Estate Planning for the Business Owner Series, Part 4: Document the Transfer


Once a business owner has an understanding of the value of the business and the tax and cash flow impacts of the transfer, the next step is to document the transfer. This may be done by the client’s separate business legal counsel or, if there isn’t one, the estate planner can usually handle the appropriate documentation. It is important to remember that if the client’s goal is to sell to a third party, all of these documents will be reviewed and scrutinized during due diligence, so it is best practice to have them all complete and organized so there is no question about the ownership of the business and the effectiveness of any transfer.

First, all of the existing documents will need to be reviewed. For example, there may be transfer restrictions in old bylaws that will need to be amended, or there may be an existing operating agreement or shareholder agreement requiring that certain consents be obtained from the manager or board in order to transfer equity. If there are lenders or other third-party agreements in place, those should also be reviewed to ensure there are no other separate consents that need to be obtained. Those agreements may also give guidance as to how the transfer must be structured. For example, a gift to a trust for the benefit of a spouse or family members of a current equity owner may be allowed, but only if the Trustee is an individual that is qualified under the bylaws or operating agreement. The existing agreements may provide guidance as to the ultimate structure of the transfer depending on the relationship between the parties.

Once it is clear that the existing documents allow the transfer, and all relevant consents are received, the next step is to assign the equity. In most instances, this can be done via a simple assignment or assignment separate from certificate. If the entity’s equity is certificated, new stock/unit certificates will need to be issued and old ones cancelled.

New members or shareholders may need to be approved by the manager or via board resolution, which require document preparation too. Similarly, if there is an existing operating or shareholder agreement in place, the transferee will, generally, need to execute a joinder to be bound by the terms of that agreement as a condition to accept the transfer. That agreement may also need to be amended to reflect the new owner as a party, including the schedule of owners typically attached to those agreements.

If there is no operating or shareholder agreement in place, whether because the business owner was the sole owner or an agreement was not put in place when prior transfers were made, the transfer should serve as the appropriate time to put such a document in place. One of the key provisions that should be included once there are multiple owners is buy-sell provisions.

Buy-sell provisions are intended to keep ownership away from undesirable owners, provide a fair process for valuing stock for transfers among owners, create a smooth transition of control and ownership, assure that there is a “market” for the equity through the other owners, provide a mechanism for funding the purchase through life insurance or defined terms, and potentially establish a value for estate tax purposes. Buy-sell provisions often include certain triggering events where an individual must offer his or her equity for sale to the other owners or back to the business. These generally include: death of an owner, termination (depending on the owner and whether for cause), divorce, bankruptcy, or disability. If a triggering event occurs, the agreement then lays out the valuation process for the applicable interest, which may be structured as a redemption, a cross-purchase, or a combination/hybrid of the two approaches. In the event of the death of an owner of a family business, the Internal Revenue Service (“IRS”) provides additional requirements for the valuation method in an agreement to be respected for estate tax purposes.

Finally, one additional point to note, in gifting the equity in the entity, since the value of the underlying equity either may not be determined with finality by the valuation expert at the time of the transfer, and still remains subject to challenge by the IRS, one recommendation would be to use a formula valuation clause in the assigning document (commonly known as a “Wandry” formula). For example, instead of gifting 20 percent of the equity, a client can give the lesser in value as finally determined for federal gift tax purposes of 20 percent of the equity or the maximum amount the client can gift without incurring any transfer tax (i.e., an amount up to the client’s remaining gift tax exemption). The maximum amount can also be a different number (i.e., two million dollars of value). By using a formula valuation, the client can prevent over-gifting if the IRS challenges the value and is successful in having a higher valuation apply. For example, if a client has $10 million of exemption remaining and makes a straight assignment of what the client thinks is $10 million of equity, and the IRS successfully challenges the value and that equity assigned is actually valued at $20 million, the client will owe gift tax on the $10 million of equity above the client’s remaining exemption (four million dollars of tax!). With a formula valuation assignment limiting the equity assignment up to the client’s remaining federal gift tax exemption and a successful IRS challenge, the client will have then only gifted 50 percent of the equity that was initially transferred, resulting in no tax due to the IRS. These types of assignments will likely have to be drafted by the estate planner. In addition, it is critically important that the Federal Gift Tax Return reporting the gift include consistent language so that the gift is always stated in terms of the formula. Even if accountants are preparing the client’s gift tax return, it is very important for the estate planner to review the return before it is filed.

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