Business Succession Planning

Transcription

1 Business Succession Planning Presented by James Philip Head Importance of Family Business > 90% of US Businesses are Family Dominated > 50% of GNP and 50% of Employment > 70% Fail After 2 nd Generation > 90% Fail After 3 rd Generation Estate Tax is Often Blamed Australia Has No Estate Tax, But The Same Failure Rate 22 Important Players > Owner > Spouse > Children Involved in Business Not Involved in Business > In-Laws Involved in the Business Not Involved in the Business > Key Employees or Advisors 33 1

2 PRECONDITIONS TO A SUCCESSFUL BUSINESS SUCCESSION PLAN > CORPORTATE/ORGANIZATIONAL DOCUMENTS NEED TO BE ACCURATE, WELL DRAFTED, COMPLETE AND UP-TO-DATE In 90% of the cases, small business have incorrect, incomplete or ambiguous corporate/organizational documents which could result in disputes and costly litigation if not modified > GOOD PERSONAL ESTATE PLAN FOR OWNER Make use of a revocable trust and fund the trust to permit a successor trustee to step into the shoes of the owner Make use of the Estate Tax Exemption with Credit Shelter Trusts 44 Elements of the Plan > Who Gets What? Fair v. Equal > Satisfy the Cashflow Needs of the Owner > Satisfy the Owner s Desire for Control > Who is Entitled to Equity in the Business? > Who is Entitled to Employment in the Business? > Should the Company Be Retained or Sold? 55 Fair v. Equal > Children Too Young to Run Business > Children Can Run Business > One Child in Business What About Others? > Multiple Children in Business > No One Wants the Business > No One Can Perpetuate the Business the Key Person Problem 66 2

3 Cashflow > Threatening Cashflow Threatens Viability of Succession Plan > Focus on After Tax Cashflow and Not Source of Funds A Dollar is a Dollar is a Dollar Rental Payments, Non-Compete Payments, Consulting Fees, Redemption Payments, Etc. Can Replicate Traditional Cashflow 77 Control > Ideally in the Hands of as Few People as Possible Need One Leader and Focal Point > Control and Ownership Can Be Managed Non-Voting Interests Shareholder Agreements Voting Agreements Restricted Stock 88 Recapitalization: Voting and Non-Voting Stock Class A Voting Stock 10% Equity 100% Control Class B Non-Voting Stock 90% Equity 0% Control S Corporation 99 3

4 Buy-Sell Agreement An arrangement for the purchase of another equity owner s interest upon the occurrence of a triggering event > Transfer restrictions to control ownership > Optional or mandatory purchases on designated triggers > Protect S election > Set price and terms for purchases 1010 Common Triggers > Termination of Employment > Death > Transfer that results in loss of S election > Transfer without consent or to non-permitted transferees > Bankruptcy 111 Form of Agreement Redemption Agreement Cross-Purchase Agreement Shareholder A Proceeds Shareholder B Shareholder A Proceeds Shareholder B Stock Purchase and Sale Stock Purchase and Sale Corporation Corporation

5 Form of Agreement Agreement Terms Redemption Cross-Purchase Purchaser Source of Price Life Insurance Ownership Change After Purchase Company is Purchaser Paid with Company Assets Owned by the Company (1 Policy Per Shareholder) Individual Shareholders are Purchasers Paid with Individual Assets Multiple Policies Owned by Each Shareholder Proportionately Can customize whose increases percentages percentages increase of remaining owners 1313 Form of Agreement Agreement Terms Redemption Cross-Purchase Basis Increase Taxation Certainty Remaining owners do not get a basis increase Potential dividend issue One transaction with more certainty of purchase being consummated Purchasers get a basis increase Clear capital gains treatment to seller Multiple purchases and greater chance of default 1414 Hybrid Agreement > Combination of Elements of Cross-Purchase and Redemption Company has the first option, other owners the second option, or the reverse > Adds flexibility to determine best option at the time

6 Restricted Stock Unregistered stock that is not transferrable for a period of time and generally becomes transferable under a vesting schedule. > S Corp Purposes Not Treated as Outstanding No Income Allocated with Respect to Shares Distributions Treated as Deductible Compensation > State Law Purposes Treated as Outstanding Shareholder Entitled to Distributions or Dividends 1616 Equity > Ideally Suited for Actively Employed Family Members Non-Active Members Receive Other Assets or Non- Voting Interests Problems with Distributions to Passive Members > Non-Family Members Preference for Phantom or Synthetic Equity Difficult to Meet Expectations 1717 Employment > Opportunity v. Obligation v. Birthright > Merit Based Hiring Some Families Require Outside Employment Before Returning to Family Business > Compensation of Family Members Often Problematic

7 Retention v. Sale > Rarely Discussed Openly Although Often Contemplated > Managing Valuation Expectations After-Tax Proceeds May Not Replicate Pre-Sale Cashflow Need to Model Counsel should be involved well before a sale to create a structure to minimize potential taxes (income/estate/gift) > Valuation Conundrum Retention Keep Value as Low as Possible Sale Maximize Value in Sale to 3 rd Party 1919 Obstacles to Sale > Unrealistic expectation of value > Lack of qualified buyers > Need for pre-sale planning > Excessive reliance on business owner s capabilities, traits, good-will, etc. > Hesitancy to part with symbol of significance and prestige 2020 Wealth Transfer Planning Considerations and Opportunities 21 7

8 Wealth Transfer Planning Tools Wealth Transfer Tax Exemptions Estate and Gift Tax Exemption $11,180,000 in 2018 Deceased Spouse Unused Exemption Portability GST Tax Exemption $11,180,000 in 2018 Wealth Transfer Tax Exclusions Gift Tax Annual Direct Payment of 529 Plan Election Qualified Family Farm Exclusion - $15,000 Qualified Tuition Front Load 5 Years Conservation Exclusion of Up to Per Person Per Year Payments and Worth of Gift Tax Easement Exclusion $1,140,000 of Value or $30,000 for a Medical Expense Annual Exclusion in 1 of Up to $500,000 of of Real Estate Used Married Couple Must Be Paid Directly Year - 5 x $15,000 = Value at Death in Active Operation of to Provider $75,000 Family Farm Wealth Transfer Tax Deductions Marital Deduction for Charitable Deduction for Deduction for Estate Deduction for Interest on Transfers to Spouse Transfers to Charity Administration Expenses Estate Tax (Including (Outright or in Trust) (Outright or in Trust) Graegin Loan Interest) Unlimited for U.S. Spouse / $152,000 for Foreign Spouse 222 Estate, Gift and GST Tax: Past and Present Year Estate/Gift Tax Exemption $5.12M $5.25M $5.34M $5.43M $5.45M $5.49M $11,180M Tax Rate 35% 40% 40% 40% 40% 40% 40% GST Tax Exemption $5.12M $5.25M $5.34M $5.43M $5.45M $5.49M $11,180M Tax Rate 35% 40% 40% 40% 40% 40% 40% Gift Tax Annual Exclusion $13,000 $14,000 $14,000 $14,000 $14,000 $14,000 $15, Planning Techniques by Asset Class Personal Real Estate Qualified Personal Residence Trust Sale-Leaseback to Grantor Trust Family Limited Partnership/LLC Remainder Interest to Charity Investment Real Estate Family Limited Partnership/LLC Sale to Grantor Trust Grantor Retained Annuity Trust Preferred Partnership Conservation Easement Charitable Remainder Trust Charitable Lead Trust Publicly Traded Stock Grantor Retained Annuity Trust Family Limited Partnership/LLC Charitable Remainder Trust Charitable Lead Trust Closely Held Businesses Sale to Grantor Trust Grantor Retained Annuity Trust Family Limited Partnership/LLC Buy-Sell Agreement Planning Charitable Remainder Trust Alternative Assets Sale to Grantor Trust Grantor Retained Annuity Trust Family Limited Partnership/LLC Retirement Plan Assets Planning for Income Tax Deferral Roth IRA Conversion Charitable Beneficiary Designation Charitable Remainder Trust Non-Qualified Deferred Compensation Planning for Income Tax Deferral Roth IRA Conversion Life Insurance Irrevocable Life Insurance Trust Sale to Grantor Trust Grantor Retained Annuity Trust Premium Financing/Split-Dollar Gift to Charity of Policy/Premiums

9 TECHNIQUES BY STRATEGY Freezing Strategies Leveraging Strategies Outright Gift Intra-Family Loans (AFR) Grantor Retained Annuity Trust Sale to Grantor Trust Qualified Personal Residence Trust Preferred Partnership Buy-Sell Agreement Planning Charitable Lead Annuity Trust Discount Strategies Family Limited Partnership/LLC Preferred Partnership Buy-Sell Agreement Planning Fractional Interest Discounts Qualified Personal Residence Trust Grantor Retained Annuity Trust Sale to Grantor Trust Qualified Personal Residence Trust Charitable Lead Trust Charitable Remainder Trust Irrevocable Life Insurance Trust Liquidity Planning Irrevocable Life Insurance Trust Planning for Section 6166/2032A Graegin Loan Planning Self-Canceling Installment Note Diversification Strategies Charitable Remainder Trust Exchange Fund Margin Loan and Gift of Cash Charitable Strategies Outright Gift to Charity Private Foundation Donor Advised Fund Supporting Organization Charitable Remainder Trust Charitable Lead Trust Charitable Gift Annuity Remainder Interest in Residence Asset Protection Strategies Re-Titling of Assets Family Limited Partnership/LLC Qualified Plan and IRA Planning Self-Settled Spendthrift Trusts 2525 Valuation Basics > Value For Estate and Gift Tax Purposes What a Hypothetical Willing Buyer Would Pay a Hypothetical Willing Seller, Neither Being Under Any Compulsion to Buy or Sell, and Both Having Knowledge of All Reasonable Facts and Circumstances Value is Further Adjusted for Discounts and Control Premiums Lack of Marketability, Lack of Control, Fractional Interest, Market Absorption, and Key Person Discounts 2626 Valuation Example > Client Died Owning a in a Closely Held Business Valued at Estate Tax Paid on Value 18 Months Later Company Sold for $300 Estate/Beneficiaries Received a Total of $75 > No Surprise, The IRS Had Some Questions About the Valuation

10 Valuation Example 2828 Valuation Example $ Valuation Example Add Back Lack of Control and Lack of Marketability Discounts $36 $100 4x $25MM $

11 Valuation Example Improvement in Operations and Market Multiples $80 Add Back Lack of Control and Lack of Marketability Discounts $36 $180 $100 $64 6x $30MM 4x $25MM 3131 Valuation Example Premium Paid By Financial Purchaser $60 Improvement in Operations and Market Multiples $80 Add Back Lack of Control and Lack of Marketability Discounts $36 $240 $180 $100 $64 8x 6x $30MM 4x $25MM 3232 Valuation Example Premium Paid By Strategic Purchaser $60 Premium Paid By Financial Purchaser $60 Improvement in Operations and Market Multiples $80 Add Back Lack of Control and Lack of Marketability Discounts $36 $300 $240 $180 $100 10x 8x 6x $30MM 4x $25MM $

12 How Close Can You Get? > Planning During a Pending Deal Sale of Company is Foreseeable However, No Certainty that Transaction Will Close Is Planning Possible? Methodology Risks 3434 Merger Arbitrage Data > Merger Arbitrage Data Deal Value / No-Deal Value Delay Between Announcement and Closing Likelihood of Deal Unraveling Financing Shareholder Approval Regulatory Approval 3535 Merger Arbitrage Transaction Value $20 / Share Pre-Transaction FMV $10 / Share

13 Merger Arbitrage Transaction Value Merger Uncertainty $20 / Share $17 / Share Pre-Transaction FMV $10 / Share 3737 Merger Arbitrage Transaction Value Merger Uncertainty $20 / Share $17 / Share Pre-Transaction FMV $10 / Share Days to Close Price 42 $ $ $ $16.03 See, Robak, Estate Planning and the Pending Deal: Lessons from the Merger Arbitrage Market, 31 ACTEC Journal 338 (2006) 3838 What and How To Gift? > Gift Easy to Value Assets Cash/Securities Later Substitution in Grantor Trust > Carefully Gift Hard to Value Assets Defined Value Clause Adequately Disclose Gifts and Non-Gifts > Assets Over Which Control May Be Retained Non-Voting Interests in Business Entities Control with Buy-Sell Agreements

14 Grantor Trust Taxation A Grantor Trust, sometimes called an Intentionally Defective Grantor Trust is an irrevocable trust used to freeze certain assets of an individual for estate tax purposes but not income tax purposes. Grantor Trust Income Earned on Assets Taxed to Client During His Lifetime Assets Excluded from Client s Estate at His Death 4040 Tax Treatment > Rev. Rul Transactions Between Grantor and Grantor Trust Disregarded > Rev. Rul Payment of Income Tax Liability Not a Gift/No Inclusion > Rev. Rul Insurance / Sec 101 > Notice Toggling > Rev. Rul Substitution Power Does Not Cause Inclusion Under 2036 or 2038 > Rev. Rul Substitution Power Does Not Cause Inclusion Under Gift to Grantor Trust Client Gift Cash or Securitie s Grantor Trust Gift Easy to Value Assets, Such as Cash or Marketable Securities Uses Client s Gift and GST Exemption Assets Excluded from Estate for Estate Tax Purposes Client Treated as Owner of Assets for Income Tax Purposes Client Retains Substitution Power to Replace Cash and Securities with Harder to Value Assets Timing on Valuation Management of Valuation Risk Dynasty Trust Structure Spouse, Children and Other Beneficiaries

15 Substitution Power Grantor Trust Client Closely Held Asset Swap Cash/Securities Grantor Trust Gift Easy to Value Assets, Such as Cash or Marketable Securities Uses Client s Gift and GST Exemption for Assets Excluded from Estate for Estate Tax Purposes Client Treated as Owner of Assets for Income Tax Purposes Client Retains Substitution Power to Replace Cash and Securities with Harder to Value Assets Timing on Valuation Management of Valuation Risk Dynasty Trust Structure Spouse, Children and Other Beneficiaries Sale to Grantor Trust Client Stock/LLC/LP Unit Sale Promissory Note Mid-Term 1.81% No Capital Gain on Sale to Grantor Trust No Gift on Sale Because Fair Value is Exchanged Gift to Trust Leveraged 9:1 Grantor Trust Funded with Gift of 10% of Anticipated Purchase Price (Uses Gift and GST Exemption) Assets Excluded from Estate for Estate Tax Purposes Client Treated as Owner of Assets for Income Tax Purposes Cashflow Received from Purchased Asset Used to Make Interest and Principal Payments on Promissory Note Excess Cashflow Can Be Distributed to Beneficiaries or Used to Purchase Life Insurance Dynasty Trust Structure Spouse, Children and Other Beneficiaries Defined Value Clause A defined value clause limits the quantity of assets gifted or sold until a final determination of value is made. The exact quantity of assets transferred remains uncertain until values are finally determined for federal gift tax purposes (i.e., when the federal gift tax statute of limitations expires or when the IRS challenges the value and this challenge is resolved). Client Traditional Gift/Sale Defective Grantor Trust $10X

16 Defined Value Clause Instead of fixing both value and quantity up-front, a defined value clause fixes only the pecuniary value of the gift or sale transaction. Potential Gift if Asset Valued at More Than $10X Client Traditional Sale Defective Grantor Trust $10X 4646 Defined Value Clause Tax Neutral Trust Assets in Excess of $10X Client Defined Value Clause Defective Grantor Trust $10X 4747 Excess Value Trusts > Potential Tax-Neutral (or Beneficial) Recipients of Excess Value Charity Zeroed out GRAT Marital Trust Incomplete Gift Trust

17 Applicable Case Law > Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944) > King v. United States, 545 F.2d 700 (10th Cir. 1976) > Succession of McCord v. Commissioner, 120 T.C. No. 13 (2003), rev d, 461 F.3d 614 (5th Cir. 2006) 4949 Applicable Case Law > Christiansen v. Commissioner, 130 T.C. No. 1 (2008), aff d 586 F.3d 1061 (8 th Cir. 2009) > Petter v. Commissioner, T.C. Memo , aff d 653 F.3d 1012 (9 th Cir. 2011) > Hendrix v. Commissioner, T.C. Memo Finality on Gift Tax Return > Adequate Disclosure of Gift on Gift Tax Return 3 Year Statute of Limitations > What Constitutes Adequate Disclosure A description of the transferred property and any consideration received by the donor Identity and relationship of donor and donee Copy of the trust and EIN Method used to determine FMV of property or a qualified appraisal Statement describing any position that is contrary to any Treasury regulation or revenue ruling

18 Finality on Gift Tax Return > If Discount Applied to FMV of Gift Amount of the discount and the basis for applying the discount must be described. In addition, the donor must affirmatively answer Yes to Question A of Schedule A of the gift tax return any time a discount is claimed to notify the IRS that a valuation discount is claimed. The failure to accurately answer Question A may cause the discounted gift to be treated as not being adequately disclosed Grantor Retained Annuity Trust GRAT An irrevocable trust used by individuals to make large gifts to family members without paying gift tax. >Zeroed-Out GRAT Short Term Trust Large Annuity Payments Zeroes-Out Gift IRS Regulations, Amended in 2003, Specifically Approve of This Planning Technique 5353 Grantor Retained Annuity Trust Grantor Retained Annuity Trust Funded with $10 Two Year Term Assume 2.2% Section 7520 Rate Assume Asset Sold Within 12 Months for $25 Taxable Gift of $1 Year 1 Annuity Payment $4,700,573 Year 2 Annuity Payment $5,640,687 Client Distribution to Children $14,658,

19 GRAT Self-Adjustment > A well-drafted GRAT will self-correct the annuity payments (and thus the gift) based on the value of the asset contributed The Trustee shall pay to me an Annuity Amount equal to % of the initial value of the trust assets contributed to the GRAT, as finally determined for federal gift tax purposes. Value of Contributed Asset 1 st Annuity Payment 2 nd Annuity Payment Taxable Gift $10,000,000 $4,700,573 $5,640,687 $ GRAT Self-Adjustment > A well-drafted GRAT will self-correct the annuity payments (and thus the gift) based on the value of the asset contributed The Trustee shall pay to me an Annuity Amount equal to % of the initial value of the trust assets contributed to the GRAT, as finally determined for federal gift tax purposes. Value of Contributed Asset 1 st Annuity Payment 2 nd Annuity Payment Taxable Gift $10,000,000 $4,700,573 $5,640,687 $1.00 $25,000,000 $11,751,432 $14,101,717 $ Irrevocable Life Insurance Trust A non-modifiable trust that owns one or more life insurance policies, therefore removing the policies from the owner s estate Client $65,000 Cash Irrevocable Life Insurance Trust Owner and Beneficiary of Life Insurance Client Retains No Incidents of Ownership Premiums Gifted to Trust Beneficiaries Have Rights of Withdrawal No Estate Tax on Insurance Proceeds Mirrors Estate Planning Documents $65,000 Cash Life Insurance Co. Crummey Withdrawal Rights Life Insurance Policy Spouse $5,000 Child $30,000 Child $30,

20 Dynasty Trust An irrevocable trust designed to transfer significant wealth to family members Transfer Assets in Trust for Multiple Generations Avoids Application of Estate Tax at Each Generation Assets Not Subject to Claims of Creditors Ex-Spouses, Contract Creditors, Tort Creditors Trust Can Serve as the Family Bank Lend to Beneficiaries for Residences Venture Capital for New Business Ventures and Opportunities Dynasty Trust Economics No Dynasty Trust Dynasty Trust Initial Gift in 2015 $10,860, $10,860, Value in 2045 $46,936, $46,936, Estate Tax $18,774, $0 Net Value $28,161, $46,936, Value in 2075 $121,713, $202,855, Estate Tax $48,685, $0 Net Value $73,028, $202,855, Value in 2105 $315,623, $876,731, Estate Tax $126,249, $0 Ending Value $189,374, $876,731, Value in 2135 $818,463, $3,789,184, Estate Tax $327,385, $0 Ending Value $491,078, $3,789,184, Assumptions $10.86 Gift in Trust in % More Transferred Estate Tax at 40% Tax Rate Applicable Every 30 Years Net 5% Annual Growth Of Assets (8% Gross Return and 3% Distribution to Beneficiaries) Dynasty Trust GST Exempt Dynasty Trust Funded with $10.86 (2 x Gift Tax Exemption) Allocate $10.86 GST Tax Exemption Distributions to Children, Grand- Children, and Remote Descendants Support, Health, Education, and Maintenance Independent Trustee Can Make Distributions for Any Purpose Loans for Purchase of Residence or New Business Waives Rule Against Perpetuities Children Grandchildren Great- Grandchildren Great-Great- Grandchildren Great-Great-Great- Grandchildren

21 Charitable Giving Strategies > Charitable Remainder Trust > Donor Advised Fund > Supporting Organization > Charitable Lead Trust 6161 Charitable Remainder Annuity Trust Charitable Remainder Annuity Trust Lifetime Trust for Client, Age 75 Initially funded with $1,000,000 asset CRAT sells asset / CRAT is tax-exempt $50,000 Annual Payment $536,685 Gift to Charity Assume 8% Growth Assume 11 Year Life Expectancy 2.2% Section 7520 Rate Annual Payment $50,000 Payments for Client s Life Client $550,000 Charity $1,499,364 Client s Death Donor Advised Funds Donor Gift of Appreciated Assets Charitable Deduction Advisory Privilege to Recommend Grants to Charities Donor Advised Fund (e.g., The Community Foundation Serving Richmond and Central Virginia) Donor s Family Charitable Fund Credited with Gifted Assets Charity

22 Supporting Organization Donor Advised Fund Smith Family Foundation (Supporting Organization) Investments Community Foundation/DAF Charitable Organizations 6464 Charitable Lead Annuity Trusts Charitable Lead Annuity Trust 25 Year Term Initially funded with $1,000,000 asset Taxable gift of $0 to Family $1,000,000 Gift to Charity Assume 8% Annual Growth Assume 2.2% Section 7520 Rate Annual Payment $52, Years Charity $1,311,000 Client s Family $3,014,799 End of 25 Year Term QUESTIONS 66 22

23 JAMES PHILIP HEAD Jim Head represents individuals and owners of closely held businesses in the areas of estate planning, estate and trust administration, fiduciary litigation, tax, gift and estate tax controversy, business planning, and other general business law matters. He regularly structures and implements business succession and transactional strategies for privately held companies, business owners, government contractors, and entrepreneurs to build, preserve, and transfer the value of their companies and personal net worth. James Philip Head Williams Mullen 8300 Greensboro Drive Suite 1100 Tysons Corner, Virginia Jim also represents banks and fiduciaries in state courts throughout Virginia, Maryland, and the District of Columbia with respect to all areas of trust and estate disputes, including breach of fiduciary duty, will and trust interpretation, will contests, lost wills, and trust modifications. Jim is listed in The Best Lawyers in America for Trusts & Estates and Tax Law (2016-present) and as a 2018 Super Lawyer for Virginia and Washington, D.C. in Estate & Probate Law. He was also honored to be listed in the editions of Who s Who in American Law and has been included in several editions of Who s Who in America, including from 2013 to 2015, and in Who s Who in Emerging Leaders for In 2007, Jim was named one of the top up-and-coming lawyers in the state by Virginia Super Lawyers Rising Stars magazine. He received a master of laws in taxation degree from Georgetown University Law Center in 2000 and graduated with honors in 1995 from the George Washington University National Law Center. While in law school, Jim was the managing editor of The Environmental Lawyer. He is a 1992 magna cum laude graduate of the University of Maryland, where he earned his bachelor of arts degree in economics