ABC s of Family Succession Planning

Transcription

1 ABC s of Family Succession Planning By: Charles F. Adler Schneider, Smeltz, Ranney & LaFond, P.L.L Superior Avenue, Suite 1000 Cleveland, OH (216) CAdler@ssrl.com

2 Common Issues Financial interdependence: Business s financial success depends on the owner Emotional investment: Invested many years of hard work, source of family identity, difficult to give up control Family/business overlap: Working with relatives Major portion of owner s wealth: Illiquidity problem

3 Elements of Orderly Transition Family Harmony Perpetuate Business by Ensuring Competent Leadership Financial Security of Owner Financial Security of Surviving Family Members Taxes are Minimized

4 Benefits of Effective Plan Smooth transition Improved communication with family, employees, customers, and suppliers Commitment to future success Happier work environment More financial security Improved customer loyalty

5 Preparing for Ownership Transition Develop competent management successors Retain key employees Select time frame for transfer Communicate to employees, customers and suppliers Transfers to children and/or relatives

6 Can the Business be Transferred? Franchise or Manufacturer s Representative Governing contracts control Personal Service Business Difficult to transfer professional businesses (physician, law, architectural, etc.) If artistic (i.e. photography or decorating) may be unique to owner Business Subject to Lending/Credit Agreements Loan covenants may prevent or make transfer difficult Lack of Eligible Transferees Often kids are not interested Mom/Dad, you have to work too hard.

7 How Much is the Business Worth? If the business is to be given away during lifetime or death, it must be valued for estate or gift tax purposes.

8 Valuation Valuation is not an exact science. Professional appraisers and others attempting to estimate or corroborate value must obtain all relevant information, such as: Company financial statements and auditor s reports; Form of organization (corporation, partnership, etc.), including governing documents; Company history; Products and/or services, markets and customers; Management history and experience;

9 Valuation Continued Major assets, both tangible and intangible; Outlook for the economy, industry, and company; Past transactional evidence of value Sensitivity to seasonal or cyclical factors; and Competition

10 Three Main Approaches to Valuation Cost or Book Approach Income Approach Market Approach

11 Cost or Book Approach This approach encompasses a variety of methods that use the historic cost of assets and the current value of liabilities. Certain methods require the adjustment of historic costs to current values. Rev. Rul , C.B. 237 Other methods also include and adjustment for intangible value not reflected in the financial statements. Intangible value is evidenced by earnings in excess of the industry average. Rev. Rul , C.B. 370 (modifying Rev. Rul , C.B. 237). It can also be evidenced by some other characteristic that is unique to the company.

12 Income Approach This approach encompasses methods that translate anticipated future earnings into a present value, including: The capitalization of earnings method: The business s equity is valued using multiples of income derived from capitalization rates or, more commonly, a general rule. For example, many small to medium sized closely-held corporations will use a factor of anywhere from four to eight times earnings as a multiple. Typically, the higher the risk associated with the business, the lower the multiple.

13 Income Approach The discounted earnings method: The business s equity is valued by discounting the anticipated stream of income to a present value With any income approach, adjustments should be made to arrive at a true statement or earnings. Adjustments can be made for bonuses, excessive salaries, certain amounts of depreciation and non-recurring expenses.

14 Market Approach This approach can be used to value the business s assets or equity based on the sale price of similar businesses. This includes: The direct sales comparison method: Value the business by comparing it to the sales price of similar recently-sold businesses. Recent sales prices are used to develop a value of the business.

15 Market Approach Rules of thumb: Valuations can involve comparable multiples of sales, net cash flow, operating cash flow or other specific measures of company performance. In many cases, these multiples will only provide an estimate for intangible assets or total assets, depending on the industry. Liabilities of the business must be deducted to develop the estimated value of the business s equity for buy-sell purposes.

16 Discounts Controlling Interest Generally, a controlling interest in a business is worth more than a minority interest. Minority Interest Generally, a minority interest is worth less than a majority interest because minority interest cannot control the company. Lack of Marketability Closely held businesses generally cannot be easily sold and no ready market exists to establish value. Therefore, a discount applied to the closely held stock value for lack of marketability may be appropriate. Typically, these lack of marketability discounts range from 10 to 35 percent.

17 Brief Review of Estate and Gift Taxes Federal Estate Tax Federal Gift Tax Ohio Estate Tax

18 Federal Estate Tax 2009 Exemption and Rate $3.5 million dollar exemption Flat 45% Rate Marital deduction is available for qualifying transfers to surviving spouse Considerable uncertainty over federal estate tax after 2009

19 Federal Gift Tax 2009 Exemption and Rates: $1.0 million exemption Gifts over $1.0 million are taxed at 41% Gifts over $1.5 million at 45%. There is no Ohio gift tax

20 Ohio Estate Tax Much of the Ohio estate tax modeled after federal estate tax system Current Exemption and Rates: First $338,333 exempt from tax Flat 7% tax on transfers over $500,000 There are no future changes to the Ohio Estate Tax built into current law.

21 Intra-Family Transfer Techniques Transfers During Owner s Lifetime Gift Techniques Outright gifts Grantor Retained Annuity Trusts ( GRATs ) Sale Techniques Sales to Defective Trusts Installment Sales Self Cancelling Installment Notes ( SCINs )

22 Outright Gifts Lifetime gifts are an obvious device to transfer ownership to family members Outright gifts $13,000 Annual gift tax exclusion Married couples may make split gifts. (Need to file gift tax returns) Gifts in Trust: Offer more control, but are more complicated Crummey trusts Discounted giving

23 Grantor Retained Annuity Trusts How They Work: ( GRATs ) Grantor creates an irrevocable trust for a term of years Grantor transfers shares of company stock to the GRAT Grantor receives an annuity payment during the trust term Annuity may be paid in kind If GRAT is successful, at the end of the trust term some shares of stock pass to the remainder beneficiaries taxfree

24 Grantor Retained Annuity Trusts ( GRATs ) Tax Consequences: Transfer to GRAT is a gift, but taxable amount of gift is reduced by the present value of Grantor s future annuity payments If business interest appreciates at a rate greater than the interest rate set by IRS, excess appreciation passes to beneficiaries transfer taxfree Grantor continues to pay income taxes on the trust s income during term

25 Sales to Intentionally Defective How They Work: Grantor Trusts Grantor creates irrevocable trust Grantor transfers 10% of value of the business interest in cash to the trust as a seed gift Irrevocable trust purchases grantor s business interest for a promissory note Grantor receives loan payments from trust s seed money and business income Ideal for generation-skip planning

26 Sales to Intentionally Defective Grantor Trusts Tax Consequences: Note is included in grantor s estate, not business interest Value of business for estate tax purposes is frozen and appreciation passes to children transfer tax free Defective because grantor must pay tax on income earned by trust, which allows further tax-free gift

27 Installment Sales How They Work: Seller sells business interest to family member Seller receives payments over more than one year pursuant to a promissory note

28 Installment Sales Tax Consequences: Seller may elect to recognize all capital gain in the year the note is signed Seller may elect to recognize gain as payments are received. Each payment consists of return of basis, capital gain, and interest on the promissory note. Interest is ordinary income to Seller Deferred gain is recognized immediately by Seller if Purchaser disposes of interest during term of installment payments

29 Self-Cancelling Installment Notes How They Work: ( SCINs ) Seller sells business interest to family member in exchange for note Payments on note last until stated term or death of Seller Note cancels if Seller dies during term Face amount of note includes risk premium to account for risk that principal will not be repaid

30 Self-Cancelling Installment Notes Tax Consequences: ( SCINs ) Each installment payment consists of return of basis, capital gain, and interest on the promissory note If Seller dies during term: Note is not subject to estate tax Unrealized capital gain is included on Seller s first estate income tax return

31 Intra-Family Transfer Techniques Transfers at Owner s Death Will: Administered through Probate Court, which requires business valuation to become public record Trust: Maintains privacy, simplifies administration Transfer on Death Designation: Immediate non-probate transfer to named beneficiary

32 Transfers at Death to Spouse Marital Deduction and Estate Tax Consequences Outright transfer to surviving spouse defers estate taxes until spouse s death Transfer in trust for spouse s benefit can take advantage of both spouse s estate tax exemptions and transfer up to $7 million to beneficiaries tax free in 2009 Practical Concerns Owner may want to provide for spouse during her lifetime but control what happens at spouse s death, particularly in second marriage situations Surviving spouse may be unwilling or unable to manage the business Who should serve as Trustee?

33 Transfers at Death to Children How do you make an equal transfer among children? All Children are Active in the Business Ownership can be divided equally among them Management succession may still cause tension No Children are Active in the Business Third party management successor must be found If inactive children not interested in owning, sell to third party

34 Transfers at Death to Children Some Children are Active and Some are Inactive in the Business Should you transfer ownership to inactive children? How will this transfer affect business and family? Inactive children may use their votes to hamper active children s ability to run business Active children may pay themselves high compensation with no distributions based on ownership If inactive children, even together, have no ability to control the business, they may have an illiquid asset that generates no income Solution: Transfer business to active children and transfer other assets, such as life insurance, to inactive children to equalize total wealth distributed

35 Intra-Family Buy/Sell Agreements Uses for Buy/Sell Agreements: Restrict the transfer of business interests to third parties Provide a market for an illiquid asset Provide a specific price or method of valuing business interests when a co-owner leaves the business Protect the interest of remaining owners by specifying events that will force a co-owner to leave Prevent a co-owner s ex-spouse from gaining an ownership interest in the business on divorce

36 Questions Feel Free to Call: Charles F. Adler Schneider, Smeltz, Ranney & LaFond, P.L.L Superior Avenue, Suite 1000 Cleveland, OH (216)