Thursday, November 19, 2009

Federal Estate Tax Developments

It is being reported that Democrats on the House Ways and Means Committee are proposing a one-year extension of the existing Federal Estate Tax levels, which would result in a $3.5 million per person exemption in 2010, rather than a one-year repeal of the Federal Estate Tax that is currently scheduled to take effect come January 1.

The plan is to apparently put the stop-gap extension in place during 2010 while a more significant tax code overhaul -- including a more permanent solution to the estate tax issue -- is taken-up by Congress. It is expected that the estate tax extension bill will be brought to the floor of the House after Thanksgiving.

Most estate planning practitioners had anticipated that 2009 would have seen a significant tax code revision including modification (but not repeal) of the existing estate tax legislation, but the health care reform debate has put this issue on the back-burner.

Why Good Documents Alone are Never Enough

I recently met with three brothers whose mother died this past spring. Their father had died in 2002. In 2000, their parents – who I’ll call Robert and Sandy Jones -- had completed an estate plan that included a joint revocable living trust. Most of their assets – which were comprised primarily of residential and commercial property worth approximately $1.25 million in 2000, plus a brokerage account worth about $150,000 – were “funded” to the trust by retitling the assets in the name of the revocable trust.

One can only assume what the Jones’ goals were, but experience tells me that there were probably two objectives:
probate avoidance and estate tax protection. In the end, neither objective was satisfied.

The first critical omission was the failure to properly apportion the assets funded into the joint trust between Mr. and Mrs. Jones. While joint revocable trusts are certainly valid in New York, to be fully effective the funded assets most be specifically allocated between the spouses. This is done by dividing the previously jointly-owned assets equally between the husband and the wife, and specifically identifying each spouse’s assets contributed to the trust on schedules appended to the trust. In this particular case, the schedules that were supposed to identify each spouse’s “portion” of trust assets were left blank.

When Mr. Jones died in 2002, Mrs. Jones probably assumed that since the trust already owned all the assets, there was nothing for her to do. She probably believed that her estate planning was a success, as she was able to avoid having to probate Mr. Jones’ estate since he owned no assets in his name alone. And, since the joint trust provided that upon her death, the trust assets would pass equally among the three sons as she desired, her estate planning was “done”.

Unfortunately, the absence of continued professional involvement with Mrs. Jones’ planning led to unintended results. Under the terms of the joint trust, upon Mr. Jones’ death “his” share of the trust assets was supposed to be funded into a “Family Trust” for Mrs. Jones’ benefit. Assuming a total estate value of $1.4 million in 2002, approximately $700,000 of assets – comprising one-half the interests in the real estate, plus one-half the assets in the brokerage account – should have been retitled in the name of the “Robert Jones Family Trust.” Mrs. Jones and her sons were to have been the Trustees of the Family Trust.

Between Mr. Jones’ death in 2002 and Mrs. Jones’ death in early 2009, Mrs. Jones acquired additional assets, including a vacation home in Florida. The newly acquired assets were titled in Mrs. Jones’ name alone, rather than to her “survivor’s trust” portion of the revocable trust. By the time of her death, her total estate – both the trust assets and the assets in her own name – were worth $1.8 million.

Since Mrs. Jones owned assets in her own name, the Jones’ three sons had to commence a probate proceeding in Orange County Surrogate Court to obtain “Letters Testamentary” that provided them with administrative control over Mrs. Jones’ investment and bank accounts, and most of the probate assets. However, because Mrs. Jones owned the Florida home in her name alone, there will need to be an “ancillary” probate proceeding in Florida, necessitating the hiring of a Florida attorney, and additional legal expense.

I had the sad duty of informing the Jones’ sons that, because their father’s Family Trust had not been funded at the time of his death in 2002, Mr. Jones’ estate exemption on the one-half of the trust assets that should have been allocated to the Family Trust was forfeited. Accordingly, the entire $1.8 million of assets owned by both the trust and in Mrs. Jones’ name at the time of her death are includable in Mrs. Jones’ taxable estate. Since New York’s estate tax exemption is capped at $1 million, the “extra” $800,000 that would otherwise have been owned in the Family Trust is fully taxable, resulting in a New York State estate tax obligation of approximately $85,200.

The moral of the story? Simply having good estate planning documents is not enough. Your estate planning must be regularly maintained and monitored to assure that all your goals can be satisfied both during your lifetime and after your death.

Sunday, November 1, 2009

Buy-Sell Agreements for Closely Held Businesses: Disability and Retirement

In a recent post I described why closely-held business owners need a “buy-sell” agreement to provide for the orderly disposition of a business owner’s interest in the business upon his or her death. Absent a buy-sell agreement, a deceased business owner’s interest in the business might well end up passing to a surviving spouse or children who have no involvement in the business. Bringing in “outsiders” to participate in an operating business is almost always a recipe for disaster.

While most of the focus in drafting a buy-sell agreement tends to revolve around the “death” issue, it is equally important that the agreement take into account other critical life events such as disability, retirement and sales of business interests to third parties.

According to the National Underwriter, a 42-year old is four times as likely to become seriously disabled then they will die during their working years. Most business owners I know work long hours, and if a closely held business were to lose the services of one of its key players for any significant period of time, the business’s operations would be severely hampered. The owners of a closely-held company should ensure that disability coverage is in place covering each of the owners. Such insurance might provide, at minimum, that income “lost” because of the absence of an owner due to disability is available to business to cover overhead. The firm’s buy-sell agreement can provide that the non-disabled owners would have the option to purchase the interest of a permanently disabled owner, and disability insurance can be obtained to help fund the purchase of those interests. Even if disability insurance has not been obtained, the cash value of any life insurance on the life of the disabled owner may be used to fund the buy-out. None of these options are possible, however, unless the buy-sell agreement has been drafted to include specific disability buy-out provisions.

It is also critical that in drafting the agreement the business owners address the common situation where an owner retires or otherwise leaves the business. I have seen many agreements incorporate a loosely based definition of “retirement” that essentially allows a business owner to walk away at any time, and requires the remaining owner or owners to immediately purchase the departed owner’s interest. Not only might the remaining owners have to come out of pocket with significant amounts of cash – or be burdened with large promissory note payments if the agreement provides for installment payments – but they must do so at a time when the business has lost the services of a key person. Properly counseled, very few business owners would opt for such a result.

One solution might be to permit a “retirement” only if an owner reaches certain milestones (for example, attaining the age of 62 with a minimum of 20-years service). The buy-sell agreement might specify that an owner who departs the business prior to the stated retirement milestones might have no ability to sell his interests to the other owners or to any third parties. Or, the agreement could specify that the remaining owners have the option to buy-out the departing owner, but are not obligated to do so if the economics do not make sense. Language can be included that provides that an owner who leaves prior to the “permitted” retirement date would not share in the appreciation of the business if it is sold to a third party at some future date, and might in fact be required to take less than the fair market value of their interest (valued as of the date of their departure) if the business’s value subsequently declines. This mechanism is designed to protect the remaining owners if the value of the business suffers as a result of the lost services and good will attributable to the departed owner.

Another important consideration in buy-sell planning is determining when, if at all, that an owner can sell his interest to someone other than another current owner. Owners in most closely-held business wish to restrict any sales to third parties except if the remaining owners unanimously agree to such a sale. While such restrictions impair the liquidity of an owner’s interest, they also ensure that all owners will be “partners” only with those persons with whom they are comfortable working.

The buy-sell agreement should also include address the concepts known as “tag along” and “drag along” rights. “Tag along” rights protect minority owners in circumstances were the majority owners contract to sell the majority interests to any third party. A tag along provision might provide that the majority owners can only sell their interests to third parties if minority owners are afforded the same sale rights and at the same sale price per share. Under a “drag along” provision, if the requisite percentage of ownership interests required under the buy-sell agreement vote to sell the entire company or its stock to a third party, then owners of the minority interests would be obligated to participate in the sale.

Buy-sell planning presents many unique challenges and opportunities. Successful planning requires that business owners commit the requisite time and resources necessary to engage in thorough discussions with their professional advisers. A well-designed buy-sell agreement can ensure that the business will survive beyond the current ownership group. But if a business has a poorly designed agreement – or like too many businesses, no agreement at all – then that business’s long-term survival will be questionable at best.