Pre-Sale Planning for Business Owners; The Benefits of an Integrated Approach A Case Study Example The sale of a business can be one of the most significant events for families of wealth. Often, family members have devoted substantial time and resources to building a successful enterprise. This dedication and sacrifice have made a meaningful difference in creating value and it is doubtful they want to sell the business without maximizing this value for the benefit of their family. While the sale of the business may be viewed as the successful culmination of years of work, it may also cause concern for the owner, who feels there is not enough time to initiate effective wealth transfer planning. In fact, many owners considering a sale don t even know what kind of planning to consider. All is not lost, however, and GenSpring s experience has shown that instituting the proper planning process before a sale has a material impact on the after-tax sales proceeds received and provides peace of mind for the owner, who can be assured they are making thoughtful and beneficial decisions for future generations. The following case study illustrates the value of sound pre-transaction planning prior to the sale of a family business. Case Study - Meet the E Family Mr. Entrepreneur (Mr. E) is a co-founder of The Widget Corporation, a C corporation, formed 15 years ago with a business partner. A recent company appraisal has valued the company at $100 million. Mr. E, who is married with two teenage children, ages 16 and 18, owns 1,000 shares of the outstanding stock of Widget Corporation. His business partner owns the remaining 500 shares, which are valued at $50 million, however, Mr. E controls the decision on whether to sell Widget Corporation. Mr. E has been in discussions with a potential acquirer who made a preliminary offer of $150 million for all of the company stock. At this price, Mr. E would receive $100 million for his stock. At a dinner party, a friend of Mr. E s suggests that if a potential sale is on the near horizon, Mr. E will need to do some planning to ensure that the E family will be able to enjoy their windfall in both the short and longer term. The friend put Mr. E in touch with GenSpring Family Offices. The GenSpring Approach: A Four Phase Process In our 25 years of experience working with clients like Mr. E we ve learned that a coordinated process around wealth planning for the future is essential Sustaining Family Wealth
Es ESTATE PHILANTHROPY Ph GOVERNANCE Go to yield the best results for the client and his family. Our approach is divided into four distinct phases: Discovery, Planning, Implementation and Administration. (Figure 2.1) Throughout each phase, GenSpring advisors draw upon their multi-disciplinary backgrounds and prior experiences with similar families to help deliver maximum value for the family. Thoughtful pre-sale planning typically involves the following elements: Taxes, Estate Planning, Philanthropy, Investments, Governance, Fiduciary and Education. GenSpring can help integrate these key elements and coordinate with Mr. E s other expert advisors (attorney, CPA and the like) to ensure all involved parties work to help achieve the desired results for the E family. Phase 1: Discovery Wealth transfer planning is not one-size-fits-all. To be effective for Mr. and Mrs. E, their children and their future generations, planning must be tailored Ta TAXES Ta TAXES Es ESTATE Ph PHILANTHROPY In INVESTMENTS In INVESTMENTS Go GOVERNANCE Fi FIDUCIARY Fi FIDUCIARY Ed EDUCATION Ed EDUCATION to the family s particular situation. In order to best customize planning for each individual family, we typically engage in a comprehensive discovery process to fully understand both the potential transaction at hand and the family s near and long-term estate planning and financial goals and objectives. During this Discovery phase, we engage Mr. and Mrs. E in a process that looks beyond the sale to help them articulate and prioritize their broader financial planning goals and objectives. At the same time, we recommend that Mr. and Mrs. E engage both an attorney and a CPA with strong backgrounds in navigating the intersection of income, gift, estate and generation-skipping tax planning. In the event the couple does not have attorneys and CPAs who are appropriately qualified to help with this type of planning, GenSpring is able to help select an GenSpring Family Offices Coordination of Pre-Sale Planning Process Discovery Planning Implementation Administration Wealth Priorities Capital Sufficiency Advisor Coordination Wealth Management Goals & Objectives Advisor Selection Facilitate Planning Trust & Entity Administration Document Review Assessment & Modeling Portfolio Construction Family Governance & Education Figure 2.1 2
advisory team that will ensure the family is getting the most effective, timely and coordinated advice. In our case study, the immediacy of the potential business sale necessitates that our first priority is to request any legal documents that might restrict the transfer of company stock to third parties (such as charities or trusts). Any transfer restrictions in the company or shareholders agreements that might jeopardize pre-transaction planning must be addressed with Mr. E and the company attorneys as soon as possible. Additionally, we must gather and review all Mr. and Mrs. E s estate planning documents. Our initial review of their current plan will provide important context for our discussions that reveal the family s goals and concerns. The Discovery phase is a critical first step for effective wealth transfer planning. We do not want to get far along in the planning process only to discover a problem that could jeopardize the pre-transaction planning. Phases 2 and 3: Planning & Implementation The foundation of pre-transaction planning in this context is the transfer of company stock. Through the planning phase important questions like the amount and to whom or what entities transfers will be made must be explored and resolved. In order to make well-informed decisions, we establish a tax baseline against which alternatives can be measured. In our case study, if Mr. E has a zero tax basis in his stock and proceeds with the sale without any planning, his federal income tax would be approximately $23,800,000. 1 Upon his death, the after-tax proceeds received by Mr. E will also be subject to federal estate tax, approximately $30,480,000. 2 Now that we have helped Mr. and Mrs. E understand the potential after-tax sale proceeds and future estate tax liabilities, we turn our focus to the feasibility of accomplishing the goals and objectives they are envisioning for the wealth. In order to understand what portion of the sale proceeds Mr. and Mrs. E will need to be able to live the life they are imagining, we determine if they are planning a one-time large purchase (such as a jet or a yacht) in the near future. Will they be making a large real-estate purchase or upgrading current residences? Will they have other sources of income outside of investment income, or will they live on investment income alone? What are their day-to-day living expenses? How much can be set aside to fund these expenses and how much can be set aside for long-term growth? The answers to these questions allow us to prepare a detailed Capital Sufficiency analysis that shows how 1 $100 million X 23.8%, which represents the long term capital gains rate of 20% + 3.8% for the Medicare surtax put in place by the Affordable Care Act. This assumes the stock is not eligible for any income tax exclusions as Qualified Small Business Stock and puts aside any alternative minimum tax and state income tax considerations. 2 $76,200,000 X 40%, the current highest federal estate tax rate, assuming that Mr. and Mrs. E use their $10.5 million 2013 federal estate tax exclusion to transfer or shelter other assets. For illustration purposes only. Actual results may vary. 3
long their capital will last based on a myriad of tax, spending and income projections. This analysis gives Mr. and Mrs. E confidence that their needs will be met and they can objectively focus on the decisions for sizing their charitable and family transfers. After reviewing the Capital Sufficiency analysis, Mr. and Mrs. E feel comfortable in giving away $5 million to charity. During the Discovery process, we learned that Mr. and Mrs. E s daughters are top-notch athletes who will attend and play softball at their parents alma mater. Knowing this, we might recommend a pre-sale charitable contribution of a portion of Mr. E s company stock (either outright or in trust) that will fulfill the couple s desire to make a large contribution to build and endow the operation of a new softball stadium at the university. Mr. E would receive a charitable income tax deduction for the value of his contribution and, as the Capital Sufficiency analysis revealed, the transfer could reduce the federal income tax he will incur as a result of the sale. By making a charitable contribution of shares that should generate $5 million of proceeds, Mr. E could save approximately $1,190,000 ($5,000,000 x 23.8%) in federal income tax. 3 The overall planning process involves the discussion and careful consideration of different risks. One primary risk of engaging in pre-transaction transfers is that the IRS could apply the assignment of income doctrine to assert that the entire gain on the sale of company stock is recognized by Mr. E, even though he transferred shares to charity. The greater the certainty of sale and the shorter the time between the transfer and sale, the higher the risk that the IRS might successfully challenge the transfer and deem all gains taxable to Mr. E. We believe the best defense against this risk is to make sure the transfer occurs well in advance of any contract to sell and the actual sale itself. By making a charitable contribution of shares that should generate $5 million of proceeds, Mr. E could save approximately $1,190,000 ($5,000,000 x 23.8%) in federal income tax. 3 Increasing the lead time of any charitable transfer of stock, however, can create another set of problems. What happens if the sale does not occur after the charitable transfer takes place? The company would find themselves with charity as a potential long-term shareholder and the charity would own an operating business that it likely has no desire to own. Working with legal counsel to give shareholders a right to sell their interest back to the company or a right of first refusal in the shareholder s agreement can help mitigate this risk. The need to transfer company stock to charity sooner rather than later also may give the donors less lead time before the transfer to work with the university to design a detailed plan for the building of the stadium. The use of a donor-advised fund (DAF), which can 3 Note that the valuation of the stock may be less than the purchase price depending on when the transaction occurs so this tax savings may vary. If the business owner lives in a high income tax state, then the tax savings may be even greater. 4
direct disbursements over time to build and operate the stadium, might present a good solution. Using a DAF also affords Mr. and Mrs. E some level of control of the sales proceeds if the school chooses to back out of its commitment. The funds cannot be returned to Mr. and Mrs. E but can be used for other charitable purposes. We routinely work with charities that establish these types of funds for our clients. During the discovery process, we also identified Mr. and Mrs. E s desire to transfer some stock to or for the benefit of their children and future descendants. After reviewing the Capital Sufficiency analysis, Mr. and Mrs. E decide that they can afford to transfer $15 million by gift. The structure of any gift must be carefully considered. Mr. and Mrs. E are concerned about the impact of such significant wealth on their children, and thus do not want them to receive financial resources outright. Consequently, it is important to discuss with Mr. and Mrs. E the advantages of using a trust as the recipient of the gift. These advantages include: Protection of the trust assets from unwise actions of the beneficiaries Protection of the trust assets from former spouses or other creditors of the beneficiaries A structured disposition of trust income and principal Flexibility to account for changes in circumstances Additional trust issues to discuss with Mr. and Mrs. E include who should serve as trustee, whether a trust protector or other trust advisors should be used, how long the trust should last, the coordination of the trust with other estate planning documents, whether Mrs. E will have access to the trust, whether the trust income will be taxed to Mr. E, and how the trust should operate if the sale does not occur. Mr. and Mrs. E should also consider certain estate planning techniques that freeze or reduce the value of their estate. One popular technique is the use of a family limited partnership (FLP) or family limited liability company (FLLC). If correctly structured and implemented, an FLP or FLLC can provide both tax and non-tax benefits. One possible structure begins with Mr. E contributing company stock to a FLP or FLLC in exchange for units in the FLP/FLLC and then transferring the units to a trust for the benefit of the children and future generations. Utilizing an FLP/FLLC can provide the following two benefits: 1. Centralized management by the general partner or managing member, who may often be Mr. E or other experienced business advisor 2. Asset protection, because limited partner/member rights are restricted under terms of the entity s operating agreement, providing very limited transferability and little or no access to cash or assets These legal benefits also impact the valuation of the ownership interests in the FLP/FLLC. Because of the significant restrictions on the limited partnership or member interest, a valuation expert may assign a discount to the value of the FLP/FLLC unit when compared to the value of the underlying assets. For example, assume Mr. E funds an FLLC with stock worth $15 million in exchange for FLLC units. A week later he makes a gift of all of his FLLC units to a trust 5
for the benefit of his children and their descendants. An appraisal of the FLLC units might conclude that they should be discounted by 33% so that the value of the units gifted is approximately $10 million, which is just under Mr. and Mrs. E s combined federal gift tax exemption, resulting in no gift tax owed. The federal transfer tax potentially saved is $1.8 million ($15 million - $10.5 million) x 40%, which is the highest federal estate tax rate) 4. In addition, no appreciation in value of the partnership units will be included in Mr. E s estate and therefore subject to federal estate tax, which could save millions more in federal estate tax. The transfer also may be designed to eliminate future estate and generation skipping transfer taxes. As with many planning techniques, the FLP or FLLC involves risks. A primary risk is that the IRS successfully disregards the valuation discount, resulting in a taxable gift of $15 million. If the IRS were to prevail in establishing the $15 million value, Mr. E will pay $1.8 million of federal gift tax (plus interest and penalties) since only $10.5 million of the gift is sheltered from federal gift tax. This risk may be mitigated by the use of a defined value formula clause in which a set amount (usually equal to the remaining federal gift tax exemption) is transferred to the FLP or FLLC with any excess amount as determined by the IRS on audit either passing to charity or back to the donor. In a few cases, courts have approved this approach, but the IRS continues to litigate the issue. Mr. and Mrs. E might consider using other techniques in addition to or in lieu of a FLP or FLLC to hedge some of the risk (such as a grantor retained annuity trust or a sale to an intentionally defective grantor trust). Effective pre-transaction planning is complex and requires the careful coordination of financial, tax and legal considerations. The complexity of the planning discussed above requires the careful coordination of financial, tax and legal considerations. GenSpring advises business owners on the type of planning discussed and is able to coordinate advice from the business owner s attorneys, CPA and other advisors to make sure all facets are addressed. Phase 4: Administration After going through an intensive discovery and planning process, many wealthy families pay the professional fees, place the documents on a shelf and quickly forget about them. However, proper ongoing administration of the plan and consistent follow up on open items are critical to achieve successful results. Given the planning put in place in our case study, ongoing care and attention must be given to: Mr. and Mrs. E, who will receive $80 million sales proceeds The FLLC, which will receive $15 million The Trust, which owns an FLLC interest The Donor-Advised Fund, which will receive $5 million Once the sale of the business has been completed, the 4 For illustration purposes only. Actual results may vary. 6
next order of business is to coordinate the payment of federal and state income taxes with the CPA. Estimated tax payments will need to be adjusted to prevent penalty payments and the CPA will want to evaluate whether or not to pay the state income tax by year end. With the creation of the FLLC and trust, existing estate planning documents should be reviewed and updated as needed. Additionally, a valuation expert will need to appraise the value of the LLC units transferred by gift to the trust. Once the DAF receives its $5 million of sale proceeds, we will assist Mr. and Mrs. E in determining how to structure a gift from the DAF to the university. For example, Mr. and Mrs. E may want to require a matching gift program or additional commitments of support from the school as a condition of funding the project. The GenSpring Discovery and Planning process uniquely positions us to serve Mr. and Mrs. E and the FLLC manager as investment advisor for the liquid sales proceeds. Applying a goals-based approach to portfolio construction, Mr. and Mrs. E s portfolio may be compartmentalized into multiple sub-allocations designed to solve for their nearterm income and longer-term wealth accumulation objectives. Additionally, the unique requirements and objectives of the family LLP/LLC, Trust and donor advised fund must also be considered in the design and management of those specific portfolios. Through the Planning process, GenSpring also considers tax sensitivity and takes a best-fit approach when deciding which investments to locate across the different family entities and portfolios. Our goal is to create an investment plan for Mr. and Mrs. E that considers financial goals, both short and long term, so that they can feel secure that their needs will be met and their overall planning is fully integrated. Conclusion After working through GenSpring s Pre-Transaction Planning Process, Mr. and Mrs. E agreed that the sale of the Widget Corporation was in their best interest and the sale proceeded. They are currently enjoying a life of travel and following their daughters collegiate successes, both on and off the softball diamond. We believe GenSpring s approach to delivering a timely and thoughtful process to pre-transaction planning allows families to unlock additional value in a sales transaction. Our experience over 25 years has shown that, while every family and transaction is unique, they can all benefit from the objectivity, integration and coordination we deliver throughout our four-phase Pre-Transaction Planning Process. Authored by GenSpring Wealth Advisory Center, with contribution from: Tim Tallach, JD, CPA, Head of Wealth Advisory Center and David Neubert, CPA, Managing Director 7
Disclaimers The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. Investment decisions should always be made based on the investor-s specific financial needs, objectives, goals, time horizon, and risk tolerance. The statements herein are based upon the opinions of GenSpring and third party sources. Information obtained from third party resources are believed to be reliable but not guaranteed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. To know more, please call 866.506.1989 or visit us on the web at www.genspring.com 2015 GenSpring Family Offices, LLC. All Rights Reserved. rev. 20161122