Succession Planning for the Closely-Held Business

Presented by:

Julius H. Giarmarco, Esq.Giarmarco, Mullins & Horton, P.C.

101 W. Big Beaver, 10th FloorTroy, Michigan 48084

(248) 457-7200jhg@disinherit-irs.com

ICLE’s 50th Annual Probate & Estate Planning Institute

Five Levels of Business Succession Planning

1. Determine business owner’s objectives for the business.

2. Determine business owner’s financial needs, including the desired level of retirement income.

3. Determine who will manage the business both short-term (during the transition period) and afterward.

4. Determine who will own the business, and how to fairly treat any inactive children.

5. Minimize transfer taxes.

Level 1 – Owner’s Objectives

1. Is the business to remain in the family or to be sold to a third party?

2. Is the business to pass to family members and non-family members alike?

3. When (or at what age) does the business owner intend to retire?

4. At what point does the business owner plan to give up control over the business?

5. How will the business be transitioned to the next generation (i.e., sale, gift, or combination of both)?

Level 2 – Owner’s Financial Needs

1. Is the business owner “cash poor”, but “rich on paper”?

2. What are the business owner’s retirement needs?

3. Does the business owner plan to increase his/her standard of living upon retirement?

4. Does the business have the necessary profit and cash flow to support the business owner in retirement?

5. Must the business be sold to support the business owner’s retirement needs?

Level 3 – Developing Management

1. Will successor managers be family members, key employees, or a combination of both?

2. Is there more than one active child to split management duties?

3. How to attract and retain key employees? Employment Agreement / Profit Sharing Non-Qualified Deferred Compensation Change of Control Agreements

4. Should outside directors or an advisory board be utilized?

5. Consider a management committee for the business owner’s Living Trust.

Level 4 – Transferring Ownership

1. The business owner can retain control by holding voting interests until death, disability or retirement.

2. Gifting business interests is more tax efficient, but selling the business may be necessary for the business owner’s retirement needs.

3. Consider salary continuation agreement for the business owner in connection with gifting program.

4. Consider irrevocable life insurance trust for the benefit of inactive children as an estate equalizer.

5. If there is more than one business owner a buy-sell agreement is essential.

Buy-Sell AgreementsObjectives

1. Guarantee a market for a deceased, disabled or withdrawing stockholder’s shares.

2. Guarantee that control over the Corporation remains in the hands of the surviving or remaining stockholder(s).

3. Fix the value of the Corporation for estate and gift tax purposes.

Buy-Sell AgreementsStructure

1. Stock Redemption.

2. Cross-Purchase.

3. Wait and See.

Disadvantages of Stock Redemption vs. Cross-Purchase

1. In a “C” Corporation, death proceeds are subject to a 15% alternative minimum tax (“AMT”).

2. Surviving shareholder does not receive a stepped-up basis in his/her shares.

3. May result in Corporation “subsidizing” the buy-out of an older and/or less healthy stockholder.

4. Family attribution rules – loss of capital gain treatment.

Buy-Sell AgreementsMajor Provisions

1. Triggering Events.

2. Purchase Price.

3. Payment Terms.

4. Funding Options.

Buy-Sell AgreementsTriggering Events

1. Death.

2. Total and Permanent Disability.

3. Retirement.

4. Voluntary Termination of Employment.

5. Involuntary Termination of Employment.

6. Desire to Sell to Third Party.

Buy-Sell AgreementsTriggering Events

7. Involuntary Transfers (i.e., bankruptcy or divorce).

8. Deadlock.

9. Tag-a-Long Provisions.

Note:

Death and disability are usually mandatory buy-outs, while the other triggering events usually just result in a right of first refusal.

Buy-Sell AgreementsPurchase Price Formulas

1. Book Value.

2. Adjusted Book Value.

3. Price Per Share (Subject to Annual Revaluation).

4. FMV Determined by CPA.

5. FMV Determined by Independent Appraisers.

6. Capitalization of Earnings.

7. Industry Formula.

Buy-Sell AgreementsPayment Terms

1. Amount of Down Payment.

2. Number of Monthly Installments.

3. Interest Rate (Prime Rate or Applicable Federal Rate Established Monthly by IRS).

4. Promissory Note (Usually Attached to Agreement).

5. Escrow Agreement (Usually Attached to Agreement).

Buy-Sell AgreementsFunding Options

1. Cash Flow (may hinder business).

2. Sinking Fund (may not be enough time).

3. Borrow (interest increases purchase price).

4. Installments (interest increases purchase price).

5. Life Insurance (consider economics).

Level 5 – Minimizing Transfer Taxes

1. Utilize annual exclusion gifts; gift tax exemption; and valuation discounts.

2. Make gifts in trust to protect beneficiaries from creditors, ex-spouses and estate taxes.

3. If sale required for business owner’s retirement needs, consider: Grantor Retained Annuity Trust (GRAT) Sales to Grantor Trust Private Annuity Self-Cancelling Installment Note (SCIN) Charitable Stock Bailout

Grantor Retained Annuity Trust

§7520 Rate 3.4%

Owner’s Age 65

Income Earned by Trust 10%

Annual Growth of Principal 5%

Term/Number of Payments 10

Pre-discounted FMV $5,000,000

Discounted FMV $3,000,000

Annual Percentage Payout 16.66%

Taxable Gift -0-

Beginning 5.00% 10.00% AnnualYear Principal Growth Annual Income Payment Remainder

1 $5,000,000 $250,000 $512,500 $499,800 $5,262,700

5 $6,316,539 $315,826 $647,445 $499,800 $6,780,012

10 $9,456,952 $472,847 $969.337 $499,800 $10,399,337

Summary $5,000,000 $3,408,963 $6,988,374 $4,998,000 $10,399,337

Shareholder

• Paying Trust’s income taxes is equivalent of tax-free gift

• Retains control as 10% voting shareholder

• Receives $124,620 annually (from interest payment and $50,000 of distributions on the 10% voting shares)

• Pays income taxes of $210,000 ($500,000 x 42%) - for annual “short fall” of $85,380 ($210,000 – $124,620)

• $500,000 FMV

• $4,000,000 FMV

• Trust earns 10% on $4,500,000 = $450,000/ year

Trust pays interest only for 9 years of $74,620 annually

($2,600,000 x 2.87%)

Gifts 10% non-voting S Corp stock

(10% x $5,000,000 = $500,000 less 35% discount = $325,000)

Sells 80% non-voting S Corp stock(80% x $5,000,000 = $4,000,000

less 35% discount = $2,600,000)

Trust’s Cash Flow$450,000($74,620)$375,380

Installment Sale to a Grantor Trust

• Trust reinvests the excess cash flow of $375,380/year

Grantor / Dynasty Trust

Private Annuity Sale

§7520 Rate 3.4%

Price for S Corporation Stock Sold $2,600,000

Payment Period Annual

Annual Payout $208,671

Shareholder’s Life Expectancy (Age 65) 20 Years

Self-Canceling Installment Note

§7520 Rate 3.4%

Price for S Corporation Stock Sold $2,600,000

No-Risk-Premium Market Interest Rate 2.87%

Interest Rate Risk Premium 2.79%

Total Interest Rate 5.66%

Charitable Stock Bail Out

Shareholder

Charitable Remainder

Unitrust

S Corp

1. Shareholder transfers his voting shares to his child and his non-voting shares to the CRT, leaving child the sole shareholder. This terminates Subchapter S election.

2. Shareholder receives a charitable income tax deduction and income for the rest of his and spouse’s lives.

3. Stock is transferred from the trust to the S corp in exchange for cash.

4. Life insurance can be purchased to “replace” the wealth passing to the CRT.

Level 5 – Minimizing Transfer Taxes

4. Statutory relief: IRC Section 303 (stock redemption) IRC Section 6166 (installment payout)

Section 303 Redemption During Shareholder’s Lifetime

S Corp

Shareholder

Insurance Company

• If stock interest is more than 35% of adjusted gross estate, the estate will qualify for a partial redemption.

Obtains Life Insurance

Insured

Pays Premiums

Section 303 Redemption Upon Shareholder’s Death

S Corp

Shareholder

Insurance Company

• Partial redemption is not treated as a dividend.

• Family continues to retain an ownership interest.

Stock Passes

Pays Death Benefits

Shareholder’s Living Trust

Some Stock

Cash

Section 6166

Assumptions:

Tax Year 2009

IRS Underpayment Rate 4.00%

Inflation Rate 5.00%

Adjusted Gross Estate $9,500,000

35% of Adjusted Gross Estate $3,325,000

Value of Business (42% of AGE) $4,000,000

Federal Estate Tax Due $2,700,000

Section 6166

Estate Qualifies for Section 6166 Benefits:

Federal Estate Tax Due $2,700,000

Amount Deferred (42% of FET) $1,136,842

Tax Currently Due $1,563,158

Two (2%) Percent Amount $598,500

Amount of Tax at ‘Going Rate’ $538,342

Net Cost of Interest $207,745

Section 6166

Year Principal

2% Interest

2% Principal

1.80% Interest 1.80%

Total Interest

Total Payment

1 $598,500 $12,090 $538,342 $9,778 $21,868 $21,868

2 $598,500 $12,090 $538,342 $9,778 $21,868 $21,868

3 $598,500 $12,090 $538,342 $9,778 $21,868 $21,868

4 $598,500 $12,090 $538,342 $9,778 $21,868 $21,868

5 $538,650 $12,090 $484,508 $9,778 $21,868 $135,552

10 $239,400 $6,045 $215,337 $4,889 $10,934 $124,618

14 $0 $1,209 $0 $978 $2,187 $115,871

Totals: $114,855 $92,890 $207,745 $1,344,585

Level 5 – Minimizing Transfer Taxes

5. Life insurance applications: Estate liquidity Funding a buy-sell agreement Informally funding an NQDC Key person insurance Section 303 funding As a hedge with a GRAT Family bank

“When I go, I plan on taking at least two of my estate-tax lawyers with me.”