Business Succession Planning Karen L. Brady, J.D. Karen Brady & Associates, P.C. (303)420-2863 www.coloradobusinessplanning.com

What is Exit Planning? A systematized process, a customized approach resulting in an owner’s transition out of the business

Why Exit Planning? Every owner leaves his or her business – voluntarily or otherwise. At that time, every owner wants to receive maximum value for his or her business.

Recipe for Successful Exit Plan A written plan developed from client’s objectives Experienced to to design and implement the plan Optimum cash flow to fund the plan Management team to succeed owner Time to implement the plan

A written plan developed from client’s objectives

Experienced to to design and implement the plan

Optimum cash flow to fund the plan

Management team to succeed owner

Time to implement the plan

Why Time is Important Allow next generation of owners to earn way into business Create liquid market for company stock while retaining control Provide for owner’s retirement income Provide for children not in business Protect assets from potential creditors

Allow next generation of owners to earn way into business

Create liquid market for company stock while retaining control

Provide for owner’s retirement income

Provide for children not in business

Protect assets from potential creditors

What Owners Often Want Shift wealth to next generation Reward loyal employees Receive maximum value Take business to next level Maintain ownership indefinitely

Shift wealth to next generation

Reward loyal employees

Receive maximum value

Take business to next level

Maintain ownership indefinitely

The Team Financial/Insurance Advisor Attorney(s) – Business Planning/Estate Planning CPA Transaction Intermediary (Broker or Investment Banker) Banker Business Consultant

Financial/Insurance Advisor

Attorney(s) – Business Planning/Estate Planning

CPA

Transaction Intermediary (Broker or Investment Banker)

Banker

Business Consultant

Timing of Transfer During Life At Death

During Life

At Death

Challenges During Life - Capital Gains Tax for Owner Gift Tax for Owner Funding the Transfer At Death - Estate Tax - Funding the Transfer

During Life

- Capital Gains Tax for Owner

Gift Tax for Owner

Funding the Transfer

At Death

- Estate Tax

- Funding the Transfer

Internal Planning Identify successor management Provide opportunity to learn Establish strong financial controls Develop culture of ownership Develop relationship between new management and advisor team

Identify successor management

Provide opportunity to learn

Establish strong financial controls

Develop culture of ownership

Develop relationship between new management and advisor team

Some Techniques Buy/Sell Agreements Family Limited Partnerships Charitable Remainder Trusts/Private Annuity Trusts Nonqualified Deferred Compensation, including: ESOPs 412i

Buy/Sell Agreements

Family Limited Partnerships

Charitable Remainder Trusts/Private Annuity Trusts

Nonqualified Deferred Compensation, including:

ESOPs

412i

Buy/Sell Agreements Agreement between owners Binding agreement on the triggers and pricing of transfer when one owner leaves/is pushed Typical Triggers: Death Disability Divorce/Bankruptcy Retirement (including R.I.P. – retired in place) Termination

Agreement between owners

Binding agreement on the triggers and pricing of transfer when one owner leaves/is pushed

Typical Triggers:

Death

Disability

Divorce/Bankruptcy

Retirement (including R.I.P. – retired in place)

Termination

Buy/Sell Challenges Pricing, which can raise IRS flags Funding Minimal wealth transfer/estate planning accomplished

Pricing, which can raise IRS flags

Funding

Minimal wealth transfer/estate planning accomplished

Family Limited Partnership/FLLC Divide ownership from use, benefit, and control Discounts are a “bonus” Allows inclusion of children not in the business Some asset protection for owner and next generation

Divide ownership from use, benefit, and control

Discounts are a “bonus”

Allows inclusion of children not in the business

Some asset protection for owner and next generation

Disadvantages of FLP/FLLC Complexity of separate entities Fiduciary duty of General Partner IRS scrutiny Loss of step-up in basis at death

Complexity of separate entities

Fiduciary duty of General Partner

IRS scrutiny

Loss of step-up in basis at death

Split Interest Trusts Charitable Remainder Trusts Private Annuity Trusts Defer capital gain tax (sometimes indefinitely for CRTs) Charitable Deduction offset other tax bite, as in use of retirement funds

Charitable Remainder Trusts

Private Annuity Trusts

Defer capital gain tax (sometimes indefinitely for CRTs)

Charitable Deduction offset other tax bite, as in use of retirement funds

Disadvantages In PATs, can’t benefit from up market In CRTs, nothing for kids to inherit In PATs – trust’s “real basis” can be less than anticipated basis if owner dies early If owner lives past life expectancy, trust may not be able to pay as promised

In PATs, can’t benefit from up market

In CRTs, nothing for kids to inherit

In PATs – trust’s “real basis” can be less than anticipated basis if owner dies early

If owner lives past life expectancy, trust may not be able to pay as promised

Nonqualified Deferred Compensation Promise to pay later for services performed now Deferral must be agreed to before services are performed If compensation plan is funded (with trust, insurance, etc.) – must be substantial risk of forfeiture to the employee, otherwise constructive receipt

Promise to pay later for services performed now

Deferral must be agreed to before services are performed

If compensation plan is funded (with trust, insurance, etc.) – must be substantial risk of forfeiture to the employee, otherwise constructive receipt

When can pay out Separation from Service Disability Death Specified time pursuant to pre-arranged schedule Change in ownership Unforeseeable emergency

Separation from Service

Disability

Death

Specified time pursuant to pre-arranged schedule

Change in ownership

Unforeseeable emergency

NQDC – Employee’s Perspective No income tax until compensation received Appreciation depends on contract Risk of Loss to Creditors of Employer Risk of Loss Because Employer Lacks Resources/Liquidity Part of Estate and is IRD

No income tax until compensation received

Appreciation depends on contract

Risk of Loss to Creditors of Employer

Risk of Loss Because Employer Lacks Resources/Liquidity

Part of Estate and is IRD

NQDC – Employer’s Perspective Keep Good Employees Fund Owner’s Buyout Can’t deduct as expense until compensation is paid Shows up on balance sheet Costs of Administration

Keep Good Employees

Fund Owner’s Buyout

Can’t deduct as expense until compensation is paid

Shows up on balance sheet

Costs of Administration

Common NQDC Direct Agreement – no funding, just a promise to pay later (minimum wage must still be paid now) Rabbi Trust – Employer funds trust but trust subject to employer’s creditors (no income tax paid by employee until accesses trust) Secular Trust – Employer funds trust which isn’t subject to creditors (employee pays income tax as trust is funded, but appreciation is tax-deferred)

Direct Agreement – no funding, just a promise to pay later (minimum wage must still be paid now)

Rabbi Trust – Employer funds trust but trust subject to employer’s creditors (no income tax paid by employee until accesses trust)

Secular Trust – Employer funds trust which isn’t subject to creditors (employee pays income tax as trust is funded, but appreciation is tax-deferred)

Other NQDC Ideas/Names Phantom Stock Incentive Stock Options Nonqualified Stock Options Top Hat Plans Excess Benefit Plans Insurance Arrangements

Phantom Stock

Incentive Stock Options

Nonqualified Stock Options

Top Hat Plans

Excess Benefit Plans

Insurance Arrangements

Employee Stock Ownership Plan (ESOP) Company establishes ESOP ESOP borrows funds to purchase stock – from company, owner, or bank ESOP purchases stock from owner Owner who sells can reinvest in “qualifying replacement securities” and defer capital gain – like a 1031 exchange

Company establishes ESOP

ESOP borrows funds to purchase stock – from company, owner, or bank

ESOP purchases stock from owner

Owner who sells can reinvest in “qualifying replacement securities” and defer capital gain – like a 1031 exchange

ESOP Advantages For Owner Creates liquidity Diversify investments without paying immediate tax Creates market for company stock Removes cash from company value

For Owner

Creates liquidity

Diversify investments without paying immediate tax

Creates market for company stock

Removes cash from company value

ESOP Advantages For Employees Become owners/vested in company Fund retirement

For Employees

Become owners/vested in company

Fund retirement

ESOP Disadvantages Complexity Still need individuals who can manage business after owner leaves

Complexity

Still need individuals who can manage business after owner leaves

412i Plans Still a good idea in a narrow set of facts Defined benefit pension plan Promise to employee specific amount of retirement benefit based on compensation, years of service, or both, funded exclusively by life insurance or annuity contracts

Still a good idea in a narrow set of facts

Defined benefit pension plan

Promise to employee specific amount of retirement benefit based on compensation, years of service, or both, funded exclusively by life insurance or annuity contracts

Reasons to Consider 412i Employer can place large amount of cash all at once and take immediate deduction Exempt from usual minimum funding standards for defined benefit plans Conservative assumptions of investment growth Insurance removes risk of employer guaranty of funds in plan

Employer can place large amount of cash all at once and take immediate deduction

Exempt from usual minimum funding standards for defined benefit plans

Conservative assumptions of investment growth

Insurance removes risk of employer guaranty of funds in plan

412i Disadvantages Investments may be more conservative than would otherwise make Lack of flexibility No loans to participants Business must have cash flow to assure funding Initial setup can be relatively high Requirements to provide for other employees often makes 412i best for cos. where owners are only employees

Investments may be more conservative than would otherwise make

Lack of flexibility

No loans to participants

Business must have cash flow to assure funding

Initial setup can be relatively high

Requirements to provide for other employees often makes 412i best for cos. where owners are only employees

412i Requirements Funded exclusively by life insurance or annuity contract(s) and guaranteed by those contracts Insurance contracts must provide level annual premium payments beginning date participant is part of plan and not going beyond participant’s retirement age Benefits of plan must be equal to benefits provided by insurance contract

Funded exclusively by life insurance or annuity contract(s) and guaranteed by those contracts

Insurance contracts must provide level annual premium payments beginning date participant is part of plan and not going beyond participant’s retirement age

Benefits of plan must be equal to benefits provided by insurance contract

Business Succession Planning Karen L. Brady, J.D. Karen Brady & Associates, P.C. (303)420-2863 www.coloradobusinessplanning.com