One of the most important decisions a business owner must
make in estate planning is selecting the appropriate business entity. That
decision will affect the income and transfer tax consequences to the owner and
the family and the ease with which the business can be shifted from one
generation to the next. Generally, there are four choices: (1) C corporations;
(2) S corporations; (3) limited partnerships; and (4) limited liability
companies.
Gift Giving and the Business Entity
An immediate consequence of the choice of business entity is
the ability of the owner to make lifetime gifts to the next generation. Making
lifetime gifts of interests in the business is an essential part of the estate
plan for three reasons: (1) the interest given away is removed from the
owner's estate, thereby reducing the overall estate tax; (2) all appreciation
in the value of the interest after the gift is removed from the owner's
estate; and (3) all income earned by the interest after the gift is removed
from the owner's estate.
C Corporation
A C corporation, unlike a sole proprietorship, is a separate
legal entity. As such, a C corporation has the right to sue or be sued, enter
into contracts, and hold and dispose of property in its own name. More
importantly, a C corporation is a separate taxable entity. Therefore, the
major disadvantage of a C-corporation is double taxation. In other words, a C
corporation pays income tax at the corporate level on its earnings and then the
shareholder pays income tax at the individual level on the after-tax earnings
distributed as dividends.
Making gifts of stock of a C corporation is relatively
simple. Usually, the business owner wants to maintain control over the
business while making gifts to the younger generation. One way to accomplish
this is to create two classes of stock‹ preferred stock and common stock. The
only difference between the two classes is that the preferred stock has voting
rights while the common stock does not. The owner can then make gifts of the
nonvoting common stock to the younger generation and, by retaining the voting
preferred stock, maintain control over the corporation.
Because the owner is giving away a minority interest, a
discount from the value of the interest is available for gift tax purposes.
The discount is based upon both the lack of control and the lack of
marketability of the stock that the donee receives. A discount of 30% to 40%
for both the minority interest and lack of marketability is generally
considered reasonable.
S Corporation
An S corporation is a corporation which has made an election
under the Internal Revenue Code to be treated as a pass-through entity for tax
purposes. All income and losses are passed through to the shareholders, and
there is no corporate level tax. The principal disadvantage of an S
corporation is the strict requirements for making and maintaining the
election.
One of those requirements is that an S corporation may have
only one class of stock. However, differences in voting rights are disregarded
so long as all of the outstanding shares have identical rights to
distributions and liquidation proceeds. Therefore, an S corporation may be
recapitalized to create preferred stock and common stock if the only
difference is the voting rights of the shares.
Another requirement is that an S-corporation may have no
more than 100 shareholders. More importantly for estate planning purposes, with
certain limited exceptions, a trust is not an eligible S corporation
shareholder. That restriction challenges S corporation owners who wish to make
lifetime gifts of stock to the younger generation.
Generally, the same valuation discounts that are available
for gifts of stock of a C corporation are also available for gifts of stock of
an S corporation.
Limited Partnership
Use of family limited partnerships has become an
increasingly popular means of transferring the family business to the younger
generation. In a limited partnership, the general partners have unlimited
liability for debts incurred in the business and complete control of the
management of the business. The limited partners are not liable for the debts
and liabilities of the limited partnership in excess of their capital
contributions and generally have no control or management rights.
Consequently, the business owner can transfer earnings and appreciation to the
next generation by making lifetime gifts of limited partnership interests
while maintaining complete control by retaining a small general partnership
interest. Again, valuation discounts of 30% to 40% for gift tax purposes may
be appropriate.
There are certain assets which should not be placed into a
family limited partnership, including (1) the family home; (2) individual
retirement accounts and other qualified plan interests; (3) stock in an S
corporation; (4) stock in a professional corporation; (5) risky assets, such
as cars, planes, and boats that are likely to attract liability in the form of
large lawsuits; and (6) personal use assets, such as art, jewelry, antiques,
or other collectibles.
Limited Liability Companies
A limited liability company (LLC) is a hybrid entity
offering limited liability to its members, like a corporation, and
pass-through income tax treatment to the owners, like a partnership. An LLC
offers the best of both the corporation and the partnership to its members and
avoids some of the disadvantages of the S corporation and the limited
partnership. See the related article in this Bulletin regarding the uses and
advantages of an LLC.
Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS,
unless specifically indicated otherwise, any tax advice contained in this
communication (including any attachments) was not intended or written to be
used, and cannot be used, for the purpose of avoiding tax related penalties or
promoting, marketing or recommending to another party any tax related matter
addressed herein.
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information about legal developments. Because the facts in each situation vary,
any legal precedents noted may not be applicable to individual circumstances.
This information is not offered as legal advice.
