Closely-held businesses come in all shapes and sizes.  Some owners own 100% of their businesses.  Some have partners. Some have children in the business.  Some do not.  A common question that a client asks the business and tax planning professional is, “Should I own my business in a trust?”  There are, of course, many nuances to this question, and every situation is different.  Nonetheless, below are some important considerations in evaluating the benefits of having a trust own a portion of the equity in a business.

Control.  Business succession planning involves both management succession – that is, who runs the business and ownership succession – that is, who owns the business.  Sometimes, transferring a portion of the equity of the business to a trust ensures that the family continues to own the business (even if non-family members run the business).  We often will recapitalize a company so that there is a voting interest which controls all business decisions, and a non-voting interest which represents the economic interest in the business.  An owner may transfer the non-voting interest to a trust and maintain control by keeping the voting interest in his or her name.

Cash flow to surviving spouse.  A common concern with business succession planning is providing cash flow to a surviving spouse.  Having a trust own a portion of the business can help address this.  The trustee could be the surviving spouse, either alone or with one or more co-trustees.  The trustees can use their discretion to receive cash flow from the business and make trust distributions for the surviving spouse’s support.

Equalization among children, or reward to child in the business.  A trust can provide for the benefit of one or more children.  If cash flow from the business flows into the trust, the trustees then can use their discretion to make distributions to (1) a child who is in the business, or (2) a group of children who are not in the business.  A trust can provide the client with great flexibility to address the family goals in this context.

Estate tax.  The business owner may make a gift of a non-voting interest in the business to a trust for the benefit of the family.  The gift removes the value of the asset from the business owner’s taxable estate, and may save estate taxes in the future upon the business owner’s death.  All future appreciation in the value of the business may be removed from the business owner’s estate.  In addition, the value of the gift may be discounted due to lack of control and lack of marketability.

Because of a concern that the federal estate tax exemption – currently $11.7 million per person – will be reduced in 2026 or earlier, many business owners with potential estate tax issues should consider this type of gift prior to a change in the law.

Asset protection.  Assets gifted to a trust are no longer owned by the business owner, and may be protected from his or her potential creditors.  Assets left to children in trust rather than outright may be protected from the child’s potential creditors.  In this way, trust ownership can provide a substantial benefit to the family.

Income tax.  A trust can be used as an income tax planning tool.  If, for example, trust income is distributed among three children, the income may be taxed at lower income tax rates.  Trusts also may be structured in a way that produces state income tax savings.

People fail to plan all the time.  One of the latest examples is Tony Hsieh, the longtime CEO of Zappos, who died unexpectedly in November, 2020, at age 46.  Mr. Hsieh had a large estate, including a number of business interests and over 100 properties in Las Vegas.  He had no estate planning documents in place at his death, nor any business succession planning.  It is likely that the estate will owe substantial estate taxes and there will be litigation for years to come.

Business owners should be sure that their business planning, including business structure, succession and tax planning, is up-to-date and reflects their wishes.  Every family business is unique, but having a portion of a business owned in a trust for the family’s benefit often has a number of advantages.

 

In the 2017 Tax Act, Congress adopted Code §1061, a provision which affects non-corporate holders of certain carried interests, which the new law refers to as applicable partnership interests (“APIs”).   Under the new law, certain long-term capital gains (“LTCGs”) relating to APIs may be recharacterized as short-term capital gains (“STCGs”) unless the gains are from assets held for more than three years.  LTCGs are taxed at a favorable 20% rate whereas STCGs are taxed at ordinary income rates.  In January 2021, the IRS released final regulations relating to these rules that retain the structure of proposed regulations published last year, but with some significant changes.

An API is any interest in a partnership transferred to a taxpayer in connection with the taxpayer (or any related person) performing substantial services in an applicable trade or business (“ATB”) for the partnership.  An ATB is any activity conducted on a regular, continuous, and substantial basis that consists of (1) raising capital and (2) purchasing investment assets (e.g., stocks, bonds) or real estate. If these rules apply, gain from a partnership’s sale of stock or other capital assets allocated to a holder of an API only gets LTCG treatment if the stock or asset was held for more than three years.

The final regulations retain the rule that recharacterization only applies to a sale of a capital asset (such as stock) and not to other types of income that is taxed at favorable capital gains rates.   Such partner’s share of qualified dividend income and gain from sale of business property (so-called Section 1231 assets), which covers rental real estate, realized by the partnership will obtain LTCG treatment without limitation.

These rules also do not apply to an API that is classified as a capital interest, which requires that the partner contributed cash or other property for such interest commensurate with its value.  Under the proposed regulations, the capital interest exception only applied if the interest is determined in the “same manner” as interests held by non-service partners.  The final regulations relaxed that rule by only requiring that allocation and distribution rights for such interest be determined in a “similar manner” to interests held by non-service partners who have made significant aggregate capital contributions.

The proposed regulations provided that the capital interest exception will not apply to any interest acquired with a loan from the partnership, a partner or a related person or a loan guaranteed by any such person.  In a taxpayer favorable change, the final regulations provide that an interest may be a capital interest even if funded by a loan from another partner (or any related person other than the partnership), provided that (1) the loan is fully recourse to the individual, (2) the individual has no right to reimbursement from any other person, and (3) the loan is not guaranteed by any other person.

These rules do not apply to APIs held by a corporation.  The final regulations retain the rule that an S Corporation or a Passive Foreign Investment Company with respect to which a shareholder has made a qualified electing fund election are not eligible for this exception.

The proposed regulations had taken an expansive approach to a transfer of an API to related persons by requiring the recognition of income on the transfer even if no tax would otherwise be imposed.  In a taxpayer favorable change, the final regulations eliminate that acceleration of income approach.  The related party rules only will affect the character of income otherwise recognized on a taxable transfer to a related person.

As a result, a non-taxable transfer to a related person (such as by gift) will not result in recognition of income.  A sale to a grantor trust that is not recognized for tax purposes will also continue to be non-taxable.  By contrast, capital gain recognized on a taxable sale to a related person may result in STCG.

Any person holding a carried interest needs to keep track of these new rules in order to ensure they can obtain LTCG treatment to the fullest extent possible.  Partnerships issuing such interests also need to keep track of these rules to ensure proper reporting to affected holders.  Lastly, the 117th Congress will be looking for ways to fund the large cost of pandemic relief.  Taxing the grant of a carried interest that has been the focus of prior legislative proposals may be one item on their list of possible revenue raisers.

Trust and estate planners are still catching their breath from the 2020 year-end and dealing with the wave of gifting transactions that many clients completed.  It seems the ink is not dry on those December transactions and we have to pivot and focus on getting gift tax returns completed.

The 2020 year-end was extremely busy due to a concern that there may be a change in the federal gift and estate tax exemption amount.  The federal exemption amount in 2021 is $11.7 million per person (for US persons), and a married couple has $23.4 million of combined exemption.  Under current law, the exemption amount returns to $5 million per person (adjusted for inflation) in 2026.  There is a concern that the Biden administration and Congress may pass legislation lowering the exemption amount earlier than 2026, and also could make changes retroactive to the beginning of this year.  In such an event, a person who made a $10 million gift in February, 2021 thinking that it was entirely within his or her gift tax exemption could turn out to have a made a taxable gift that exceeds the reduced exemption amount.

What should clients do in 2021?  Does the concern about retroactive changes to the gift and estate tax exemption amount mean that clients should do nothing or wait and see?  We think the answer to that question is no.

For a client whose wealth profile indicates for gifting, it is still good tax planning to undertake a gifting transaction.  The “use it or lose it” concept – that is, the idea that it is better to make substantial gifts that use one or both spouses’ $11.7 million exemption while it is available – continues to apply.  For example, if the federal government passes tax legislation that reduces the exemption amount and is effective when enacted or a later effective date (a scenario perhaps much more likely than retroactivity), a client who took advantage of the more generous exemption amount in 2021 should be well served.

In addition, a client can make a gift in one of several ways that will take into account a possible change in the law to reduce the exemption amount.  For example, a client may incorporate a “defined value” provision in the gift that would adjust the amount gifted to the client’s remaining exemption amount, thus protecting for this possibility.

Gifts are usually structured as gifts to trusts, which have many benefits for clients, including control, investment flexibility, asset protection, long-term family wealth planning and more.  This type of planning continues to be important in 2021.

To revitalize a state suffering from the economic and personal hardships wrought by the COVID pandemic, New Jersey Governor Murphy signed into law on Jan. 7, 2021, the New Jersey Economic Recovery Act of 2020.  The Act adopts a series of incentives to both encourage businesses to settle in New Jersey and prevent Garden State businesses from fleeing to greener pastures elsewhere.  Many of these programs will be administered by the New Jersey Economic Development Authority (“Authority”).

The new Emerge Program provides tax credits to encourage economic development, job creation and the retention of significant numbers of jobs in imminent danger of leaving the state. The program will target businesses that build, acquire or lease space in the state with plans to create or retain full-time jobs.

Eligibility is subject to a requirement that the award of tax credits, the resulting capital investment and the resulting job creation or retention will yield a net positive benefit to the state ranging from at least 200 to 400 percent, depending on the location of the requested credit amount.  The Emerge Program has minimum requirements for the necessary capital investment based on the type of project, the size of the business and the types of jobs at stake.

For start-ups, the New Jersey Innovation Evergreen Fund is created to combine state funds with private capital to support innovative new businesses. The Fund will be capitalized by auctioning up to $300 million in tax credits.  The cash will be invested in qualified venture firms for the purposes of investing in qualified businesses in New Jersey.  A qualified venture firm must invest in an early-stage or emerging growth company in exchange for an equity stake in the business.  The Authority will certify whether a firm meets such criteria and require the firm to make a matching contribution from its own funds to invest in a qualified company.

The Fund may generally invest no more than $5 million in an initial investment in a qualified venture firm that will invest in a qualified company.  A qualified company must have its principal business operations in New Jersey and intend to maintain its principal business operations in the state after receiving the investment.  The company must be in a targeted industry (such as high-tech companies) and employ fewer than 250 people at the time of the investment.

The Main Street Recovery Finance Program will provide a direct $50 million appropriation for grants, loans, loan guarantees, and technical assistance to small and micro businesses.

New Jersey also adopted its first historic property tax credit, which acts as a subsidy to cover part of the cost of rehabilitating historic properties.  These properties must be listed in the New Jersey Register of Historic Places.  Many of these properties are in New Jersey’s oldest and most distressed neighborhoods.  The new Brownfields Redevelopment Incentive Program provides tax credits to compensate developers of projects located on brownfield sites for remediation costs, which are also often in economically distressed communities.

The innovative Food Desert Relief Act provides tax credits (and in some cases, grants or loans) to incentivize businesses to establish and retain supermarkets and grocery stores in communities lacking adequate services, which are referred to as food deserts.   Bodegas, corner stores, and mid-sized retailers will be given a chance to stay afloat and expand into healthier food options.

There are numerous additional incentives in the more than 200-page Act covering a diverse set of areas (e.g., tax credits for films and offshore wind facilities).  The procedures for applying for and obtaining benefits under all these new incentives needs to be adopted by the Authority.  While these procedures may be complex to ensure the intended benefits achieve their goal, the good news is the Act will create a massive infusion of state funds to assist business and communities in a time when other sources of funding may be limited.

 


As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice.  For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.

The 2017 Tax Act made life harder on individuals living in high tax states (such as New York, New Jersey, and California) by limiting the deduction for state and local taxes (“SALT”) to $10,000.  In an attempt to circumvent this restriction, several states have adopted a new pass-through entity tax imposed on partnerships, LLCs, and S Corps, which is deductible in computing the entity’s taxable income passed through to its partners or shareholders.  The state then allows those partners or shareholders to get a credit for all or a portion of their share of this new tax against their own personal state tax liability.

With the holiday season approaching, the IRS gave affected taxpayers a gift by announcing they will issue proposed regulations allowing the pass-through entity to fully deduct this new tax even though it may be viewed as a surrogate for an impermissible SALT deduction of its owners.  Notice 2020-75.  This approach, however, offers no assistance to wage earners or self-employed individuals who pay state tax and remain subject to the SALT deduction limitation.  It also offers no assistance to business being conducted through a single member LLC.

New Jersey, Connecticut and five other states have adopted this entity tax.   In Connecticut, this tax is mandatory whereas in New Jersey and five other states (Louisiana, Maryland, Oklahoma, Rhode Island, and Wisconsin), the tax is elective, so an entity has the choice to apply it or not.  Elective treatment is beneficial since this new tax may not work to the benefit of all partners.  Without a pass-through entity tax, depending on income sourcing and nexus of the entity, non-resident partners may be able to pay less state tax on the flow through income if they live in a low or no income tax jurisdictions.  On the other hand, with the pass through entity tax election, those same non-resident partners may be unwittingly subsidizing their resident partners personal state income tax.  Each entity should model out the impact on all its partners to determine if it should elect to be subject to this new tax.

New Jersey’s pass-through entity tax is imposed at graduated rates that range from 5.675% to 10.9%, which is slightly higher than the maximum individual income tax rate of 10.75%.  Single member LLCs and sole proprietorships cannot, however, elect to pay the pass-through entity tax.

To illustrate, a New Jersey partnership has five individual partners (each having a 20% interest) and $5M of NJ taxable income.  Without this new tax, each partner has $1M of taxable income and NJ tax paid by the partner is non-deductible due to the SALT limitation.

If the partnership elects, the partnership pays $427,887.50 of this new tax, which is deductible, so the partnership only reports $4,572,112.50 of taxable income ($5M minus $427,887.50).  Each partner includes 20% of $4,572,112.50 taxable income on its tax return, which is $914,422.50, rather than $1M.  Taking into account the maximum 37% federal tax rate, this strategy can reduce the individual’s federal taxes by $31,664.  While each partner is subject to NJ tax on this income, NJ gives the partner a tax credit for 20% of the LLC’s state tax payment of $427,887.50 or $85,577.50, which can eliminate or significantly reduce added NJ tax.

Planning Tip:  Individuals using single member LLCs to conduct business could admit a second member, which makes the LLC into a tax partnership that can take advantage of this new tax.  The second member can have a small interest in the LLC (1%) so the individual still retains control and most of the cash flow from the business.  Alternatively, the individual can incorporate his or her business and elect to treat it as an S Corporation, which can also take advantage of this new tax.

Other states may look to follow the lead of these pioneering states and adopt their own pass-through entity tax.   The good news is there is now an avenue for some taxpayers to reclaim the SALT deduction through this new entity level tax.  Like many other tax changes, its use will not be simple, and it may not work to the benefit of all partners.  Any entity that has a choice to elect or not elect needs to now “crunch the numbers” to see if the new law makes sense for it and its owners.