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Succession Planning for Small Practices

  • Written by Martin M. Shenkman

A milestone for the solo professional practitioner is the growth of the practice into a partnership. Two common scenarios are: Your client makes a staff member a junior partner, or a colleague joins your client to create a two-partner firm. What should you consider when advising a client making this transition? Similar considerations apply to your practice and succession plans.


What are the specific reasons your client wants to make a partner or merge his or her practice? Be certain that the structure of the transaction reflects and meets those goals. Be certain that recital clauses — sometimes called "Whereas" clauses — at the beginning of the legal documentation for the transaction spell out those goals. If they are not clear to you, they are not satisfactory. These should provide the guidelines for the deal now and a clear explanation to a court if a problem arises in the future.

Balance of Power

Be certain that your client understands the dynamics of the situation. If your client is promoting an employee to partner, the employee has limited negotiation power, and more steps should be taken to protect and favor your client. If your client is merging with a colleague owning a comparable solo practice, the dynamic will be different. Although these considerations are obvious to the outside adviser, the practitioner in the midst of the process often misunderstands the overall dynamic.

Weighing Appropriate Disclosure

Due diligence and disclosure are always necessary, but the level should be appropriate to the relationship of the parties. If a longtime employee is being promoted to junior partner, he or she may know the practice well; however, he or she may not know the finances (debt) and perquisites. To make the transition work, even a longtime boss must permit reasonable disclosures. In many instances, counsel to one of the parties will use boilerplate disclosure provisions, which may be either excessive or inadequate to the circumstances; endeavor to tailor those before costs are incurred or antagonism results. The practice CPA as perhaps the most neutral of the advisers may be in the best position to address this.

Due Diligence

Regardless of the knowledge and familiarity with the practice the new partner may have, representations in the documents addressing the transaction should always be included to provide some level of protection. Lien and judgment searches, a good standing certificate for the entity and credit checks on the individuals and the practice should be done regardless. Even the most honest and careful of practitioners may have issues of which they were unaware. The time to address this is prior to the consummation of the transaction. 

Old Practice Documents

If the practice is organized as an entity, be certain minutes and governing documents are current and accurate prior to the transaction and that revised documents are executed to reflect the results of the transaction. Too often, only new documents are executed, and the informalities of the former solo practice remain gaps. 

Type of Entity

Consider what type of entity should be used for the post-transaction partnership. If your client had operated as a sole proprietorship, an entity should be formed. If a professional corporation is used for the new partnership, and there is a lawsuit for malpractice for an act the new partner committed as a partner, and your client was not involved in the matter, then the new partner and the corporation will be held liable, not your client. 

Many state statutes permit the formation of a special form of general partnership, or in some instances, a limited partnership known as an LLP. LLPs also are called registered limited liability partnerships and are recognized in many but not all states. This form of practice entity offers greater protection than a general partnership form of operation; the degree of additional protection will vary depending on the provisions of state law. In most instances, the protection an LLP provides is significant but limited. The protection is that you should not automatically be held liable for the professional malpractice acts of another partner. Professional Limited Liability Company (PLLC) provided in many state statutes include special provisions governing professional service LLCs.

New Practice Documents

Practice documents should address issues critical to the relationship of your client and the new partner, including detailed parameters for how the practice will be managed and the anticipated contributions of each professional involved. Management and control issues are vital to deal with while both you and your new partner are cordial and optimistic. Compensation arrangements, allocation of client workload and administrative responsibilities should be specified. Even if specific details cannot be agreed to, a general framework can prove useful in the event of a dispute. It should be a comprehensive agreement addressing vacation, termination (with and without cause), disability, death, divorce, retirement, future succession planning, insurance planning, buy-sell and other planning.


If your client's goal is retention of a key employee, the agreement should have incentives for duration of the employee/new partner's continuation with the practice and penalties for an early departure (e.g., a buyout on departure could reflect a substantial penalty that diminishes with each year with the practice). Incorporate into the arrangements a bonus arrangement, or kicker, based on years the new partner continues with the practice.


If the end goal is for the current practice owner to retire, does the current deal reflect that goal? Too often, practitioners have sold some equity to a younger partner without an assured strategy for the remaining equity. This could make it difficult for the senior partner to eventually sell out and retire. If complete succession is a future goal, at minimum, confirm it in the documentation and include a mechanism to achieve it. 

Binding the Partnership

The appearance of the practice following the transaction will be that the new partner has the authority of a partner. If the new partner is not an equal colleague, then the intent may be that the former solo practitioner retain certain controls. The documentation should carefully restrict the actions of the new junior partner and protect your client's decision making and control. Be wary, however, a designated partner may create liabilities for your client's practice if third parties had no knowledge of the restrictions on the junior partner's authority.


Be a nitpicker in a positive, not a negative way. Too often, the parties in the deal are so focused on the big, economic issues that important administrative issues which later create considerable friction are overlooked. Are there any expectations by either party as to participation in the ownership of the building housing the practice or liability on the practice office lease?


Control issues are often the most contentious issues. Their resolution will vary depending on the relationship and clout of each party. Some junior partners are partners in name only, with the senior partner continuing to control key practice decisions. If the new junior partner is joining the practice with the expectation of becoming a full partner, then the governing documents could include a mechanism for gradually increasing the junior partner's involvement, authority and control position.


Income and equity issues need to be clarified for your client's new partner. The new partner may only be a non-equity contract partner with limited contract rights created under the practice's governing agreement, but not full participatory partnership. This may be offered to a valued employee who does not possess all the skills for becoming a full partner but is vital to the practice. This type of arrangement could be structured by using a two-member LLC naming your client as manager and a member and the junior partner as a member with you. The LLC would be taxed as a partnership. Profits and other benefits could be allocated in any manner consistent with tax requirements (e.g., Code Section 704(b) substantial economic effect). This arrangement could be structured as a corporation with a voting and non-voting class of stock. Your client could retain all the voting stock, and the junior partner can own non-voting stock. 

Personal Planning

Coordinate and plan the results of the practice changes with your client's personal financial planning. The new practice partnership agreement disability provisions should be evaluated in light of your client's disability planning. For example, if your client has a disability policy with a 90-day waiting period, continuation of some compensation and benefits in the practice for 90 days of disability absence may be advantageous. Your client's interest in his or her professional practice may be one of the largest assets in his or her estate, and the primary factor affecting key financial planning milestones are death, disability or retirement. So, coordinate practice decisions on practice retirement plans with personal savings goals, life insurance, etc.

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Planning Life Insurance Post-ATRA

  • Written by Martin M. Shenkman, CPA/PFS, MBA, J.D.

By: Martin M. Shenkman, CPA/PFS, MBA, J.D.

Insurance has, and will always remain, an integral part of many estate plans, regardless of the status of the estate tax. Life insurance can be used, as it has for many decades, to build an estate (e.g., for a young client with a modest estate and a family to support in the event of premature death), provide liquidity to an estate (e.g., a client the whose estate is primarily comprised of real estate or business interests), for funding buyout agreements, and more. The American Taxpayer Relief Act of 2012 (“ATRA”) has changed the use of life insurance in profound ways.  What are some of the new factors practitioners should consider?

Don’t Cancel Existing Life Insurance Without Reviewing All Options: Insurance was frequently purchased as a means of paying estate tax. A classic tax plan for many clients was to purchase survivorship life insurance payable on the death of the second spouse to die and held in an insurance trust to cover the estate tax. For many clients the primary purpose for these policies is not irrelevant. Unless the client’s estate will exceed the $5.25 million exemption, or $10.5 million for a couple, no federal estate tax will be due. What should be done with the policy? Consider the options:

• Cancel the policy for the cash value. If the policy is held by a trust, the cash value should be paid to the trustee and distributed pursuant to the terms of the trust. While this is the simplest and obvious step, it is often not the best for the client.

• Consummate a tax-free exchange for another policy that will provide advantageous income tax planning benefits or better serve the clients new post-ATRA objectives.

• Use the existing policy, a paid up policy, or a scaled back death benefit to cover estate liquidity needs (perhaps reduced to reflect the reduction or elimination of federal estate taxes as a liquidity need).

• Exchange the policy for an annuity that meets cash flow needs and is consistent with the client's current financial and retirement plans.

• Sell the policy into the secondary market, which might net the client more than the cash surrender value.

Review Adequacy of Existing Coverage: If insurance is held for personal wealth creation or income replacement (e.g., a young person seeking to provide for his or her family in the event of premature death), be certain that the assumptions underlying the policy are reviewed. Too often clients assumed much higher investment returns on insurance proceeds than may be realistic now. If the client’s net worth was adversely affected by the recession, is the coverage still adequate? While tax and asset protection are important issues, assuring adequate and appropriate coverage is essential. Remember that in many situations life insurance is purchased online, sold to a client by an insurance consultant, or purchased on the recommendation of an estate-planning attorney, and no projection of what the client’s real needs are, may have ever been done. Even when projections are done, if they are not revisited periodically they may be useless. Even a rudimentary budget and projection will often demonstrate that clients are dangerously underinsured, or over insured with costly policies that don’t serve their needs.

Be Sure Any Changes to Trust Owned Insurance Comply with the Trust Requirements: If the life insurance is held by a trust, be certain that the client has his or her estate planning attorney review the trust to assure that the desired transaction is permissible. Practitioners, post-ATRA, have frequently been asked to help with transactions to terminate policies or change policies. Caution: Be careful not to help facilitate a transaction that violates the terms of the trust unless there is guidance from an attorney supporting what is being done. If a beneficiary later sues the trustee for violating the terms of the trust you don’t want the figures pointing at you. The mere fact that the client that established the trust wants to do something does not mean it is permissible. The trustee, not the client who formed the trust, is the decision maker.

Gifting Assets to Avoid State Estate Tax May be a Costly Strategy: Insurance may be better than gift strategies many are considering. Many clients might benefit from gifting away assets before death to avoid tax in a decoupled state. However, this is not always the optimal strategy. Assume for example, that your client owns a business structured as an S corporation that she started with a negligible investment decades ago. The business is presently worth approximately $4 million. Her investment assets are worth about $1 million, so that her estate has a total value of $5 million. She is domiciled in a decoupled state with a $1 million exemption. One planning option would be for her to gift her S corporation stock to an irrevocable self-settled domestic asset protection ("DAPT") trust. That would permit her to receive trust distributions in future years if she needed, but nevertheless have the assets and any growth in them removed from her estate. Most important, if she lives in any decoupled state (other than Connecticut which has a gift tax) there will be no gift tax consequences to her gift. This can be a simple and effective way to avoid state estate tax. That could provide a state estate tax savings of approximately $400,000. That tax savings could be especially important to realize if your client wished to bequeath the business intact to her son and her remaining assets to her daughter. Under this dispositive scheme the state estate tax, if paid from the residuary bequeathed to her daughter would eliminate almost half of the daughter's inheritance thereby benefiting the son in an even more lopsided manner. If instead the state estate tax were made the burden of the son, it could prove a difficult cash flow drain on the business the taxpayer wishes to retain intact. But a very different approach may be preferable. Leave the business interests in the estate so that the tax basis is stepped up on death and use life insurance to cover the state estate tax.

Consider Life Insurance to pay State Estate Tax: Life insurance can be used to address state estate tax in a decoupled state. Permanent life insurance may grow in use as a simple solution to the state estate tax cost faced by clients domiciled in decoupled states. Regardless of the federal estate tax, more than 20 states have decoupled from the federal estate tax system, and many have exemption amounts much lower than the federal level. The practical issue is to what degree clients who believe that their wealth levels will never subject them to federal estate tax will be willing to accept (for many "tolerate" may be a more apt description) the cost and complexity of sophisticated estate planning if the only "assured" savings will be a reduction in state estate tax. But even that might not be assured if a surviving spouse moves to a new state: the state changes its laws, etc. Client hesitancy to undertake more comprehensive planning may be compounded by the fact that successful estate planning that shifts assets outside the state taxable estate will be offset to some degree, perhaps to the point of generating negative overall tax consequences, by a loss in basis step up because assets are removed from the estate. With capital gains tax rates higher than state estate tax rates, this will be a significant issue for many. Many clients may opt to avoid the decision of whether to undertake more involved planning, or the complexity of whether and how to use portability and/or a bypass trust and the myriad of ancillary decisions, by looking to life insurance to address the state estate tax costs, or alternatively the capital gains cost heirs may face.

Does Your Client Really Have to Keep Doing Annual Crummey Notices: Crummey powers have been used in almost every life insurance trust. But as common as they are, they are a constant source of confusion and frustration for clients. While insurance trusts should continue to be used regardless of whether the client is subject to an estate tax (to protect and control the insurance proceeds), are Crummey powers really necessary?  Historically a key step in every life insurance trust plan was to assure that gifts to the life insurance trust qualified for the gift tax annual exclusion ($10,000 inflation adjusted, $14,000 in 2013). But if the client will never be subject to an estate tax why bother? The exclusion is $14,000/donee in 2013. These are the annual notice provisions whereby the trustee notifies every beneficiary that a gift was made to the trust and that the beneficiary has a time period during which he or she may withdraw it. The beneficiaries would typically be notified in writing. In many cases the beneficiaries would be requested to sign a counterpart to the written notification confirming their receipt of the notice. Might it now become practical to actually draft Irrevocable Life Insurance Trusts (ILITs) without Crummey powers? For clients with moderate wealth estates, if they are really certain that they will never be subject to a federal estate tax, why burden them with annual homework they don't want to do and too often don't handle properly if at all? Note that if a trust doesn’t include annual demand powers, a gift tax return will be required each year gifts are made to allocate gift tax exemption since gifts to the trust will not qualify for the annual gift exclusion. Perhaps there is another alternative that no practitioners would have recommended prior to ATRA. Consider having beneficiaries sign a one-time statement waiving the right to future written Crummey notices and acknowledging that they will be made orally and the trustee signing agreeing to give verbal notice. While the common advice in the past was to use written notices so that there would be proof to show the IRS that notice was given on an audit, the only 709 or 706 most clients will ever file will be one to secure portability on the death of a first spouse. There seems to be no reason why a verbal notification should not suffice to meet the requirements of a present interest gift. Caution: Be certain that the trust document does not require an annual written notice be given if the intent is for the trustee to merely give an oral notice.

Consider Income Tax Advantages of Life Insurance: Because of the post-ATRA environment of higher income taxes and the 3.8% Medicare tax on passive investment income, the special income tax treatment afforded life insurance will have increased importance. For the wealthy client unconcerned about federal estate taxes, the favorable income tax attributes of life insurance may outweigh the estate tax benefits that had previously proven the draw. The higher income tax rates ATRA imposed enhance the use of permanent life insurance as a savings vehicle. The long-term returns on a properly structured traditional cash value life insurance policy are attractive. While many may believe that the cost structure of life insurance is such that the use of life insurance as part of an investment plan is inadvisable, look again at the actual returns the particular client has realized from his or her investment portfolio over time. Many clients have so lacked the discipline necessary for investment success that a quality like insurance policy will have actually outperformed what the client has realized. Life insurance companies, by law, are required to keep substantial reserves. The reserves are low risk. The fear created by the recent recession has made many clients worried over their investment portfolio. Adding a reasonable component of permanent life insurance as ballast to the client's investment portfolio may be appealing to some clients. The post-ATRA income tax benefits may enhance that.  

Clients can Access Insurance Cash Value (even in trust) Tax Free:  A valuable benefit of permanent life insurance is the tax-free build up of value inside of the policy. Clients can, with a modicum of monitoring and planning, access this cash value in the future if desired. Even if the policy is held in trust this may be feasible. For example, wife establishes an insurance trust to own permanent insurance on her life and names her husband and children as beneficiaries. An independent trustee may be able to borrow money out of the policy in future years and distribute those funds to the husband, all income tax free. Unless the policy is characterized as a modified endowment contract ("MEC"), and if the policy isn't surrendered and withdrawals don't exceed the client's tax basis in the policy, the excess of the policy cash value above the income tax basis in the policy is not subject to income tax. The client can avoid income tax when withdrawing money from the policy if the withdrawals are limited to the income tax basis, and then thereafter cash is withdrawn in the form of loans taken out for the excess above basis. If the insured dies with a policy in force, any cash value above the income tax basis not previously withdrawn is also not subject to income tax, even if the policy is a characterized as a MEC.

Watch the Transfer for Value Rules Trap When Moving Policies: Post-ATRA many clients may seek to move life insurance policies around to meet the new planning realities. For example, a client may have a life insurance policy held in a corporation that was to be used for a redemption buy out. Now, they may wish to simply transfer a policy that may no longer be needed for that purpose into an insurance trust to protect it, and retain the policy for its income tax advantages. Be careful not to inadvertently trigger the transfer for value rules in this type of transaction as that could make all the death proceeds taxable. Unless improperly transferred, the death benefit paid under a life insurance policy is not generally subject to income tax.

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7 Estate Planning Tips for the Closely Held Business Post-2010 Tax Act

  • Written by Martin M. Shenkman

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, better known collectively as the 2010 Tax Act P.L. 111-312, was signed into law by the President on December 17, 2010. Key changes of the law, which practitioners are well familiar with, are the $5 million unified exemption and the new concept of “portability.” Portability may enable a surviving spouse to benefit from the unused exemption from the first spouse to die, although there are a number of significant issues that may affect this benefit. Many, perhaps most, clients believe they don’t need to plan at all given the new exemptions and portability. For many clients, especially those owning closely held businesses, this will prove to be a costly mistake.

Estate planning for business owners has never been only about federal estate tax, although for wealthy clients, that remains an issue. And, as practitioners know, but many clients seem to have forgotten, in 2013, the exemption drops to $1 million if Congress does not act. What should practitioners be recommending to business clients in light of these massive changes, and why? Consider the following checklist:

Gift Valuable Business Interests

Gift valuable business interests now to take advantage of the new large $5 million gift exemption. This provides for a tremendous opportunity to shift business interests to the next generation now.

If this is not taken advantage of, the opportunity might be lost forever. The Obama administration has already proposed reducing the $5 million to $1 million. With pressing budget problems, no one should assume that this will remain intact for long. If the reduction to $1 million happens, clients owning large businesses will be precluded from simple planning.

Gift Non-Controlling Interests

Gift non-controlling interests in businesses now. Discounts for lack of marketability and lack of control are still permitted.
There have been a host of proposals to restrict or eliminate these discounts. If enacted, the ability to leverage gifts of business interests will be lost. Clients looking to transition business interests to the next generation should not lose this opportunity.

Reallocate Business Interests

Reallocate business interests between non-married partners. The estate tax law has always been biased against non-married partners. The portability provisions of the new law are no exception as this tremendous benefit is not available to non-married partners.

If clients have “personal” partners with whom they would like to share the equity in a business, the new $5 million gift exemption provides an opportunity for all but the wealthiest of partners, to shift assets without a gift tax.

For example, Jane Smith owns a successful marketing firm as well as the building in which it operates. Her partner, Sandy Jones has a modest net worth. Jane wants to make sure Sandy is provided for. She might take advantage of the new large gift exemption and gift Sandy a large percentage of the limited liability company that owns the building leased to the business.

This would assure Sandy a cash flow for life if anything happens to Jane, yet no current gift tax would be due. Even if the exemption is reduced to $1 million at a future date, Jane’s primary goal of assuring Sandy’s financial security would have been met.

Use the New Gift Exemption

Use the new gift exemption to structure asset protection planning. For business owners, passive assets can be segregated and transferred into protective structures to protect them from business claims.

For example, Steve Smith owns Widget Manufacturing Corporation. Corporate assets include raw land adjacent to the factory that was purchased for future expansion plans and is being leased to a local private school for overflow parking in the interim, the factory/plant property and the operating assets.

Widget is divided into three separate entities in a corporate division under Code Section 355: raw leased land, factory property and operating assets. The leased land is sold to a dynasty trust for family members, and the factory property is sold to a different trust for an installment note.

Steve retains control over the operating post-division corporation and makes gifts to the children active in the business. The objective is to isolate the raw land and building into separate structures to insulate them from potential business claims. Given the availability of discounts and the $5 million exemption, this type of planning may be feasible now, but not at a future date.

Review Life Insurance Plans

Most business clients have used some type of life insurance to address liquidity issues and the payment of estate tax. These insurance plans should be reviewed and evaluated in light of the massive estate tax law changes, but the continued estate tax uncertainty.

Some clients have taken a knee-jerk reaction deciding to cancel life insurance — potentially a catastrophic choice. Instead, consider advising clients to consider having new insurance projections done to determine the least amount that they can pay in premiums until perhaps the end of 2013 (in case the estate tax issues aren’t resolved until near year end as in 2010) and maintain their policies in force and in good shape.

This is a safer approach in that the client can minimize payments but retain coverage should tax law changes prove it worthwhile.

Split-Dollar Plans vs. Cash 

Some business clients have complex split-dollar insurance arrangements that have been created to fund the liquidity issues of their business interests. Split-dollar was often used when the cost of annual insurance premiums exceeded the available annual gift exclusion amounts and the client wanted the protection and tax benefits of having their life insurance held by an irrevocable trust.

The new $5 million gift exemption may permit many of these clients to simply make a gift of cash to their insurance trusts and then have the insurance trust unwind and repay them. This can be used to unwind the split-dollar arrangement, avoid the need for an exit strategy for the plan, and simplify their insurance planning going forward.

Gift to Grantor Trusts 

Clients with valuable business or real estate holdings may have sold some portions of their business interests to grantor trusts for notes.

For example, Jane Smith sold 40% of her real estate firm to a Delaware dynasty trust in exchange for a note. The sale was consummated several years ago to freeze the value included in her estate and have future appreciation in the business interests sold growing outside her estate.

When the equity in the business was sold, the trust gave Jane back a note for about 95% of the purchase price. To support the validity of the transaction, Jane’s insurance trust, which has substantial value in permanent policies, guaranteed the dynasty trusts repayment of 10% of the face value of the note to Jane.

These transactions sometimes involved guarantees, especially for larger dollar transactions. It may be possible for these clients to use some of the increased $5 million gift exemption to gift sufficient assets (perhaps interests in the business previously sold) to their trusts and then unwind the guarantees.

It may be feasible for smaller transactions to gift dollars to the trust that can be used to repay the client/seller/grantor for the loan used in the previous sale of business interests to the trust and eliminate the notes and all financing for the transaction.

Regardless of what should occur in the future with the estate tax, helping clients with valuable business interests capitalize on the current law to simplify existing transactions, safeguard assets, and implement succession plans, will be worthwhile.

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Valuation and Buy Sell Agreements

  • Written by Martin M. Shenkman

When valuing an interest in a closely held business, one of the first steps is to review the legal documents that address buyout agreements for the business. The various agreements to buy out an owner can sometimes provide valuable information for determining the value of the business. In other instances, the values stated or implied in such agreements may be misleading. Here are some factors to consider:

Independent Council

If each side to the transaction had his or her own independent attorney the weight the IRS will attribute to the particular valuation methodology is greater. Estate of Joseph H. Lauder, T.C. Memo 1992-736. But the same concept also applies to your use of any "appraisal." If the appraisal was completed for a family for gift tax purposes the bias is obviously lower and even if in the range of what is fair value may warrant further analysis before use for a different purpose. The Lauder case pointed out a number of other fundamentals practitioners must consider in evaluating the strength of any valuation for tax purposes. Was an independent professional used? Was the value used in transactions prior to death? Was there arm's length bargaining (e.g., one child receiving the business and another child receiving another asset)?

Non-Tax Use

Economic or business use of the buy sell agreement will strengthen its import on a tax audit. For example, if the buy sell agreement was used as part of the applications for lenders or bonding to demonstrate corporate responsibility that would support the figures or formula used. Estate of Marlin Rudolph v. U.S., U.S. D.C. So. Dis. Indiana, No. 91-151-C, February 5, 1993. Also, if the owners obtain life insurance that can corroborate that the buy sell was not set in contemplation of death

Insurance Reliance Misplaced

Insurance is a tremendous tool to fund buy sell agreements, but be wary of relying on insurance as foolproof. If the insured commits suicide and the policy coverage is void, how will the buy out be concluded? PLR 9315005. Also be wary of indirect gifts if a controlled entity redeems shares.

Excessive Insurance

For many buyouts, the price is set with consideration of the cost of insurance coverage. Since term insurance is so inexpensive they might purchase a larger amount of coverage than the actual value. For young business owners this can be a dangerous mistake. This could create an inappropriate inference as to the insured amount being argued to be the real value in the event of a divorce or estate tax audit. It would be preferable to state what the current value is believed to be and what should happen with the excess insurance coverage.

Premium Values Should Not Govern

If a price is paid to buy out a minority shareholder to gain control, or if a partner is going through a divorce and the other owners or entity repurchase the divorcing owners shares to avoid the disruptions and difficulties of the divorce litigation, document that a premium was paid at the time of such a transaction and why, to provide some corroboration at a later date if a lower value is later used in a gift or estate planning transaction. If not, the IRS would likely argue that the third party transaction actually set the fair value for the business, rather than recognizing it as a unique special purchase that should not be used to infer arm's length value.

Ancillary Steps Critical

Too often practitioners focus almost exclusively on the valuation aspects of gift planning transactions. Ancillary issues are often as or more vital to address, so think and plan broadly. For example, if the client engages in a sale for a private annuity (typically structured to a defective or grantor trust) the client should have a greater than 50% opportunity to survive more than a year. There is a rebuttable presumption that if the client survives 18 months that the test is passed. Consider obtaining letters from two physicians indicating a two year survival period or even having a formal life expectancy analysis completed. While valuation remains critical to the success of such a transaction, it is not the sole factor.

Divorce Valuations

If stock in a closely held business is repurchased in a divorce the IRS may view the entities payment for the ex-spouse's equity as a payment of a divorce obligation and tax the spouse retaining the business. Thus, the structure of the transaction, not only the value, must be planned. John A. Arnes, 981 F.2nd 456, aff'g DC Wash.

What is Being Valued?

In a recent case the taxpayer formed a one member LLC and transferred assets to the LLC. Gifts were then made to heirs and portions of the LLC were sold to family trusts. What was appropriate to value? The underlying assets or the minority interests in the LLC that were given or sold? The IRS argued that since the LLC was a single member disregarded entity for tax purposes under the check the box regulations it should be disregarded for gift tax purposes. The court, however, held that the fact that the entity was disregarded for income tax purposes does not mean it should be disregarded for gift tax purposes and discounts were permitted. Pierre v. Commr., 133 TC No. 2 (2009). Similarly, when clients consummate a series of transactions it may be possible that the entity will be disregarded in the valuation process. In a number of different tax cases the courts have sided with the IRS that a purported transfer of assets to an entity followed by a contemporaneous, or even just a too rapid, transfer of entity interests would be deemed a transfer of the underlying assets, not merely the entity. Linton v. U.S. 2—9 WL 1913255; Shepherd v. Commr., 283 F.3d 1258 (11th Cir. 2002), Senda v. Commr., 433 F.3d 1044 (8th Cir. 2006). Practitioners should be wary of first determining what is proper to value before focusing on the nuances of the valuation itself.

Related Party Transactions

When valuing a closely held business, care should be taken to assure that all loan transactions are properly documented and that other intercompany transactions are supported by appropriate contractual arrangements. Too often, family and related-party transactions are treated with informality. You should not lightly value a cash transfer as a loan instead of equity if there is no written loan agreement. Similarly, intercompany transfers and management fees must be properly confirmed and documented. If the prices involved are not arm's length, it is often not only a matter of making an adjustment for purposes of an appraisal, but also assuring that sufficient documentation and proper pricing exists so that not only the IRS, but courts and credits as well, will respect the transactions.

Consider all Valuations

For closely held business provisions for buy sell purposes for retirement, death, disability, partial disability, and perhaps others must be addressed. Agreements often include "bad boy" provisions that provide a reduced payout if the equity owner being terminated had lost a license essential to participate, committed theft of business/entity assets or opportunities, etc. Each of these "buy out" prices or formula often has an objective different than that of determining the fair value of an interest in the entity. For example, the "bad boy" provisions are designed to penalize, death provisions may be based on the cost and availability of life insurance, retirement payments may be intentionally reduced to permit business succession and on the premise that equity owners should save for their own retirement. Each of the various "valuation" approaches should be evaluated as part of a valuation and identified or labeled for its intended purpose

References Should Work

If you refer to tax definitions or incorporate the definition of disability from an insurance policy, be sure to clarify the intent and provide for backup in case the tax rules change or the policy lapses.

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Checklist: FLP and FLLC Planning

  • Written by Martin M. Shenkman


Family limited partnerships and family limited liability companies (collectively, “LLCs”) are the foundation of many client plans. LLCs can provide a myriad of planning benefits for the client:



  • Management and control benefits (e.g., by naming a manager and successors).
  • Investment benefits (e.g., by consolidating small accounts of various family members and family trusts into a single investment account that can simplify investment management and perhaps qualify for lower breakpoints on investment management fees).
  • “Inside” asset protection (e.g., a real estate rental property owned by an LLC, if subject to a lawsuit by a tenant, should protect the client’s home and brokerage account and only expose LLC assets).
  • “Outside” asset protection (e.g., a physician that has minority interest in an LLC holding family wealth may make those interests difficult to reach for a malpractice claimant).
  • Estate planning (e.g., discounts, but proposals abound to restrict or eliminate these).
  • Avoid ancillary probate (e.g., by transforming real estate that would be subject to probate in a state where the property is located, into an intangible asset that can pass without local probate).


With so many benefits, LLCs have become ubiquitous in planning. When preparing a Form 1040 identifying single member LLCs on Schedule C or E, and multi-member LLCs typically taxed as partnerships for income tax purposes on Schedule E, practitioners can begin to address a host of compliance and planning issues, and create real value added for clients and post-tax season work. Here is a checklist of some of the many items that might warrant addressing:

Permanent File: Be certain that you have, if not assemble, an appropriate permanent file. Without appropriate permanent file documentation you cannot ascertain who has authority to sign a tax return, or make required tax calculations. Often merely assembling a reasonable permanent file will identify glaring problems (e.g., not every member signed the operating agreement). This should include at minimum the following:

  • Formation documents for the entity (e.g., the certificate filed with the state in which the LLC was formed). The name of the filing will vary by state. Be certain that the copy reflects stamps from the state agency indicating acceptance and the date of the acceptance.
  • Amendments to the formation documents, if any.
  • Authorization for the LLC to do business in other states. With the growing use of sophisticated dynastic and self settled trusts (typically formed in either Alaska, Delaware, Nevada or South Dakota) the LLC may be formed in one of those states but perhaps then should be authorized to do business in the state in which the LLC conducts business (e.g., even an investment business).
  • Governing agreement (operating agreement for an LLC and partnership agreement for a partnership), including any amendments. It is generally advisable to have an annotated operating agreement that highlights and explains decisions pertinent to tax planning and compliance. If there is a Tax Matters Partner (TMP) you need to be aware of this. Some attorneys draft TMP provisions as a control feature for a particular member even if a TMP is not otherwise required. You cannot determine the tax consequences to the heirs of a deceased member, or of a new member buying an interest, without knowing whether the operating agreement provides for an IRC Sec. 754 election.
  • Documentation of contributions to the LLC. This might include a bill of sale, wire transfer documents, deed, or other documents. Details on the member’s tax basis of each asset contributed, and for non-cash items an appraisal or other confirmation of fair value. Details on any contributed assets are subject to debt. If marketable securities constitute the majority of contributed assets work papers confirming the inapplicability of the IRC Sec. 721 investment company rule should be maintained.
  • Membership interest certificates. Some lawyers issue certificates, analogous to stock certificates, for LLC membership interests. Determine if these are being used and if so obtain copies. Verify that the ownership interests reflected on the membership interest certificates, those in the current operating agreement and the Forms K-1 are all the same.
  • Transfer of membership interests. Especially in the family LLC context, it is common to have membership interests transferred by way of gift to younger family members and trusts. Documents might include an assignment, executed counterpart of the operating agreement or an amended and restated operating agreement, appraisal or gift tax return.
  • Good standing certificate. Periodically it is advisable for the attorney for the entity to order a good standing certificate [from the state] to corroborate the status of the entity.
  • If trusts or other entities are members, basic documentation confirming who can sign and that they have the legal authority to be members should be included. A letter from the attorney for the LLC may be advisable.
  • Transactional and operational records. This could include leases to or from the LLC, contracts with key employees, an investment policy statement for an investment LLC, and consents or actions by the manager of the LLC. The documentation will have to relate to the function and purpose of the LLC. So if a family or business LLC is used to own life insurance then copies of the insurance policies, buy-out agreement, if applicable, should be obtained.


Convert Partnerships: Identify situations in which the client owns an interest as an individual general partner in a limited partnership. It may be advisable, subject to income tax implications of debt or guarantees, to convert the entity into a limited liability company to provide the client limitation on personal liability. As a general partner, the client faces unlimited personal liability on lawsuits or claims against the limited partnership. See Rev. Rule 95-37, IRB 1995-17, 10. The consequences of debt must be considered. To avoid any tax consequences on the conversion of a partnership into a limited liability company, there must not be any change in the proportionate responsibility of each partner for the debts of the partnership. If a shift in a partner's share of liabilities occurs, for example, as a result of the LLC assuming recourse debt of the predecessor partnership, gain could be realized. Treas. Reg. Sec. 1.722-1.

Watch Out for the Investment Company Rule: With so many taxpayers setting up LLCs in 2012 to fund gifts to take advantage of what many thought would be the last great chance at estate planning before a $1 million 2013 estate tax exemption, watch out for this trap. The contribution of property to an LLC in exchange for equity interests in the LLC is a realization event for tax purposes. Treas. Reg. Sec. 1.1001-1(a). Therefore, absent an express Code provision providing for non-recognition gain will have to be recognized by the taxpayer making the contribution to the extent that the fair market value of the LLC interests received in exchange exceed the adjusted tax basis of the property contributed. IRC Sec. 1001; Treas. Reg. Sec. 1.1001-1(a). Non-recognition treatment, however, will generally apply to such transactions. IRC Sec. 721(a). However, if specified exceptions to the non-recognition rules are applicable, gain may have to be recognized. IRC Sec. 721(b); 7701(a)(45).  If appreciated securities are transferred to the LLC on funding, all gain may be triggered if the LLC is characterized as an “investment company.”  The LLC must be classified as an investment company by virtue of having more than 80% of its assets constituting “listed property” which generally means marketable securities. Second, once the LLC is classified as an investment company, taxation will occur if the assets transferred are not “diversified portfolios.” If the assets transferred are not diversified, then the transaction must result in diversification which is not insignificant. Practitioners should test all transactions and take remedial action. While ideal to address before the transaction there are steps which can be taken after the fact to potentially cure the problem.

Business Purpose: To be respected for tax purposes, the LLC must be bona fide, and transactions must be for business reasons. Treas. Reg Sec. 1.701-2(a)(i). If the LLC is not respected as a distinct legal entity, any asset protection benefits the client hoped for will be lost. Identify LLCs that may have uncertain or uncorroborated business purposes for post-tax season follow-up. Many of the determining factors of a business that will be respected are in the purview of the practitioners (independent books and records, handling matters in a business like manner and no commingling of funds, proper documentation for loans, etc.).

Phantom Income: How does income on the K-1 compare to actual cash flow received by the client? Many families use LLCs to manage assets, provide asset protection and provide discounts for estate planning purposes. But what happens if distributions lag well behind taxable income. Language can be added to an operating agreement to require minimum distributions to meet tax costs. Because of different tax status of different members and different states, the distribution cannot be calculated exactly. If a formula is used, or a specified percentage, be certain that it is reasonable for your client. The objective in many instances is to assure some reasonable level of distribution to meet expected tax costs. Guidelines could be added for distributions of an estimated amount equal to the federal maximum tax rate multiplied by taxable income to assure members adequate cash flow to pay federal tax. However, inclusion of such provisions in an operating agreement will undermine discounts for tax purposes and asset protection as well. In the context of a divorce, a mandatory distribution provision may change the evaluation of the LLC interest as a source for the payment of alimony and child support.

Built in Gain or Loss:  If the market value of contributed assets exceeds the contributing members adjusted tax basis in that property, any gain the LLC realizes on the sale of that property has to be allocated back to the contributing partner during the seven years following the contribution. Be certain to track the necessary information in the LLC permanent file to facilitate the appropriate calculations and allocations. IRC §704(c)(1)(A).

Change in Partnership Interest:  You have to determine a member’s distributive shares of LLC (for an LLC taxed as a partnership) items when a member's interest changes during the year. The general rule is that the LLC should determine the member's distributive share using the interim closing of the books method. However, by agreement of the members (what does the operating agreement provide for?) it may be permissible to use the proration method. Under this method, the partnership allocates the distributive share of LLC partnership items (except for extraordinary items) under IRC Sec. 702(a) among the members in accordance with their pro-rata shares of those items for the entire year. See Prop. Reg. 1.706-4 and the proposed changes to Reg. 1.706-1.


Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.

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