benefit of the minor. If the donor is himself the custodian, however, there is a possibility that the full value of the transferred property would be included in the donor's estate for federal estate tax purposes.

An alternative means of transferring property to a minor is through the use of a trust for the minor's benefit. In order to secure tax savings, the trust has to satisfy the following Internal Revenue Service requirements. First, the transfer has to be for the benefit of a minor, meaning an individual who has not attained age 21 as of the date of the transfer. The trust must provide that trust income and principal may be used for the donee's benefit prior to his reaching age 21 and any income and principal not expended for the donee's benefit during his minority must pass to the donee upon his attainment of age 21. If the donee dies before reaching age 21, such unexpended income and principal must be paid either to the donee's estate or as the donee might appoint. The trust can provide that when the minor reaches age 21 he has a limited period in which he can force immediate distribution of the trust fund. If such power is not exercised, the trust can continue on its own terms.

If the foregoing requirements are met, the donor of the trust is allowed the advantage of an Internal Revenue Code gift tax provision that has become a familiar feature of gift-giving programs. A donor is permitted to exclude from the total gifts made in the tax year the first $10,000 of a gift made to an individual. If the donor's spouse joins in the gift (the spouse need not have any interest in the property being transferred), the exclusion is $20,000. Stated simply, either $10,000 or $20,000 worth of property can be transferred by a donor free of federal gift tax to a single individual in a given tax year. Such a gift can be repeated in each succeeding year.

In regard to the gift tax exclusion where the transfer is in trust, the exclusion applies only to the transfer of a "present interest." A right to a distribution of trust principal at the termination of a trust constitutes a future and not a present interest. Were it not for the special dispensation given in the case of a trust for the benefit of a minor, a transfer to such a trust would typically not qualify for the $10,000/$20,000 exclusion because the transfer would not be of a present interest.

The Internal Revenue Code, however, eliminates the "present interest" requirement where the trust is for the benefit of a minor and the requirements described above are satisfied. Thus, if amounts no greater than the annual exclusion are given to the trust for the benefit of a minor each year, such transfers would escape gift tax and would not be subject to estate tax upon the donor's death. The donor's appointment of himself as trustee would not negate the tax benefit.

Trusts and other estate planning instruments require careful planning and knowledge of the law. Always consult a qualified professional for advice on estate planning issues.