The Three Levels of Business Succession Planning Sponsored by: September 17, 2011 San Diego, California Presented by: Julius H. Giarmarco, J. D. , LL. M. Giarmarco, Mullins & Horton, P. C. 101 W. Big Beaver Road, 10 th Floor Troy, Michigan 48084 (248) 457 -7200 jhg@disinherit-irs. com www. disinherit-irs. com
IRS Circular 230 Disclosure To ensure compliance with requirements imposed by the IRS, we inform you that any U. S. federal tax advice contained in this presentation is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.
The Three Levels of Business Succession Planning Ø Selecting Management and Retaining Key Employees. Ø Transitioning Ownership and Securing Retirement for the Founders. Ø Selecting a Transfer Strategy to Minimize Gift and Estate Taxes.
Estate, Gift, and GST Taxes Year Estate Tax Exemption Basis Method GST Tax Exemption Top Estate/GST Tax Rate 2009 $3, 500, 000 Step-up in basis $3, 500, 000 45% -0 - Modified carryover basis -0 - 0% $5, 000, 000 Step-up in basis $5, 000, 000 35% $5, 000 35% $1, 000 Step-up in basis $1, 0004 55% $1, 000 55% 20101 20112 20123 2013 Gift Tax Exemption Top Gift Tax Rate $1, 000 45% $1, 000 35% The Tax Relief Act of 2010: Beginning in 2011, introduction of the portability of the estate tax exemption between married couples (Note: not applicable to GST tax exemption). 3 Estate, GST, and gift tax exemptions are indexed for inflation in 2012. 4 Indexed for inflation ($1. 4 M estimate). 1 2
Case Study Ø John James is the founder, president and sole owner of JJ Enterprises (JJ), a successful manufacturer of machine tools. Ø John is 65 years old. His wife Mary is also 65. Ø JJ has two key executives. 5
Case Study Ø Their son, Bradley (age 35) is vice president of marketing at JJ. § Aspires to succeed John as president and controlling owner. § John generally concurs, but has concerns about Bradley’s wife. Ø John and Mary have another son, Blaze (age 30), who is not and does not want to be involved in the business. Ø Bradley has two minor children; and Blaze has three minor children. 6
Case Study Ø JJ is worth $10 M to the right buyer. Ø John’s annual salary and bonus is $300 K. Ø JJ is an S corporation with taxable income averaging $1 M over the last four years. Ø JJ has a profit-sharing plan. § No equity or nonqualified retirement plans for key executives. § No other retention plans for key executives. 7
Case Study Ø John and Mary own the business real estate, which has an estimated value of $5 M. They own it jointly to avoid probate. Ø Their residence and vacation homes are valued at $2 M and $1. 5 M and are owned jointly. The mortgages have been paid off. Ø John and Mary have personal investments of $1. 5 M, most owned jointly. Ø John has a $5 M life insurance policy owned by an irrevocable life insurance trust (ILIT). 8
Case Study Ø John’s profit-sharing account is $1 M; Mary is the beneficiary, and Bradley and Blaze are the contingent beneficiaries. Ø John and Mary have pour-over wills, living trusts with the usual “A/B” structure, powers of attorney, healthcare directives, and John has an ILIT. 9
John & Mary’s Balance Sheet Value Residence (Joint) $2, 000 Vacation Home (Joint) $1, 500, 000 Business (S corp) (John) $10, 000 Building (Joint) $5, 000 Non-Qualified Investments (Joint) $1, 500, 000 Profit-Sharing Plan (John) $1, 000 Life Insurance (ILIT) ($5, 000) Gross Estate $21, 000 1 2 1 Cost basis of $500, 000; assume 10% distributions and 4% principal appreciation. 2 Annual renewal term policy.
John & Mary’s Objectives 1. Retain control of the S corporation until death, disability or retirement. 2. Pass the entire business to Bradley at John’s death. 3. Retain the two key employees to assist in the transition period. 4. Treat both sons fairly, if not equally. 5. Guarantee retirement income (which may have to come from the business). 6. Reduce or eliminate estate taxes.
Projected Estate Tax Liability in 2031 No federal estate taxes at first death Current Net Estate Life Insurance Total Estate By-Pass Trust $5, 000 $44, 000 $ 5, 000 $49, 000 ILIT $5, 000 Marital Trust / Surviving Spouse $39, 000 After-Tax Estate $28, 850, 000 Federal Taxes $10, 150, 000 Distribution to Heirs After-Tax Estate By-Pass Trust ILIT Total $28, 850, 000 5, 000, 000 $38, 850, 000 Distribution to Family: 79. 3% Assumes 4% after-tax growth through 2031. Assumes the estate tax exemption is $5 M and the estate tax rate is 35%.
Options to Pay the Estate Tax if John & Mary Do Nothing 1. 2. 3. Good IRC Section 6166 (5 -year deferral; 10 -year installment payment of estate tax). Better IRC Section 303 (redemption of stock to pay death taxes). Best Irrevocable Life Insurance Trust. Ø Discounted dollars. Ø Can purchase assets from estate. Ø Can loan monies to estate.
Installment Payments Under Section 6166 Ø Extension of time to pay estate tax, but only for amount of estate tax attributable to the closely held business. Ø Value of business interest must exceed 35% of the adjusted gross estate. Ø Payments commence in fifth year after estate tax return due date. Interest-only need be paid during first four years, then principal and interest.
Installment Payments Under Section 6166 Ø Interest rate: § Rate on first $1, 360, 000 for 2011 of business value is 2%. § Rate on excess is 45% of normal rate on underpayments. § No deduction allowed for any interest on Section 6166 deferral.
Installment Payments Under Section 6166 Ø Tax will be accelerated upon: § Distribution, sale, exchange of 50% of the value of the business – valued as of the date of decedent’s death. § Withdrawal of 50% of the value of the business. § But, transfer to beneficiary doesn’t cause acceleration. • However, subsequent transfer by beneficiary will cause acceleration.
Section 303 Redemption Ø To qualify for sale or exchange treatment (as opposed to dividend treatment) under Section 303, the stock must exceed 35% of the adjusted gross estate. Ø Generally, little capital gain since stock receives “step up” at death. Ø Must be used to pay funeral costs, medical expenses of last illness, estate administration expenses and death taxes.
Section 303 Redemption During John’s Lifetime Insurance Company Pays Premiums S Corp Obtains Life Insurance John Insured If stock interest is more than 35% of adjusted gross estate, the estate will qualify for a partial redemption.
Section 303 Redemption At John’s Death Insurance Company Pays Death Benefits S Corp Cash § Partial redemption is not treated as a dividend. John Stock Transferred Some Stock John’s Living Trust § Family continues to retain an ownership interest.
Life Insurance – The Threshold Inquiries Ø How much is John willing to spend on life insurance? § Term insurance will be less expensive than permanent insurance in the short run. § But should consider permanent insurance for a permanent need. Ø Who will be the insured – John, Mary, or both? § To protect Mary, John should be the insured. § For estate liquidity or equalization for Blaze, Mary could be the insured (assuming she has the longer life expectancy), or a survivorship policy could be used.
Life Insurance – The Threshold Inquiries Ø Who will be the policy owner and beneficiary? § Given the size of the estate, an irrevocable life insurance trust should be the owner and beneficiary. Ø Who will pay the premiums and under what type of arrangement? § Gifts from John and Mary using their $26, 000 annual gift tax exclusions per child / grandchild. § Loan regime split-dollar with the Corporation.
Level 1: Selecting Management and Retaining Key Employees Ø Will Bradley be ready to manage the business upon John’s death, disability or retirement? Ø If not, what options are available to retain the two key employees during the transition period: § § Employment agreements with profit-sharing provisions. Stock option plans (but this dilutes the family’s equity). Change of control agreements. Non-qualified deferred compensation (NQDC) plans.
Level 1: Nonqualified Deferred Compensation Plans Ø Plans are “nonqualified” because they do not have to comply with the rules for qualified plans. (Nor do they afford the same level of protection for the participant. ) Ø Participant must be part of a select group of management or highly-compensated employees (“Top Hat Plan”).
Level 1: Nonqualified Deferred Compensation Plans Ø Defined benefit arrangements: § Employer funded retirement benefit based on a formula typically involving years of service and compensation over time. Ø Defined contribution arrangements: § Employee and/or employer funded account balance plan similar to a 401(k) plan. Ø In either type of plan, the employee is an unsecured general creditor of the Corporation.
Level 1: Nonqualified Deferred Compensation Plans Ø If executive remains a general unsecured creditor of the company, the amounts deferred are not subject to taxation. Ø The amounts distributed will be ordinary income to the executive and deductible by the employer at the time of payment (not the time of deferral like qualified plans). Ø This is particularly important to discuss with S corporations, like JJ.
Level 1: NQDC Plan Design Options Ø Ø Ø Ø Type of plan (DB or DC). Type of payout (lump sum or annuity). Benefit for surviving spouse? 100% vesting for change in control or termination without cause? Reasonable compensation. Impact on the value of the business and lenders. Funding. Section 409 A requirements.
Level 1: Sec. 409 A Requirements Ø Distributions can only be made upon one of six circumstances: 1. 2. 3. 4. 5. 6. Separation of service. Disability. Death. Fixed time specified in plan. Change in control. Unforeseen emergency.
Level 1: Funding a NQDC Plan Ø Pay-as-you-go: § Benefits are paid from the general assets of the company, so it maintains use of funds. § But executive is at risk for payment. Ø Sinking fund: § Plan assets are placed in a designated account or fund (with after-tax dollars). § Company controls but at least there us an identifiable asset for satisfaction of future liabilities, subject of course to risks. § Requires time to accumulate funds.
Level 1: Funding a NQDC Plan Ø Corporate Owned Life Insurance (COLI); § Company is owner, beneficiary and premium payer of policies on the key executives. § Premium is not deductible, but generally: • Cash value builds on tax-deferred basis. • Cash value can be accessed on tax-free basis (if done properly). • Death benefit is not taxable when received by the company (but C corporations are subject to a 15% AMT).
Level 1: Non-Qualified Deferred Compensation Plan 2 JJ 3 1 Insurance Company 4 Key Employees 1 JJ promises to provide a death, disability or retirement benefit. 2 JJ purchases life insurance to “informally” fund benefits. 3 Asset values help pay benefits and/or recover costs. 4 Benefits are paid based on contractual specifications.
Level 2: Transitioning Ownership and Securing Retirement for John and Mary Ø Decision tree: § The personal and business variables that will determine the extent and pacing of John’s transfer of the business. Can John give up the action? § How to transfer ownership (for wealth transfer purposes) but retain control for personal and business purposes (use voting / non-voting shares). § Should Bradley be given the stock or pay for it? § The impact on employees, creditors and customers. § The costs and potential risks of delay. Federal estate tax is only vulnerable to lifetime gifting.
Level 2: Transitioning Ownership and Securing Retirement for John and Mary Ø Equalization between Bradley and Blaze: § § What does “equal” mean? Does John really mean “equal” or just “fair”? When should equalization occur? True equalization for Blaze will be difficult to accomplish. • Can it be handled with other existing assets? • If not, an irrevocable life insurance trust is recommended.
Level 2: Transitioning Ownership and Securing Retirement for John and Mary Ø Options for securing John and Mary’s Retirement: § Retain control of JJ, thereby maintaining access to a salary and bonus. § Sell (as opposed to gift) Company to John (i. e. , installment sale or private annuity). § Life insurance on John’s life owned by an ILIT for the benefit of Mary. § A non-qualified deferred compensation plan to provide John with a pre-retirement death, disability or retirement benefit (with survivor benefits for Mary).
Level 3: Selecting a Wealth Transfer Strategy Ø How? § § § Gifts of stock. Stock bonuses. Private Annuity. Grantor Retained Annuity Trust (GRAT). Installment Sale to Intentionally Defective Grantor Trust (IDGT). § Ownership first, control later by gifting or selling nonvoting shares. Non-voting shares may also qualify for valuation discounts.
Level 3: Selecting a Wealth Transfer Strategy Ø When? § As soon as possible, to remove future appreciation from John and Mary’s estate. § When is the best time to plant an oak tree? Ø Impact of transfer to Bradley: § Bradley’s compensation expectations. § Note requirement for pro-rata distributions in S corporations.
Level 3: Private Annuity Ø Structure: § John (annuitant) sells JJ stock to Bradley in exchange for a life annuity. § Present value of annuity stream equals fair market value of assets sold, resulting in no gift. § When John dies, payments terminate. § Annuity may not be secured. § Bradley cannot deduct any part of payments.
Level 3: Private Annuity John (Age 65) Sale of $6. 5 M of non-voting stock in JJ (with basis of $500 K) Annual Payout of $473, 488. 30 Bradley Ø Fair market value of stock is $10 M, less 35% valuation discount. Ø Capital gain realized in year one is $6 M; each payment is divided into interest income ($140, 154. 96), and a nontaxable recovery of basis ($333, 333. 34). Ø Calculation assumes a 19. 5 year life expectancy. Ø Standard valuation tables may be used if annuitant has at least a 50% probability of living one year. If the annuitant survives for at least 18 months, the 50% test is presumed to have been met. Regs § § 1. 7520 -3(b)(3) and 25. 7520 -3(b)(3). Ø IRC Section 7520 Rate = 2. 4%.
Level 3: GRAT Ø John transfers JJ stock to an irrevocable trust. Ø Annual annuity paid to John for a term of years (in cash or in kind). Ø Assets remaining at end of term pass – tax free – to Bradley. Ø Statutory technique.
Level 3: GRAT Ø Tax-free gift of appreciation in excess of IRC Section 7520 rate. Ø John’s payment of GRAT’s income taxes is also a tax-free gift to Bradley. Ø No risk of unintended gift tax (because annuity self adjusts when initially set as a percentage of the fair market value of the transferred property).
Level 3: GRAT Diagram John (age 65): Gift of $6. 5 M of JJ stock (after discount) Gift = $4. 17 Contribution of JJ Non-Voting Stock Annual Annuity Payment of $813, 689. 50 (12. 52%) Remainder transferred to Bradley (or trust for Bradley’s benefit): Assumptions: 10% income/4% growth: 10% income/8% growth: Section 7520 Rate = 2. 4% GRAT Value: $10 million Remainder after 10 years $21. 8 M $34. 6 M Bradley
Level 3: GRAT Drawbacks Ø Grantor must survive the GRAT term. Ø Assets must out perform the IRC Section 7520 rate. Ø Cannot allocate GST exemption until end of GRAT term. Ø Practical downside is transaction costs only.
Level 3: Bullet-Proofing a GRAT Ø John can purchase insurance on his life (to be owned by an ILIT for the benefit of Bradley) to provide the funds needed to pay estate taxes (on the stock bequeathed to Bradley) should John die before the end of the GRAT term. Ø Alternatively, Bradley can purchase life insurance on John’s life to provide the funds necessary to purchase the stock (pursuant to a buy-sell agreement) if John dies before the end of the GRAT term.
Level 3: Intentionally Defective Grantor Trust Ø An IDGT is a type of trust where all income earned by the trust is taxed to the grantor because the trust is drafted to be “defective” for income tax purposes, but “effective” for estate and gift tax purposes. Ø Defective nature of trust also allows for a “taxfree” gift to the trust’s beneficiaries when grantor pays income taxes otherwise attributable to the trust or its beneficiaries.
Level 3: Installment Sale to an IDGT – Summary of Technique Ø John sells JJ stock to an IDGT in exchange for an installment note. Ø For estate tax purposes John should make an initial “seed” gift (at least 10% of the total transfer value) to the IDGT. Ø To the extent that the growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note, the “excess” is passed on to the trust beneficiaries free of any gift, estate and/or GST tax.
Level 3: Installment Sale to an IDGT – Summary of Technique Ø No capital gains tax is due on the installment sale to the trust because the trust is “defective” for income tax purposes. Ø IDGT’s basis in the assets is John’s carry-over basis. Ø Interest income on installment note is not taxable to John because the trust is “defective” for income tax purposes. Instead, John pays the taxes on all of the IDGT’s income.
Level 3: Sale to an IDGT 1. Gifts $650 K of JJ Non-Voting Stock Grantor/ John 2. Sells $5. 85 M of JJ Non-Voting Stock (No Capital Gain Tax) 3. $5. 85 M Note to Grantor Balloon Payment in 9 Years IDGT f/b/o Bradley 5. Excess Cash Flow / Premiums 6. Death Proceeds (Income and Estate Tax Free / Leverages GST Exemption) Life Insurance Company 4. $142, 740 annual interest (Interest Rate 2. 44%) Advantages: • Value of assets sold frozen at 2. 44% for nine years (assumed mid-term AFR). • John’s estate further reduced by the income taxes paid on behalf of the trust. • The trust property escapes estate taxation for as long as permitted under state law. • IDGT can purchase a life insurance policy on John’s life. Upon John’s death, the death proceeds can be used to purchase John’s voting shares in JJ and the building used by JJ.
Level 3: Installment Sales to an IDGT - Example Assumptions FMV of Assets Sold to IDGT $ 5, 850, 000 $650, 000 Gift to Trust Interest Rate (Mid-Term AFR) 2. 44% Terms (Years) 9 Payment Structure Interest-Only w/Balloon Payment Period Annually Timing of Payments Year End of Period Beginning Balance Income 10. 00% Installment Payment Ending Balance 1 $5, 200, 000 $520, 000 $(126, 880) $5, 593, 120 2 $5, 593, 120 $559, 312 $(126, 880) $6, 025, 552 3 $6, 025, 552 $602, 555 $(126, 880) $6, 501, 227 4 $6, 501, 227 $650, 123 $(126, 880) $7, 024, 470 5 $7, 024, 470 $702, 447 $(126, 880) $7, 600, 037 6 $7, 600, 037 $760, 004 $(126, 880) $8, 233, 161 7 $8, 233, 161 $823, 316 $(126, 880) $8, 929, 597 8 $8, 929, 597 $892, 960 $(126, 880) $9, 695, 676 9 $9, 695, 676 $969, 568 $(5, 326, 880) $5, 338, 364 Amount passing to beneficiaries free of estate and gift tax And income tax on trust income is paid by grantor as additional “gift” without gift tax
Level 3: Grantor Trust vs. Non-Grantor Trust NON-GRANTOR TRUST Year Beginning Balance Taxable Income 7% Less: Taxes at 40% Ending Balance Year Beginning Balance Taxable Income 7% Less: Taxes at 40% 1 $10, 000 $700, 000 $(280, 000) $10, 420, 000 1 $10, 000 $700, 000 $ 2 10, 420, 000 729, 400 (291, 760) 10, 857, 640 2 10, 700, 000 3 10, 857, 640 760, 035 (304, 014) 11, 313, 661 3 4 11, 313, 661 791, 956 (316, 783) 11, 788, 835 5 11, 788, 835 825, 218 (330, 087) 6 12, 283, 966 859, 878 7 12, 799, 892 8 Ending Balance - $10, 700, 000 749, 000 - 11, 449, 000 801, 430 - 12, 250, 430 4 12, 250, 430 857, 530 - 13, 107, 960 12, 283, 966 5 13, 107, 960 917, 557 - 14, 025, 517 (343, 951) 12, 799, 892 6 14, 025, 517 981, 786 - 15, 007, 304 895, 992 (358, 397) 13, 337, 488 7 15, 007, 304 1, 050, 511 - 16, 057, 815 13, 337, 488 933, 624 (373, 450) 13, 897, 662 8 16, 057, 815 1, 124, 047 - 17, 181, 862 9 13, 897, 662 972, 836 (389, 135) 14, 481, 364 9 17, 181, 862 1, 202, 730 - 18, 384, 592 10 14, 481, 364 1, 013, 695 (405, 478) 15, 089, 581 10 18, 384, 592 1, 286, 921 - 19, 671, 514
Level 3: IDGT vs. GRAT Ø With IDGT: § No mortality risk. § Can allocate GST exemption to seed gift. § Mid-term AFR is less than Section 7520 rate. § Back-loading (i. e. , interest only with balloon payment vs. level annuity payment). § Not a statutory technique. § Possibility of unintended gift tax, which may be mitigated by using a “defined value” clause.
Level 3: Buy-Sell Agreement During John’s Lifetime Insurance Company JJ Pays Premiums John Agreement Pays Premiums IDGT f/b/o Bradley John Obtains Life Insurance on Bradley’s Life IDGT Obtains Life Insurance on John’s Life
Level 3: Buy-Sell Agreement Upon John’s Death Insurance Company Pays Death Benefits JJ Option to Must Purchase IDGT f/b/o Bradley John 1 st 3 rd Stock Passes Option to Purchase 2 nd John’s Living Trust
Level 3: Why Use Life Insurance to Fund Buy-Sell Agreement? Ø Creates a lump sum of cash when needed. Ø Results in a quick settlement of the buy-sell transaction. Ø Generally, an income tax free death benefit. Ø Income tax free access to cash values for a lifetime buy-out.
Level 3: Estate Equalization Ø John and Mary can leave Blaze their nonbusiness assets. Ø John and Mary can “make up” the difference by funding a survivorship ILIT for the benefit of Blaze. Ø Alternatively, the IDGT f/b/o Bradley can loan premiums to Blaze’s ILIT under a loan regime split-dollar arrangement.
Level 3: Estate Equalization John & Mary Insurance Company 1 John & Mary create an irrevocable trust, and make gifts of life insurance premiums to the trust. 2 Pays Insurance Premium. 3 Pays death benefit upon death of John & Mary – income and estate tax free! 4 Transfers Cash. John & Mary’s Estate 6 Pays Debts and Taxes. 5 Transfers Assets. IRS ILIT fbo Blaze
Level 3: Family Bank Structure: A family LLC or family limited partnership. Members/Partners: Bradley and Blaze. Capital Contributions: Either gifts from John and Mary and/or contributions directly from Bradley and Blaze. FLLC’s/FLP’s Investments: A survivorship policy on John and Mary’s lives.
Level 3: Family Bank Indicated Use: If shares in JJ are transferred (either during John’s lifetime or death) to both sons. Purpose: To provide funds for Bradley to “call” Blaze’s shares, or for Blaze to “put” his shares to Bradley.
Level 3: Top 10 Uses of Life Insurance in Family Business Succession Plan 1. Estate Liquidity. 2. Funding Buy-Sell Agreements. 3. Estate Equalization. 4. Funding Nonqualified Deferred Compensation Plans. 5. Key-Man Insurance.
Level 3: Top 10 Uses of Life Insurance in Family Business Succession Plan 6. Funding a Section 303 Redemption Plan. 7. As a hedge against premature death with a GRAT. 8. To leverage the excess cash flow in connection with an installment sale to an IDGT. 9. Asset Protection Planning. 10. To fund a Family Bank.
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