Proposed Tax Regulations Eliminate Possibility of Clawback of Lifetime Gifts for Estate Tax PurposesAs previously posted, the Tax Cuts and Jobs Act signed into law in December 2017 (the “2017 Act”) made significant changes to the federal wealth transfer system with respect to gift and estate tax transfers during the calendar years 2018 through 2025. One of these changes was increasing the basic exemption amount that can be transferred free of gift, estate and generation skipping transfer (GST) taxes. Prior to the enactment of the 2017 Act, the exemption amount was $5 million (as adjusted for inflation in years after 2011). Under the 2017 Act, the exemption amount was doubled to $10 million, which, after being adjusted for inflation, is now $11.4 million in 2019 (or $22.8 million for a married couple). However, the increased exemption amount is scheduled to “sunset” on January 1, 2026, to the 2017 levels, as adjusted for inflation.

One recommendation included in our earlier blog post was for individuals to consider using their increased exemption amounts to make significant gifts to family members. While almost any asset can be used for making gifts, interests in closely held businesses can be an attractive asset to use for a number of reasons, including business succession and tax valuation reasons.  This can be especially true if such significant gifts are combined with other estate planning strategies, such as gifts to intentionally defective grantor trusts. However, there are always a number of tax considerations that need to be taken into account in making significant gifts, including whether such gifts are made efficiently from an income tax perspective. In any event, an advantage of making such significant gifts would be to use the increased exemption amounts prior to their sunset in the year 2026, or earlier if the tax laws are changed by Congress before such time. This is similar to estate planning that occurred in late 2012, when the exemption amount was scheduled to be reduced from $5 million per person to $1 million per person.

One concern of making such lifetime gifts prior to the sunset of the increased exemption amounts is whether the IRS would try to “clawback” such gifts into someone’s taxable estate when he or she later died, if the amount of such person’s lifetime gifts exceeded the exemption amount at the time of that person’s death. For example, if someone makes a $10 million gift in 2019 (when the exemption amount is $11.4 million) and then dies 10 years when the exemption amount has been decreased to $5 million (as adjusted by inflation), would the IRS take the position that estate taxes are owed at the time of that person’s death? This has been a concern because the gift and estate tax system is “unified,” and the amount of lifetime gifts is taken into account in calculating estate taxes in a decedent’s estate.

In November 2018, the Treasury Department issued proposed regulations stating that in such a situation, the credit to be applied in computing estate tax in a decedent’s estate would be based upon the higher exemption amount in effect at the time of the gift. Thus, there would be no clawback of lifetime gifts that later exceeded the exemption amount at a decedent’s death, if the exemption amount is decreased due to the sunset of the increased exemption amount in the 2017 Act or other changes by Congress.

Please feel free to reach out to any of Bradley’s trust and estate attorneys if you would like to discuss the possibility of making gifts to take advantage of the increased exemption amount. As gift and estate tax laws change (either due to the sunset of the increased exemption amounts or potential changes by Congress), we will update the Family Business Advocates blog to inform clients and others of such changes, and the advisability of making lifetime gifts in connection with such changes.

Avoiding Risk when Serving as an Advisory Board MemberI am a fan of advisory boards when family-owned companies are transitioning from a board of directors consisting solely of family members. It is a good way to test the waters before moving to a board of directors that includes independent (non-family) members in a fiduciary capacity. I am also a fan of individuals who are willing to serve as members of advisory boards. They play an important role in the life of a family-owned company by bringing new perspective and business expertise. Typically, advisory board members find the work rewarding. However, the role is not without risk.

Although a member of a corporation’s advisory board does not owe statutory fiduciary duties to the corporation or its shareholders, she may unintentionally adopt such duties if, by her actions, she becomes a de facto director of the corporation. In addition, if the corporation and advisory board adopt an engagement letter that spells out the advisory board’s functions, members of the advisory board may be subject to liability if they stray from the boundaries set out in the engagement letter.

If an advisory board member begins to act as a member of the board of directors, she will be considered a “de facto” director. A de facto director’s actions are binding on the corporation so far as third persons are concerned and, thus, an advisory board member who becomes a de facto director would likely owe fiduciary duties like those of an actual director. In order to avoid the danger of an advisory board member becoming a de facto director, each member of the advisory board should take care to avoid taking on responsibilities and performing functions reserved for the board of directors.

If a corporation and its advisory board wish to shield the advisory board members from the various fiduciary duties and potential liabilities of a legal board of directors they should adopt an engagement letter that clearly delineates the advisory board’s roles and the standards by which those roles are to be performed. The letter should also make clear that the advisory board is not to perform roles reserved for the board of directors. The letter should require that the advisory board keep certain legal matters confidential. Lastly, while any indemnification provision included in a corporation’s certificate of incorporation typically does not cover the advisory board, the corporation may (and should) contract to provide indemnification to advisory board members for liability that may arise from their service.

The following is a suggested list of provisions to be included in the engagement letter:

  • The advisory board should not be referred to as a “board” but instead an “advisory committee” or other appropriate title.
  • The advisory board does not have decision-making powers or voting authority.
  • The recommendations of the advisory board are not binding and are subject to review by the corporation’s board of directors.
  • The advisory board should hold meetings separate from the board of directors.
  • Advisory board members should not be counted in determining whether a quorum is present at board of director meetings.

In addition to adopting an engagement letter, the corporation and its advisory board may wish to adopt certain behavioral safeguards. For example, advisory board members should not be informally referred to as “directors” or “the board,” but as “advisors” or another appropriate term. Also, when decisions are made by the board of directors after discussion with the advisory board, resolutions should be adopted by the directors and the meeting minutes should reflect that the advisory board members did not participate in the vote. These suggestions can help ensure that the advisory board remains in a purely advisory role without any semblance to the contrary.

The Importance of Dividend Policies for Family-Owned BusinessesIn our family business practice, we commonly see conflicts between shareholders who are active in the business and shareholders who are not active in the business. The conflict usually arises from the relatively rich compensation paid to the active shareholders (in the forms of salary, bonuses and other benefits) versus the relatively paltry dividends paid to the inactive shareholders. Of course, what is “rich” and what is “paltry” is often in the eye of the beholder. Without question, though, a lack of investment liquidity is a genuine concern for a family business owner who is not active in the family’s business.

It is important for family business owners to recognize that every business has a dividend policy—regardless of whether the directors and shareholders have ever even discussed one. What the company does with excess cash is its dividend policy. Does the company re-invest excess cash to grow the business? Does the company reduce debt or make an acquisition? Does the company repurchase shares? Or does the company pay dividends? If a family-owned business pays above market compensation to family employees, or purchases vehicles and vacation homes for the use of family members who are not active in the business, the company is in reality paying dividends to the family members who receive these payments or other benefits. How the company allocates excess cash flow among the various alternatives makes up its dividend policy.

In some cases, the board or controlling shareholders may make dividend decisions for the wrong reasons. Deferring dividend payments to keep money away from younger generation shareholders, or to avoid making distributions to certain minority shareholders, may lead to family conflicts and potentially legal disputes. Not paying dividends for the purpose of acquiring non-operating assets in the business, or to enable the controlling shareholder to pursue personal projects in the business, may also lead to problems.

There is no rule of thumb for how much a family business should distribute in the form of dividends. However, we find that family business owners who have thoughtful discussions about setting a realistic dividend policy, and who then follow their policy, are less likely to have conflicts.  In addition, paying dividends allows family business owners to invest assets outside of the business and diversify their portfolios.

Different family businesses will have different approaches to dividend policies. One approach is for the owners to set the expectation that all shareholders—regardless of whether they are active in the business—are entitled to receive a certain return on their investment each year. The shareholders, acting through the board of directors, can then direct management to operate the business accordingly. This approach tends to focus management’s attention on generating sufficient earnings and cash flow to meet the owners’ expectations. Outside consultants may be helpful in advising business owners on how to set realistic expectations and policies.

Implementing a dividend policy is a good way to minimize conflicts among business owners–and the key to establishing a well-functioning dividend policy that is open and encourages candid communication among the family business owners.