With death or disability, the carefully constructed vision for a business’s future may disintegrate. Unless estate planning is done with meticulous care, the wrong people may end up running your business and assets may be unfairly distributed to the next generation.
What would happen, asks attorney Martin Shenkman, if your business partner becomes disabled and her power of attorney designates her husband, whom you never liked. That husband could now be voting half the stock in the company.
Shenkman warns business owners to keep the future in mind as they develop their estate plans, paying particular attention to four issues: assigning the power of attorney, writing the shareholder’s agreement, making detailed instructions in the will about who gets what, and setting up an insurance trust to help distribute equitably their financial legacies.
Shenkman, whose specialties are estate planning and administration as well as tax and corporate planning for closely held businesses, leads a day-long “Estate Planning Bootcamp” for the New Jersey Institute for Continuing Legal Education on Thursday, June 15, at 9 a.m., at Pines Manor in Edison. For details or to register, check www.njicle.com or call 732-214-8500.
For closely held business owners in particular, several issues require close attention as part of estate planning:
Possibility of owner becoming disabled. Because death and taxes are certain, business owners usually try to make adequate provisions for them. But what preparations must be made in case an owner becomes disabled? To prepare for this unpleasant eventuality, business owners should sign a power of attorney, a legal document designating an agent to make legal, financial, and other decisions — not including healthcare — if they are unable to do so.
The problem, says Shenkman, is that “people don’t think about disability, and it is often not addressed.” A business power of attorney should designate very specific authorities rather than rely on general language. Authority to vote stock and to pledge stock for a loan should be spelled out.
Not only should owners think carefully about who they are naming as an agent, but also about whether they want to create a separate power of attorney for family assets. If that is to be the case, the document governing family assets should indicate that the family agent is not to make decisions about business assets.
Disability planning must also ensure that a business document like the shareholder’s agreement is in synch with the power of attorney, which usually governs personal affairs. Owners should designate, for example, who will vote their shares if they are disabled, because if they do not specify a person themselves, tremendous uncertainty may result. If no one does the necessary pre-planning and coordination between business and personal documents, then a partner’s spouse may end up voting without sufficient knowledge of the business.
Potential for a business to change its structure or be sold. When business owners are deciding how to dole out assets to their heirs, they have to decide who the business will be left to and have to make provisions for any changes that may occur in the business’s status.
For example, what happens if the will specifies that the building is going to the daughter and the business to the son, but while still alive the owner borrowed money on the building to buy new equipment for the business. Who then is responsible for repaying the loan if the owner dies? In this case, the daughter would be responsible for the loan, probably leaving her very angry with her brother. “Such a common transaction can undermine everything you’re planning to do,” observes Shenkman.
And what if the business originally was organized as a sole proprietorship, which the owner bequeaths in his will to his son, but the business later changes to an LLC? Probably the son would still inherit the business. But what if the owner radically changed the structure of his business to protect it against liability — by setting up separate companies to own the real estate, the equipment, and the operating company? Do these three entities go to the son? Or what if the business was sold before the owner’s death — does the son get the cash proceeds from the sale or the real estate purchased with those proceeds?
Think about these and other scenarios and update business and estate documents as changes occur.
Implications of New Jersey’s Prudent Investor Act. This law requires the diversification of the assets of an estate or trust. Suppose 50 percent of an estate is the family business — can fiduciaries continue to hold the business or must they sell it off to diversify the assets? If the will is silent about what will happen, and as a result, everything goes into a trust for the son and daughter, then the trustee may be obligated to sell the business.
To guard against this eventuality, both the will and the trust that is part of the will should give the trustee the right to hold the stock as long as family members continue to work in the business.
Setting up an insurance trust. Life insurance can perform two important functions for business owners who are planning an estate. First, it can be used by heirs to pay off the estate tax, and, second, it can help transfer the business equitably to the next generation, so that if one child gets the business, other children can get the proceeds from the insurance.
By setting up a trust, that life insurance will not be subject to estate tax when the parent dies. For owners of S corporations, Shenkman advises seeing a tax advisor for the special provisions necessary in any trust as well as in your will.
Besides seminars like the ICLE event, which he does as a service for his colleagues, Shenkman has written 34 books on tax and estate-planning topics, and he has a website called laweasy.com with free documents and advice (this is in addition to his firm’s website, www.shenkmanlaw.com).
Shenkman received his bachelor’s degree in economics and finance from the University of Pennsylvania’s Wharton School in 1977, an MBA in economics and finance from the University of Michigan in Ann Arbor in 1981, a CPA designation, and a law degree from Fordham University School of Law in 1985. He started his law firm in 1989.
A native of Detroit, with parents who were business owners, Shenkman feels strongly about careful estate planning. “The key lesson,” he says, “is that there are some very special things that, as a business owner, you need to address in estate planning documents, and if you haven’t, it’s not going to work out the way you wanted it to.”
For estates of New Jersey residents dying on or after January 1, 2002, the New Jersey Estate Tax (“NJET”) can come as an unwelcome surprise. Since then, the NJET has been “decoupled” from the Federal Estate Tax (“FET”), which means that estates previously exempt from all death taxes are exempt no longer. The reason is simple: the NJET is payable if the decedent’s taxable estate exceeds $675,000, no matter what year the death occurs, whereas the FET is payable only if the taxable estate exceeds the federally exempt amount, which has been increasing for several years and is currently at $2 million per person.
A simple example will illustrate the point: Mr. Smith dies in 2006 with a taxable estate of $1.5 million. Since this amount is less than the FET exemption amount of $2 million, the estate is not subject to FET. But the estate’s value is well in excess of the NJET exempt amount of $675,000, so a NJET in the amount of $64,400 is due.
Most of the estate planning during the years prior to decoupling revolved around how to avoid or minimize the FET; since then, however, the emphasis has shifted, of necessity, to planning for the impact of both federal and New Jersey taxes. One way to avoid the NJET (but not the FET) is to take up residence in a state which is constitutionally prohibited from decoupling (Florida and Arizona are two of the handful of states that fall into this category).
Even for those who plan to remain in New Jersey, there is hope. By utilizing one or more of the techniques described below, a taxpayer can mitigate the impact of the NJET. Suppose, for example, that a single person has $1 million of assets. If he or she dies owning them, the NJET would be $33,200. However, if pre-mortem gifts totaling $325,000 were made, the NJET would be avoided, since the base for computing the tax generally does not include such lifetime transfers. These lifetime gifts can be made in amounts up to $1 million (the FET lifetime ceiling). The downside to making this type of transfer is that the basis of the gifted property is carried over from the donor, so that a subsequent sale could trigger an income tax. To avoid this outcome, cash and cash equivalents could be selected for transfer.
Another way of depleting the taxable estate is to make “Annual Exclusion” gifts (currently up to $12,000 per year per donee; $24,000 with “gift-splitting”) on a continuing basis. Over time, the value of these transfers (including post-transfer appreciation) can be considerable.
Finally, lifetime deductible gifts, such as transfers to charitable and like organizations, will reduce both the federal and New Jersey tax base on a dollar for dollar basis. To the same effect, the creation of an Irrevocable Life Insurance Trust would reduce the federal and New Jersey taxable estates on a dollar for dollar basis, to the extent of the face value of the policies used to fund the trust.
Joseph M. Jacobs, a trusts and estates attorney, has offices at 5 Independence Way, Suite 300, Princeton. 609-514-5137.