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Family Business Succession: Valuations, Sales, SCINs,

and Tax Reform

THURSDAY, NOVEMBER 7, 2019, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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November 7, 2019

Family Business Succession: Valuations, Sales, SCINs, and Tax Reform

Griffin H. Bridgers, Attorney

Hutchins & Associates

gbridgers@hutchinslaw.com

Cleveland G. Clinton, Partner

Gray Reed & McGraw

cclinton@grayreed.com

Norman A. Lofgren, Senior Counsel

Gray Reed & McGraw

nlofgren@grayreed.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Norm Lofgren and Cleve Clinton

Family Business Succession: Valuations, Sales, SCINs, and Tax Reform

Family

6

Family

Business

7

Family

Business

Succession8

9

Most Small Business Owners Have No Succession Plan

10

Entrepreneur Owner

• Person who organizes and operates a business or businesses, taking on greater than normal financial risks in order to do so

• Mavericks – Entrepreneurs who

• Dare big

• Plan big

• Think big, and

• Often get into big trouble

11

Entrepreneur v. Enterprise

Closely-Held Business

• Few owners – often family

• Financial risk is all on entrepreneur

• “Governance” is closely-held - if not all entrepreneur

Enterprise

• Multiple owners – often non-Family

• Financial risk is all enterprise shared

• Governance is shared, formal and often Institutional

12

Entrepreneur’s Business Mindset

Maverick’s Business

Approach:

• Self-motivated

• Knows product & market

• Takes risks

• Flexible

• Passionate

Concerned that Estate Planning Spawns Infusion of Possible:

• Reliance upon uninspired

• Uninformed/inexperienced

• Guarded/risk averse

• Rigid/unadaptable

• Indifferent

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Sudden Death & No Plan –Business & Family Risks

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• No One Firmly in Charge

• Employees Leave

• Customers Leave

• Suppliers are Compromised

• Daily Operations Are Ineptly Handled

• Business Goodwill (Value) Plummets

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Maverick’s Sudden Death –Business Risks

• Spouse’s Living Resources Depleted

• Outdated or Partially Complete Estate Plan

• Outdated or Nonexistent Entity Structure and Business Plan

• Tailored for Maverick’s Sole Control

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Maverick’s Sudden Death –Family Risks

Sudden Death and No Plan –Interim Make-Do Options

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Maverick’s Sudden Death –Business Planned Stop-Gap

• Manager / supervisor

• Consider stay bonus and non-qualified deferred compensation plan

• Identify to all employees the substitute person-in-charge

• Key employees

• Non-competition

• Non-solicitation

• Customers

• General services agreement with agreed-upon terms

• Vendors / suppliers

• Memorialize any favorable terms or conditions

• Communicate all stop-gap plans to spouse and family 19

Maverick’s Sudden Death –Business Management Band-Aids

• Advisory board of directors• Retired business owners & industry consultants

• Industry/trade groups• Utilize mentors/be a mentor• ID an out-of-territory competitor

colleague to provide temporary emergency operations aid

• Advise spouse of competitors• In emergency, direct they be

called to promote bidding

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No Business Plan –But Intends Family Business Succession?

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Family Business Succession?

• Does the next generation share maverick’s vision?

• Is the next generation prepared to run the family business without maverick?

• Are their estate and business plans that complement each other?

• If not, why does maverick want the next generation to run his family business?

22

Predictable Owner Shortcomings

• No vision

• Not communicated or shared

• No project delegation

• Not modeled or encouraged

• No shared management & leadership

• Not permitting mistakes

• Micromanaging

• No defined roles & accountability

• Poorly defined roles

• Poorly defined expectations

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Foreseeable Family Obstacles

Obstacles

• No interest in business

• No shared vision

• Jockeying for control

• Sibling rivalry

• Sense of entitlement

Solutions

• Regular family meetings

• Encourage acquiring external experience

• Hire family into established job

• Create advisory board

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Agreed Family Succession –Interlaced Business and Estate Plans

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Maverick’s New Structure Keeps Control and Provides Complementing Business and Estate Plans

• Not a sole proprietorship

• Corporation • Is an option, but not seen as nimble• Older businesses – often “C” corp converted to

limited partnership

• Limited partnership • Has advantages but considered cumbersome• Two entities – LP & GP

• Limited liability company

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Maverick’s Entity StructureLimited Liability Company

• Member interest ties seamlessly to estate plan

• Family/company agreement

• Becomes much of the business plan

• Readable like a contract

• Coupled with a members’ agreement

• Ensures maverick’s control until agreement termination, or maverick’s death or incapacity

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What if family rejects running the business?

• Now you know – find out early

• Simplifies estate / business planning

• Estate planning is now assets, not business

• Business planning is about growth for sale

• Simplifies financial planning

• Sales proceeds required to fund

• Expert current company appraisal

• Simplified exit planning – reach value & sell

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Valuation31

Valuation

• What is the darn thing worth?

• Most people are not qualified to tell you.

• Don’t listen to your friends

• Business owners tend to overvalue

• Emotional investment overshadows reality

• Don’t settle for less that what its worth!

• Family or expediency…

• Timing is everything

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Valuing the Business

• What is it worth?

• Various methods of establishing “value”

• Multiple of EBITDA

• Varies significantly depending on industry

• “Book” Value

• Book value represents the total amount a company is worth if all its assets are sold and all the liabilities are paid back.

• “Market” Value

• Public…easy

• Closely Held…Appraisal33

Fair Market Value

The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. (Treas. Reg. 20.2031-1(b))

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How to Determine FMV?

• Hire a qualified business valuation specialist

• ASA (American Society of Appraisers)

• ABV

• CVA (Certified Valuation Analyst)

• General Appraiser Certification

• CPA?

• CFA?

• MAI (real estate)

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Appraisers Job

• What does he/she do?

• Looks at published studies of purchases of similar companies

• Analyzes all relevant factors (value of underlying assets, legal, structure, tax, control, liability, marketability)

• Applies discounts or premiums

• Provides a professional opinion of value

• Make sure the appraiser will back up opinion in court

36

Closely Held Business

• Family considerations

• Gift or sale to family members?

• Careful to sell for FMV…or could be a disguised gift

• Keep good books

• Annual audits?

• Fractional ownership

• Majority vs. Minority

• S corp?

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3838

Buy Sell - Valuation

• Funding the buy sell

• Need to establish value

• Formula

• Book value

• Valuation

• Combination

• Insurance

• Redemption vs. Cross purchase

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Structure Concerns

• Entity

• C Corp

• Partnership

• Disregarded Entity

• Tax Structure

• S Corp

• C Corp – BIG Tax

• Asset Sale vs. Stock Sale

• HoldCo?

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Methods of Transfer41

Methods of Transfer

• Is the owner selling on the open market?

• Is there a transfer to a related party?

• Family

• Key employees

• ESOP

• What about estate planning?

42

Selling to an Outsider

• Timing is key

• Waiting for a seller’s market can make the difference

• Are unsolicited offers coming in?

• Talk to your family and key employees about selling? Are there other options?

• Have the courage to turn down a good offer if its not right for you.

43

When it’s a go…

• Get your ducks in a row…

• Get company books in order

• Get your estate planning done (more on this later)

• Get your transition/key employee team up to date and in the know

• Get a valuation

• Talk to your accountants and advisors regarding structure

• Get a legal team in place44

Stock Sale vs Asset Sale

• As a seller…stock sale is usually better

• Capital Gains treatment

• Seller can divest prior liabilities (unless otherwise indemnify)

• Cleaner transaction

• Buyer may want asset sale

• Acquire underlying assets at stepped up basis

• Reset depreciation and amortization

• Can segregate unattractive assets and liabilities

• Others 45

Built in Gains Tax

• Is a sale on the horizon?

• 2 levels of tax if business is a C corp

• Corporate tax for sale of assets

• Qualified dividend on liquidating dividend

• S Corp better – 1 level of tax

• BIG tax look back is 5 years…get the clock running

46

Brokers/Investment Bank

• Using professionals to help bring the business to market is a good thing!

• Even if offered privately…they can help you determine if the offer is market rate

• Get a means of comparison

• If business owner is keen to sell…they can help offer the sale through their networks and get competing offers

• Sometimes the highest offer isn’t the best offer

47

Estate Planning

• Estate Tax/Gift Tax rate is 40%

• Exemption is $11.4 million (reverts to lower exemption 1/1/2026)

• Ability to move business out of taxable estate before sale can mitigate transfer taxes

• How?

• Adapting structure of business

• Gifts and Sales

• Irrevocable Trusts

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Intra-Family Transfers

• If owner desires to simply send control and/or equity to the next generation…the answer is simple…make a gift and/or sale of the equity

• Valuation is key

• Make sure that a succession plan is in place

• Multiple family members

• Some involved in business and others aren’t

• Some want control…and aren’t ready

• Communicate

49

Gift?

• Owner can give up to Exemption Amount ($11.4 million) to family

• $22.8 million of value if gifts made from 2 spouses

• Must file Form 709 – gift tax returns

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Sale?

• Sale cannot be less than market rate

• Intra-family transfers must be not less than Applicable Federal Rate (Nov. 2019)

• Short Term – 1-3 years = 1.68%

• Mid Term – 3-9 years = 1.59%

• Long Term – 9+ years = 1.94%

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Downside to Gifts

• Transferred tax basis in stock or assets

• Relinquish control or income stream

• NextGen may have the business acumen, but not the sophistication to handle wealth, OR vice versa

• Gift Taxes at 40% > Capital Gains 20%

52

Testamentary Transfers?

• Is it better to keep ownership until death?

• Perhaps…step-up in basis on death

• Testamentary trusts

• 754 elections

• Keep income stream

• Management concerns?

• Give away non-voting interests in business

• Keep control until nextgen is ready

53

Lifetime Transfers to Trusts

• Irrevocable Spendthrift Trusts can:

• Shield wealth/business from outside creditors

• Remove assets from transfer tax system

• Protect spendthrift descendants from themselves

• Bifurcate control of business from beneficial ownership – USE of thoughtful Trusteeship or other fiduciary roles

• Keep Business whole for multiple generations

• Downside – transferred tax basis54

Spousal Trust(s)

• Owner wants to keep beneficial ownership AND remove assets from taxable estate

• Give business equity to trust for spouse

• Post sale, spouse can take distributions for his/her needs without inclusion in estate

• Non-reciprocal trusts?

55

BDIT

• Want your cake and eat it to? Grantor Trust provisions under IRC Sec. 678

• Can SELL ownership in entity to a trust created for owner’s benefit.

• Can retain control and beneficial ownership

• MAY remove business assets/proceeds of sale from taxable estate??

56

Re-Structuring the Ownership

• Family Limited Partnerships

• Bifurcate control and equity

• Create structure where discounts are available

• DLOC and DLOM

• Example

• Business is spread among 3 LLCs (OpCo, EmployCoand LandCo)

• FMV is $100,000,000

• Move 3 LLCs into FLP/HoldCo

• Create discounts of 25%-45%57

Why do this?

• Owner can gift and/or sell discounted FLP equity to family (or trusts)

• Move assets out of taxable estate prior to sale of the actual business to 3rd party

• Illiquid business interests are much more effective to plan and mitigate estate taxation than cash or liquid assets

• Leverage discounts…transfer more with less tax impact

58

Is the business an S corp?

• Cannot contribute S corp stock to a limited partnership

• Can create similar discounts by recapitalizing stock among voting and non-voting shares

• Small amount of voting and large non-voting

• E.G. 10 voting – 990 non-voting

• Voting and non-voting equity is the only caveat to the single class of share rule for S corps

59

Self-Cancelling Installment Note60

SCINs

• SCIN – Self Cancelling Installment Note

• Great in low interest rate environment

• Intra-family business succession strategy

• Basics

• Owner sells business to children for a Note

• Term of the Note is less than the actuarial life expectancy of seller

• Note cancels on death of seller – “Mortality Charge”

• Because of cancellation provision – the note is not includable in the taxable estate of seller on death

61

Why do a SCIN?

• Low interest rates

• Prorate capital gains – prorate over term of note

• “Freeze” estate – if the business appreciates in value after the sale

• Risk Premium (or “mortality charge”) built into the loan…so when there is a cancellation, there is no inclusion in estate

• Creates an annuity stream for seller

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BUSINESS SUCCESSION

CONSIDERATIONS AFTER TAX REFORM

Griffin H. Bridgers

Hutchins & Associates LLC

Denver, Colorado

What Has Changed?

• 21% C corporation tax rate

• 199A deduction for pass-throughs (partnership, S corporation, disregarded entities)

• Lower individual itemized deductions for state and local taxes (capped at $10,000 per year)

• Higher standard deduction ($12,200 for 2019), which discourages itemization at an individual level

• Higher estate tax exemption ($11,400,000 for 2019)

• Higher annual retirement plan contribution limit ($19,000 for employee contribution, $56,000 for combined employer and employee contributions, $6,000 catch up over age 50, $6,000 for IRA contributions)

65

Planning by Entity

• C corporation

• S corporation

• Partnership (LLC or state law partnerships)

• Disregarded entities (single-member LLC; grantor trust)

• Irrevocable Trusts

• Estates and Revocable Trusts

66

C Corporations

• More favorable with 21% corporate income tax rate, combined with maximum 20% rate on qualified dividends

• Beware dividend treatment for sales and redemptions of stock• Difference – return of basis taxed as dividend

• Beware family attribution rules

• Preferred stock freeze transactions may still be in vogue

• NOL harvesting may be more limited

• Basis step-up (for up to $11,400,000 of stock per shareholder without estate tax liability) may be useless if corporate assets sold• To harvest large step-up in stock, conversion to S corporation may be

valuable

• Alternatively, could taxable stock reorganizations be used?

67

C Corporations, Continued

• Beware General Utilities doctrine – still cannot remove appreciated assets without recognition of gain• Tax-free spinoffs may be useful, but can be difficult between related

parties

• Buy-Sell Agreement Issues• Redemption Agreements are subject to limitations of Code Sections 302

and 303

• Life insurance may be included in corporate E&P

• Beware family attribution rules

• No transfer-for-value rule exception for sale of policy between shareholders

• Beware of Code Section 2703

68

S Corporations

• Is there a recent conversion from C corporation?• Built-in gains (BIG) tax for sales of appreciated assets within 5 years• Dividend tax on old and cold C corporation E&P (known as AAA, or

accumulated adjustments account)

• General Utilities can still bite you• Note, however, that liquidation or redemption of stepped-up stock in

exchange for in-kind distribution of appreciated asset(s) could zero out gain• May not apply with respect to hot assets, like inventory and accounts receivable

• Still consider family attribution rules

• Use 199A deduction

• Limit compensation to shareholder/employee, within reasonableness standard, to avoid self-employment income

• Beware – is there a 338(h)(10) election in place for stock sale, or a 336(e) election for stock distribution?

69

S Corporations, continued

• Beware of continued S corporation qualification• Who can be a shareholder?

• Trusts must be electing small business trust (ESBT), qualified subchapter S trust (QSST), or grantor trust

• Entity must be disregarded entity (such as single-member LLC)

• Cannot have two classes of stock by capital rights

• i.e., preferred and common stock not allowed

• However, can have voting and non-voting common stock

• Valuation issues • May be eligible for valuation discounts

• Beware of Code Section 2703

• Lower C corp rate may create argument for tax-affecting valuation, taking away IRS tendency to apply premium to S corporation value

70

Partnerships

• Biggest boon is 754 election • Sale of partnership interest or death of partner permits application of outside

basis step-up to inside basis of partnership assets

• Also 199A eligible

• Beware effect of 704(c) and 704(e) among family members• Kiddie tax now uses tax brackets for trusts and estates

• Valuation: may be able to claim discounts for limited partnership interests, even for non-minority interest• GP interest may not be discount-eligible or may command premium

• Can IRS include partnership assets in contributing partner’s gross estate? See IRC 2036 and 2038, Powell v. Commissioner, and Strangi v. Commissioner • This may be a good thing for estates below $11.4 million

• Note also – are gifts of partnership interests present-interest gifts?

71

Partnerships, continued

• Liberal transfer-for-value rule exceptions for life insurance

• Technical termination rules no longer apply• However, make sure there are still at least two partners after buy-out

• Beware distributive share and allocation issues• Targeted allocations and cash distribution waterfalls

• Profits interest issues and safe harbor

• Traditional allocations – do they have substantial economic effect?

• Beware the now rare nonrecourse deductions

• Note the new partnership audit regime – adjustments at partnership level • What authority does partnership representative have to bind partners in

settling tax deficiency?

72

Disregarded Entity

• Often a single-member LLC

• Make sure there was no past check-the-box election to be taxed as an association (C corporation)

• Eligible for 199A deduction

• Beware state and local taxes on sale of interest (sales and use taxes)

• On addition of partner, beware entity formation issues:• If resulting entity is corporation – check IRC 351 qualification

• If resulting entity is partnership – check IRC 721 qualification, as well as 704(c) and 704(e) issues with respect to new partner

73

Irrevocable Trusts

• Is grantor trust status advisable?• Pay income tax of beneficiaries without gift tax or circular calculation

• Allows for sale of appreciated assets with disregarded gain

• Allows for deathbed “swap” of assets to maximize step-up in basis

• Beware, however, the ongoing issue of grantor trusts at death (no estate tax on post-contribution appreciation of trust assets for now, but for how long?)

• Non-Grantor Trusts• Trusts owning interests in pass-throughs may be eligible for 199A

• Highly-compressed tax rates, so typically not a good idea to retain income in trust (especially ordinary income)

• Due to DNI rules, capital gains typically taxed to trust (even if distributed) unless trustee has state-law power to allocate to income

74

Irrevocable Trusts, continued

• Sale to Grantor Trust• Respected for gift and estate tax purposes, and ignored for income tax

purposes, under current law

• This is what is meant by a “defective” grantor trust

• This could go away in future

• Can remove future appreciation of sold property from gross estate

• Still have to include promissory note, plus interest, in gross estate

• Note that upfront gift of cash for down payment may be needed

• Commonly accepted safe harbor is 10%

• Make sure note is respected and enforceable to avoid gift recharacterization

• Beware entity-level tax and shareholder-level tax (if any)

75

Irrevocable Trusts, continued

• Sale to Non-Grantor Trust• New “hot” strategy is deferred sales trust

• Uses 453 to defer gain on sale of appreciated asset to non-grantor trust

• Typically not available to defer recapture

• Largely untested – letter of code and regs allow it, but IRS could challenge on a variety of grounds such as related party rules, form over substance, and step transaction to name a few

• Alternatives to explore for tax deferral• 1031 exchange

• Qualified opportunity zones

• Carried interests for managing partners (but beware 704(c))

76

Estates and Revocable Trusts

• Estates taxed the same as trusts for income tax purposes• Revocable trust may be treated as income tax estate if 645 election made

• Note several tax elections to be made by executor of estate• 2023A special use valuation

• 6166 deferral of estate taxes

• 303 stock redemption

• Portability election

• QTIP/reverse QTIP election

• Allocation of GST exemption

• Valuation discounts

• Alternate valuation date

77

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Family

Business

Succession

Questions?

• Thank you!

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