August 12, 2004
An Estate Plan for a business owner involves more than the normal and typical estate planning considerations. Every Estate Plan should include the four basics: a Homestead Declaration, Durable Power of Attorney, Health Care Proxy and Will, however business owners must also consider the impact of potentially significant estate taxes as well as succession planning to ensure a smooth transition to heirs.
The least commonly understood estate planning document, the Homestead Declaration, is a relatively straightforward document which when filed properly with the Registry of Deeds protects the equity in one’s home in an amount up to $300,000.00. This amount is in addition to any liability coverage one might have on their homeowner’s policy and possibly an additional umbrella insurance policy. It is important to remember that a person may have only one Homestead Declaration since it must be on his or her principal residence, and this does not apply to every piece of real estate that one owns. It is also important to remember that some refinances and home equity loans subordinate or release a Homestead Declaration. Therefore, it is important to review the details of one’s mortgage to determine whether the Homestead Declaration should be re-filed after a refinancing transaction.
The Durable Power of Attorney (POA) is a document that allows a person to nominate and appoint another individual to make financial decisions in the unfortunate event of incapacity. This document terminates upon death. In most situations the POA provides for unlimited control and access to a person’s personal and financial affairs. It also allows sale of real estate, access to retirement plans and filing capacity for all necessary tax returns. It is important to nominate and appoint a person who has the business experience, ability and trustworthiness to serve, as well as the time and availability to make decisions when necessary. There should also be a backup person named in a POA to allow a contingent person to serve in the event that the principal and first named agent are both unable to serve.
The Health Care Proxy is a similar document that allows another to make decisions on behalf of the principal, this time for medical purposes. Within this document, it is important to include specific language regarding the principal’s wishes to be kept alive by machines or preference to be removed from life support if there is not a reasonable likelihood of recovery. In addition, this document should provide for specific desires such as organ donorship or wishes to include specific funeral arrangements and burial instructions. Again, the nominee should have the ability and time to make informed decisions and should also be aware of any particular issues regarding the principal for whom he or she will be making decisions. Since this document will likely be executed during an emotional time, and the designee will likely be a close family member, it is important that the designee understands and respects specific wishes, so his or her personal preferences do not interfere.
A Will becomes effective only upon the death of its creator. In essence, a Will nominates and appoints an executor to make all necessary decisions and carry out its terms upon death. The Executor’s job includes marshalling and providing a listing of all assets to be distributed as well as filing the necessary tax and probate forms in order to effectuate the distribution of the deceased individual’s property. This job should be considered very seriously, as it is normally not a benefit to serve in this capacity, but may be considered more of a responsibility and often times a liability.
Within a Will, one makes distribution of his or her assets, which may include stocks, bonds, real estate, bank accounts, and other assets, which may include closely held business stock or interest in a partnership or corporation. It is important to keep in mind that assets solely in the decedent’s name will pass through probate, and thus through the Will. Most retirement plans, including 401(k) plans and individual retirement accounts, retirement plans, and other assets that may be jointly held, will not pass through probate, but rather to the surviving joint owner or to the named beneficiary under that particular account. Therefore, it is important to pay attention to the titling of assets and possible re-titling of assets once an estate plan has been completed. If not, the documents may be properly drawn, but the effectiveness of them will be negated by the improper titling of assets which may result in the assets not passing pursuant to the terms of the Will.
A Trust is an additional document often utilized in an estate plan. Several different forms of Trusts may be utilized, the most common being a Revocable Living Trust. This provides for assets to be either distributed upon death or to be administered and held in Trust for the benefit of various beneficiaries until the time the Trust creator determines the assets should pass to the beneficiaries, which may include friends, family, and charities. Various alternatives are made in these situations. Sometimes funds are left to be distributed to children at specific ages and amounts, or possibly funds may be held in trust for the benefit of a child for his or her lifetime, with ultimate distribution made to grandchildren upon certain ages.
Within a Trust document, there may also be language specific to tax issues in order to preserve one’s available Federal and Massachusetts Estate Tax credit. Each individual has an exemption or lifetime credit available to them regarding distribution of assets upon death. The current 2004 exemption is $1,500,000.00 for Federal purposes and $850,000.00 in Massachusetts. These amounts may be left to any person other than a spouse and qualify for the exemption.
One potential trap for the unwary with regards to estate tax laws is an unlimited marital deduction between spouses. This means that anything left to a spouse is non-taxable, thus excluding the government from its share. This unlimited amount appears to be gratuitous, however, upon the second death, a minimum rate of 45% is levied. This amount is taxed on assets already taxed during one’s lifetime. Thus the government sets a trap for a married person with significant assets. Upon death of the second spouse the taxes are due in nine months.
One may wish to make use of a Trust to avoid huge tax penalties upon death of the second spouse. Rather than leaving assets to one’s spouse, thus qualifying him or her for the unlimited marital deduction, assets are left in a Trust for the benefit of the spouse, who has a right to income and a portion of the principal on an annual basis for his or her lifetime. By leaving them to an entity other than the spouse, assets do not qualify for the unlimited marital deduction, and they are then taxed in the estate of the first to die. Thus upon the second death, the assets in the Trust, hopefully with appreciation, will pass to the next generation without any estate tax liability.
When a business owner has specific assets and business real estate, it is again important to add additional language within certain documents to provide for a continuation of the business if desired. The principal may determine that the person nominated to serve for normal transactions in the POA should not be the same person who should be attending to the closely held business decisions. In this event, a separate POA may be established to provide for these business interests, which will be administered and kept separately from the normal course of business of the principals and the personal (non-business) assets.
Similarly, the selection of an Executor who will attend to the disposition of various assets, which may include the continuation of a business, throughout the administration of the estate, should also be considered. This may be an opportunity to name a corporate fiduciary or co-executors to serve under the Will in order to facilitate and administer both business and non-business assets.
Additionally, the person or entity serving as the Trustee of the Trust should also be deemed to be appropriate to handle the continuation and management of the Trust during the lifetime of the beneficiaries, and before the business is liquidated, sold or transferred to the next generation.
Whether a first, second, or successor generation of closely held business is being considered to be transferred by estate planning techniques, consideration must be given as to whether the transfer should be made during lifetime, post death or possibly a combination of both. This requires involvement of a professional accountant to attend to the income tax and corporate tax issues that must be considered to minimize the tax applied upon the transfer of the entity whether by sale, gift, or combination of both.
Another important consideration when discussing business planning is the need to assure a smooth transition of ownership in the event of an unanticipated, catastrophic event, such as an untimely death or disability of an owner. In such a case there is a critical need to have proper agreements in place to provide for a fair and equitable transition of the ownership in the business. Closely held businesses can employ buy-sell agreements between their respective owners, whether they are partners of a partnership, stockholders in a corporation, or members of a limited liability company.
Such agreements are effective planning and transition vehicles because they require the estate of the deceased or disabled owner to sell and transfer his or her ownership interest in the business to the remaining owners, while simultaneously requiring the remaining owners to purchase the interest. This agreement also provides that a fair and just consideration be paid for the ownership interest being acquired.
Funding the cost of these acquisitions under a buy-sell agreement can be provided, in the case of death, by maintaining relatively low-cost term life insurance policies on each of the business owners. Additionally, these agreements can provide that the purchase price to be paid for a deceased or disabled owner’s interest in the business can be made partially from insurance proceeds, partially from the current cash flow of the business, and/or partially by way of a promissory note, thereby minimizing the impact on the day to day operations of the business.
The resulting impact from failing to have such a transition mechanism in place can be dramatic. Consequences can include ongoing disputes about ownership, business valuation, and payment mechanisms, which can result in the initiation of costly and time-consuming litigation between the owners of the business.
The transition of a business from an older generation to a younger generation of the family requires special attention. Many corporate, tax, legal, and emotional issues need to be addressed. One of the most difficult decisions is the senior’s consideration for future financial security. The senior business owner may have also personally guaranteed a loan or lease of the business, and it is important for the succeeding business owner to know his or her liability down the road. In addition, a child may want the parent to enter into a non-competition agreement, which will guard against the parent’s future competition. Also, the parent may consider requesting a consulting agreement, which will provide financial security. Additionally, an agreement may be drawn which includes restrictions on company stock in the event that the child develops marital problems or predeceases the parent.
Various succession plans may be effectuated, and each must be reviewed on its own merits and unique situation. Some may be as simple as having the parent make a gift of the stock or partnership interest to the child, and others may be much more complex, as for example, the child may wish to have more control sooner than the parent wishes to relinquish it. In such a situation it may be advisable to include an outside Board of Directors or possibly include business managers in the strategic planning of the transition of the business to the younger generation. The business may also have an advisory board if the owners have difficulty agreeing who should be in charge of which situation or agreeing on designated levels of responsibility within the entity being transferred.
The transition of business assets upon death is complex and potentially costly. All business owners must take the time to consider the implications of their own untimely death and also establish a plan for transition of assets to family members. Although each situation is unique, the ultimate goal is usually the same among business owners. Each wants his or her business interests or assets to pass to heirs with minimal impact upon the business itself and in the least financially damaging means possible. Careful planning with professional counsel can help minimize stress in an emotional time.
Hyman G. Darling, Esquire, Chairman of Bacon & Wilson’s Estate Planning and Elder Law Department, is recognized as the area's preeminent estate planner. His expertise includes all areas of estate planning, probate and elder law. Hyman can be reached at 413-781-0560 or firstname.lastname@example.org.
Gary G. Breton, Esquire, is a member of Bacon & Wilson’s Banking and Finance Department. His major emphasis of practice includes representation of financial lending institutions, as well as both individual and business borrowers. He also represents numerous business clients in the startup, purchase and sale of businesses. Gary can be reached at 413-781-0560 or email@example.com.