Business Succession Planning

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

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

What Owners Often Want

• 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

Timing of Transfer

• 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

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

Some Techniques

• 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:

DeathDisabilityDivorce/BankruptcyRetirement (including R.I.P. – retired in place)Termination

Buy/Sell Challenges

• 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

Disadvantages of FLP/FLLC

• 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

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

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

When can pay out

• 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

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

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)

Other NQDC Ideas/Names

• 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

ESOP Advantages

• 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

ESOP Disadvantages

• 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

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

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

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

Business Succession Planning

Karen L. Brady, J.D.

Karen Brady & Associates, P.C.

(303)420-2863

www.coloradobusinessplanning.com