PLANNING FOR THE BUSINESS OWNER INTEGRATING ESTATE AND SUCCESSION PLANS

Business Succession vs. Estate Planning

Estate planning

Plan for transfer of all assets
Provide for all family members
Primarily focused on future needs

Business succession planning

Focus on one asset: the business should provide for orderly transfer of business to specific, intended successors. Must address both current operational needs and future goals.

Non-tax considerations as important as tax issues

Absence of family governance and/or business succession plan often cause business’ failure to survive to next generations, not lack of tax planning.

First Critical Step: Identify Business Succession Goals

Overall goals direct estate and tax planning for business and owner.

Key areas:

Anticipated Successors – Who Will Take Over the Business?

Transfer to other owners
Transfer to family members or key employees
Sale to a third party

Timeframe – When Do You Want to Leave?

Specific number of years
Retirement
Death

Financial Objectives – What Do You Want from the Business?

Maximum current income stream
Reinvest for growth and cash-out in future (e.g., upon sale)
Source of retirement income

Planning the Exit

Transfers to Other Owners – Buy-outs for Death, Disability, Retirement/Withdrawal.

Avoid Conflict. Advanced planning avoids conflict at potentially stressful time.

Use Agreements. Address issues in buy-sell or shareholders agreements (“BSAs”).

Buy-out Structure.

Three general structures for buyouts:

Redemption: Business buys-out departing/deceased owner.
Cross Purchase: Other owners buy-out departing/deceased owner.
Hybrid: Combines aspects of above (e.g., company has right of first refusal before owners can purchase interests).

Selection will depend on type of business and potential tax issues.

Valuation of the Business
Critical: Determines what owner receives at death/departure
Accuracy: Buyout value should closely reflect actual value
Funding: Impacts determination of liquidity and funding requirements
Taxation: Affects value for income & estate tax purposes.
High Value: Increases taxes and illiquidity for owner’s estate
Low Value: May not be respected by the IRS
Result – high estate tax liability for estate without receipt of offsetting proceeds for business interests.
Fixing Estate Tax Value: A BSA may fix estate tax value of business interest if it: Requires estate to offer business interests for sale at decedent’s death. Prohibits lifetime sales/dispositions other than as provided in BSA.

Family Business Consideration – BSA can still allow lifetime gifts of business interests and satisfy this requirement. Sets a reasonable and ascertainable price (or method to determine). Can set a fixed price, require an independent appraiser, use a formula relating to the financial elements of the business, etc.
Is a bona fide business arrangement. Is enforceable and adopted for a valid business purpose.

Family business consideration: Courts recognize that orderly transitions at death and maintaining family control are valid business objectives.

But IRS still closely scrutinizes for lack of a business purpose any BSA among family members 

Is not to be used as a device to pass decedent’s interests to family for less than adequate consideration (also a requirement under older law).

Particularly targets family businesses: A BSA among related parties will be subject to closer scrutiny on this issue. Has price and other restrictions comparable to similar arrangements entered into by persons in arm’s length transactions. Vague test, with little case law to interpret – may be difficult in some private company settings to find comparables.

Burden of proof rests with the taxpayer – higher scrutiny for a family business with related parties

Buy-out Funding. Options may include one or combination of the following:

Life insurance and/or disability insurance.
Payment from business assets and operations.
Promissory notes (notes terms and/or interest rate can be set in agreement or negotiated at buy-out). Issuance of non-voting interests in exchange for voting interests (may entitle owner to on-going income/distributions.

Transfers to Family Members.

Advanced Planning. Exit strategy requires significant advanced planning and adoption of clear succession plan to ensure successful transition.

Strategic and Leadership Issues. Plan should: Identify family members who will take over leadership and management. Provide restructuring/redemption plan to provide for non-active family members.

Plan should:
Address transfer restrictions for business interests (i.e., transfers only to family members or trusts). Make provisions for bankruptcy/divorce of family members (e.g., require buyout of the interests or conversion to assignee interest).
Provide maximum benefit for income and estate tax purposes .

Passive and Active Owners. Options to equalize inheritance/benefits among active and passive family members to avoid family conflict disrupting business operations.

Split ownership into passive (non-voting) and active interests.
Active family member(s) receive control over business; passive members still share in business growth. Equalize with other assets or life insurance.
Passive members receive equivalent benefit from cash or other assets. Simple and eliminates involvement of passive family members in business.

Retaining Key People. Offer incentives to retain key employees – their knowledge/experience can help to smooth transition. E.g., 162 bonus plans, deferred compensation, retirement, profits sharing plans. Selling to Third Party.

No Family Participation. Good option if family participation not possible or desired.
Resolve Conflicts Pre-Sale. Owner conflicts can delay sales and impact value. Anticipate and address potential conflicts well before sale – easier than trying to address disparate interests under pressure of a closing. Use BSAs to set out the sale process and each owners’ rights/duties
Perform Pre-Sale Due Diligence. Most sales begin with a preliminary price agreement, subject to buyer’s “due diligence”.
Price rarely increases, but may decrease, given buyer’s discoveries.
Buyer often requires exclusivity in negotiations once due diligence begins, so seller does not have time to “fix” issues. Smart sellers should examine businesses well before sale to identify potential issues and structure operations to facilitate a due diligence review.

Review Tax Issues and Sale Structure. Seller potentially can negotiate sale structure in tax favorable manner. Optimum sale structure depends on entity (e.g., partnership, C corp., S corp.). Potential tax ramifications depend on the sale structure – a taxable transaction (e.g.,stock or asset sale) or tax-free reorganization (e.g., stock swaps).

Unique Estate Planning Considerations for Business Interests

Coordinate business plan with estate plan.

Confirm Proper Disposition. Ensure estate planning documents dispose of business interests as desired and incorporate terms of BSAs.
Use Trusts. Consider using trusts to hold interests passing to beneficiaries.
Consider structuring as long-term dynasty trusts.
Flexibility in fiduciary and jurisdiction selection (for state income tax or asset protection considerations).
Ability to structure dispositive provisions.
Investment management and training.
Creditor protection for beneficiaries (bankruptcy, litigation, divorce, etc.).Trustee selection is critical.
Consider qualifications, willingness to hold business interests and business acumen and ability.
Dynasty trusts may need corporate trustee for continuity.
But corporate trustees may be unable/unwilling to manage business interests.
May need to bifurcate trusteeships or appoint a business advisor (below).
Include business specific provisions.
Limits on application of spendthrift trust provisions to business interests if needed to secure credit lines.
Specifically authorize trustee to own/retain business interests, continue business operations and participate in business decisions.
Include exemptions from requirements for trust diversification, prudent investor,
income productivity, etc.

Address Incapacity. Planning documents must deal with incapacity.
Execute DPOAs to designate agents to handle financial matters, including managing business interests and satisfying BSA obligations.
Use revocable trusts to hold business interests, so successor trustee automatically takes over upon owner’s incapacity.
Can include provisions to specifically address management of business interests.

Consider a Business Advisory Committee (BAC). Provides guidance to fiduciaries regarding management of business interests when owner is disabled/deceased.

“Mini” Board of Directors. Typically composed of trusted group of individuals (e.g.,family members, key employees) who have familiarity with the business.
Can serve as a training ground for active, “junior” family members.
Precatory vs. Mandatory. BAC can provide advisory or binding guidance.
Guidance standards can be customized to your needs.
Fiduciaries should be relieved of liability for following the BAC’s advice.
Designating Members. You designate initial members, successors and methods for selecting successors.
Should specify qualifications for membership (experience, age, etc.).

Plan for liquidity needs.

Quick liquidity. Estates of business owners often need quick liquidity after death:

Estate administration expenses.
Income stream to support surviving family members.
Estate taxes due, in cash, nine months after death.

Options include:
IRC § 6166 estate tax payment extension for estate consisting largely of closely-held
business interest.
But complex requirements to obtain extension that can be difficult to comply with
initially and over the long-term.
Life insurance (can avoid estate tax if properly held in trust).
Maintenance/investment in side fund of other assets borrowing.

Tax Planning for Business Interests

See advice early. Seek tax planning and wealth preservation advice well before sale.

Effectiveness of many tax-saving techniques depends on valuation. Business interests generally have lower value when a sale is not anticipated and can be transferred at this value for a lower tax cost.

Evaluate wealth transfer strategies.

Income tax issues. Lifetime gifts may have adverse income tax consequences. Gifted property takes a “carry-over” tax basis.
Federal and state LTCG taxes on gain from later sale of interests may exceed estate taxes that would have been due at death.
Basis “step-up”. Inherited assets get basis “step-up” to fair market value.Large, indexed federal unified credit allows you to hold more assets until death and achieve a basis step up without incurring federal estate taxes.
Heirs benefit from estate tax savings and basis step-up.
Global analysis required. Need to perform comprehensive analysis of a gift versus a bequest, looking at total income and estate tax exposure.
Preservation of federal unified credit to attain basis step-up may be preferred Goal. Minimize taxable estate and preserve federal unified credit.
Options. Transfer assets/business interests through zero gift strategies GRATs.
Transfer interests to irrevocable trust and retain right to receive an annuity for a term of  years.
Annuity payments based on value of contribution and federally set 7520 rate for month of contribution.
7520 rate remains low.
GRAT assets must beat 7520 rate to transfer wealth to remainder beneficiaries, gift and estate tax-free.

Low 7520 rates increase likelihood of wealth transfer

Issues:
Not as efficient for GST tax planning
Difficult to avoid satisfying annuity payments in-king (with return of business interests) if business distributes limited cash.
GRAT structures
Zero-Out GRATs – Good for limited exemption planning
Present value of owner’s retained annuity equals
present value of assets contributed to GRAT.
No taxable gift made at transfer to GRAT.
Implement strategy with no or minimal gift tax exemption.

Rolling GRATs – Good for hedging performance.
Transfer property to zero-out GRAT with short (e.g., 2-year) term and transfer each subsequent annuity payment to new GRAT.

Limits impact of market volatility because shorter GRATs not bogged down by poor initial performance.
Minimizes estate tax inclusion risk since terms are shorter. Installment Sales to Grantor Trusts Sale disregarded for income tax purposes; no gain recognized.
IRS requires minimal interest rate on note equal to AFR.
August 2018: Mid-term 2.80% / Long-term 2.95%
If assets sold appreciates more than AFR, owner transfers tax-free wealth to trust beneficiaries.

Like GRATs, installment sales benefit from current low rates

Notes:
Recommend initial gift for capitalization of trust. Efficient for GST tax planning
Consider valuation issues. Transfer interests when maximum potential for appreciation (business close to lowest value).
Take advantage of applicable valuation discounts (while available).
Lack of marketability, lack of control, etc.
Transfers more value for less.
Review governing documents. They may need changes to implement planning.
Recapitalize business into voting and non-voting interests.
Change BSAs to allow transfers to family, trusts, etc.
Consider Techniques While Available.Targeted transactions. Administration’s budget proposals target rolling GRATs, sales to grantor trusts, and dynasty trust planning:
10-year minimum term GRATs.
Estate/gift taxation of assets sold to grantor trusts in disregarded transactions (e.g.,installment sales between grantor and grantor trust).90-year limit on application of GST exemption to trusts.
Impact of enactment. Proposed changes, if enacted, would impact/eliminate tax efficiency of these strategies right now, none of these changes have taken effect or are close to enactment.