MOVIE OUT-TAKE

Father: "You didn’t want the business?"

Son: "No."

Father: "Why didn’t you tell me sooner?
I could have sold it to your Uncle
Eddie for twice its value and taken
your mother on a ‘round the world
cruise."

From the movie: "While You Were Sleeping"

I. WHAT IS "SUCCESSION?"

For purposes of this discussion, "business succession planning is preparing for the transition..." of a closely held business, as a going concern, to one or more members of the "owner’s" family:

"The process of creating and implementing a strategic plan for the family business that is designed to mesh the emotional and financial needs of the owner, family and key employees with the needs of the business as a viable entity," Koren, "Preserving the Patriarch’s Patrimony for the Prodigal and Other Paranormal (or Normal) Progeny: Non-Tax Considerations In Family Business Succession Planning," 31 U. Miami Inst. on Est. Plan., Ch. 12 (1997).

A. Succession by inheritance. If the intention is to essentially make a bequest, the owner should consider some type of "freezing" (or "deep freezing) device to pass the business.

B. Succession by sale.  If fewer than all of the founder’s children will be receiving interests in the business, "equality" may demand that a "fair market value" approach be considered.

II. INITIAL ISSUES.

A. Is it a Family business or a family Business? Which comes first?
B. What is the "culture" of the family and the business?
C. What will be the likely "politics" after the founder is gone?
D. Is it important to provide a "business home" for relatives?
E. Is retirement income for the founder a consideration?
F. Is ongoing support for the founder’s wife important?
G. Family identity in community.
H. Maintaining family harmony.
I. Is the founder "open" or "closed" ?

1. Can his children and wife frankly discuss estate planning with him?
2. Is his sense of self so bound up in his "creation" that he can’t let go?

J. Will there be a need for outside management? If so, for how long?
K. Might the family benefit from a family business consultant?
L. Is there a (preferably written) business succession plan?

III. FACTORS FAVORING SUCCESSION.

A. Business already in 2d, 3d, etc. generation. The most critical stage is survival into the second generation. Only thirty percent of family businesses are able to carry on beyond the founder’s lifetime. For those which do, the odds may not be that much better. Of businesses which are successfully passed down one generation, only forty percent remain viable at the "grandchild" level. LeVan, "Passing the Family Business to the Next Generation: Handling Conflict," 22 U. Miami Inst. on Est. Plan. at 13-32 (1988).

B. Are one or more children or in-laws, active in the business?

C. If more than one child or in-law is active in business, is there harmony among prospective owners?

D. Is the economic outlook favorable for business? Sometimes it’s helpful to ask our client whether he would invest in this business today.

IV. FACTORS FAVORING ALTERNATIVES.

A. No "heir apparent" or serious conflicts among probable successors. Might want to explore sale to employees or competitors.

B. Founder too much of a "key man." Is the business, in fact, the founder, personally, so that it will "die with him" ?

C. Outlook not "rosy" for business or product. Consider sale of assets or, preferably sale of stock.

V. FACTORS INFLUENCING "SHAPE" OF BUSINESS SUCCESSION PLAN.

A. Older generation’s need for cash.
B. Whether all or fewer than all "heirs" will be active owners.
C. Estate tax considerations.

VI. POLITICS AND GOVERNANCE.

One reason why many businesses fail in the second or later generation is that ownership may not have been successfully separated from control.

A. Classical Background. Aristotle classified political structures based on the fact that government may be for the good of the governed (the shareholders) or the governors (the managers) and may be concentrated in one or a few or shared by many. He envisioned the "true forms" of government as monarchy, aristocracy and constitutional republic. Each of these had the potential to degenerate into "perverted forms" of tyranny, oligarchy and democracy (anarchy). Aristotle posited a monarchy led by the perfect king as the highest form of government.

In most family businesses, the "monarchy" form will only work if the monarch owns all the stock and none of his siblings or cousins work for him. On the other hand, the firm of Pietro Beretta, the Italian firearms manufacturer, has been in business since 1526. In each generation, a single family member has emerged as the leader.

B. More Modern Perspective. Charles D. "Skip" Fox described three forms of family business polity. Fox, "Non-Tax Considerations in the Succession of Closely Held Businesses," : 36 U. Miami Inst. On Est. Plan., ¶903 (2002).

1. Controlling owner. This includes Malcolm Forbes, who left fifty one percent of his empire to his son, Steven. Like a monarch, the "controlling owner" can be efficient. He can also be dictatorial and vindictive. See the example in part IX, below.

2. "Sibling Partnership." This is analogous to Aristotle’s "aristocracy." This form works fine as long as all of the "aristocrats" are equal. Unless they all agree that either one of them will be the "chief" or that they each will have different, and equally valuable, functions, the relationship will not work.

3. The "Cousin Consortium." As ownership becomes more fragmented, potential for conflict is magnified. Active v. inactive owners. "Blood" relatives v. in-laws.

VII. DONATIVE BUSINESS SUCCESSION PLANNING—USING TRUSTS AND GIFTS CREATIVELY TO MEET OBJECTIVES.

A. The Heir Apparent - Prince Chuck

FACTS: Phil Battenberg started a manufacturing business in the 50s. Phil and his wife, Betty, have four children: Chuck, Andy, Annie and Eddie. Each of the children were offered an opportunity to work in the business. Andy became a professor and the two "girls" had no interest in manufacturing. Chuck has worked in the business his entire life. He has passed up opportunities for more lucrative work to stay with his father, who has always told him: "stick with me, kid and all this will be yours." Chuck is married and has two sons, Billy and Hal. Billy works in the business. Hal is pursuing other goals.

Phil and Betty come in to discuss their estate planning. They want to treat their children "equally." They also want Chuck to have the business. The business is worth $2MM and they have other assets worth $2. 5MM.

Obviously, if Chuck receives the business and the others divide $2. 5MM, the children will not be treated "equally."

DISCUSSION: What is "equality?" Clients speak of "equality." They may really mean "equity." Chuck, now in his 50s, has worked in the business all his adult life for substantially less money than he would have received in the outside world. In the past 5-8 years, he has virtually run it. Nevertheless, his father has consistently held on to the reins of power and has drawn off virtually all of the earnings. After several meetings, Phil and Betty realize that giving Chuck the business would be equitable. True "equality" would be inequitable.

This is a "happy family." Andy, Annie and Eddie understand and appreciate the contribution which Chuck has made to the family and the business.

WHAT WE DID:

1. Cristofani Trust.

Phil created an irrevocable trust funded with stock in the business. The trustee was Phil’s trusted accountant. If Chuck survived Phil, then the principal would pass to him. If he did not, then it would pass to his son, Billy. During the term of the trust, Chuck, his three siblings and nine of Phil’s grandchildren were discretionary beneficiaries. This gave us thirteen annual exclusions. Each of Phil and Betty transferred stock having a value of $260,000 to the trust. See Cristofani v. Commissioner, 97 T. C. 74 (1991), acq. in result only, 1991 A. O. D., 1996-010 I. R. B. 1996-29 Kohlsaat v. Commissioner, T. C. Memo 1997-212. This is an excellent opportunity to use discounts to "leverage" annual exclusions. See Rev. Rul. 93-12, 1993-1 C. B. 13. Although they continued to do this for several years, Phil was still reluctant to pass control of the business to Chuck.

2. Life Insurance.

Phil wanted Chuck to have the business free of estate taxes. Obviously, the taxes would then have to be paid by the other children. Betty created an irrevocable life insurance trust with a $1MM policy. The beneficiaries were Andy, Annie and Eddie. The proceeds would be available to pay estate taxes so that all of the non-business assets passed "tax free."  Note that at this time, Phil and Betty left Chuck the business but still did not give it to him.

3. Use up "Exemptions."

Some years later, at about age 80, Phil decided it was time to give Chuck the rest of the stock. He and Betty were able to do so within their remaining "exemptions" at fairly deep discounts.

PLANNING POINTS:

1. Equality is not always equity. A better term for what clients call "equality" might be "rough justice."

2. Annual exclusion gifts, especially when combined with discounts for lack of control and marketability are one of the most powerful "tools" we have, especially in light of the Cristofani case.

3. "Exemptions" or annual exclusion amounts, or whatever they’re called this week, should not be hoarded away. They should be used creatively, to make gifts of discounted interests.

4. Most importantly, in making this type of plan "work," is that the family understand and approve.

5. The real "Phil" died two years ago and the family is strong and harmonious.

B. The "Regency" Trust.

FACTS: Josephine has been managing the family business since her husband, Joe, died. Josephine is chairman of the board and number one son and heir apparent, Joe II, is president and CEO. If Joe II survives his mother, the business will pass to him. His children, Joe III and Peggy Sue, are less than ten years old. Although the family hopes that the business will continue into another generation, there is no assurance of this. In no event does Josephine want the business to get into the hands of Joe II’s wife.  She is unanimous in this.

DISCUSSION: When we speak of "business succession planning," we normally refer to having the business continue in the family. Successful succession can also be the sale of the business as a going concern for the family’s benefit. What we want to avoid is selling "parts" for "breakup value." We needed to create a flexible way to professionally manage the business as Joe III and Peggy Sue were growing up, giving them the opportunity to take it over at an appropriate time. At the same time, the door had to be opened to sell the business if it was in the family’s best interests.

WHAT WE DID: We created a trust to hold the stock in the business and gave the Trustee (the family’s accountant) broad powers, including the power to sell. Consider language similar to the following:

SUGGESTED LANGUAGE:

"If JOE, II, does not survive:  If JOE, II, does not survive the Settlor, and if any of JOE, II’s issue survive the Settlor, the Trustee shall retain all stock and other equity interests in Amalgamated Bathing Machine Company ("ABATH" ) as the principal of a new, separate and distinct trust, to be known as the Business Trust. The Trustee shall hold, administer and distribute the assets of the Business Trust as follows:

a. Term of Trust.  The Trust shall be for a term of twenty years from the date of the Settlor’s death, unless terminated earlier in the exercise of the Trustee’s discretion.

b. Distributions.  To the extent that the assets of the Trust consist of assets other than stock and other equity interests in ABATH, and to the extent that those assets are not needed to pay the administrative expenses of the Trust, the expenses of retaining that stock and other equity interests in the Trust, or for other reasonable purposes, the Trustee may distribute income and principal to those members of a class consisting of JOE,  II’s issue who are living from time to time for their educational expenses, support in reasonable comfort and general welfare.

c. Termination. This trust shall terminate at the end of the twenty year period beginning with the date of the Settlor’s death, at any time when no stock or other equity interests in ABATH are included in the Trust assets or at any time when the Trustee, in the exercise of his sole, absolute and unfettered discretion, believes that termination of the Trust would be in the beneficiaries' best interests.

d. Disposition. Upon the termination of the Trust, the Trustee shall distribute the principal, including all accrued and undistributed income, as follows:

(1) Primary Disposition.  If any of JOE, II’s issue are then living, the Trustee shall distribute those assets to those issue, per stirpes. The share or shares of any of JOE, II’s children shall be added to, and made a part of, their respective Trusts under the provisions of [insert reference to grandchildren’s trusts]. The shares, if any, of JOE, II’s grandchildren, and more remote issue, shall be distributed to those issue, subject to the provisions of [insert reference to minority provision].

(2) Contingent Disposition.  If none of JOE, II’s issue are then living, then the Trustee shall distribute those assets to those of the Settlor’s issue who are then living, in stirpital shares, subject to the provisions of [insert reference to minority provision].

C. Keep Them Working.

FACTS: Barry is the creator of a low-carb protein drink and is and now the semi-passive CEO of a successful business, Barry’s Banana Blast (BBB). His income ("S" corporation earnings) is between $1 and $1. 5 million annually. His second wife,Mary, is not involved in the business. Barry’s son, Harry "works" in the business but would rather be out surfing in North Dakota. The business is really managed by two long term non-family employees, Larry and Garry.

DISCUSSION: Barry’s primary objective is to perpetuate the business as a source of employment, most especially for his current employees. He does not want the business sold, if at all possible. Secondly, he does not want his son to become a "trust fund baby" and would like to encourage him to work. He also wants to "tie" his two essential managers to the business. He would like to leave eighteen percent of the business interest to Mary, twelve percent to Larry, twenty-five percent to Garry and forty-five percent to Harry. He does not want the stock to pass outright because the "new owners" would probably sell the business.

WHAT WE DID: We created separate trusts for each beneficiary. If any of the beneficiaries does not survive Barry, then his or her share will be re-allocated among the other beneficiaries. In order to keep day to day management of the business in the hands of those most capable and, at the same time, to restrict the ability of the managers to sell the business, there will always be both "business" trustees and an "independent" trustee.

The initial "business trustees" will be the two managers, Larry and Garry. If either of them cannot serve, then the other will serve alone. If neither of them can serve then Mary and Harry will become business trustees. The business trustees will be authorized to manage the business on a daily basis, but will not be able to increase their compensation or to sell the business or its assets. All "extraordinary" corporate decisions will be made solely by the independent trustee.

No stock in the business may be distributed to the beneficiaries of the Trusts. To provide an incentive for the two managers and Harry to remain at their jobs, all of the income of their respective Trusts will be distributed to them, as long as they are full-time employees of the business.

Each of the four Trusts will terminate at the death of its beneficiary. The interests in the business will be allocated, pro-rata, among the other Trusts. After all of the beneficiaries' lifetimes, all of the stock in the business will be distributed to the then employees of the business under a formula which recognizes both their compensation and their years of employment.

SUGGESTED LANGUAGE:

1. Distribution Provisions.

LARRY’S and GARRY’S Trusts.

For the purpose of this Section, each of LARRY and GARRY is called the Beneficiary. The Independent Trustee shall hold, administer and distribute the assets of each Beneficiary’s Trust as follows:

Income.

Stock and Interests in BBB. If, at any time or times, the Beneficiary is a full time employee of BBB, then the Independent Trustee shall distribute all of the income of the Interests in BBB included in the Beneficiary’s Trust to the Beneficiary. The Independent Trustee shall make a binding and conclusive determination of whether the Beneficiary is a full-time employee of BBB.

General Provisions. The Independent Trustee may, in its absolute discretion, distribute any part or all of the annual net income (including the income of Interests in BBB if the Beneficiary is not a full time employee of BBB) to the Beneficiary. The Independent Trustee may distribute the income which it believes advisable for the Beneficiary’s support in reasonable comfort, considering the standard of living to which he is then accustomed. That Trustee shall consider the income and resources which it knows are available to the Beneficiary from all other sources. That Trustee need not distribute any of the income, and shall accumulate any undistributed net income, adding it to the Trust's principal at least annually. That undistributed income shall be commingled with the principal and held, administered and distributed as part of that principal.

Principal. The Independent Trustee may, at any time or times, distribute principal, with the exception of Interests in BBB, to the Beneficiary, which that Trustee, in its absolute discretion, believes advisable for the Beneficiary’s support in reasonable comfort, or may refrain from making distributions. The Independent Trustee is granted the further absolute discretion to determine: when, how and whether to make distributions; the specific purposes for making them; and the assets and amounts to distribute. The Independent Trustee shall consider the income and resources which it knows are available to the Beneficiary from all other sources, and shall consider the standard of living to which he is then accustomed. It is the Settlor’s specific intention that no Interests in BBB be distributed."

2. Ultimate Disposition to Employees.

Interests in BBB. Each employee of BBB on the Ultimate Disposition Date who has, at that time, been a full-time employee for at least twelve months is called an "Eligible Employee." The Independent Trustee shall distribute one half of the Interests in BBB, pro rata, among the Eligible Employees on the basis of whole years of service, with any continuous twelve month period of full time employment counted as a full year of service. The Independent Trustee shall distribute the balance of the Interests in BBB among the eligible employees based on their pro-rata shares of total compensation in the twelve months immediately preceding the disposition date. The Independent Trustee shall make a binding and conclusive determination of whether any person is a full-time employee, his or her length of service and his or her compensation.

3. Trustee Provisions.

It is important to clearly delineate the rights and liabilities of the business trustees and the independent trustee. See Cohan, "The New Breed of Quasi-Fiduciaries - Splitting Duties and Personal Liability for Wrong Doing," 6 U. Miami Inst. on Est. Plnng., (1972).

Excerpt from Trustees' Powers.

"Except as to rights and discretions specifically granted to the Business Trustees, all rights and discretions shall be exercised solely by the Independent Trustee. As used in this ARTICLE NINE, the term "the Trustees" includes the Business Trustees and the Independent Trustee. However, the rights and discretions of the Business Trustees are limited to those specifically granted to the Business Trustees. All other rights and discretions shall be exercised by the Independent Trustee.

Business Powers.

Operation. The Business Trustees shall have the right and discretion to hire, retain and discharge employees, officers, agents and independent contractors; to fix the conditions of their employment and their compensation; however, the Independent Trustee shall have the sole right to increase the compensation of any Business Trustee who is an employee of BBB; the Business Trustees shall have the right and discretion to hire management consultants and professional management services; to carry on any kind of business activity; to change the nature of the activities carried on by any business; to maintain and authorize contributions to any tax qualified pension, profit sharing, stock bonus, thrift or other similar employee benefit plan and to take whatever actions as are required to maintain the qualification of those plans; to ratify and disaffirm contracts; to obtain insurance coverage for officers' and directors' liability, and to pay the premiums out of the trust;the Independent Trustee shall have the right to obtain capital through private or public offerings of securities, to comply with any State or Federal laws requiring the registration of those securities and to pay the costs and expenses of underwriting and registration from the trust;

Management. The Business Trustees may continue to operate any business in the same manner in which it was operated at the Settlor's death; the Independent Trustee may discontinue any business and dispose of it to any authorized person, on any terms and conditions; may expand, contract or change the scope, nature or size of the activities of any business;"

4. Relieving Trustees of Liability.

"Exculpation of Trustees."

Generally. No person, who is not a beneficiary, who deals with the Trustees shall be bound to see to the application of any asset received by the Trustees or to inquire into the authority for, or the propriety of, any action taken or not taken by the Trustees. No Trustee shall be responsible for any act or omission of any other Trustee. If the Trustees become liable, as trustees, to any person who is not a beneficiary in connection with matters not within the Trustees' control and not due to the Trustees' own actual fraud, gross negligence or willful misconduct, the Trustees shall be entitled to indemnity out of the trust's assets. No successor Trustee or additional Trustee shall be liable as a result of accepting any trust before receiving an account approved or judicially settled as provided for in [insert reference to accounting provision].

Business Trustees and Independent Trustee. The Settlor has specifically given the discretions to distribute assets to beneficiaries to the Independent Trustee. The Settlor has further given to the Independent Trustee the rights and discretions to participate in any decision regarding the sale, liquidation, merger or consolidation of BBB, its acquisition by another corporation, association or individual;the sale, other than in the ordinary course of business, of its assets as well as any act, the carrying out of which requires greater than a simple majority either under the by-laws or certificate of incorporation of BBB or under the statutes of the State of Connecticut.

The Business Trustees have been given the rights and discretions to manage the ‘day to day' business of BBB, with the exception of increasing their own compensation.

Accordingly, the Business Trustees shall have no responsibility for the investment of Trust assets, to see to the application of any asset received by any beneficiary or to inquire into the authority for, or the propriety of, any decision made by the Independent Trustee. The Independent Trustee shall have no responsibility for any management decision made by the Business Trustees within the scope of their rights and discretions."

VIII. SUCCESSION BY SALE.

A. When Preferable.

1. Sibling rivalry. A far more sagacious man than the humble writer of this outline noted that "one really doesn’t know his family until he has divided an inheritance with them." The stories of Cain and Abel and of Joseph and his brothers are as relevant today as when they were 5,000 years ago. After the founder’s lifetime, simmering rivalries will come to a rapid boil.

a. Alternatives to Sale.

(1) Separation. Consider dividing the business along product or geographical lines. NOTE: One must meet the "active trade or business" requirements of §355. See Regs. §1. 355-3(a).

(2) Distribution of Other Assets. See Section VII A, above.

2. No Family Members Interested. Consider a buy-sell agreement with a competitor or with the owner of a similar business in a different location.

B. Funding the Sale.

1. Straight installment sale. Be careful to avoid the "Maxwell" issue. See "No Forgiveness" at 4b, below. Even though the formalities of a transaction may have been observed and the "debt" was adequately secured, if there is no real intention of making repayment or enforcing the obligation, these facts are of little significance, Van Anda v. Commissioner, 12 T. C. 1158, 1163.

2. Self Cancelling Installment Note (SCIN).

a. Sale is for promissory note for term of years.
b. Note provides that, if seller dies prior to end of term, buyer’s obligation is cancelled.

(1)"Balance" should be excluded from seller’s gross estate.

(2)Note must reflect a "premium" to reflect the fact that the seller’s estate may not collect the full amount. It must take into account the age and, possibly, the state of health, of the seller and the financial stability of the buyer. The premium can be an increase in the sale price or in the interest rate. It should not be "separately stated."

c. In Estate of Moss v. Commissioner, 74 T. C. 1239 (1980), the decedent sold all of his stock in a funeral home to his employees for promissory notes. The notes provided that: "Unless sooner paid, all sums, whether principal or interest, shall be deemed cancelled and extinguished as though paid upon the death of J. P. Moss." At the time of the sale, the decedent was in average physical and mental condition. He died two years later from a condition that had not been diagnosed when the notes were executed.

It is important to note that Moss is purely an estate tax case. It is not an income tax decision.

The taxpayer and the Service agreed that the transaction was a bona-fide sale for adequate and full consideration. The Court noted that the cancellation provision was "part of the bargained for consideration provided by decedent for the purchase price of the stock." They contrasted the SCINs with cancellation by will because "all interests that the decedent had in the notes lapsed at his death…. Since there is no interest remaining in the decedent at his death…the notes were not includible in his gross estate."

d. Planning the SCIN. It is vitally important that a SCIN be planned, drafted and administered as if it were an arms' length deal between unrelated parties.

(1) The Wrong Way. In Musgrove v. U. S., 33 F. Cl. 657 (F. Cl. 1995), Father lent $300,000 to Son. The note provided that it would be "forgiven" at Father’s death. Son did not know when or if he could repay the money. There was no mention of, or demand for, the "loan." Son was the sole beneficiary of Father’s estate. Father had been seriously ill for two years prior to the "loan" and died one month after the note was signed. The Court held that the transfer was a gift. This is an extreme example of an almost fraudulent transaction that was held to be a disguised gift. The repayment schedule, interest rate, security and other aspects of the contract should mirror "commercial reality."

(2)  The Right Way. To the contrary, in Wilson v. Commissioner, 64 T. C. M. 583 (1992), the Court held that a valid SCIN had been created. Mrs. Wilson was in good health when she sold her house to her children in return for a secured note which provided for repayment either after demand or in fifteen years. Interest was added to principal annually. The Court stated that the intention had been for the children to sell their house and pay the note with the proceeds.

In another taxpayer victory, Mr. Costanza owned investment  real estate which was appraised for $830,000 in 1991. The next year, Mr. Costanza decided to return to his native Italy and sell the properties to his son, Michael. The sale was for the appraised value and Michael’s obligation was secured by a mortgage payable over eleven years. The note would be cancelled upon Mr. Constanza’s death.

Mr. Constanza’s physician testified that he had a life expectancy of between five and thirteen years. He died unexpectedly seven months after the sale.

The Tax Court held that the transaction was not a bona fide sale, primarily because Michael had paid the first three installments with belated checks. There was evidence, however, that Mr. Constanza agreed to quarterly payments. Constanza v. Comm’r., TC Memo 2001-128.

The Sixth Circuit reversed the Tax Court on the "bona fides" issue. The Court stated that "there was no evidence that either party presumed that Mr. Constanza would die within a short time. He died from unexpected complications of surgery. "There existed at the time of the transaction a real expectation of repayment and intent to enforce the … indebtedness. The appellate court found that the Tax Court was "clearly erroneous in finding that the SCIN was not a bona fide transaction. No. 01-2207, 6 C. A., February 19, 2003. 2003 Fed. App. 0055P (Electronic).

(3) Don’t be a Hog. Musgrove and Constanza are similar to the "bad facts/good facts" FLP cases. See, e. g. : Est. of Thompson v. Comm’r., T. C. Memo 2002-246 ;Est. of Harper v. Comm’r., T. C. Memo 2002-121; Reichert v. Comm’r., 114 T. C. 144 (2000) and Est. of Schauerhamer, T. C. Memo 1997-242. The government tried to argue that, if Mr. Constanza didn’t believe that he would not survive to the end of the note term, he wouldn’t of have done a SCIN. This argument, in the court’s words, "questions the validity of any SCIN, an argument that the tax court has long since rejected.

(4) DIR. Jarrod Jablonski, of Global Undersea Explorers (www.gue.com) coined the term "do it right" and the acronym "DIR" to describe his style of scuba diving. Because SCINs FLPs and similar transactions are subject to intense scrutiny by the government, the Constanzas were "DIR divers." They had a fair market value appraisal. The sale was planned, documented and carried out as a commercial transaction. Mr. Constanza, althought he had a heart condition, was not looking directly into the mortality mirror.

e. When a SCIN makes sense. If the founder is "sicker than his age" but not expected to die in the near future, a SCIN can be an excellent method of business succession planning. See Regs. §20. 7520-3(b)(3).

f. No Retained Interests. The sale should be a complete break with the business. The more that the seller "keeps his hand in," the more it looks less like a sale and more like a transfer with retained interest. The seller should not retain any economic benefits from the business which a "stranger" in a similar situation would not have.

g. Treatment of Gain.

(1) Background. Under §453B(f)(1), a "disposition" occurs if an installment obligation is cancelled or otherwise becomes unenforceable. §453B(c) provides that "except as provided in §691, the disposition rules of §453B do not apply to the transmission of installment obligations at death." The Service has held that this provision makes the gain element in SCINS and item of Income Respect of a Decedent. Rev. Rul. 86-72, 1986-1 C. B. 253.

(2)The Frane Case.  In Frane v. Commissioner, 98 T. C. 341 (1992) aff’d. in part and rev’d., in part, 998 F. 2d 457 (8 CA 1993), Mr. Frane, who was not in ill health, sold his business to his four children for notes which provided that, upon Mr. Frane’s death, they would be "cancelled and extinguished as though paid." NOTE: These are the same words used in the Moss case. The Service characterized the cancellation at Mr. Frane’s death as I. R. D., and as an asset includible in Mr. Frane’s gross estate. The estate took the position that there was no estate tax inclusion and no income. On the first point the Tax Court agreed with the estate.

The majority held that §453B(f) applied and treated the cancellation as if Mr. Frane had disposed of the obligation in a manner that produced gain reportable on his final 1040, not on the estate’s return.

To some extent, Mr. Frane "shot himself in the foot" because the notes provided that they were to be "cancelled and extinguished as though paid." The transaction appears more like cancellation of a note by will than a true SCIN, which reflects a premium for the risk to the seller’s estate of non-payment.

On appeal, the Court upheld the estate tax exclusion. They reversed on the income tax issue, holding that the gain was reportable on the estate’s 1041.

(3) Judge Halpren Points The Way. Arguably, there should be no recognition of income. A SCIN is different from an ordinary installment note that passes to the buyer or is "cancelled" in the seller’s Will. With a SCIN, the parties have received what they bargained for. The seller received consideration in money or money’s worth at inception.

In the dissenting opinion in Frane, Judge Halpren noted that, if the note were drafted differently, taxation of gain could possibly have been avoided. He suggested language similar to the following:

"THE PARTIES INTEND THIS TO BE A CONTINGENT PAYMENT SALE. The purchase price of the stock is variable, and will be somewhere between $0 and $141,050, depending upon how long seller lives. A condition precedent to each contingent payment is that seller be alive on the scheduled potential payment date. Consequently, if seller dies before any scheduled potential payment, the obligation to make such payment does not come into existence."

3. Private Annuity.

a. What is it? Sale for a series of unsecured payments over the seller’s presumed life expectancy.

b. Income for Ma and Pa. Can be for more than one lifetime. Useful to provide a stream of income for the founder and his wife.

c. Estate Tax Exclusion. Like a SCIN, generally no portion of the property is included in the seller’s gross estate. If the annuity is for two lives and the second annuitant is not the seller’s spouse, there will be an inclusion in the gross estate under §2039. Also, if the business is incorrectly valued, a portion of the purchase price can be considered a transfer with retained interest under §2036. Please see "Necessity for Proper Valuation" at 4a, below.

d. No Security. Unlike a SCIN, the annuitant (seller) may not retain a security interest in the business. Retention of a security interest could cause all of the gain to be recognized within one year.

e. Do Not Key Annuity to Income. The annuity payments should not "track" the income from the property. A "bootstrap acquisition" may be re-characterized as a transfer with retained life interest. See Rev. Rul. 79-94, 1979-1 C. B. 296; Lazarus v. Commissioner, 58 T. C. 854 (1972), acq. 1973-2 C. B. 2, aff’d. 513 F. 2d 824 (CA9, 1975). The Ninth Circuit decision in Ray v. U. S., 762 F. 2d. 1361 (1985) is instructive. It contains an interesting observation about the true nature of annuities: "Were this an annuity arrangement, one would expect the exhaustion of both income and principal over the lifetime of the annuitant." This is probably the largest difference between a properly structured private annuity and an installment sale or SCIN. The Court referred to its earlier decisions in LaFargue v. Commissioner, 689 F. 2d 845 (1982) and Stern v. Commissioner, 747 F. 2d 555 (1984)  in which the amount of the annuity was not calculated to bear a "mathematical relationship" to the income of the transferred asset. The annuity payments were not "simply a conduit for…income."

f. Risks.

(1) Buyer may have insufficient resources to pay the annuity, could become insolvent or acquire creditors.

(2) Seller could "live too long." If the seller keeps ticking, the buyer could take a licking.

4. Important Issues and SCINS and Private Annuities.

a. Necessity for Proper Valuation. Both a SCIN and a private annuity require that the business be properly valued. To the extent that there is a "bargain sale," the transaction may be re-characterized as a gift with retained life interest.

b. No Forgiveness. The need to structure the transaction in a commercially reasonable manner cannot be overemphasized. In Estate of Maxwell v. Commissioner, 3 F. 2d. 591 (2 C. A. 1993);the annual forgiveness of a portion of a mortgage in an amount equal to the annual exclusion demonstrated that there was never an intent to collect a debt. The Court held that a gift of the entire property was made in the first year.

In Deal v. Commissioner, 29 T. C. 730 (1958) the Court held that the transaction was tax motivated and that the entire gift took place in the year of conveyance because there was no intention to enforce the notes. Therefore, the notes were not consideration. In Haygood v. Commissioner, 42 T. C. 936 (1964), the donor conveyed property to each of her two sons, and took back a vendor’s lien (mortgage) from each son for the full value of the property. The taxpayer cancelled the first $3,000 payments the day after the execution of the deeds, and in subsequent years cancelled the other $3,000 payments. The court held that the gifts were only of $3,000 per year although a specific finding was made that the "seller" never intended to collect or enforce the notes, and that, when the notes were executed, the "purchasers" were not in a financial position to make the payments.

One should not rely on Haygood and other similar cases, such as Kelley v. Commissioner, 63 T. C. 321 (1974) too heavily. They are very "fact specific." It is far more prudent to avoid "planned forgiveness." Failure to respect not only the form, but also the substance, of a business transaction can result in a very large gift and could cause inclusion in the seller’s gross estate under Section 2036.

For White Haired People Only: Remember the old advertising slogan, LS/MFT? It’s as good today as in the forties. It might mean "Lack of Substance Means Failed Transactions."

5. Comparison of SCINS and Private Annuities.

 

	SCIN	PRIVATE ANNUITIES
Income for Seller	More geared to "bargain to buyer" than to income stream to seller	Can provide ongoing source of income for the seller and his spouse.
Security	Seller can retain mortgage or other security	No security interests allowed.
Estate Freezing	Yes	Yes
Basis	Value of obligation at inception	Generally fair market value but may be reduced if annuitantdies early or increased if he lives beyond life expectancy.
Interest Deduction	Interest deductible by buyer.	Not deductible by buyer. More expensive for buyer than SCIN
Actuarial Risk	No real actuarial risk. Impetus for SCIN may be more "donative"than economic.	Risk to buyer that seller will live too long
Taxation of Gain	Gain taxed over term of note.	Gain taxed over life expectancy

IX. "AND SOME NOT"
Following are two examples of "getting it wrong" - both driven by overactive egos.

A. Save the Business. Mess up the Family. Jim Bob was the founder of a highly successful business. Although his oldest son, Eggbert was a vice president, Jim Bob really ran the show. He insisted on leaving Eggbert 80% of the stock, with the balance going to his number two son, Jim Bob, Jr. Almost immediately upon Jim Bob’s death, Eggbert moved into his office, voted himself his father’s salary and started treating his brother like an employee. He told his mother that all "perks" would immediately stop. The business prospered. The family fell apart.

B. Try to Save the Family. Mess Up Both Business and Family. AJAX once boasted that he was worth $3.5 million. When he died, we settled his estate as insolvent. What went wrong?

AJAX, at the height of his power, was the owner of several machine tool factories. He had three houses. As the machine tool business worsened, he continued to provide employment to almost all of his workers. He continued to pay extraordinary salaries to his children.

AJAX'wife received a house worth $75,000, the maximum bankruptcy exemption in Connecticut. She is living in straitened circumstances at a time when she once believed that she would be living like the Princes in France.

Like Jim Bob, AJAX' ego got in the way. Although he knew, probably better than anyone, that he should have sold his businesses while they were still viable, he refused to do so. Perhaps he thought it would be a sign of weakness.

The first step in business succession planning is to take a good look at the business and the family. Determine whether the business should continue into the next generation or whether there are other alternatives would make both business and "family" sense. There then has to be a well thought out business succession plan. This is not a "cookie cutter" document. It is also a team effort. Consider whether a family business consultant would be helpful.

The succession plan should include a mechanism which will provide cash to the Founder and for "non-active" family members and will not be a drain on the business' resources. Family limited partnerships, SCINS, private annuities and other "leveraged" techniques may be useful.

Lastly, the plan should be reviewed periodically. Marriage, divorce, changes in health as well as economic factors could make the best thought out succession plan obsolete.

Business succession planning can be one of our most rewarding and challenging jobs. Good luck.

Additional Reading:

Ackerman, "Innovative Uses of ESOPs in Estate Planning for Business Owners," 33 U. Miami Inst. on Est. Plan., Ch. 12 (1999).

Deener and Fiore, "Kohlsaat Confirms Viability of Crummey/Cristofani Trusts," 23 ACTEC Notes 174 (1997).

Edwards, "Planning and Drafting to Avoid Sibling Rivalry: Can We Prevent What Nature Hath Ordained," 28 U. Miami Inst. on Est. Plan., Ch. 9 (1994).

Gregory and Forsberg, "Leveraged Transfers of Business Assets," Probate Notes, November, December, 2002.

Horn, "Transferring Control of Family Businesses With Discounts in Value for Lack of Control," 24 ACTEC Notes 157 (1998).

Zaritsky, Family Wealth Transfers, Warren, Gorham and Lamont, at pp 12-13 through 12-39 (SCINS and Private Annuities).