Business Succession Problems

By By: Edward H. Trompke

A recent tax court decision in a Texas case points out the continuing problems that arise in business succession planning.

The tax court found that approximately 1.6 million dollars worth of assets were not properly disposed of in the succession plan. The combined gift and estate tax on those assets amounted to over $500,000, plus penalties and interest.

The case involved several pieces of investment real estate, with a combined value of approximately $700,000, investments with a value of approximately $800,000 and other assets. The husband and wife owned most of the properties separately. When the wife died no succession or estate plan had been put in place. A postmortem estate plan was therefore adopted by the husband. The husband created a family limited partnership into which he contributed the business properties, along with his house, car and other personal property. He created a family trust to be the general partner of the family-limited partnership.

The husband then gave each of his two children approximately 30% interests in the partnership. As to the trust, the husband received a lifetime interest in the assets and income, with the remainder interest in his children.

The husband made several glaring mistakes. He transferred his residence to the partnership and paid no rent to the trust or the partnership for use of the residence. This showed that he controlled the property as though it was still his personally. He deposited approximately $20,000 of partnership funds into his personal checking account, whether by intent or mistake. This also showed that he treated the assets as though they remained his personally.

Although he and his children were co-trustees of the trust, the children allowed him to manage the business affairs of the partnership and trust without any significant involvement from them. This last problem may have been the most significant. The father continued to control the business aspect of the real estate, even though he claimed to the IRS that he had transferred management power to his children as co-trustees of the trust.

The IRS applied a long-standing rule that a person who transfers property to another, but retains enjoyment of the property to himself or herself, makes no transfer. There does not need to be an express agreement that the transferor can continue to enjoy the property if the IRS sees evidence of an implied agreement at the time of the transfer. Enjoyment of the property means use of the economic benefits of the property.

The evidence that the IRS relied on was the co-mingling of the personal and partnership funds, the husband/father living in the residence without paying rent, and his management of the trust without consulting the other trustees.

What could he have done differently? First, his personal assets, such as the residence, checking accounts, car and the like should not have been placed in the same entity as the business assets. This made the transaction look bad from the start.

Second, control of the business assets should have been shared by the father and children. The trust, as general partner of the partnership, should have required the action of the two children, as trustees, for all business decisions. This way, the father could show that he had in fact transferred control to his children.

Third, the children should have stepped up and taken actual control of the business assets. The court found their inaction to be strong evidence of an implied agreement to allow the father to keep the assets as his own.

The lesson for all business owners from this case is that the business succession plan must reflect reality. The older generation must in fact transfer control to the younger generation. If the older generation does not desire to let go, then they should save their money and use the funds that they would have paid for the succession plan to pay the taxes later. Creating sham entities is a waste of time and effort.

If, however, the older generation is prepared to transfer the power to manage the business, then qualified business succession planners must be involved.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should consult with competent counsel with regard to specific situations.

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