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Business Succession Planning and Exit Strategies for the Closely Held and Family Owned Business
 

Business Succession Planning and Exit Strategies for the Closely Held and Family Owned Business

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    Business Succession Planning and Exit Strategies for the Closely Held and Family Owned Business Business Succession Planning and Exit Strategies for the Closely Held and Family Owned Business Presentation Transcript

    • Presenters: Neil Morganbesser, Co-Founder and President Alexander B. Kasdan, Managing Director Louis A. Mezzullo, Partner John L. Babala, Partner BUSINESS SUCCESSION PLANNING AND EXIT STRATEGIES for the Closely Held and Family Owned Business October 3, 2013
    • 1 Neil Morganbesser is co-Founder and President & CEO of DelMorgan & Co. where he provides senior leadership within the firm and helps oversee all client engagements. Mr. Morganbesser is also CEO of Globalist Capital LLC, DelMorgan’s broker-dealer affiliate. Mr. Morganbesser has over 20 years of experience providing financial and strategic advice to a full range of clients, including entrepreneurs, large corporations, governments, family businesses, private equity funds, and special committees of public companies. Mr. Morganbesser has been affiliated with some of the leading institutions in the world, and his experience ranges from representing the offshore owners in the sale of a small, private U.S. company for $10 million to representing the special committee of a large, public company in a $9 billion negotiated management buyout with a highly complex financial structure. Mr. Morganbesser has truly global experience with the most sophisticated transactions, across a broad range of industries and in a large number of jurisdictions, as the lead banker on a wide variety of transactional and other advisory assignments, including domestic and cross-border mergers, acquisitions, joint ventures, sales and divestitures, restructurings, special committee assignments, unsolicited acquisitions and hostile defense. With transactional experience in over 30 countries, Mr. Morganbesser has successfully advised on over 75 transactions. Until May 2008, Mr. Morganbesser was the head of West Coast and Asia Mergers & Acquisitions at Bear Stearns & Co., as a Senior Managing Director based in Los Angeles. Prior to joining Bear Stearns in May 2001, Mr. Morganbesser was an investment banker in the Mergers, Acquisitions and Restructuring Department at Morgan Stanley (in New York from 1993-1998 and in Los Angeles from 1998-2001). From 1990-1993, Mr. Morganbesser was a corporate and M&A attorney at the preeminent New York law firm of Wachtell, Lipton, Rosen & Katz. Mr. Morganbesser graduated with an A.B. magna cum laude in Applied Mathematics / Economics from Harvard University (Phi Beta Kappa) in 1986 and received his J.D. and M.B.A. degrees (Order of the Coif, with honors) from Stanford University in 1990. 100 Wilshire Blvd. Suite 750 Santa Monica, CA 90401 (310) 319-2000 www.delmorganco.com nm@delmorganco.com
    • 2 Alexander B. Kasdan is a Managing Director at DelMorgan & Co. He has more than twenty years of investment banking, real estate, corporate law and corporate strategy experience. Mr. Kasdan has executed over 100 domestic and cross-border transactions totaling more than $10 billion in overall volume in a variety of industries. Prior to joining DelMorgan, Mr. Kasdan founded Convergence Capital Partners, LLC, a boutique investment banking advisory and real estate investment firm and was an investment banker at Barrington Associates, Peter J. Solomon Company, Credit Suisse First Boston and Merrill Lynch. Mr. Kasdan practiced law with O’Melveny & Myers LLP (formerly O’Sullivan Graev & Karabell LLP) and Paul, Hastings, Janofsky & Walker LLP (formerly Battle Fowler LLP), where he specialized in mergers and acquisitions, private equity and corporate finance transactions. In addition, Mr. Kasdan served as Corporate Counsel in charge of business development at Schlumberger Ltd., a global oilfield and information services company. Mr. Kasdan graduated magna cum laude from Middlebury College with a B.A. degree in Economics and Italian and was elected to Phi Beta Kappa during his junior year. In addition, he holds a J.D. degree from Columbia University Law School and has studied at the University of Florence in Italy. Mr. Kasdan is admitted to the Bar in the State of New York. Mr. Kasdan is a Senior Advisor to Governance and Transactions LLC, an advisory firm established in 2003 by Mr. James L. Gunderson, former Secretary and General Counsel of Schlumberger Limited, to assist boards, management and owners with corporate governance, compliance, structuring and strategic transactions. 100 Wilshire Blvd. Suite 750 Santa Monica, CA 90401 (310) 980-1718 www.delmorganco.com ak@delmorganco.com
    • 3 Louis A. Mezzullo is a partner at McKenna Long & Aldridge LLP. His principal areas of practice are Taxation, Estate and Business Succession Planning, and Employee Benefits. Mr. Mezzullo is a former member of the faculty of the University of Miami School of Law Graduate Program in Estate Planning. He was an adjunct professor of law at the University of Richmond Law School from 1978 until 2006, and was on the faculty at the University of San Diego School of Law in 2009. He is listed in Who’s Who in American Law, Who’s Who in Emerging Leaders and Who’s Who in America (Marquis Who’s Who Publishers), and in The Best Lawyers in America (for Tax, Employee Benefits and Trust and Estates) (Woodward/White Publishers). In 2012, Mr. Mezzullo was elected to the National Association of Estate Planners & Councils (NAEPC) Estate Planning Hall of Fame as an Accredited Estate Planner. Mr. Mezzullo frequently serves as an expert witness in matters related to estate, tax, and business planning and trust administration, including malpractice matters on behalf of defendant attorneys. Mr. Mezzullo holds a J.D. degree from University of Richmond School of Law, Gold Medal Recipient for Best Student in Graduating Class, Phi Alpha Delta, Omicron Delta Kappa, 1976; a M.A. degree from University of Maryland, 1976, and a B.A. degree from University of Maryland, with high honors, Phi Kappa Sigma, Phi Beta Kappa, 1967. PO Box 2329 6050 El Tordo Rancho Santa Fe, CA 92067 (858) 400-1303 www.mckennalong.com lmezzullo@mckennalong.com
    • 4 John L. Babala is a partner at McKenna Long & Aldridge LLP. He acts as outside general counsel to both public and private companies in industries such as aerospace and defense, energy, financial services, food and beverage, health care, marine services, private equity, real estate, technology and third party logistics. His experience includes mergers and acquisitions, private equity investments (companies, sponsors and funds), offerings of debt and equity securities (including SEC compliance), and corporate finance. He also advises directors and senior management on complex matters of corporate governance, such as directors' fiduciary duties and special committees related to transactions. In addition to representing companies based in the U.S. and California in particular, he represents parties from, or transactions in, Africa, Australia, Canada, China, France, Japan, Mexico and the UK. Mr. Babala has been recognized as a Super Lawyer Rising Star by Law & Politics, publishers of Los Angeles magazine. He publishes and lectures regularly on corporate law, mergers and acquisitions, and securities. Mr. Babala holds a J.D. degree from University of Michigan Law School, 1995, and a B.A. degree from Alma College, 1995. 300 South Grand Avenue 14th Floor Los Angeles, CA 90071 (213) 243-6110 www.mckennalong.com jbabala@mckennalong.com
    • mckennalong.com+mckennalong.com+ Louis A. Mezzullo McKenna Long & Aldridge LLP Rancho Santa Fe, California lmezzullo@mckennalong.com Business Succession Planning
    • 5508230.1+ 2+ A.  Background 1.  Business succession planning is planning for the orderly transfer of the management and the ownership of a business to new managers and new owners to avoid a liquidation of the business as well as unnecessary taxes and other expenses, and in a manner that carries out the family’s nontax objectives. a.  Note that the ownership of the business and the management of the business may go to different people. b.  Management may even go to non-family members. c.  Ownership may be transferred outside of the family. I.  INTRODUCTION
    • 5508230.1+ 3+ 2.  Even if the federal estate tax were repealed, and even if the federal income tax were repealed, business succession planning would still be necessary. a.  The estate tax is an additional, but significant, issue that must be addressed. b.  Usually, the estate tax issue involves providing the funds to pay the estate taxes at the death of the founding entrepreneur (or, in the case of a married person, at the death of the survivor of the entrepreneur and his or her spouse if the unlimited marital deduction is being used). c.  Some of the suggested strategies may involve transactions that are subject to income tax, such as intra-family sales not involving grantor trusts. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 4+ 3.  Business succession planning requires: a.  Creativity and flexibility; b.  Understanding the company’s financial situation and appreciation for the family’s dynamics; c.  Knowledge of the tax and nontax law, including corporate, partnership, limited liability company (LLC), and employee benefit law; and d.  Knowledge of the estate planning and administration issues. B.  Characteristics of the Family Business 1.  A family business is an enterprise owned and controlled by one or more families who expect succeeding generations to own and manage it. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 5+ a.  Only about 30% of family businesses survive to the second generation and 12% to the third generation. b.  However, lost in the statistics may be family businesses that did not pass to the next generation because the family decided for good reasons that it was the better alternative. 2.  Most businesses in the United States are closely held and create over 75% of all new jobs. 3.  Family businesses generate about half of our gross national product and are prominent in retailing, distribution, and services. 4.  Surveys report that family business owners are more satisfied with the quality of their work lives than the general work force. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 6+ 5.  The strengths of a family business are independence, a feeling of accomplishment, and money. 6.  Main sources of tension in a family business. a.  The fear of the crippling effects of estate taxes on the business. b.  Emotion and control issues, not disagreements based on facts. c.  Sibling rivalries. d.  The older generation’s feeling that there is a right not to be forced to retire. 1)  In a family business, “retirement” in the owner’s mind may mean keeping control but not having to worry about day to day matters. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 7+ 7.  Consultants advise dealing with the succession issue at least 10 years before retirement and putting new management in place at least 5 years before retirement, although planning should actually occur much sooner. a.  Waiting too long makes customers, suppliers, and creditors nervous. 8.  Business succession planning frequently is 10% planning and 90% money. a.  Consequently, if there isn’t proper planning or lots of cash, the business may not survive the death of the founding entrepreneur. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 8+ C.  Liquidity Needs of the Business Owner 1.  For most family business owners, the business represents the most valuable, and often the most illiquid, asset in the owner’s estate. 2.  During the business owner’s lifetime, the business is generally the primary source of economic and emotional support for the business owner’s family. 3.  As the primary asset of the owner’s estate, the business will be the source of funds to pay estate taxes, debts, and administration expenses, as well as to pay for the support of the surviving spouse and other dependents. 4.  Without proper planning, the business may have to be sold to meet the liquidity needs of the family. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 9+ D.  Issues Facing the Business Owner 1.  The business owner planning to transfer the business to the next generation is confronted by many issues. a.  Should the owner sell the business during the owner’s lifetime? b.  Should the business be continued after the owner’s death? c.  Who will control the business after the owner’s death? d.  Who will own the business after the owner’s death? e.  Who will manage the business after the owner retires or dies? f.  Will the owner’s children be treated equally in the distribution of the owner’s estate? I.  INTRODUCTION (cont’d)
    • 5508230.1+ 10+ 2.  The owner’s objectives for the business must be consistent with the owner’s estate plan. a.  For example, if the owner wants the business to pass to one particular child, steps must be taken to provide for the other children and the payment of the estate taxes attributable to the business. E.  Goals of Owners of Businesses 1.  Retain control. 2.  Retain income to continue lifestyle of the owner and owner’s spouse. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 11+ 3.  Satisfy estate-planning objectives. a.  For example, treating children equally or fairly. b.  Perhaps making some provision for grandchildren and more remote descendants during the owner’s lifetime or at the owner’s death. 4.  Provide for the continuity of the business, partly psychological. 5.  Concern for employees of the entity. a.  Providing for “key” employees. b.  Providing retirement income to all employees. c.  Providing other fringe benefits to employees. d.  Perhaps giving some employees an equity interest in the business. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 12+ 6.  Concern for the community in which the business is located. a.  Providing employment. b.  Contributing to local civic, cultural, and charitable organizations. 7.  Charitable desires. See example below. 8.  Dynasty concerns. a.  Ensuring the business will survive the next generation. b.  This usually involves dealing with potential or real sibling rivalries. c.  The duration of any trust holding business interests will be limited by the applicable rule against perpetuities, if there is one in the applicable jurisdiction. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 13+ 9.  Reduce transfer taxes. a.  May involve lifetime transfers to reduce the founding entrepreneur’s interest to a minority interest, thereby reducing its value for estate tax purposes. b.  However, what if the business is sold after a substantial portion has been transferred to children or more remote descendants? c.  How does the founding entrepreneur retain control? 10.  Reduce income taxes. 11.  Reduce administration expenses. 12.  Provide for liquidity, including the payment of estate taxes. a.  See discussion of I.R.C. § 6166 below. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 14+ F.  Disposition of Business 1.  Sale of assets. a.  In the case of a C Corporation, a sale of assets will involve two levels of tax, once to the corporation on the unrealized appreciation of its assets and once to the shareholders on the excess of the value of the liquidating distribution over their basis in the stock. 2.  Sale of stock. a.  It is usually difficult to find a buyer of the stock of a closely held corporation because of potential unknown liabilities. b.  In addition, the purchaser may not want the existing basis for the corporation’s assets, although there are ways to have the basis reflect the purchase price for the Corporation. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 15+ 3.  Tax free acquisition — merger. a.  A tax-free exchange will usually require that a significant number of the family members receive stock in the acquiring company rather than cash and the stock will usually be subject to restrictions on resale for a period because of securities laws. 4.  Tax free division — split up, split off, or spin off. a.  May be useful when there are sibling rivalries. b.  Examples: divide the business geographically, by product line, or into retail and wholesale components. 5.  Sale to an ESOP. a.  See the example below. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 16+ 6.  Sale to employees. a.  May be an appropriate strategy when no family members are interested or capable of taking over the management of the business and it is not practical to bifurcate the ownership and the management because the cash generated by the business does not enable the business to provide enough compensation to nonfamily members to entice them to assume major roles in running the business. b.  The issue here is finding the necessary financing. 7.  Give or sell to family members during lifetime. a.  A sale will usually involve taxable gain. b.  A sale may be a way to treat children equally when not all of them are active in the business. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 17+ c.  A taxable sale will avoid any gift tax, assuming it is for full and adequate consideration. 8.  Sale to grantor trusts – family members as beneficiaries. a.  See the example below. b.  This technique avoids both income and gift taxes if structured properly. 9.  Transfer equity interests to one or more grantor retained annuity trusts (GRATs). a.  See discussion of GRATs below. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 18+ 10.  Give or sell to family members at death. a.  Allowing family members to purchase the ownership interest of a decedent at a pre-established price may have unintended transfer tax and nontax consequences because of I.R.C. § 2703 if the price is not equal to the fair market value of the interest as determined for federal estate tax purposes. 1)  It could affect qualifying for the marital deduction or the amount of the marital deduction. 2)  It could raise the issue as to who will pay the additional estate tax on the additional value. a)  One way to deal with this issue is to have the purchasing family member pay the additional estate tax attributable to the increased value. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 19+ 11.  Liquidation of the business, including bankruptcy. a.  The business succession plan has failed or one was never adopted or implemented. b.  The forced liquidation or bankruptcy results in the loss of intangible value, including good will and going concern value. G.  Conclusion Careful planning involving the entire family at an early stage, followed by implementation and follow-up, will significantly increase the chances for the successful transition of the business to the next generation. I.  INTRODUCTION (cont’d)
    • 5508230.1+ 20+ A.  ESOP Example 1.  An ESOP (employee stock ownership plan) is a qualified retirement plan in the form of a stock bonus plan or a combination of a stock bonus and money purchase pension plan that satisfies certain requirements and is designed to invest primarily in employer securities. I.R.C. § 4957(e)(7). 2.  In 2013, an employer may contribute to an ESOP up to $51,000 per each employee, plus interest on a qualifying loan. I.R.C. § 415(c). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES
    • 5508230.1+ 21+ 3.  A loan to an ESOP is exempt from the prohibited transaction rules if the proceeds are used within a reasonable time to acquire qualifying employer securities and it meets certain other requirements. I.R.C. § 4975(d)(3); Treas. Reg. § 54.4975-7(b)(4). 4.  A C Corporation may deduct dividends paid on its stock held by the ESOP. I.R.C. § 404(k). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 22+ 5.  A shareholder of a C corporation may defer gain on the sale of stock to an ESOP if the ESOP holds at least 30% of the stock after the sale and the shareholder reinvests the proceeds in stock or securities issued by a domestic operating corporation within a 15-month period beginning three months before the sale. I.R.C. § 1042. a.  If replacement securities are held until the selling shareholder dies, the gain will be eliminated altogether under I.R.C. § 1014. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 23+ 6.  Example (based on the gift and estate tax regime in 2011): Value+of+Company $ 40,000,000 ESOP+Loan+to+buy+51%+of+the+Company’s+stock $ 20,400,000 Value+of+the+Company+aIer+deducLng+the+loan $ 19,600,000 ESOP+Loan+Income+Tax+Benefit $ +++4,000,000 Ownership+Control+Value+of+the+Equity $ 23,600,000 Less+30%+Lack+of+Control+Discount+ $ +++7,080,000 Marketable,+noncontrolling+interest $ 16,520,000 Less+a+35%+Lack+of+Marketability+Discount++ $ +++5,782,000 Fair+Market+Value+of+the+Equity+for+Transfer+Tax+Purposes $ 10,738,000 Value+of+49%+of+Equity $ +++5,261,620 II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 24+ 7.  Note that the value of the remaining equity is less than the gift tax applicable exclusion amount of $10,500,000 available to Mr. and Mrs. Entrepreneur in 2013. 8.  Note also that Mr. Entrepreneur can retain control over the day to day operations of the Company, even though 51% of the stock is owned by the ESOP. B.  Sale to a Grantor Trust Example 1.  A grantor trust is a trust where the grantor of the trust (generally the person who contributed the assets to the trust) is treated as owning the assets for income tax purposes. I.R.C. §§ 671-679. a.  Consequently, transactions between the grantor and the trust, including sales, are not recognized for income tax purposes. Rev. Rul. 85-13, 1985-1 C.B. 184. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 25+ 2.  However, transfers to a properly structured trust are recognized for gift and estate tax purposes. a.  Consequently, assets transferred to the trust will not be included in the grantor’s estate for estate tax purposes. b.  Transfers to the trust will not be taxable gifts if the grantor receives fair market value for the transferred asset. c.  If the grantor takes back an installment note, there will not be a taxable gift as long as the principal is equal to the fair market value of the transferred asset and the interest rate charged is equal to the applicable federal rate. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 26+ 3.  Example: Mr. Entrepreneur owns 100 shares of the stock of an S Corporation having a fair market value of $20,000,000. He also owns commercial real estate having a fair market value of $20,000,000. He has four children, two active in the business and two not active in the business. He wants to treat the children equally, but does not want the children who are inactive in the business to have any ownership in the business. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 27+ To carry out his desires, Mr. Entrepreneur could do the following: a.  Recapitalize the corporation to create 10 shares of voting stock and 90 shares of nonvoting stock. b.  Sell 90 shares of nonvoting stock to grantor trusts having as beneficiaries the two children who are active in the business. 1)  Assuming a 50% combined discount for lack of control and marketability, the value of the stock sold to the trusts would be $9,000,000 (90% times $20,000,000 = $18,000,000 times 50% = $9,000,000). c.  Transfer the commercial real estate to a limited liability company (LLC) in exchange for a 90% nonvoting membership interest and a 10% voting membership interest. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 28+ d.  Sell the 90% nonvoting membership interest in the LLC to grantor trusts having as beneficiaries the other two children. 1)  Assuming a 50% combined discount for lack of control and marketability, the value of the LLC interests sold to the trusts would be $9,000,000 (90% times $20,000,000 = $18,000,000 times 50% = $9,000,000). e.  To avoid a number of potential tax problems, Mr. Entrepreneur should contribute $1,000,000 to each of the trusts, using some of his gift tax applicable exclusion amount of $5,250,000 in 2013 (or using some of his and his wife’s gift tax applicable exclusion amounts through a split-gift election) II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 29+ f.  At his death or the death of the survivor of him and his wife, Mr. Entrepreneur would leave the voting stock in the corporation to the two children active in the business and the remaining membership interests in the LLC to the other two children, or to trusts for the benefit of the children. C.  GRATs 1.  In a GRAT, an older family member transfers an asset to a trust and retains the right to receive a fixed dollar amount for a period of time, after which the transferor’s interest terminates and either the asset is distributed to the beneficiaries, usually younger family members, or the trust continues on for some period. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 30+ 2.  Under I.R.C. § 2702, the value of the gift is the value of the transferred asset less the value of the retained annuity interest, provided the requirements contained in I.R.C. § 2702 and the regulations thereunder are satisfied. a.  The present value of the retained interest in a GRAT for transfer tax purposes is determined using the so-called 7520 rate, which is 120% of the federal mid-term rate. b.  Consequently, if the value of the asset transferred to the GRAT does not increase in value by more than 120% of the federal mid- term rate, there is no tax-free shifting of value to the remainder beneficiaries of the trust. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 31+ 3.  Also, if the transferor dies before the end of the annuity term, the assets in the GRAT will be included in the transferor’s estate under I.R.C. § 2036(a), because he or she has retained the right to enjoy the income from the transferred assets, but only to the extent of the value of the assets necessary to provide the annuity payments. 4.  If the transferor’s estate were entitled to continuing payments, the present value of those payments would be includable in the transferor’s estate under I.R.C. § 2033. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 32+ 5.  Benefits of a GRAT a.  The benefit of a GRAT is the potential shift of value to younger beneficiaries free of transfer tax. 1)  This objective may be accomplished with minimal gift tax liability if the value of the donor’s retained annuity interest is close to the value of the asset transferred to the trust. 2)  Because the retained annuity interest in a GRAT may be valued as an annuity for a specified term of years, rather than as an annuity for the shorter of a term certain or the period ending upon the grantor’s death, it is possible to fix the value of the donor’s retained annuity interest at the same value as the value of the transferred asset (hence the zeroed-out GRAT), although many commentators suggest that there be at least a small gift element. Walton v. Commissioner, 115 T.C. No. 41 (2000). Treas. Reg. § 25.2702-3(e), example 5. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 33+ b.  It is also possible to fix the value of the asset for gift tax purposes with relative certainty by tying the amount of the annuity payment to a percentage of the transferred asset’s value as finally determined for gift tax purposes, because any increase in value on audit would cause a corresponding increase in the amount of the annuity payment, resulting in a very small increase in the value of the remainder interest, which is the measure of the gift. c.  Seed money is not required. d.  Finally, because the requirements of a GRAT are spelled out in the Code and the regulations, there is greater certainty that the desired tax consequences will be achieved. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 34+ 6.  Disadvantages of a GRAT a.  If the grantor dies during the term of the GRAT, the value of some or all of the assets in the GRAT will be includible in the grantor’s estate. b.  In addition, the value of the retained interest is based on 120% of the mid-term rate, which in most cases will be higher than the applicable federal rate used for determining the minimum interest to be paid on the installment note in the case of an installment sale to a grantor trust to avoid any taxable gift in connection with the sale. c.  Also, the grantor cannot allocate his or her GST tax exemption to the transfer of assets into a GRAT until his or her interest terminates. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 35+ d.  Finally, distributions from a GRAT may only be made to the holder of the annuity interest during the term of the interest, while in the case of an installment sale to a grantor trust there are no restrictions on who may receive distributions from the trust before or after the note has been satisfied, although the grantor should not be a beneficiary of the trust to avoid inclusion of the trust assets in the grantor’s estate. 7.  Although there is proposed legislation that would require a minimum 10-year term and a minimum value of the remainder interest, and prohibit any decrease in the annuity, this would not affect the use of a GRAT in the context of a family owned business where a ten-year GRAT would be more typical. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 36+ a.  Such a company would likely appreciate in value on an incremental basis, rather than having the volatility of a publicly traded company. b.  The cash flow from the company over the longer term may avoid the necessity of distributing interests in the company to satisfy the annuity, thereby avoiding annual valuations. 8.  Example a.  The use of a GRAT may be beneficial if the value of the property transferred to the trust will increase at a rate in excess of the rate determined under I.R.C. § 7520. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 37+ b.  The transfer of a minority interest in an S corporation or a limited partnership interest to a GRAT may allow the annuity payment to be lower than the actual pro rata portion of the expected income attributable to the stock or partnership interest due to the minority discount that would apply to the value of the stock or partnership interest when transferred to the trust. c.  For example, assume the owner of an S corporation having a fair market value of $1,000,000 transfers 49% of the stock (which can be nonvoting) to a trust, retaining the right to an annuity equal to 2% of the initial value of the assets of the trust, payable for 20 years. Assume that the appropriate interest rate for valuation purposes under I.R.C. § 7520 is 2% (the 7520 rate for September 2013. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 38+ Assume also that the value of the minority interest held by the trust is $294,000, based on a 40% minority discount (60% times $490,000). The annual payment would be $5,880, which is 2% of the discounted value of the minority interest, but only 1.2% of the undiscounted value of the interest ($490,000). If the corporation increases in value (including retained earnings) at a rate greater than 1.2%, a shift in value to the remainder beneficiary will be achieved transfer-tax free. By contrast, if no minority discount were applicable to the interest held in trust, the corporation would have to increase in value at a rate greater than 2% to achieve a similar transfer-tax free shift in value. Thus, contributing property that is subject to a minority discount allows the grantor of the trust to leverage the benefits of a GRAT. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 39+ d.  Note, however, that in PLR 9707027, involving the funding of a GRAT with cash, marketable securities, and certain limited partnership interests, the facts state that the value of any gifts of non-publicly traded partnership interests made to the GRAT will be determined without regard to any discounts for the grantor's lack of control. Presumably, the IRS required the grantor to agree to such a method of valuing the limited partnership interests. D.  Qualifying for Installment Payment of the Estate Tax 1.  Under I.R.C. § 6166, the federal estate tax attributable to closely held businesses may be paid over two to ten equal installments. a.  In most cases, the installment payments of the estate tax must begin on or before the fifth anniversary of the due date of the estate tax return. I.R.C. § 6166(a)(3). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 40+ b.  Interest is paid on the unpaid estate tax in annual installments beginning one year after the estate tax return was due. 1)  The interest rate on the deferred estate tax on the first $1,430,000 in 2013 (which is adjusted for inflation) of closely held business interests (after taking into account the applicable exclusion amount, $5,250,000 in 2013) is 2%. I.R.C. § 6601(j). 2)  The interest rate on the balance is 45% of the interest rate charged on underpayments of tax under I.R.C. § 6621. The rate is 1.35% (45% times 3%) for the calendar quarter beginning July 1, 2013. Rev. Rul. 2013-10, 2013-26 I.R.B. 1257. I.R.C. § 6601(j). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 41+ c.  The amount of the federal estate tax that can be paid in installments is the amount that bears the same ratio to the estate tax, reduced by the credits against such tax, as the closely held business amount bears to the amount of the adjusted gross estate. I.R.C. § 6166(a)(2). 1)  The closely held business amount is the value of the interests in closely held businesses that qualify under I.R.C. § 6166(a)(1). I.R.C. § 6166(b)(5). 2.  In order to elect to pay the estate tax attributable to closely held business interests included in the estate in installments, the value of the closely held business interests must exceed 35% of the value of the decedent’s adjusted gross estate. I.R.C. § 6166(a)(1). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 42+ a.  The adjusted gross estate is the value of the gross estate reduced by the sum of the amounts allowable as a deduction under I.R.C. §§ 2053 (expenses, debts, and taxes) and 2054 (losses), based on the facts and circumstances existing on the due date, including extensions, for filing the estate tax return, or, if earlier, on the date the return is filed. I.R.C. § 6166(b)(6). 1)  Because the statute refers to “allowable” deductions, such amounts reduce the gross estate for purposes of the 35% requirement regardless of whether they are actually claimed as a deduction on the estate tax return or they are claimed as deductions on the estate’s income tax return instead. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 43+ b.  The decedent must be a citizen or a resident of the United States at the time of death. c.  The executor must make an election on a timely filed estate tax return, including extensions. 3.  An interest in a closely held business is: a.  An interest as a proprietor in a trade or business carried on as a proprietorship; b.  An interest as a partner in a partnership carrying on a trade or business if 20% or more of the total capital interest is included in determining the decedent’s gross estate or the partnership has 45 or fewer partners; or II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 44+ c.  Stock in a corporation carrying on a trade or business if 20% or more of the value of the voting stock of the corporation is included in determining the decedent’s gross estate or the corporation has 45 or fewer shareholders. I.R.C. § 6166(b)(1). 4.  In determining whether the 35% requirement has been satisfied and the amount of the estate tax attributable to closely held businesses that may be deferred, the value of an interest in a closely held business does not include the portion of the interest attributable to passive assets held by the business. a.  A passive asset is an asset other than an asset used in carrying on a trade or business. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 45+ b.  A passive asset includes stock in another corporation unless the stock in the other corporation is treated as owned by the decedent because the executor has made an election to treat the stock held by a holding company as business company stock under I.R.C. § 6166(b)(8). I.R.C. § 6166(b)(9)(B)(ii). 1)  However, if a corporation owns 20% or more of the value of the voting stock of another corporation or the other corporation has 45 or fewer shareholders and 80% or more of the value of the assets of each corporation (not taking into account the stock held in the other corporation by the first corporation) is attributable to assets used in a trade or business, both corporations will be treated as one corporation for this purpose. I.R.C. § 6166(b)(9)(B)(iii). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 46+ a)  For example, if XYZ corporation owns 30% of ABC Corporation, which is also equal to 30% of the value of XYZ’s assets, and at least 56% of the value of XYZ’s assets (or 80% of the value of its assets not taking into account its ownership of ABC) consists of assets used in its trade or business, and at least 80% of the value of ABC’s assets consists of assets used in its trade or business, XYZ and ABC would be treated as one corporation for purposes of satisfying the 35% requirement. b)  While not entirely clear, this treatment should apply to more than one subsidiary as long as either the ownership or number of shareholders requirement is satisfied. c)  This provision should also apply to partnerships and LLCs. c.  It is not clear whether inter-company loans will be treated as passive assets, although they should not be treated as passive if they are used for conducting the trade or business of the subsidiary. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 47+ d.  The holding company rules should apply to partnerships and LLCs treated as partnerships. e.  In TAM 8848002, life insurance proceeds received by the company’s creditor were excluded from the amount qualifying for installment payment. 5.  The determination of whether the 35% requirement is met is made immediately before the decedent’s death, although the value may be determined at either the date of death or the alternate valuation date, and real property held as an asset in a closely held business will be valued under I.R.C. § 2032A if the estate satisfies that section’s requirements. I.R.C. § 6166(b)(2) (A) and (4). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 48+ 6.  For purposes of determining whether an interest is an interest in a closely held business, special rules apply for determining the number of owners. a.  Interests held by a husband and wife as community property, joint tenants, tenants by the entirety, or tenants in common are treated as owned by one of them. I.R.C. § 6166(b)(2)(B). b.  The property owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries. I.R.C. § 6166(b)(2)(C). 1)  A person is treated as a beneficiary of a trust only if the person has a present interest in the trust. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 49+ c.  Any stock or partnership interests held by the decedent’s family are treated as owned by the decedent. I.R.C. § 6166(b)(2)(D). 1)  Members of the family include the decedent’s spouse, brothers and sisters, ancestors, and descendants. I.R.C. § 267(c)(4). 7.  For purposes of the 20% tests for determining whether an interest qualifies as a closely held business interest and whether two or more closely held businesses are treated as a single entity, an executor may elect to treat a capital interest in a partnership and any non-readily-tradable stock treated as owned by the decedent under the constructive ownership rules discussed in 6.b. and 6.c. above as owned by the decedent. a.  If this election is made, the special 2% interest rate and the five- year deferral are not available. I.R.C. § 6166(b)(7). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 50+ 8.  If an executor elects, holding company stock will be treated as business company stock to the extent it represents direct or indirect ownership through one or more other holding companies by the holding company in a business company. a.  A holding company is any corporation holding stock in another corporation. b.  A business company is any corporation carrying on a trade or business. c.  If the election is made, the special 2% interest rate and the five- year deferral are not available. d.  The stock of the holding company must be non-readily-tradable. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 51+ e.  If the stock of the business company is readily-tradable, the installments must be paid over five years. f.  For purposes of the 20% voting stock requirement, holding company stock deemed to be business company stock is treated as voting stock to the extent that voting stock in the holding company owns directly or through one or more other holding companies voting stock in the business company. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 52+ g.  Note that the election under I.R.C. § 6166(b)(8) is not needed if a corporation owns 20% or more of the value of the voting stock of another corporation, or such other corporation has 45 or fewer shareholders, and 80% of more of the assets of each corporation is attributable to assets used in carrying on a trade or business, excluding for this purpose the stock owned in the other corporation. I.R.C. § 6166(b)(9)(B)(iii). In such a case, the two corporations are treated as one. I.R.C. § 6166(b)(8). II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 53+ 9.  Interests in two or more businesses will be treated as one business if 20% or more of the value of each business is included in the value of the decedent’s gross estate. a.  Interests held by a surviving spouse in property held by the decedent and surviving spouse as community property, or as joint tenants, tenants by the entirety, or tenants in common are treated as having been included in the decedent’s gross estate for this purpose. 1)  Note that an interest held by the spouse individually will not qualify for this exception, and must be treated under the rules discussed above for family members. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 54+ b.  As noted above, an executor may elect to have other attribution rules apply, but the special 2% interest rate will not apply and the five-year deferral of principal payments is not available. I.R.C. § 6166(c). 10.  Other Issues: a.  What qualifies as a trade or business. 1)  Note that the IRS has taken a more liberal view of when real estate that is leased to a business qualifies as a trade or business under I.R.C. § 6166. 2)  In addition, the IRS has allowed a business that is managed by a company in which the decedent owns at least a 20% interest to qualify as a trade or business under I.R.C. § 6166. See Rev. Rul. 2006-34, 2006-26 IRB 1171 II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 55+ b.  The mechanics of making the I.R.C. § 6166 election. c.  Acceleration of the deferred tax if certain dispositions of closely held business interests occur. d.  Liens to secure the payment of the deferred tax. e.  Other special and miscellaneous rules. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 56+ E.  Using Life Insurance to Provide Liquidity 1.  Life Insurance provides instant cash, usually on an income tax free basis, to pay estate taxes and other administration expenses and to buy out a deceased owner’s interest. 2.  Once it is decided that life insurance has a role, the next concern is keeping the proceeds out of the insured’s estate if possible. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 57+ 3.  One way of excluding the insurance proceeds from either the insured’s estate or the value of the company is to have the older generation establish grantor trusts for the benefit of members of the younger generations. a.  The older generation family members would gift and sell equity interests to the trusts established for members of the younger generations, avoiding any income tax on the sale. b.  The trusts for the members of the younger generations would purchase insurance on the lives of the members of the older generation sufficient to enable the trusts to purchase the equity interests owned by the older generation family members at the death of the survivor of the husband and wife. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 58+ 1)  Note there would be no income tax incurred on either purchase; the original purchase by the grantor trust would be disregarded as a purchase by the grantor and the purchase at the death of the older family member would presumably be at the fair market value of the equity interests, which would also be the basis of the equity interests under I.R.C.§ 1014. c.  The trust could be designed so that the assets in the trusts would not be included in the estate of the younger generation family members. 1)  In fact, if the trusts were established in a jurisdiction with no rule against perpetuities, the trusts could last indefinitely. 2)  Because the trusts could have a zero inclusion ratio, there would be no estate or generation skipping transfer tax liability. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 59+ F.  Using a CRUT to Reduce Tax Liability 1.  A charitable remainder trust (CRT) benefits one or more non- charitable beneficiaries during the lifetime of the non-charitable beneficiaries or for a term of years. 2.  At the termination of the non-charitable beneficiary’s interest, the CRT benefits a charity. 3.  A CRT may be a charitable remainder annuity trust (CRAT) or a charitable remainder unitrust (CRUT). a.  Under a CRAT, a specific sum of money, which must be at least five percent (and not more than 50 percent) of the initial net fair market value of the property donated to the trust, is distributed at least annually to a non-charitable beneficiary. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 60+ 1)  For example, a CRAT to which $1,000,000 is contributed might provide that $50,000 per year is to be distributed to the donor during his or her lifetime. 2)  Upon the death of the donor, any assets remaining in trust are distributed to the selected charity. I.R.C. § 664(d)(1). b.  Under a CRUT, the non-charitable beneficiary does not receive a fixed payment each year. Instead, the non-charitable beneficiary receives a unitrust amount, which is calculated as a percentage (not less than five percent or more than 50 percent) of the net fair market value of the trust assets, as determined at least annually. 1)  For example, under a CRUT, the donor might be entitled to receive an amount equal to seven percent of the value of the trust assets, as determined on January 1 of each year. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 61+ 2)  Any assets remaining in trust at the death of the donor will be distributed to the selected charity. I.R.C. § 664(d)(2). 4.  The CRUT is the more flexible of the two types of CRTs for planning purposes. a.  The creator of a CRUT may transfer additional assets to a CRUT at a later date. 1)  Additional contributions may not be made to a CRAT. Treas. Reg. § 1.664-2(b). b.  Under either type of CRT, the principal of the trust may be invaded to make the necessary annuity or unitrust payments to the non- charitable beneficiary. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 62+ 1)  However, under a CRUT, it is possible to prohibit unitrust payments in any year in which income is not sufficient to pay the unitrust amount. a)  Missed unitrust payments may be made up in later years when income is sufficient, up to the amount of unpaid unitrust amounts. b)  The trust instrument must specifically require this distribution scheme; it may not leave the distribution of the income or unitrust amount to the discretion of the trustee. I.R.C. § 664(d)(3). 2)  By establishing a CRUT in this fashion, a donor may invest assets for capital appreciation during the early years of the trust, while deferring payment of the unitrust amounts until later years. a)  In this way, CRUTs may be used to provide retirement income. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 63+ 3)  A CRUT may also be established as a FLIP CRUT, which permits the CRUT to convert from an income only CRUT to a traditional CRUT upon the happening of certain events, such as death, attainment of a certain age, the birth of a child, a marriage or divorce, or the sale of an unmarketable asset such as real estate or closely held or restricted stock, that are not within the discretion of the donor. Treas. Reg. § 664-3(a)(1)(i)(c). a)  A FLIP CRUT provides a number of planning possibilities, including providing for a surviving spouse, the education of a child, the possibility of a child’s divorce or disability, and additional income at retirement. b)  It also provides a better result when nonmarketable assets are transferred to a CRUT. c)  Once the asset is sold, the trust can convert to a straight unitrust so that investments can be made for total return and without any concern for current yield. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 64+ 5.  Example a.  Mrs. Entrepreneur, a widow age 72, owns 1,000 shares of the voting common stock of Main Street Dress Company, which is a C Corporation. Her basis in the stock is $1,000,000. She has three adult children, none of whom are interested in running the business. She has been approached by several chain stores about buying the business. b.  In 2013, Mrs. Entrepreneur contributes the shares to a 5% FLIP income only unitrust with a make-up provision and language authorizing realized gains from post-gift appreciation to be treated as trust income. Treas. Reg. § 1.664-3(a)(1)(i)(b)(3). The trust agreement also provides that when the shares are sold, the trust will convert to a standard unitrust. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 65+ The trust agreement also makes an exception to the normal duty to diversify and specifically authorizes the trustee to retain the shares. She retains the unitrust interest, and names the State Foundation, which is a public charity, as the remainder beneficiary. At the time of the contribution, the value of the corporation was appraised at $10 million. To retain control, Mrs. Entrepreneur names herself as the initial trustee. c.  Mrs. Entrepreneur receives both an income and gift tax deduction for the value of the remainder interest. d.  During the first three years of the trust, because the corporation pays no dividends, Mrs. Entrepreneur receives no distributions from the trust. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 66+ e.  In 2016, the shares are sold for $12 million. Although the value of the corporation was reappraised each year at the same $10,000,000, the buyer was willing to pay more than the appraised value because it was a “strategic buyer.” f.  In 2016, Mrs. Entrepreneur is entitled to a distribution from the trust equal to $2 million, which is the sum of the unpaid unitrust payments, $1,500,000 (3 years times 5% times $10 million) and $500,000, which is 5% of the $10 million trust asset value as of the valuation date for 2016. g.  The proceeds of the sale will be invested in a diversified portfolio. h.  Beginning in 2017, Mrs. Entrepreneur will receive the 5% unitrust interest (5% of the value of the trust assets determined each year) without the income cap that applied before the sale of the shares. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 67+ i.  If Mrs. Entrepreneur wanted to pass an equivalent amount of value to her children, she could create an irrevocable life insurance trust and have the trust purchase a $10 million policy on her life, using the annual exclusion and perhaps part of her gift tax exemption to pay the premiums. II.  PROVIDING LIQUIDITY/EXIT STRATEGIES (cont’d)
    • 5508230.1+ 68+ A.  Steps in the Business Succession Planning Process 1.  Gather information about the business and the family, including financial information about the company and each family member. 2.  Determine which advisors are necessary or desirable for the planning process, which may include: a.  The family’s attorney; b.  The company’s attorney; c.  An attorney experienced in business succession planning if none of the other attorneys has such experience; d.  An attorney experienced in estate planning if none of the other attorneys has such experience; III.  BUSINESS SUCCESSION PLANNING PROCESS
    • 5508230.1+ 69+ e.  Any other attorney that represents an individual family member; f.  The CPA for the company; g.  The CPA or CPAs for the family members; h.  A qualified business appraiser; i.  A banker; j.  A trust officer; k.  An insurance professional; and l.  A family business consultant. 3.  Determine a range of values of the business for planning purposes under various scenarios, including a leveraged buy- out, an initial public offering, and the liquidation of the business. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 70+ 4.  Review the existing estate planning and succession-planning documents, including wills, trusts, shareholders’ agreements and other agreements concerning the business, charitable foundation documents, etc. 5.  Interview family members to determine their goals, interests, and feelings about other family members, especially the role of each family member in the business. a.  If it is the lawyer who is doing the interviewing, it should be clear that the lawyer is not representing any of the parties individually with regard to the business succession planning process. b.  The lawyer’s role in this case is not as an advocate, but more of a mediator or facilitator. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 71+ 6.  Discuss with the family the concepts of business succession planning, including the difference between transferring management and/or control, and transferring ownership. 7.  Discuss the family’s goals with the family members, which may include one or more of the following: a.  Retain control with the existing owner or owners. b.  Retain income to continue lifestyle of owner and owner’s spouse. c.  Satisfy family’s estate planning objectives. d.  Provide for the continuity of the business, partly psychological. e.  Satisfy concern for employees of the entity. f.  Satisfy concern for the community in which the business is located. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 72+ g.  Satisfy dynasty concerns. h.  Satisfy charitable desires. i.  Reduce transfer taxes. j.  Reduce income taxes. k.  Reduce administration expenses. 8.  Discuss the various exit strategies the family should consider, including some or all of the following: a.  Sale of assets. b.  Sale of stock. c.  Tax-free acquisition — merger. d.  Tax-free division — split-up, split-off, or spin-off. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 73+ e.  Sale to an ESOP. f.  Sale to employees. g.  Sale to family members. h.  Sale to grantor trusts – family members as beneficiaries. i.  Gift to family members during lifetime. j.  Bequest or sale to family members at death. k.  Liquidation of the business, including bankruptcy (which is often the result when there is no plan in place). 9.  Suggest an appropriate business succession plan with appropriate alternatives, setting forth the various tax and non- tax considerations and consequences resulting from the suggested plan and alternatives. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 74+ 10.  Determine cash needs of the business during the implementation of the suggested plan. 11.  List and describe the steps, including the necessary documents, to carry out the suggested plan and coordinate the implementation of the plan, including the drafting of documents, with local counsel and other advisors, such as CPAs, trust officers, financial advisors, and insurance professionals. 12.  Put in place a procedure for ensuring at least an annual review of the plan and its implementation. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 75+ B.  Evolution of the Family Business (Family Ownership) 1.  Founding owner. a.  Usually this is the initial stage of the family business, unless two or more siblings started the business together. b.  One or both parents will usually own all the equity in the company and have complete control over the company. 2.  Next generation. a.  If only one of the children assumes control of the company after the retirement or death of the founding owner, the structure of the business may remain the same as it was when the parent was in control. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 76+ b.  If more than one child is active in the business, the dynamics of the management of the business will change dramatically. 1)  No longer will the shots be called by one person. 2)  The potential for discord will be elevated. c.  The business will revert to the founding owner stage if one child ends up buying out the other siblings or the business is split up into separate entities with each entity owned or controlled by a different child. 3.  Third generation and beyond. a.  At this stage it is likely that two or more cousins will be active in the business. b.  Management will be more structured, and the board of directors or its counterpart in an LLC will take on more importance as the governing body of the company. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 77+ 4.  Third generation and beyond. a.  This stage could witness a favorable outcome for the family with a sale to a third party or an acquisition by a larger company in some type of tax-free exchange of ownership interests. b.  This stage could also be the ultimate failure of the planning process or lack thereof, where either the assets of the company are sold without any consideration received for good will and other intangible value or the company goes into bankruptcy. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 78+ C.  Steps to a Successful Plan and Implementation 1.  Mission Statement. a.  Developing a mission statement for the family should involve all of the adult family members in the process and will expose any significant differences of opinion with regard to core values that will alert the advisors to potential problems when developing the business succession plan. 1)  The mission statement should set out the core values of the family and the role the family wishes to play in the community, including charitable desires. b.  A separate mission statement for the company will highlight the different considerations that go into the business relationships as opposed to the family relationships. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 79+ c.  In addition to a mission statement for the company, a strategic plan for the company for the next five or ten years will also help in developing the business succession plan. d.  All of these documents should be reviewed periodically and amended as the circumstances and family’s desires change. 2.  Objectives. a.  In addition to mission statements for the family and the company, more detailed objective should be agreed upon. b.  Naturally, the objectives should be consistent with the mission statement, but will be statements of items the family and the business want to achieve or should accomplish. 3.  Specific goals/timetable. a.  Specific goals with regard to the development of the business succession plan should be established early in the process, with specific dates for accomplishing the goals. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 80+ b.  Likewise, specific goals for the business should be established and a periodic review should be scheduled to determine if the goals are being met in a timely matter. 4.  Communication Guidelines. a.  Regularly scheduled meetings of the family should be set out. b.  Rules of order for conducting the meetings should be established. 1)  These should not be too formal in nature, but should assist in ensuring that the meetings are conducted in a civilized atmosphere that is conducive to an exchange of ideas and opinions. c.  In addition, regular meetings for the conduct of the business should be established, if not already in place. 1)  These could be combined with the family meetings, but if nonfamily members are added to the board of directors or other governing body, combining the two meetings may not be appropriate. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 81+ 5.  Appoint an advisory board. a.  This could be a first step in adding nonfamily members to the board of directors or other governing body. b.  The number and make up of the advisory board would depend upon the perceived need of the company for outside expertise. c.  The members of the advisory board would receive compensation. d.  The board would meet regularly, perhaps quarterly or when otherwise needed. e.  Terms should be established, so that members who were not participating in a constructive manner could be removed without having to be prematurely terminated. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 82+ 6.  Consider adding nonfamily members to the board of directors. a.  This would be a sign of a mature business and that the current owners recognized the importance of objective input. b.  However, having nonfamily members on the governing body could create problems if the outside members joined with recalcitrant family members to oppose sound business decisions. 1)  Although the nonfamily members could be removed by the equity owners, such action could lead to more disruptive discord among the family members. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 83+ 7.  Get the family to commit to the process. a.  Identify the reasons for engaging in, as well as the benefits to be derived from, the business succession planning process. b.  Stress importance of each family member participating in the process or otherwise refraining from Monday-morning quarterbacking once the process has been completed. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 84+ D.  Ethical Issues 1.  Conflicts of interest in general. 2.  Active v. non-active family members. 3.  Nonfamily employees and/or equity owners. 4.  Multi-generational representation. 5.  Representing couples jointly. 6.  Previous representation of some but not all of the players. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 85+ E.  Obstacles to Achieving a Workable Business Succession Plan 1.  In-laws. 2.  Non-active family members. 3.  Reluctance of founding owner to give up control. 4.  Providing for the liquidity needs of the business and the family. a.  Estate taxes and administration expenses. b.  Replacing key employees. c.  Funding buy-sell agreements. d.  Providing retirement income to the founding owner and spouse. e.  Providing other assets to non-active family members. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 86+ 5.  Divorce. 6.  Non-family key employees. III.  BUSINESS SUCCESSION PLANNING PROCESS (cont’d)
    • 5508230.1+ 87+ A.  Avoiding Disputes 1.  Voting stock should not be given to younger family members nor should younger family members be made the managers of an LLC or general partners of a limited partnership. 2.  If voting stock is to be transferred to children who are active in the business, voting stock should not be transferred to children who are not active in the business. Also children who are not active in the business should not be managers of an LLC or general partners of a limited partnership. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES
    • 5508230.1+ 88+ 3.  A general partnership should not be used for family business planning. Not only is there risk of exposure to liabilities, but also each member of the partnership has an equal say in the management of the partnership under state law. 4.  Preferred or fixed value interests may be given to those younger family members who are not active in the business. 5.  Downside protection may be provided to those younger family members who are not active in the business and have received an equity interest in the business, including a preferred or fixed value interest, by giving them a put right (the right to require the entity to redeem their equity interests) and by placing restrictions on the active younger family members’ ability to receive excessive compensation and other financial benefits. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 89+ 6.  Similarly, it may be appropriate to give the active family members a call right so that they can buy out the inactive family members if irreconcilable differences develop over running the business. 7.  Break-up provisions may be provided for in the organizational documents that allow one or more of the younger family members to dissolve the entity after the death of the last to die of the older family members. a.  This technique is appropriate for entities holding nonactive assets such as real estate and marketable securities, but would not be appropriate for a going concern where a break-up followed by a liquidation of the business could result in a severe loss in value. b.  In addition, such a provision may reduce the lack of control discount when the assets consist mainly of passive investments. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 90+ 8.  Providing for mediation or arbitration in the event that there is a dispute among the family members may avoid unwanted publicity and expenses. 9.  A party who brings an action and is unsuccessful should be required to pay attorneys’ fees. 10.  Assets other than interests in the family business may be left to inactive family members. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 91+ 11.  Parents should distinguish between treating children equally (each child receiving an amount equal in value) and treating them fairly, where the amount each child receives may vary depending upon the child’s participation in the business and other factors. a.  This takes into account that fact that the value of the business may be attributable in part to the services of those younger family members who are active in the business. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 92+ B.  Planning for Possible Divorce 1.  The best solution may be to provide for the disposition of the family business in a premarital agreement. a.  A premarital agreement is usually more appropriate in the context of a second marriage, and it may be difficult to convince a client or a child of a client to enter into one when he or she is marrying for the first time. 2.  A postmarital agreement, which is legally enforceable in some states, may be a way of dealing with a business in the event of a divorce. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 93+ 3.  Consider whether the purchase price under a buy-sell agreement will be treated as the value of the interest in connection with a property settlement pursuant to a divorce. a.  It is doubtful that the purchase price will be considered the value of the interest if the agreement was entered into in contemplation of the divorce, it is among related parties, and the purchase price is unreasonably low. b.  On the other hand, if the agreement was entered into well before the divorce appeared on the horizon, it is among unrelated parties, and the purchase price is commercially reasonable, the purchase price may be considered the value of the interest. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 94+ 4.  Note that in most states the court cannot require the transfer of specific assets, although the value of the assets is considered in determining what each spouse is entitled to receive under a property settlement. 5.  In connection with gifts, advise donees to keep the gifted property separate, so that it will not be considered either community property in community property states or marital property in states that have adopted equitable distribution. a.  Again, a good solution would be to have the donee enter into a premarital or postmarital agreement, but this is often not acceptable to the donee. b.  However, if enough is involved, he or she may be willing to enter into the premarital agreement, even in the case of a first marriage. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)
    • 5508230.1+ 95+ c.  Also, if the donee works in the business, some of the future increase in value may be considered community property (or entitle the other spouse to reimbursement) or marital property, depending upon state law. d.  Another alternative would be to make gifts to trusts rather than outright in order to prevent the gifted assets from becoming community or marital property. IV.  SPECIAL CONSIDERATIONS APPLICABLE TO FAMILY-OWNED BUSINESSES (cont’d)