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Wealth Planning Advisory 4Q17

Two Novel Approaches To Family Business Succession Planning

In the right situation, two novel approaches are available for transitioning ownership of a family business.  They are a “profits interest” in entities such as a limited partnership (LP) or a limited liability company (LLC) that is taxed as a partnership and a corporate spinoff.

A profits interest in an LP or an LLC in exchange for services rendered by a current or future partner or member offers the following key benefits: (1) a profits interest entitles the owner to share in the future earnings and appreciation in the entity; (2) a profits interest does not result in taxable income to the recipient on the date it is granted; and (3) a profits interest can help to retain key employees. Comment:  Based on IRS regulations, a profits interest converts the recipient from a W-2 employee to a partner for tax purposes. This subjects the recipient to self-employment taxes.

The second novel planning device for the succession of ownership of a business is the corporate spinoff, which has been commonly used in corporate reorganizations. However, in light of a private letter ruling (PLR 200645010) issued by the IRS in 2006, the corporate spinoff also presents new planning possibilities for the succession of ownership of a family business.

In that regard, PLR 200645010 presented the following scenario: (1) two sons and their mother owned a corporation that operated out of two locations, and (2) the two brothers disagreed as to the vision for the business.

To rectify this disagreement, the corporation formed a subsidiary corporation and transferred the assets of one of the business locations to the subsidiary in exchange for the subsidiary’s stock.  Shortly thereafter, one of the brothers exchanged all of his stock in the corporation for stock in the subsidiary. Likewise, the mother exchanged part of her stock in the corporation for stock in the subsidiary. The end result was that one brother and the mother owned 100% of the stock in the corporation, and the other brother and the mother owned 100% of the stock in the subsidiary. After the spinoff and the exchange of stock, each brother was placed in a position to apply his vision to his business, and all of this occurred without income tax consequences.

For a corporate spinoff to avoid income tax consequences there must be a business purpose. A business purpose is a real and substantial non-federal income tax reason for the spinoff at the corporate level not the shareholder level. In PLR 200645010, the IRS found that the corporate business purpose was the elimination of conflict between the brothers, which prevented the corporation from developing a cohesive business strategy. Although a private letter ruling can only be utilized by the taxpayer requesting the ruling, it does give a good indication as to how the IRS might view situations with similar facts and circumstances.

This Planning Advisory is not intended as tax or legal advice. Also, it is not intended to offer penalty protection or to promote, market, or recommend any information contained herein. Before acting on the information in this Planning Advisory, a competent professional should be consulted.