Regardless of where you stand on the debate over whether or not the Federal Estate Tax should be repealed, this tax raises issues that should be of concern to everyone who has worked hard to build a successful small business in the hopes that the business will provide security for their children for many years into the future.  The inevitability of death and taxes can shatter your hopes and dreams.

Upon your death, the “fair market value” of your business will be included in your estate and in 2011 can result in a Federal Estate Tax of up to 35% (plus a NYS Estate Tax of up to 16%) of that value, after the exemptions and assuming no unlimited marital deduction to a spouse is available.  Since most small businesses usually represent the largest asset in an estate and generally do not have large reserves of cash, many families find that they have to sell the business in order to pay the estate tax on the business.

Even if you believe that the real value of your business is not high enough to worry about the impact of estate taxes, it has been my experience that the IRS usually determines the “fair market value” of your business to be higher then the price you might actually be able to sell it for since the “fair market value” is a theoretical accounting value and does not necessarily reflect the real value of the business after taking into effect all of the variables in the marketplace.

Unless and until the estate tax is repealed, this dilemma will continue to plague the hard working owners of small businesses and their families.   The only practical solutions presently available are sound estate planning strategies.

One such estate planning strategy is the Family Limited Partnership (FLP).   A FLP is set up in the same manner as any other partnership.  The business owner transfers the business to the FLP, names himself/herself as the general partner with a very small ownership interest and gradually transfers the remaining interest in the business to the children as limited partners.   The general partner makes all the decisions, including under what conditions power and money will pass to the children, while the limited partners hold most of the equity.

In the next installment, we discuss the benefits and possible pitfalls of a Family Limited Partnership.