Estate Planning Considerations
Estate planning is the personal exit strategy for a stockholder, partner or member (collectively “business owner”) to leave the business following the business owner’s incapacity or death. When a business is in its infancy, business owners tend to be focused primarily on forming and building the business and less interested in liquidating or exiting the business. Estate planning is the process of a business owner executing the necessary legal documents to grant third parties the legal authority to act on behalf of the business owner’s interest in the company so that the business owner’s investment continues to benefit an incapacitated business owner during his or her lifetime and then inures to the benefit of the business owner’s heirs following the business owner’s death. In short, the legal documents appoint who will be in charge and where the business interest will go when the business owner becomes incapacitated or passes away.

For single owner entities such as sole proprietorships, single shareholder corporations or single member limited liability companies, estate planning documents generally appoint an agent to take over the business for purposes of liquidating the business and either utilizing the proceeds for the incapacitated business owner or distributing the proceeds to the deceased business owner’s heirs. For multi-owner entities, estate planning documents appoint an agent to negotiate with the other business owners or with the company to sell an incapacitated or deceased business owner’s interest to the company or the other business owners or to continue to allow the incapacitated business owner or deceased business owner’s heirs to continue to be owners in the business.

The business owner is the one who decides who shall control and who shall enjoy his or her ownership interest in the business following the business owner’s incapacity or death. However, it is the business, through its organization documents and buy-sell agreements, which decides whether the incapacitated business owner or the heirs of a deceased business owner will: 1) be allowed to continue as business owners; or 2) be required to sell the deceased business owner’s interest to the company or to the other business owners; or 3) be relegated to the role of a mere assignee.2

In turn, a business owner must consider competing objectives when entering into business formation documents. First, a business owner should consider which would be better for the business, allowing inactive business owners (an incapacitated owner or a deceased owner’s heirs) to remain in the business or requiring the business or remaining business owners to come up with the cash to purchase an incapacitated or deceased owner’s interest. Second, a business owner should consider whether he or she would want to continue in the business with an incapacitated or deceased business partner’s volatile spouse, irresponsible children or random charitable organizations or come up with the cash necessary to purchase the incapacitated or deceased business partner’s interest. Finally, a business owner should make certain that his or her investment in the business ultimately benefits the business owner or his or her heirs.

 

Planning for Incapacity
A well conceived buy-sell agreement should address what should happen if a business owner should become incapacitated. If a business owner is expected to perform the duties of manager or of employee,

a buy-sell agreement may define incapacity broadly to include any condition which renders the business owner unable to perform his or her duties even though the business owner may be mentally competent. For example, if the business is owned by a group of dentists and each dentist is expected to generate revenue for the business, any condition which makes the dentist unable to perform his or her duties may be an “incapacity” which would trigger a sale of the dentist’s interest pursuant to the buy-sell agreement. By contrast, if the business owner is merely a passive investor, incapacity would generally be defined as a mental incapacity which renders the business owner unable to participate in a company vote, unable to receive payments, unable to negotiate a sale of the business owner’s interest in the company or unable to execute documents.

Generally, in an active business where a business owner performs managerial tasks or where the business owner is also an employee of the business, the inability to manage or work would trigger an obligation for the business owner to sell his or her ownership interest and the company to purchase his or her ownership interest. If the incapacity which triggers the obligation to sell does not involve a corresponding mental incapacity the transactions may be consummated between the company and the business owner. However, if the incapacity includes diminished mental capacity, the company may not be able to deal directly with the business owner but would instead be required to consummate the transactions with the business owner’s agent. However, the appointment of an agent to transact business on behalf of the incapacitated business owner is generally accomplished by the business owner’s personal estate planning and not by the business, and unfortunately, many business owners fail to engage in comprehensive estate planning. In turn, the business may be in the position of continuing to deal directly with the incapacitated business owner until the business owner’s agent can demonstrate that the agent has the legal authority to transact business on behalf of the incapacitated business owner. It should be presumed that the business owner has legal capacity and legal authority to act on his or her own behalf until the company is presented with the legal documents granting an agent to act on behalf of the business owner.

The definition of incapacity which triggers an agent’s authority to act is generally defined by the documents creating the agency or by state law. Business formation documents rarely address the appointment of an agent. However, some business formation documents require that an agent must be a member of the incapacitated business owner’s family or another one of the business owners in order for the incapacitated business owner to retain his or her ownership interest in the company rather than having to sell his or her interest pursuant to the buy-sell agreement.

When a business owner becomes incapacitated, there are essentially four types of agents which may be able to act on behalf of the incapacitated business owner: 1) a joint owner; 2) a court appointed conservator; 3) a power-of-attorney; 4) a Trustee.

First, if corporate stock, partnership interest or membership interest is owned jointly by two or more business owners, a joint owner would presumably have the legal authority to unilaterally transact business if the other joint owner were to become incapacitated. Closely held business interests are generally not owned jointly. However, a stock certificate or ledger, a partnership agreement or operating agreement could show joint ownership, and presumably either joint owner could act on behalf of the joint ownership interest.

Second, a court appointed conservator would be granted authority to access an incapacitated person’s assets. If an incapacitated business owner has done no estate planning or if the incapacitated business owner does not believe that he or she is incapacitated, a court appointed conservator would be required in order to strip the incapacitated business owner of his or her ability to act and to appoint a conservator as agent for the incapacitated business owner.

Third, the holder of a power-of-attorney would be able to transact business on behalf of an incapacitated business owner. A power or attorney is a written document executed by the business owner granting an agent the ability to act on behalf of the business owner.

Finally, if an incapacitated business owner owns his or her business interest in his or her revocable trust or in another business, a successor Trustee or successor officer, general partner or manager would be acting as an agent for the incapacitated business owner. Generally, when a business owner establishes a trust which is intended to own his or her business interest, the creator of the trust (“Grantor”) is also the manager of the trust (“Trustee”). When a business owner forms another business which is intended to own his or her business interest, the business owner is also the officer, general partner or manager of ownership entity.

 

Owner Agent Legal Authority
Joint Owners None Either or both joint owner

Individual None Individual (no appointed

Power of Attorney)

Individual Power of Attorney -Individual

(has appointed Power of Attorney)

 

 

Trust Trustee

-Power of attorney provided individual does not object

 

-Court appointed conservator if one is appointed takes priority over individual and power of attorney

 

Trustee (original business owner or successor Trustee)

 

Business Officer, General Partner Specified by business Manager

 

Court Appointed Conservator Conservator Conservator

 

Restrictions on Outside Agents
Some closely held businesses prohibit third party outside agents from acting on behalf ofa business owner even when the business owner becomes incapacitated. The rationale is that the business owners have chosen to go into business with each other but have not signed on to being in business with a business owner’s randomly selected agents. Such agreements would specify that during any period, temporary or permanent, the business owner is not able to act on his or her own behalf, the business owner would be treated as a mere assignee with no active role in the company. Some organizational documents would allow an agent to act provided the agent is one of the other business owners or perhaps a member of the family. For example, the Smith family owns a company known as the Smith Waterless Laundry Company, formation documents for the company may limit the recognition of a power of attorney holder or Trustee to other owners of the company or to members of the Smith family.

 

Successor Trustees
Generally, when a business owner establishes a revocable living trust which is intended to own his or her business interest, the Grantor (and sometime the Grantor’s spouse) is also the Trustee. The trust should provide a convenient mechanism for the successor Trustee to use trust assets for the benefit of the incapacitated Grantor and his or her loved ones. The trust should also provide detailed instructions regarding the manner of care that should be given to the incapacitated Grantor. Within the trust, incapacity is generally defined as a mental incapacity which results in an inability to effectively manage assets. Determination of incapacity should not necessarily require court involvement. Instead, a trust may provide that the physician regularly attending the Grantor, or two or more other physicians would be authorized to determine the Grantor’s incapacity. However, a court determination should be available at the Grantor’s option if the Grantor disagrees with the physician’s determination of the Grantor’s incompetence.

If a trust is the owner of a business interest, the incapacity provisions in the company’s buy-sell agreement and formation documents should be drafted to address the incapacity of the grantor of the trust and not

 

the incapacity of the owner of the interest (as the trust cannot become incapacitated). For example, the definition of incapacity contained in the operating agreement of a limited liability company might provide that if a Membership Interest is owned by a trust or business, the incapacity of the human being who is the grantor of the trust or the incapacity of the human being who is the officer, general partner or manager of the business shall cause the trust or business member to be deemed incapacitated.

 

Powers of Attorney
A power of attorney is a document which grants an agent the legal authority to act on behalf of the person granting the power of attorney (the “Principal”). In the context of business planning, the power of attorney would grant an agent the ability to act on behalf of a business owner. The document granting the agent the power to act defines the scope and duration of the agent’s authority. Some powers of attorney are drafted broadly in scope granting the agent the ability to do any act which the principal could legally do. Other powers of attorney limit the scope of the agent’s authority to completing a single act – negotiate a sale, sign a document, manage an asset. Even if the scope of the agency is described broadly, state law may specify that a particular activity must be specifically authorized in the document granting the power of attorney in order for a principal to grant an agent the ability to conduct that particular act. For example, state law may require a specific provision authorizing an agent to change beneficiaries on retirement accounts and life insurance. Similarly, the formation documents of a company could specify that the company will not recognize an agent’s authority to act unless the document granting an agent the authority to act on behalf of the principal specifically references acting with respect to the principal’s business interest. In addition to defining the scope of the agent’s authority, the power of attorney document should specify when the agency begins and ends. Some powers of attorney come into effect upon signing a document and remain in effect until the principal revokes the power or the principal passes away. Other powers of attorney spring into effect upon a triggering event such as the principal’s incapacity and remain in effect until the principal regains capacity or passes away.

 

Under most powers of attorney, incapacity is generally defined as a mental incapacity. Guidelines for determining incapacity are generally prescribed by the document creating the power of attorney. Usually, the document specifically states that a court determination of incompetency should not be required. In order for a power of attorney to be effective:

The document creating the power must satisfy the formalities required by the state where it will be used.
Depending on the state where the power is to be used, the document creating the power might need to be less than two or three years old.
The agent must demonstrate that a trigger event (if any is required) has occurred—that the principal is incapacitated.
The company needs to agree to recognize the agent’s authority to act for the business owner (some states allow suit against those refusing to recognize power of attorney documents).

 

Planning for Death
Methods of Transferring Ownership at Death
When someone passes away, there are essentially three ways that assets may pass from the deceased owner to someone else. In general, all three of the methods work. In establishing a comprehensive estate plan, it is important to make certain that one method for transferring assets does not undermine another. The first way to transfer assets is by what are called “nonprobate transfers.” The second method for transferring assets at death is through probate. The final way to transfer assets at death is through a revocable living trust.3 A deceased business owner’s interest in the company or proceeds from the purchase of the deceased owner’s interest in the company may pass to others by any one of these three methods.

 

Nonprobate Transfers
Nonprobate Transfers are referred to as “nonprobate transfers” because assets pass from a decedent to someone else without having to go through the court proceeding known as probate. There are essentially two types of nonprobate transfer. The first type of nonprobate transfer is a transfer which occurs following the death of a joint owner who owns the asset as “joint owner with right of survivorship.” If a business interest is owned jointly by two or more individuals “with right of survivorship,” upon the death of one joint owner, the asset becomes owned by the surviving joint owner(s). What is required to transfer ownership is to provide the company with the deceased owner’s death certificate and request that the company update its records to show that the business interest is now owned by the surviving joint owner(s). If the joint owners are married to each other, the joint ownership may be characterized as “community property” or as “tenancy by the entirety” depending on the state where the couple resides or where the company is located. The rules governing community property and tenancy by the entirety may also have a component of right of survivorship. While Utah law would allow joint ownership of business interests, most business interests are not owned jointly with right of survivorship.

The second type of nonprobate transfer occurs upon the death of an asset owner who has designated a pay-on-death beneficiary. A pay- on-death beneficiary designation is generally a contractual arrangement between an asset owner and a financial institution to transfer assets to a named beneficiary following the death of the asset owner. Pay-on-death beneficiary designations are most commonly used to transfer retirement accounts, bank accounts and life insurance proceeds following the owner’s death. In turn, if an individual has completed the necessary paperwork to designate a beneficiary to receive the asset following the asset owner’s death, upon the death of the asset owner, the financial institution would transfer the assets to the named beneficiaries. What is required to process the transfer is to deliver a death certificate to the financial institution and to complete the paperwork required by the financial institution. The Utah Nonprobate Transfer Act, the Utah Limited Liability Company Act, the Utah Corporation Act and the Utah Limited Partnership Act fail to address whether or not a business

 

interest may be transferred from the deceased business owner to named beneficiaries by pay-on-death beneficiary designation, the concept has been done and has seemed to work. The concept of freely entering into contractual arrangements appearing throughout the code sections governing business would suggest that parties could contractually agree to allow business owners to transfer company ownership at death by pay-on-death beneficiary designation.

 

Probate
Probate is a court proceeding for the purpose of transferring assets from a deceased person to his or her heirs, devisees or creditors following his or her death. A court action is required to transfer assets because it should not be easy for individuals to simply show up and take assets following someone’s death. Instead, the court would insure that the right people receive the decedent’s assets. If an individual has a Will, a written set of instructions appointing someone to be in charge of the estate (personal representative, executor or administrator) and specifying to whom assets should be distributed, the Will would generally govern the probate process. An individual who passes away with a Will is said to have died “testate.” A Will is a document which provides instructions for allocating a decedent’s estate assets upon death. However, a Will has no power over assets which do not become part of the decedent’s “probate estate.” Assets held in joint tenancy with right of survivorship and assets in which the decedent had designated a pay-on-death beneficiary will not become part of the decedent’s probate estate. A Will remains an unused document during the Will creator’s lifetime. Upon death, for the Will to work, it must be put through an administrative, court supervised procedure called “probate.” While probate horror stories persist, probate in Utah is fairly inexpensive and painless.

If an individual does not have a Will, if the Will is not probated within three years of death or if the Will fails to dispose of all of the decedent’s assets, state statutes provide default provisions for distributing assets to the decedent’s “heirs.” An individual who passes away without leaving a Will is said to have died “intestate.” The decedent’s heirs are relatives whose priority to receive assets is based on the degree of kinship

 

between the decedent and his or her relative. An unrelated person, no matter how important the person is to the decedent, will not be included as an intestate heir. Domestic partners, lifetime companions, foster children / parents, step-children, charities and pets are not intestate heirs. In order to insure that assets will pass to unrelated parties, a decedent must execute a Will, own an asset in joint tenancy with right of survivorship, sign a beneficiary designation form, or create and fund a trust.

In Utah, probate does not have to be an expensive or laborious process. If there is no contest among heirs (family members) or devisees (recipients under the Will), the probate process can be completed informally by submitting pleadings to the court without personally appearing in court. However, if there is a contest, probate can become expensive and time consuming. Furthermore, if the assets which become part of the probate estate (no joint owner with right of survivor, no pay- on-death beneficiary, no trust ownership) consist of personal property (no real estate) with a total value of less than $100,000, assets can be claimed by sworn affidavit in lieu of conducting a probate.

If a business owner owns his or her business interest in his or her individual name with no joint ownership and no pay-on-death beneficiary, the business interest will be part of his or her probate estate. If the business formation documents or buy-sell agreement provide that the business must purchase a deceased business owner’s interest or allow the decedent’s heirs to continue to own the business interest, the business must determine who has the legal authority to act on behalf of the deceased business owner. There are three documents which might be provided to the business as proof of authority to act on behalf of a deceased business owner. First, if a Will has been duly probated, the court will issue a document known as “Letters Testamentary” evidencing the authority of a personal representative to act on behalf of the deceased business owner’s estate. Second, if a probate action has been initiated for a deceased business owner who died intestate (without a Will), the court may appoint an estate administrator and issue “Letters of Administration” granting someone the authority to act on behalf of the intestate estate or the court may sign an order detailing whom should

 

receive the assets of the deceased business owner’s estate. Finally, if the total value of the probate estate is less than $100,000 (including the total value of the deceased business owner’s business interest), the business may be presented with an Affidavit of Small Estate.

 

Revocable Living Trusts
A revocable living trust is a trust created during the trust creator’s (“Grantor’s”) lifetime where the Grantor retains control over trust property and reserves the right to amend or revoke the trust. Provided the Grantor is not incapacitated, the Grantor is generally the sole beneficiary (the one entitled to enjoyment of trust property) and the sole Trustee (the trust manager). During periods of the Grantor’s incapacity, a successor Trustee manages the assets for the benefit of the Grantor and the Grantor’s dependents. Upon the Grantor’s death, the successor Trustee distributes assets according to the provisions of the Trust. If the trust is fully funded (all assets are titled in the name of the trust or the trust is named as pay on death beneficiary) the trust can usually be administered without court involvement.

Because a revocable living trust is what the internal revenue code would deem a “grantor trust,” where the income of the trust is taxed to the grantor, and the trust is treated as a “disregarded entity” for tax purposes, the trust is not required to have a separate tax identification number. The trust identification number is the Grantor’s own social security number. Also, because the Grantor is treated as an owner for tax reporting purposes, there is no need to file a fiduciary return for the trust, and all income should be reported on the Grantor’s regular 1040 return.

 

Forming a Trust
Under Utah law, a trust may be established by simply indicating that assets are to be held in a fiduciary capacity. Unlike creating a Will, establishing a trust does not require adhering to formal execution requirements. However, as a practical matter, formal execution procedures are likely to make a trust less vulnerable to later challenge. Even though the drafting and signing procedures remain loose, executing

 

a trust requires that the Grantor have testamentary capacity and that the Grantor understands what he or she is executing. However, the Grantor need not be able to articulate the purpose of every provision contained in the trust. The trust should be signed by the Grantor(s) and the initial Trustee(s). While they need not sign the trust in the presence of a Notary, it is usually a good idea. If a Grantor’s capacity to execute a trust is questionable or likely to be challenged, the Grantor may want to sign the trust in the presence of additional witnesses or video tape the signing of the trust.

 

Who Could Benefit from Establishing a
Trust?

Almost everyone could benefit from having a revocable living trust rather than relying on a will, joint tenancy, or pay on death beneficiary designations.

Trusts provide instructions for managing assets in the event of disability.
Upon death, fully funded trusts provide a convenient mechanism for paying final expenses, funeral and burial costs, and taxes prior to distribution to beneficiaries.
Beneficiaries under the trust can be allocated a specific percentage of the estate or a specific dollar amount rather than merely receiving the fluctuating balance of a particular account under joint tenancy or beneficiary designation.
Trusts can protect assets from the claims of a beneficiary’s creditors (but usually not the Grantor’s creditors).
Trusts can provide a life estate for a spouse or partner with the amount not used by the spouse or partner going to the decedent’s chosen successor beneficiaries.
Trusts are generally easier and less expensive to administer than Wills.
Finally, fully funded trusts usually avoid probate.

 

(1) Disadvantages to Creating a Trust.
There are a few disadvantages to creating a trust. First, while trusts are generally less expensive to administer than a will, trusts generally cost more to create and fund than a Will. Second, to avoid probating an estate, a trust must be fully funded. Many attorneys who assist clients with establishing trust and online resources which assist consumers with establishing a trust rely on the client/consumer to fund the trust. Most clients/consumers do not follow-through with the funding. Funding can sometimes become burdensome for those who are not familiar with the process.

 

Trust Provisions.
While trust documents generally contain a fair amount of standard boilerplate instructions, no two Grantors are alike. In fact, family profiles are becoming increasingly more unique, and many trusts need extensive customization. Nevertheless, there are some general guidelines to follow when drafting the trust.

 

Grantor Remains in Control.
During the Grantor’s lifetime, the Grantor should have complete authority to amend or revoke the trust and add or subtract assets. During periods of the Grantor’s disability and upon the Grantor’s death, the trust should not be subject to amendment or revocation.

 

Disability Provisions.
The trust should provide a convenient mechanism for the successor Trustee to use trust assets for the benefit of the incapacitated Grantor and his or her loved ones. The trust should also provide detailed instructions regarding the manner of care that should be given to the incapacitated Grantor. The trust should clearly define “incapacity,” and the definition of incapacity in the trust may differ from the definition of incapacity which appears in the business formation documents and buy-sell agreements. Incapacity should be defined as a mental incapacity which results in an inability to effectively manage assets.

 

At Death.
Following the Grantor’s death, the trust should provide for the appointment of a Successor Trustee. However, the designated Successor Trustee does not have the legal authority to act on behalf of the trust until it formally accepts its appointment in writing. If a deceased (or incapacitated) business owner owns his or her business interest in his or her trust, the business should be presented with an Affidavit (sworn statement in front of a Notary Public) from the Successor Trustee as evidence that the Successor Trustee has the authority to act on behalf of the trust. Utah law provides that third parties dealing with a Successor Trustee may rely on such Affidavit as proof of authority, and third parties would not have to examine the entire trust document. The Successor Trustee would gather trust assets, pay the final expenses of the deceased Grantor and distribute the Grantor’s Trust assets as specified in the trust.

 

Businesses Owning Business Interests
Some business owner’s elect to own business interest in another business (“Business Entity Investor”). The organization documents of the Business Entity Investor would determine who has legal authority to act on behalf of the Business Entity Investor and who owns the Business Entity Investor. If it is important that the Business Entity Investor be owned and controlled by a particular individual, the formation documents and buy-sell agreement should require that particular individual’s involvement as a condition for the Business Entity Investor to remain a business owner.

 

Exit Strategies
While leaving a business can be more difficult than forming and building the business, there are essentially four options for exiting a business whether voluntarily, due to incapacity or due to death: 1) close the doors and walk away; 2) sell the entire business; 3) sell the business interest to the business or to the other business partners; or 4) leave the business interest to heirs.

 

Close the Doors
If the sole purpose of the business is to provide employment to the business owner, when the business owner no longer wishes to remain employed or is unable to continue to perform his or her duties, perhaps the simplest approach for exiting a business is to simply close the doors and walk away. If the business has some inherit value separate and distinct from the work that was being performed by the business owner, one of the other options for exiting the business may be more favorable.

 

Sell Business
If a business has some market value separate and distinct from the work performed by the business owner, but there are no other business owners or family members who would make good candidates to continue the business, the best approach for exiting the business may be to sell the business (or its assets including good will) to unrelated third parties. Most active businesses are likely to have a greater value if the business owner is available to assist in transitioning the business to the new owner. However, in the case of the business owner’s incapacity or death, the business owner may not be available to transition the business to a new owner. Instead, a timely sale of the active business would produce the greatest purchase price. The longer the doors remain closed and consumers are directed to other businesses, the less attractive the business becomes to would-be purchasers.

 

Redemption
If a business has multiple business owners or key employees who may become business owners and the inherit value of the company is not tied to services performed by an exiting business owner, the most common exit strategy and perhaps the most lucrative exit strategy is selling the business interest to the business, to the other business owners or to key employees. When a business owner structures an exit strategy which relies upon other business owners or key employees to purchase an exiting business owner’s interest, the business owner must consider that he or she may be on the selling end of the transaction or on the purchasing end of the transaction. If both sides of the transaction are not equally appealing, the transaction will not occur.

 

Purchase Price
If the business is to be sold to remaining business owners or key employees, determining the purchase price may become complicated. If the parties are not related to one another, the parties may negotiate at arms-length to agree on a purchase price without having the transaction be deemed by the IRS as a partial gift and a partial sale. If the parties are related to one another, the purchase price should be fair market value in order to avoid having the transaction be deemed a partial gift (subject to gift/estate tax) and a partial sale.

 

Life Insurance
Many buy-sell agreements rely upon life insurance to effectuate a purchase of a deceased owner’s business interest. However, if a purchase price is tied to the random amount of life insurance which may be insuring a business owner, the value of a business owner’s interest may be over-valued or under-valued. This can present an unworkable result if the purchase of a business owner’s interest is triggered by incapacity and not by death as the proceeds from life insurance would not be available to fund the purchase unless the business owner dies.

 

Promissory Note
If there is insufficient cash available to purchase an exiting business owner’s interest, the business formation documents and/or buy-sell agreement may provide for the purchase to execute a promissory note in exchange for the exiting business owner’s interest so that the payments may be made over time.

 

Heirs as Owners
An exiting business owner may elect to leave his or her business interest directly to his or her heirs for the heirs to continue in the business. This arrangement would need to be authorized under the formation documents and buy-sell agreement of the company. Furthermore, there would need to be compatible business objectives between the remaining business owners and the heirs of the exiting business owners. If business owners who remain actively involved in the business wish to reinvest company profits back into the business and the passive investor heirs of the exiting business owners wish to receive distributions, the conflicting objectives may provide an unworkable relationship.

 

Estate Tax (Death Tax)
The federal estate tax was first imposed as a method for raising federal revenue during times of war. Eventually the estate tax became a permanent source of revenue for the federal government. The gift tax became a necessary corollary to the estate tax to prevent taxpayers from circumventing the estate tax by giving away all assets during life. Estate tax is imposed on the estate of a taxpayer following the taxpayer’s death. Estate tax is imposed on the decedent’s estate and not on the recipients of the assets. However, if the decedent has not otherwise provided a method for paying the estate tax, the size of a recipient’s gift may have to be reduced to cover the estate tax. Estate tax liability is calculated as a percentage of the combined value of all assets owned by the taxpayer at the time of death less certain deductions and exemptions.

Gift tax is imposed on a taxpayer when the taxpayer transfers property to another individual during the taxpayer’s lifetime. Gift tax is paid by the person making the gift not by the recipient of the gift. A gift is the transfer of ownership of an asset for less than its fair market value. Unless a gratuitous transfer qualifies for one of the exemptions, exclusions, or deductions, gift tax would be imposed.

A comprehensive history of gift and estate tax is beyond the scope of this chapter. In short, a decedent can gift or bequeath an unlimited amount to his or her spouse (provided the spouse is a citizen of the United States) without paying any gift or estate tax. Additionally, the first

$5,430,0004 transferred during lifetime and/or death to a non-spouse is not subject to gift or estate tax. The tax rate imposed on cumulative transfers which exceed the exemption is 40%. If someone passes away without using up his or her entire exemption, his legal spouse can claim the unused exemption. For example, if one spouse passed away in 2015 without using any of his or her $5,430,000 exemption, his or her surviving spouse could claim the deceased spouse’s unused exemption so that the surviving spouse would have an exemption of $10,860,000. In turn, most individuals do not need to engage in estate tax planning because most people would not have a taxable estate.

 

Estate Planning and Business Formation and Administration

Estate Planning Tie-in With Business Formation and Administration
A well conceived business succession plan requires coordinating the Estate Planning documents of each business owner with the organizational documents of the business. Ideally, the concurrent drafting and executing of estate planning documents and business formation documents may result in a coordinated and seamless business succession plan. More often, however, business planning and estate planning are not conducted concurrently and existing documents may need to be amended so that the business formation documents are compatible with the personal estate plan of a business owner. Typically, new business owners invest their time and resources into forming and operating a business. Only after the business has become successful do many business owners focus on personal estate planning.

Conflicting Business Objectives
The owners of some businesses may share a single common business objective such as forming a business to employ the business owners, investing in assets to provide business owners with passive income, starting a business with the goal of selling the business or developing a business that will someday be run by the business owner’s heirs. When the business objectives of the various owners of a single business differ significantly, the incapacity or death of a business owner may result in disputes and ultimately the failure of the business. If every business owner hopes that the other business owners will buy out his or her interest, there may be no purchaser for the business. If more than one business owner thinks his or her own child will someday take over the entire business, there may be dueling heirs vying for control of the business. Unfortunately, even common business objectives sometimes evolve into competing objectives. In general, divergent business objectives are best resolved by the original business owners rather than by the agents of an incapacitated or deceased business owner.

 

Conflicting Interfamilial Business Objectives
It is not uncommon for a business owner to groom one or more of his or her descendants to take over the business. It is uncommon, however, for all of the business owner’s descendants to actively operate the business following the business owner’s exit from the business. More common is the scenario where one or more children are actively involved in the business and the other children are not. How does a business owner transition the business to one or more children while treating the other children equitably? One approach has been to leave the business to those who are active in the business and leave cash (often proceeds from life insurance) or other assets to the children who are not actively involved in the business. Another approach is to leave the business equally to all of the children but structure the ownership to grant the control of the business to those who are actively involved in the business. Yet another approach is to require those children who are actively involved in the business to buy-out the children who are not involved in the business. Whether or not the children feel like they are treated fairly depends on the ongoing success of the business. If the business thrives in the hands of the children who are actively managing it, those who are not enjoying the profits of the business feel like they are treated unfairly. If the business suffers in the hands of the children, the children who are forced to continue to run the business question the fairness of their siblings being able to retire early and live on the inherited cash while they have to work for every penny they spend. Perhaps there is no ideal solution, but it is important to understand the conflicting objectives in order to establish the best plan under the circumstances.

 

Drafting Formation Documents and Buy-Sell Agreements to be Compatible with Estate Plans
The terminology used throughout the formation documents and buy-sell agreements of a company should be compatible with the identity of the various business owners. A business interest may be owned by one or more individuals, by a trust, by a business entity or by a charitable organization. Using the death of a “business owner” would seem nebulous when the business owner is a trust, entity or organization. Requiring that all officers and managers also be owners of the company may be awkward if the owners are entities and not individuals. Requiring that a shareholder also be a licensed professional makes no sense if all of the shareholders are professional corporations. If a company is intended to be owned solely by doctors, the organizational documents should contemplate that a doctor may own his or her interest in his or her own name, in the name of a revocable living trust, or in the name of a professional corporation or limited liability company. If a company is to be owned by unrelated investors, the organizational documents should contemplate that an investor may be an individual, a trust or an entity.

 

Drafting Organizational Documents
Organizational Documents of a company generally include the filings with the state(s) where the company is organized and/or conducts business and the agreements and resolutions among business owners. For sole proprietorships, organizational documents may include dba registrations. For general partnerships, organizational documents may include partnership agreements, resolutions, delegations of authority and public notices limiting authority. For limited partnerships, organizational documents may include Certificates of Limited Partnership (sometimes referred to as Articles of Limited Partnership by other jurisdictions and older Utah state filings), registration as foreign limited partnership conducting business in the state, limited partnership agreements, resolutions and delegations of authority, and powers of

 

attorney. For limited liability companies, organizational documents may include Certificates of Organization (also referred to as Articles of Organization by other jurisdictions and prior versions of the Utah Limited Liability Company Act), registration as foreign limited liability company conducting business in the state, affidavits of authority, operating agreements, resolutions and delegations of authority, and powers of attorney. For corporations, organizational documents may include Articles of Incorporation, registration as foreign corporation conducting business in the state, bylaws, agreements, resolutions and delegations of authority, and powers of attorney.

In this chapter, discussion of organizational documents may be treated as separate and distinct from buy-sell agreements. However, buy- sell provisions are sometimes contained within a partnership agreement or operating agreement rather than in a separate buy-sell agreement. If there are buy-sell provisions in the partnership agreement or operating agreement, it is important that they do not conflict with the provisions of a separate buy-sell agreement.

 

Documents Filed with the State
The formation document filed with the state of Utah2 should be drafted or modified to reflect the accurate required information. Often, business owners start a business by filling out an online form provided by the Division of Corporations and Commercial Code, and the company organizers may not yet have determined the ownership or management structure of the business. Furthermore, fledgling businesses often undergo changes in ownership and changes in management as the business gains momentum. The formation documents filed with the state should accurately reflect the current information as evidenced by the company’s other organizational documents and the company’s business operations. If an individual general partner transfers his or her general partnership interest to a corporation, the Certificate of Limited Partnership should be amended to reflect a change in general partner. If an individual member of a member managed limited liability company transfers his or her membership interest to a trust or company, it would probably make sense for the limited liability company to be a manager managed limited liability company instead of a member managed limited liability company. If the company changes its address, its registered agent or its management team, the state filing should be updated to reflect the changes. The business is put in jeopardy when business owners and/or their agents are able to utilize discordant organizational documents as fuel to challenge the integrity of the business for a business owner’s own personal agenda.

 

Agreements Among Owners
Similarly, the agreements among owners3 should be drafted, modified and updated to accurately reflect the current ownership of the company, management of the company and options available to the company and/or business owners when a business owner exits the company. The documents should contemplate that an owner may be an individual, a trust, an entity or a charity. Common terminology such as “disability,” “retirement,” “professional licensing,” “member of the family,” “spouse,” “descendant” and “death” are terms which have no meaning when applied to trusts or entities. Additionally, each individual business owner should negotiate provisions which are compatible with his or her own business succession plan. If a business owner wishes to have his or her interest pass to his or her children rather than allowing a business partner to purchase his or her interest, the agreements should facilitate that objective. If a business owner wishes to have his or her business interest purchased by the other business owners following his or her incapacity or death, the agreements should provide options and mechanisms for funding the purchase. If the company is to eventually transition from owners who are all actively running the business to some owners who active participants and other owners who are passive investors, the agreements may need to provide a mechanism for striking a balance between retaining earnings and distributing profits.

 

Evidence of Ownership
All company records should reflect the correct ownership of the various business owners’ interest. A company may elect to evidence

ownership by certificates, schedules, exhibits to agreements or other written documents. If a corporation, partnership or limited liability company is the owner of a business interest, the various state filings, agreements, tax returns and other internal company records should reflect such ownership, and the company should make certain that the proper signature block and signatory appears on all documents executed by the owner entity. If a trust is the owner of a business interest, the various state filings, agreements, tax returns and other internal company records should reflect such ownership, and the company should make certain that the Trustee signs in its capacity as Trustee.

If a business owner initially owns his or her business interest in his or her individual name and subsequently forms a trust or company to own the interest, the business owner should execute the necessary assignment of interest to transfer the ownership interest to the trust. If the formation documents of the company do not allow an individual to transfer his or her interest to a trust or business entity, the company may need to amend its formation documents to allow the transfer. The assignment of interest should be approved by the necessary percentage of other owners and by the management of the company. The company should then update its records to reflect the new ownership.

 

Buy-Sell Agreements
As previously mentioned, some partnerships and limited liability companies include buy-sell provisions in the partnership agreement or operating agreement. Some of those same companies also have a separate and distinct buy-sell agreement. Unfortunately, if the organizational documents and the separate buy-sell agreements are not created at the same time and coordinated with one another, the two documents may have conflicting provisions. In turn, the organizational documents and buy-sell agreements should be drafted and/or revised in conjunction with one another to make certain no conflicts exist. The discussion of buy-sell provisions herein would pertain to buy-sell provisions contained within partnership agreements or operating agreements as well as stand-alone buy-sell agreements.

Buy-sell agreements almost always include death as a triggering event. Some agreements also include disability, retirement, refusal

 

to work, lack of performance, termination of employment, failure to maintain licensing as triggering events. Unfortunately, buy-sell agreements are often drafted using boilerplate forms borrowed from other entities, obtained on-line, or provided by life insurance companies and many business owners sign the documents without reading them. In turn, when the buy-sell provisions are activated, the plan may not work the way that the parties had intended.

 

Purchase from Owner
The buy-sell agreement should specify that the business interest is to be purchased from the actual owner of the business interest, whether the owner is an individual, a trust or a business interest. As simplistic as this may appear, some buy-sell agreements specify that payments are to be made to the owner’s “spouse” or “family” or “estate.” Trusts and business entities don’t have spouses, families or estates.

 

Triggering Events
The trigger events should be those the parties intend to include in the document. It does not make sense for “termination of employment” to trigger the owner’s obligation to sell and the company’s obligation to purchase if any of the owners are not employees at the time the agreement is signed. Furthermore, trusts and business entities do not retire, become incapacitated or pass away. If the buy-sell provision is to be triggered by a human being who is a Grantor or Trustee of a Trust or an owner or manager of a company, the buy-sell agreement should reference the human being in such triggering events.

 

Obtain Tax Advice
The parties should obtain tax advice pertaining to the income tax consequences and the gift and estate tax consequences associated with determining the purchase price and payment terms. While unrelated parties may be able to negotiate a purchase price without associated gift and estate tax consequences, when the purchase/sale is between related parties, a purchase price other than fair market value may result in taxable gifts/bequests between the parties. Furthermore, depending how the transaction is structured, a business owner may be able to structure

 

a sale to reduce the associated income tax.

Determining Purchase Price
The purchase price is generally “fair market value.” While unrelated parties may negotiate a purchase price which may appear to deviate from fair market value, when related parties exchange assets for less than or greater than fair market value the transaction may be deemed a partial sale and a partial gift. It is presumed that unrelated parties would negotiate at arms-length, and related parties would not. The following are some of the methods business owners often employ to determine purchase price which would not necessarily reflect fair market value:

 

Fixing the purchase price at an amount equal to life insurance proceeds;
Requiring the business owners to select a purchase price annually;
Using a formula based on prior years’ profits and the selling business owner’s pro rata share;
Appraising the assets of the company and applying the selling business owner’s pro rata share;
Allowing the selling owner and purchasing owner(s) to negotiate the transaction following the triggering event.
By contrast, fair market value is generally the middle ground equal to the highest price a willing and able purchaser will pay for an asset and the lowest price a willing and able seller will accept as payment for the asset. The buy-sell agreement may require one or more appraisals by individuals or companies qualified to render an appraisal, and certainly an appraisal conducted by a qualified appraiser is more likely to withstand scrutiny. Before fair market value can be determined, it is necessary to determine the nature of the asset being valued. If a business owner owns 100% of the business, the appraisal would presumably be the market value of the company. A company’s worth may be determined by its earnings, by its good will, by its assets or by a combination of these factors.

However, if the business owner does not own the entire company, the appraisal would value the business owner’s actual interest in the company. It is the intangible ownership interest in the company that is valued rather

 

than the assets owned by the company. What would a willing and able purchaser pay for stock, partnership interest or membership interest? If the selling business owner does not own enough interest in the company to control the company, his or her interest in the company may be discounted for lack of marketability and/or lack of control. Why would someone want to purchase an interest in a company if the purchaser cannot compel a distribution from the company, force a liquidation of the company, compel a redemption of the interest, participate in management of the company or otherwise exercise some control? The answer is that for the right price, almost anything can be sold.

For example, if an appraiser determines the fair market value of 100% of a limited liability company to be $10,000,000. Logic would suggest that a 20% interest in the company would be

$2,000,000 ($10,000,000 X .20 = $2,000,000). However, if the

organizational documents of the company require a majority, super majority or unanimous vote of membership interest to do any of the following actions, a purchaser is unlikely to pay $2,000,000 for the membership interest:

 

Compel distributions from the company to its members;
Sell substantially all of the property in liquidation of the company;
Admit any substitute or additional members into the company;
Amend the operating agreement;
Change or reorganize the company into any other legal form;
Dissolve and liquidate the company;
Redeem, liquidate, purchase or otherwise acquire the membership interest of a member; or
Return the capital of a Member.
Instead, the partial ownership interest in the company would be discounted for lack of marketability and lack of control.

 

When ownership interest in a business is to be gifted or sold to an heir of the business owner, the discounted value may be viewed as

 

favorable if the transaction results in a reduction of gift tax, estate tax or income tax. However, when the ownership interest in a business is to be sold to the other business owners or to the company, the selling business owner may feel undercompensated for his or her interest. In turn, in negotiating the purchase price provisions of a buy-sell agreement, each party should consider whether discounts for lack of marketability or lack of control should be factored into the valuation.

 

Funding the Buy-Sell Agreement
The parties should develop a strategy for funding the buy-sell agreement. The most obvious source of funding for purchasing a decedent’s business interest is life insurance. However, the ownership of the policy and the pay-on-death beneficiary of the policy should be structured so that the sale may be consummated utilizing the proceeds of the insurance. If the business or a surviving business owner is expected to purchase a deceased business owner’s interest using life insurance proceeds insuring the deceased business owner, the business or the surviving business owner must be paid the insurance proceeds. It is not helpful to effectuate the sale of the business interest if a life insurance policy is owned by the deceased business owner and payable to the deceased business owner’s estate, spouse or revocable trust. If the business owner’s estate, spouse or trust owns both the business interest and the life insurance proceeds, the purchaser would need to find other assets to purchase the business interest. Additionally, the identity of the owner and pay-on-death beneficiary may have income tax and/or gift and estate tax consequences to consider.

If the buy-sell triggering event is something other than death or if life insurance proceeds would be insufficient to purchase all of the exiting business owner’s interest, the purchaser may have to use its own capital, obtain third party loans or offer a promissory note in exchange for the existing business owner’s interest. The buy-sell agreement should provide flexibility to allow the purchasers the ability to thrive in the business but also provide full compensation to the exiting business owner.

 

Failure to Purchase Ownership Interest
A buy-sell agreement may allow for or even contemplate that following a triggering event, a business owner or his or her assigns may continue to own interest in the company. The organizational documents may allow the business owner’s interest to retain its status as a full- fledge owner or the organizational documents may allow or require the ownership interest to be converted to the interest of a mere “assignee.” In negotiating the buy-sell agreement, a business owner should understand that following a triggering event, a trusted business partner may become an adversary. In turn, if a business owner or his or her heirs is unlikely to remain in a controlling position in the company following a triggering event, the business owner may wish to include provisions in the buy- sell agreement to contractually require the company or other business owner to purchase the exiting business owner’s interest, and insure that the company or other business owners have a mechanism for purchasing the interest—use of insurance, use of capital, use of company profits. If it is unlikely or unrealistic that the company or other business owners will be able to purchase the interest, the wisest course of action may be to require that the business be sold to third parties. Unfortunately, it is not uncommon for business owners to lack a realistic exit strategy and simply hope for the best. Perhaps the business will someday be fat with cash. Perhaps that key employee will come around. Perhaps one of the next generation will take an interest in the business and take it to new heights.

 

Keep It Current
It is easy to focus on the business of operating the business and disregard the organizational structure of the business. It is not uncommon for organizational documents and buy-sell agreements to become out dated and antiquated. Best practices would require visiting the organizational structure and buy-sell agreements on an annual basis to:

 

Update organizational documents and buy-sell agreements to reflect change of owner (existing owners, assignments to trust, assignments to business entities, admitting new owners);

 

Update lists of owners, officers and mangers to reflect correct and current: name, address, telephone number, e-mail address and tax identification numbers;
Make certain the company continues to be registered with the state(s) where the business is organized and/or where the company conducts business;
Make certain that the company and the company principals remain adequately insured;
Make certain that those who are expected to purchase the business interest of exiting business owners following a triggering event have the desire and the financial ability to purchase the interest;
Make certain that address changes are provided to state agencies, county recorders, venders and tax preparers;
Consult with attorney and/or accountant to determine whether changes state law or changes tax laws warrant revising the organizational documents or business structure; and
Determine whether a sale of the business should be pursued rather than attempting to transition the business.