Business Succession Planning 04 2009

Business Succession Planning

Vincent J Gallo CLU ChFC AEP

Vincent J Gallo & Associates, Inc.

Winston-Salem, NC

Agenda

• Overview of business succession planning

• Estate planning fundamentals

• Business succession planning techniques

Overview of business succession planning

• More than 80% of businesses in the U.S. are private and/or

family dominated

• Businesses owned or dominated by the members of a

single family make up 175 of the Fortune 500

• International Family Business Program Association

estimated that family firms contribute 60%-75% of the

U.S. G.D.P.

• Closely held businesses have an extraordinary

failure rate:

– 70% do not survive to the second generation

– 85% do not survive to the third generation

– The average family owned business lasts only 24 years


Estate planning fundamentals

• General Rule - All asset transfers are

taxable

– Exceptions

• Marital transfers

• Annual gifts

• Tuition or medical expenses

• Charitable gifts

• Unified credit (or “lifetime exemption”)

• Qualified Family Owned Business Exclusion

– Additional exclusion is available for qualified family

owned business interests (QFOBI)

– Can increase overall exclusion amount to $1,300,000

– In order to qualify

• QFOBIs must exceed 50% of the gross estate

• Decedent or member of family must have “materially participated”

in business for at least 5 of last 8 years

• Situated in U.S.

• Other qualification requirements

Estate planning fundamentals

Minimizing Estate Taxation

• Best way to reduce overall estate taxation is

through “Estate Reduction”

• Reduce the value of the taxable estate

– without losing control

– while retaining cash flow

– paying minimum transfer taxes

Wealth transfer techniques

• Five techniques for business succession

planning– Buy/Sell Agreements

– Family Limited Partnerships

– S Corp Recapitalizations

– Employee Stock Ownership Plans

– Intentionally Defective Grantor Trusts

• Technique #1: Buy/Sell Agreements– Agreement among Company and Shareholders to buy

stock from shareholders upon certain events:

• Disability

• Retirement

• Death

• Divorce


• Technique #1: Buy/Sell Agreements– Two Types of Agreements

• Stock Redemption - Company buys stock from shareholder

• Cross Purchase - Other shareholder(s) buy stock from shareholder

• Common to use insurance or borrowing to provide funding

– How it works

• Company and shareholders enter into agreement

• Upon specified event, affected shareholder must sell stock to

company and/or other shareholders


• Technique #1: Buy/Sell Agreements– Price is either set annually, or more likely, an appraisal

process is outlined in the agreement

– Advantages

• Provides protection to the company and shareholders

• Provides liquidity to shareholders

– Disadvantages

• Accomplishes only minimal estate planning

• No wealth transfer achieved


• Technique #2: Family Limited Partnerships

– Family Limited Partnership (“FLP”) is a limited

partnership established under state law

– There are 2 classes of partners:

• General Partner - Very little economic interest (typically 1%) but virtually all management control

• Limited Partner - Virtually all of the economic interest, but very little management control

– Donor contributes assets to the FLP in exchange for both

general and limited partnership interests



– Donor makes gifts of limited partnership interests to next generation.

• Annual exclusion

• Unified credit

– Valuation discounts are often taken. The two types:

• Lack of marketability

• Lack of management control (minority interest)

– Retention of general partnership interest allows senior generation to

retain control while transferring value out of taxable estate.



– Advantages

• Discounts

• Separation between ownership and control

• Consolidated management of assets

• Potential asset protection

– Disadvantages

• Separate entity which requires administration and tax returns

• General partner has fiduciary duty to limited partners

• IRS scrutiny


• Technique #3: “S” Corp. Recapitalization

– What is it?

• FLP-type technique for “S” Corporations

– “S” Corporation

• Cannot be owned by a partnership (FLP not available)

• Cannot have more than one class of stock

– However, “S” corporation can have more than

one kind of stock (voting vs. non-voting)



– “S” Corporation is recapitalized to have:

• Voting common stock

• Non-voting common stock

– Gifts of non-voting common stock are then made to the next generation

– Discounting available:

• Lack of Control

• Lack of Marketability



– Advantages

• Discounts

• Separation of ownership and control

– Disadvantages

• Potential premium placed on the voting stock

• Wealth transfer is not accomplished without additional gifting or

other transfer techniques


• Technique #4: Employee Stock Ownership Plan

– Closely-held company establishes an employee stock ownership plan

(“ESOP”)

– ESOP borrows funds to finance purchase

– ESOP purchases stock from principal owner(s)

– Selling shareholders may elect to reinvest the proceeds in “qualifying

replacement securities” in order to defer capital gains tax

– May leverage against bonds to finance diversification

– Capital gains are deferred until replacement securities are sold, or

eliminated entirely if held until death or donated to charity



– Advantages

• Owners/Sellers

– Provides liquidity

– Diversification without paying current taxes

– Beneficial scenarios

• Retiring shareholder

• Creation of a market for company stock

• Relieve company of cash surplus

• Employees

– Become owners of corporation (motivation)

– Retirement benefit



– Disadvantages

• Must have individual(s) who are willing and able to continue business

after current owners have sold

• ESOPs are effective but are subject to many rules and regulations and

should be considered only after a thorough examination of all factors

involved


• Technique #5: Intentionally Defective Grantor Trust

– Accomplished by selling asset (stock) to trust in exchange

for a small cash down-payment and a long-term installment

note

– “Freezing” Technique

• Freeze value of an asset

• Freeze return on an asset



– Trust

• Usually children are beneficiaries

• Defective - income taxes are paid by grantor

• Income taxes paid on trust income are not additional gift

– Sale to trust

• Business owner receives cash and installment note for balance

• No capital gain on sale

• Installment obligation is paid through income received by trust



– Advantages

• No income taxes on sale to trust

• Payment of income taxes on trust does not create additional gift

• Trust can control timing and amount of distributions to

beneficiaries

– Disadvantages

• Cash flow may be insufficient to pay installment obligation

• Seller’s estate will include balance of outstanding note

• Undistributed trust income is subject to higher trust tax rates


• Summary

– A number of techniques exist to minimize

estate tax exposure while achieving owner’s

wishes

– A number of factors influence the choice of

which technique(s) is appropriate

– Whichever technique is used, should be part of

a comprehensive financial and estate plan

Business succession planning



Family Limited

Partnership

1% General

Partner

99% Limited

PartnersChildren

Grandchildren

Gifts

Parents transfer

assets to partnership

in tax-free exchange



Qualified

Replacement

Securities

Employee Stock

Ownership Plan

(must own 30%

of company)

“C” corporation

Bank

Retirement Contributions

Business

Owner(s)

Cash

Stock

Cash

Cash

Interest & Principal

Payments on Note



Parents Grantor Trust

Grantor Trust

Cash and

Company

Stock

Parents

Cash and

Note Receivable

Company Stock

Cash (gift)

Beneficiaries

Final Thought

• Having a Good Estate Plan Will Not

Accelerate the Date of Death

• Private companies have key advantages vs. public

ownership

– Typically, no separation between ownership and control

– Investors have longer term perspective

– Management invests less personal and financial capital

in managing investor expectations

– Flexible organizational structures


• Objective forward planning is critical

• Advance planning permits balancing of

income, charitable and family wealth issues

• Estate taxes are confiscatory yet elective


• Effect of Estate Taxes Without Planning

Your Family's Share of Your Estate

The Government's Share of Your Estate


• Effect of Estate Taxes With Planning

Your Family's Share of Your Estate

The Government's Share of Your Estate

Estate Tax Savings???


Marketing Strategy• Review All Succession Alternatives

• Don’t show bias to one technique

• Optimize transfer transaction• Control

• Valuation

• Identify Liquidity Need

• Cost Out Alternatives• Installment Sale at Death

• Loans

• Life Insurance

• Identify Funding Alternatives• Term of payment

• Leverage

Questions or

Free initial Consultation

Please contact:

[email protected]

Or

336.765.0122

mailto:[email protected]

Economy & Finance

Business Succession Planning 04 2009