drafting tax-effective succession plans for closely-held...
TRANSCRIPT
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Drafting Tax-Effective Succession Plans for
Closely-Held Businesses: Navigating
Competing Concerns Ensuring Business Continuity, Preserving Owner Liquidity, and Minimizing Tax Liabilities
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, SEPTEMBER 8, 2015
Presenting a live 90-minute webinar with interactive Q&A
Brian M. Annino, Member, Annino Law Firm, Atlanta
Julius H. Giarmarco, Chair of Trusts and Estates Practice Group,
Giarmarco Mullins & Horton, Troy, Mich.
Martin S. Varon, Partner, IAG Forensics & Valuation, Marietta, Ga.
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CONSIDERATIONS FOR COUNSEL IN DESIGNING SUCCESSION PLANS
Brian M. Annino, Esq. Annino Law Firm, LLC
707 Whitlock Ave., Ste E16 Marietta, GA 30064
(404) 934-5978 [email protected] www.anninolawfirm.com
September 8, 2015 Considerations for Counsel in Designing
Succession Plans
Roadmap
• Why succession planning?
• Who is the client?
• Understand the Client’s goals.
• Consider the options.
• Associate with necessary experts.
• Execute the plan and stay in touch!
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 5
Why be concerned about succession planning?
• Ensure continuity of a family-held or closely held business.
• Reward key employees for loyalty.
• Avoid family disputes or protracted litigation.
• Legacy and retirement planning.
• Ensure a market for purchase of business interests that otherwise would not exist.
• Ensure liquidity of a deceased shareholder’s estate.
• Insurance for a family business.
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 6
Who is the client?
• Are you representing the business entity or a shareholder? – Review ABA Model Rules 1.7 and 1.13 (as may be
adopted in your jurisdiction) – Be wary of conflicts of interest. – When in doubt, ensure that shareholders with
competing interests are represented by independent counsel.
• Red Flags: When a shareholder asks you to keep a secret from other shareholders or seeks counsel as to what is in “their best interest.”
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 7
Understand the client’s goals!
• Meet client and understand their goals and objectives. • It’s our job to listen to our client’s goals and advise of
how to accomplish them in a lawful tax-efficient manner.
• Example: Clients, a husband and wife, want to transfer business they wholly own to children. They are interested in making transfer during their lifetime but are concerned about unnecessarily paying taxes. – Clients’ goal is to transfer business to children. – Determine value of business and analyze if business can be
transferred during lifetime in tax-efficient manner and analyze benefits of same vs. waiting until the second spouse to pass away.
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 8
Explore the Options (Today’s focus)
• Trusts and family-limited partnerships
• Buy-Sell Agreements
• Asset Purchase Agreements and Mergers
• Inter vivos transfers to family members
• Funding options for purchases, acquisitions, and mergers.
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 9
Utilize a teamwork approach
• Quarterback the team as legal counsel.
• Engage tax counsel or a CPA (if nec.)
• Utilize a Certified Valuation Analyst – Too often overlooked, but a proper valuation is critical
and provides protection in the event of an audit.
• Understand client’s industry and get assistance from industry experts – Example: Consult with IT professional regarding
potential ramifications of patent application on future value of biz.
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 10
Execute the Plan…but stay in touch.
• Work with client and the team to draft and implement plan.
• Our job is just starting. – Check in regularly with client.
– Does the plan still meet client’s needs?
– Has valuation changed?
– New shareholders?
– This is why we are better than online/self-help legal solutions.
September 8, 2015 Considerations for Counsel in Designing
Succession Plans 11
Tax-Effective Succession Plans for Closely-
Held Businesses: Navigating Competing
Concerns
Entity and Valuation Questions
Martin S. Varon
Initial Considerations
• Mentally Ready?
• Financially Ready?
Entity and Valuation 13
• Do Nothing (allow a life event to determine)
• Close down (liquidate)
• Plan
– Sale of business (asset or stock)
– Private Equity Group- Recapitalize
– Management Buy Out
– ESOP (Employee Stock Ownership Plan)
– Gift / Transfer at Death
Possibilities
Entity and Valuation 14
Standards of Value
• Fair Market Value
• Fair Value
• Investment Value
• Intrinsic or Fundamental Value
• Book Value
• Strategic Value (Synergistic Value)
Entity and Valuation 15
Fair Market Value
“the price, expressed in cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in a open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Rev. Ruling 59-60, SAS #1
Entity and Valuation and the Impact of Valuations 16
Fair Value
• Value of corporation’s shares immediately before the effectuation of the corporate action to which the shareholder objects
• Using normal and current valuation concepts and techniques AND
• Without discounting for lack of marketability or minority status
1999 Revised Model Business Corporation Act
17
Investment Value
• The value to a SPECIFIC owner or investor
• This is the value to the specific individual or entity’s motivation, their perception, their situation
Entity and Valuation 18
Intrinsic or Fundamental Value
• Value based upon perceived judgment of the financial analyst observing the investment characteristics of the subject entity
• Does not look to the specific investor’s circumstances
19
Book Value
• Accounting term, not valuation term
• Equals Total Assets (net of depreciation)
• Less Total Liabilities
• GAAP
Entity and Valuation 20
Strategic or Synergistic Value
• Value to a Specific Buyer because of added benefits
– Reduction of costs
– Economies of Scale
– Addition strategic alliances
– Eliminating Competition
– Market Share Enhancement
Entity and Valuation 21
Approaches to Valuation
• M – Market Approach
• I – Income Approach
• A – Asset Approach
22
Market Approach
• Guideline Public Companies
• Guideline Transaction Method
• Past Transactions Method
• Buy-Sell Agreements
• “Rules of Thumb”
Entity and Valuation 23
Income Approach
• Discounted Cash Flow (DCF)- projecting future cash flows into perpetuity and discounting it back to present value using a rate of return
• Capitalization-estimating a single period’s cash flow dividing it by a rate of return adjusted for the expected growth
Entity and Valuation 24
Asset Approach
• Adjust Assets and Liabilities to fair market value
• Subtract fair market value of liabilities from fair market value of assets
• Remove Non-Operating Assets and Liabilities
25
Levels of VALUE
Entity and Valuation 26
Asset Transfer Vehicles
Presented by:
Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C.
101 W. Big Beaver Road, 10th Floor
Troy, Michigan 48084
(248) 457-7200
www.disinherit-irs.com
Sponsored by:
Strafford Publications, Inc.
Dynasty Trust
Discretionary Distributions
to Children for Life
Discretionary Distributions
to Grandchildren for Life
Discretionary Distributions
to Great-Grandchildren
for Life
Future Generations
Grantor
Advantages Creditor protection
Divorce protection
Estate tax protection
Assets remain in bloodline
Dispositive plan protection
Spendthrift protection
Consolidation of capital
Gift should take advantage
of any remaining lifetime gift
exclusion and lifetime GST
exclusion
No transfer tax paid.
No transfer tax paid.
No transfer tax paid.
No transfer tax paid.
Lifetime Gifting
28
Power of Compound Growth Economics:
Assumptions
• $1 million contributed to trust
• Trust lasts 120 years
• 40% transfer tax imposed on non-dynastic
trust assets every 30 years
Lifetime Gifting
29
Power of Compound Growth Chart
$1 Million Example: Dynasty Trust vs 40% Estate Tax Every 30 Years
After-Tax Growth
Value of Dynasty Trust
After 120 Years
Value of Property if No
Trust
3.00% $34,710,987 $4,498,544
4.00% $110,662,561 $14,341,868
5.00% $348,911,561 $45,218,993
6.00% $1,088,187,748 $141,029,132
7.00% $3,357,788,383 $434,169,374
8.00% $10,252,992,943 $1,328,787,885
9.00% $30,987,015,749 $4,015,917,241
10.00% $92,709,068,818 $12,015,095,319
Lifetime Gifting
30
How much is enough – with 4% inflation:
$1 Million Example: Dynasty Trust vs 40% Estate Tax Every 30 Years
After-Tax Growth
Real Value of Dynasty
Trust after 120 Years
Real Value of Property
if No Trust
4.00% $1,000,000 $129,600
5.00% $3,152,932 $408,620
6.00% $9,833,386 $1,274,406
7.00% $30,342,587 $3,932,399
8.00% $92,650,964 $12,007,564
9.00% $280,013,543 $36,289,755
10.00% $837,763,631 $108,574,166
Lifetime Gifting
31
How much is enough – with 4% inflation?
$1 Million Example: Dynasty Trust vs 40% Estate Tax Every 30 Years
After-Tax
Growth
Real Value of
Dynasty Trust
after 120 Years
Real Value of
Property if No
Trust
Inheritors
4.00% $62,500 $8,100 16
5.00% $197,058 $25,538 16
6.00% $614,586 $79,650 16
7.00% $1,896,411 $245,774 16
8.00% $5,790,685 $750,472 16
9.00% $17,500,846 $2,268,109 16
10.00% $52,360,226 $6,785,885 16
Lifetime Gifting
32
Family Limited Liability
Companies (“FLLCs”)
Family Limited Liability
Companies (FLLCs)
FLLCs:
An FLLC is a partnership between family members,
which exists for a business purpose.
The FLLC consists of one or more manager(s) who
control the daily operation of the entity, and
members who are “silent” partners not actively
involved in the business.
Although operating as a business, the FLLC also
serves as an important estate planning and business
continuation device.
34
FLLCs
Use of an FLLC is appropriate when there is a:
Wish to transfer the business to the next generation
without relinquishing immediate control.
Need or desire to shift income to another family
member who may be in a lower income tax bracket.
Desire to reduce the value of the owners’ business
interest for estate tax purposes and shift future
appreciation to the next generation.
35
FLLCs
Use of an FLLC is appropriate when there is a (cont.):
Wish to give assets to children now, without giving
too much – too soon, to the children.
Desire to protect assets transferred to children from
going to an ex-spouse as a result of a divorce
settlement.
Need to make it difficult for creditors to seize assets.
36
FLLCs
Advantages to the Business Owner:
The owner, as Manager, controls the FLLC and its
assets.
The owner may also receive reasonable
compensation for managing the FLLC.
The children, as non-voting members, have no
managerial control over the underlying assets owned
by the FLLC or the FLLC’s income distributions.
Non-voting members do not earn compensation in
the form of a salary but may earn income from a
share of the FLLC’s profits.
37
FLLCs
FLLC Parents
1. Transfer Business
2. Voting and non-voting
membership interests
3. Gift / sell non-voting
membership interests
to children
Insurance
Company
4. Pay Premiums 5. Death Proceeds
Child A GRAT fbo
Child B
IDGT fbo
Child C
38
FLLCs
Advantages to the Business Owner (cont.):
As a result of the gifts of non-voting membership
interests to the children, the owner has removed
assets from his/her estate and has transferred
portions of the business to the children.
As a result of potential valuation discounts (for lack
of control and marketability), the owner can transfer
a greater portion of the business to the children while
reducing estate and gift taxes.
39
FLLCs
Advantages to the Children:
The children now own a portion of the business.
Through regular gifts of non-voting membership
interests, the children can own an increasing share
of the business each year.
Members enjoy limited liability.
Distributions of net profits are generally made in
proportion to the ownership interest in the FLLC and
taxed individually to each member.
40
FLLCs
Tax considerations:
Future appreciation on the gifted portion of the FLLC is
removed from the business owner’s taxable estate.
The donee’s basis in the transferred portion of the FLLC
interest will be the same as the donor’s basis before the
gift was made.
FLLCs are “pass-through entities” taxed as partnerships.
As a result, individual members earn income when the
partnership earns income. The income must be
recognized and reported annually on the member’s
income tax returns even if the income is not distributed by
the FLLC.
41
FLLCs
Tax considerations (cont.):
As a result of the FLLC’s pass-through tax nature,
creditors of individual partners holding charging
orders may be subject to reportable income even if
the FLLC makes no distributions.
This provides further asset protection against
creditors, because the creditor may be KO’d by the
K-1.
42
Grantor Retained Annuity Trusts
(“GRATs”)
GRATs
How does a GRAT work?
Gift of property into trust.
Annuity payment is returned to Grantor annually at IRC
Section 7520 rate for a set term.
It is possible to combine a trust term with a high annual
annuity to reduce the gift tax value to zero or close to
zero.
Appreciation in excess of the IRC Section 7520 rate is
passed to the remaindermen free of transfer taxes.
If the assets do not appreciate faster than the Section
7520 rate, they are returned in kind to the Grantor.
44
GRATs
What are the advantages of a Grantor Retained
Annuity Trust?
Large estate tax savings.
• Transfer most of the future appreciation in growth
assets to children at little or no gift tax cost.
Very low tax risk.
• The IRS has promulgated regulations to govern
use of GRATs – it is a “safe harbor” technique.
Easy to implement and administer.
45
GRATs
Ideal assets.
Assets that will appreciate faster than the IRC
Section 7520 rate.
Stocks and marketable securities.
LLC interests, partnership interests and S corporation
stock.
46
GRATs
Valuation discounts.
Transfer is a gift for tax purposes – subject to gift tax
(ordinarily current FMV).
Grantor is entitled to 2 key discounts to current FMV:
• Remaindermen must wait to receive the property
(until GRAT term is over).
• Grantor retains the “right” to get the property back
if he/she dies before the GRAT term is over.
These discounts can result in substantial reductions
to current FMV.
47
GRATs
Tax benefits.
After the GRAT term, the property is out of the
Grantor’s estate for estate tax purposes.
All appreciation is removed from the Grantor’s
estate.
No gift tax consequences unless Grantor has
already used up his/her lifetime exemption.
48
GRATs
Tax benefits (cont.)
The trust is a grantor trust, so the Grantor does not
realize any income tax on the annuity payments. But
the Grantor is responsible for paying the GRAT’s
income taxes.
Any income taxes the Grantor pays for the GRAT
reduces the Grantor’s taxable estate and preserves
assets for the Grantor’s beneficiaries.
49
GRATs
Drawbacks.
Grantor must survive the GRAT term to achieve the
estate tax savings.
• (You can “hedge” this problem with life insurance.)
Grantor must pay income tax on assets in Trust.
• (But this is essentially a tax-free gift to the
remaindermen.)
The GRAT is an irrevocable trust – there may be no
commutation.
50
GRATs
Typical GRAT terms.
The GRAT must be established for a term of years (2
years is minimum).
Multiple GRATs with varying terms can be used to
minimize mortality risk.
Multiple GRATs with different assets can be used to
hedge against one of the GRATs failing.
Annuity payments may be re-GRATed, creating a
“rolling” series of GRATs.
The annuity may be “back-end loaded” such that the
annuity starts low and increases by as much as 20%
each year.
51
GRATs
Interest Rate Sensitivity.
When interest rates are low, as they are now, a
GRAT is more likely to succeed.
This is because the GRAT assets are more likely to
appreciate at a rate greater than the IRC Section
7520 rate (sometimes called the “hurdle” rate).
When the GRAT term ends, the remainder
beneficiaries will receive the difference between the
actual appreciation and the IRC Section 7520 rate,
transfer tax free.
52
GRATs
Income Tax Treatment.
There will be no income tax consequences
associated with the initial transfer of assets to the
GRAT, or the annuity payments back to the grantor,
provided the GRAT qualifies as a “grantor trust”.
As long as the GRAT is a grantor trust, transactions
between the grantor and the trust will be disregarded
for income tax purposes. See Rev. Rul. 85-13.
53
GRATs
Income Tax Treatment (cont.)
In most cases, a GRAT will qualify as a grantor trust
under IRC Section 677 (regarding the grantor’s
retained right to income).
Since it is theoretically possible, however, that the
income from the trust assets could exceed the
annuity payments, consider adding another grantor
trust trigger (such as the power to substitute assets
under IRC Section 675(4)(C)) to ensure grantor trust
treatment.
54
GRATs
Power to Substitute Assets.
Apart from ensuring grantor trust treatment, there is
another reason to give the grantor the power to
substitute the GRAT assets with assets of equivalent
value during the GRAT term.
If the GRAT assets “overperform,” and the grantor
would prefer to freeze the appreciation he or she
passes on to his or her children, the power to swap
assets can be very useful.
55
GRATs
Not Ideal for GST Planning.
Under the estate tax inclusion period (“ETIP”) rules,
it is not possible to allocate GST tax exemption to a
GRAT until after the term expires (or the grantor
dies, if earlier). See IRC Section 2642(f) and Treas.
Reg. Section 26.2632-1(c).
Accordingly, it is not possible to “leverage” the initial
gift (which could be very low or even zero) to exempt
the ultimate remainder interest (which could be much
more valuable than the assumed remainder interest
at initial funding) from GST tax.
56
Grantor (age 65):
Gift of $6.5M of
stock (after 35%
discount)
Gift = $4.17
GRAT Value:
$10 million
Children
Remainder transferred to Children
(or trust for Children’s benefit):
Assumptions:
10% income/4% growth: $23.4M
10% income/8% growth: $36.6M
Gift = $5.61
Section 7520 Rate = 2.2%
Contribution of Non-Voting Stock
Annual Annuity Payment of
$731,215.55 (11.25%)
Remainder after
10 years
GRATs
57
GRATs
Bullet-Proofing a GRAT.
Grantor can make gifts to an ILIT (for the benefit of
the children) to provide the funds needed to pay
estate taxes (on the stock bequeathed to the
children) should the Grantor die before the end of the
GRAT term.
Alternatively, the children can purchase life insurance
on the Grantor’s life to provide the funds necessary to
purchase the stock (pursuant to a buy-sell
agreement) if the Grantor dies before the end of the
GRAT term.
58
Intentionally-Defective Grantor
Trusts (“IDGTs”)
IDGTs
What is an IDGT?
An IDGT seeks to take advantage of the differences
between the estate tax inclusion rules of IRC Sections
2036-2042 and the grantor trust income tax rules of
IRC Sections 671-678.
An IDGT is an irrevocable trust that effectively removes
assets from the grantor’s gross estate.
For income tax purposes, however, the trust is
“defective”, and the grantor is taxed on the trust’s
income.
The IDGT’s income and appreciation accumulates
inside the trust gift and GST tax free.
60
IDGTs
Common grantor trust triggers:
The trust includes a power exercisable by the grantor
(in a non fiduciary capacity) to reacquire trust assets by
substituting assets of equivalent value. IRC Section
675(4)(C).
The trust includes a power held by a non-adverse party
to add to the class of beneficiaries (other than the
Grantor’s after-born or after-adopted children). IRC
Section 674(a).
The trust includes a power to enable the trustee to loan
money or assets to the grantor from the trust without
adequate security. IRC Section 675(2).
61
IDGTs
Funding the IDGT prior to sale.
Amount of seed funds.
• The “seed fund” reduces the risk that the sale will
be treated as a transfer with a retained interest by
the grantor under IRC Section 2036.
• In PLR 9535026, the IRS ruled that IRC Sections
2701, 2702 and 2036(a) did not apply if the note
retained by the grantor was bona fide debt.
62
IDGTs
Funding the IDGT prior to sale (cont.)
In Sharon Karmazin, Tax Court Docket No. 2127-03,
the IRS challenged an IDGT sale on the basis that
IRC Code Sections 2701 and 2702 applied, but later
dropped both arguments.
In Karmazin, the trust had 10% seed money. The
case was settled out of court with the only
adjustment being a reduction of the valuation
discount from 42% to 37%.
63
IDGTs
Why an installment sale to an IDGT works:
1. No capital gains tax on sale. Rev. Rul. 85-13.
2. Freezes value of appreciation on assets sold at the
AFR.
3. Interest payments not taxable to grantor.
4. Payment of IDGT’s income taxes by grantor leaves
more assets in the IDGT – gift tax free. Rev. Rul.
2004-64.
5. Back end-loading (i.e., interest only with a balloon
payment).
64
IDGTs
Why an installment sale to an IDGT works (cont.):
6. Valuation discounts increase effectiveness of
technique.
7. Possible discount for value of note in seller’s estate.
8. IDGT is an eligible Subchapter S shareholder.
9. Lower interest rate than used in GRATs.
10. An IDGT can purchase an existing life insurance policy
on the life of the grantor without subjecting the policy to
taxation under the transfer-for-value rule. Rev. Rul.
2007-13.
65
IDGTs
Disadvantages to an IDGT sale:
Requires 10% seed funding.
Note is taxable in grantor’s estate (unless SCIN is
used).
Potential cash flow problems for grantor by paying
IDGT’s income taxes.
Likely no step-up in basis at grantor’s death.
Possible gift and estate tax exposure (under IRC
Section 2036) if IDGT has insufficient equity.
66
IDGTs
Sale Agreement / Note.
The IDGT can make a down payment or issue a
promissory note for the full value of the property.
The note is typically structured to provide annual
payments of interest only with a balloon payment at
the end of the term.
The interest is normally set to be equal to the
Applicable Federal Rate (AFR) at the time of sale.
An independent written appraisal of the asset being
sold to the IDGT should be obtained.
67
IDGTs
Sale Agreement / Note (cont.)
It is common for a nine-year note to be used in IDGT
transactions, which would apply the mid-term rate.
The note typically permits prepayment in kind.
The note can be a self-canceling installment note
(SCIN).
68
IDGTs
Possible IRS Attacks on IDGT Sales: IRC
Section 2701
Under IRC Section 2701, the amount of the taxable gift
is the value of the property transferred minus the value
of any “qualified interests” retained by the transferor.
If the IDGT note has a fixed due date and payments
are made at least annually, the payments should be a
qualified retained interest.
However, the required return for a preferred
partnership interest is generally much higher than the
AFR.
69
IDGTs
Possible IRS Attacks on IDGT Sales: IRC
Section 2702 and Woebling, Tax Court Docket
No. 030261-13
IRC Section 2701 provides that except for GRATs,
GRUTs and QPRTs, any other split interest held by
the grantor in a trust is valued at zero, resulting in a
taxable gift of the FMV of the property sold.
If the IDGT is bona fide debt, then IRC Section 2701
does not apply.
70
IDGTs
Possible IRS Attacks on IDGT Sales: IRC
Section 2036(a)(1)
If the note is a retained interest, then IRC Section
2036(a)(1) would cause the entire trust property to
be included in the grantor’s estate at its date-of-
death value.
If the note is respected as bona fide debt, there is no
retained interest.
71
IDGTs
Avoiding IRS Attacks on IDGT Sales:
Observe all note formalities and make all payments
according to the payment schedule.
Provide seed money (or guarantees) equal to at
least 1/9th of the value of the assets sold.
Don’t peg payments to IDGT’s income.
Put all of the IDGT’s assets at risk for the note.
72
IDGTs
GST considerations.
As long as the grantor allocates his or her
generation-skipping tax (“GST”) exemption to gifts to
the IDGT, the trust assets will be exempt from the
GST tax.
The GST exemption does not need to be applied to
the sale to the IDGT.
73
Grantor Trust vs.
Non-Grantor Trust
NON-GRANTOR TRUST GRANTOR TRUST
Year
Beginning
Balance
Taxable
Income
7%
Less:
Taxes at
40%
Ending
Balance Year
Beginning
Balance
Taxable
Income
7%
Less:
Taxes at
40%
Ending
Balance
1 $10,000,000 $700,000 $(280,000) $10,420,000 1 $10,000,000 $700,000 $ - $10,700,000
2 10,420,000 729,400 (291,760) 10,857,640 2 10,700,000 749,000 - 11,449,000
3 10,857,640 760,035 (304,014) 11,313,661 3 11,449,000 801,430 - 12,250,430
4 11,313,661 791,956 (316,783) 11,788,835 4 12,250,430 857,530 - 13,107,960
5 11,788,835 825,218 (330,087) 12,283,966 5 13,107,960 917,557 - 14,025,517
6 12,283,966 859,878 (343,951) 12,799,892 6 14,025,517 981,786 - 15,007,304
7 12,799,892 895,992 (358,397) 13,337,488 7 15,007,304 1,050,511 - 16,057,815
8 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
74
IDGTs
Grantor IDGT f/b/o
Children
Life
Insurance
Company
1. Gifts $650K of
Non-Voting Stock
2. Sells $5.2M of JJ
Non-Voting Stock
(No Capital Gain Tax)
5. Excess Cash Flow /
Premiums
6. Death Proceeds
(Income and Estate
Tax Free / Leverages
GST Exemption) 3. $5.2M Note to Grantor
Balloon Payment in 9 Years
4. $126,880 annual interest
(Interest Rate 2.44%) Advantages:
• Value of assets sold frozen at 2.44% for nine years (assumed mid-term AFR).
• Grantor’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 Grantor’s life. Upon Grantor’s death, the
death proceeds can be used to purchase Grantor’s voting shares.
75
Installment Sales to an IDGT -
Example
Assumptions
FMV of Assets Sold to IDGT $ 5,850,000
Gift to Trust $650,000
Interest Rate (Mid-Term AFR) 2.44%
Terms (Years) 9
Payment Structure Interest-Only w/Balloon Payment
Payment Period Annually
Timing of Payments End of Period
Year 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
76
IDGTs v GRATs
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.
77
OVERVIEW OF BUY-SELL AGREEMENTS
Brian M. Annino, Esq. Annino Law Firm, LLC
707 Whitlock Ave., Ste E16 Marietta, GA 30064
(404) 934-5978 [email protected] www.anninolawfirm.com
September 8, 2015 Overview of Buy-Sell Agreements 78
Roadmap
• What is a Buy-Sell Agreement?
• What Triggers Action in a Buy-Sell Agreement?
• Funding Sources for Various Contingencies.
• Federal tax considerations.
• Business Valuations.
September 8, 2015 Overview of Buy-Sell Agreements 79
What is a Buy-Sell Agreement?
• A binding executory agreement amongst co-owners requiring a departing owner to sell his interests in a business and the remaining owner to buy the departing owner’s interests.
• Analogies: Premarital Agreement; Estate Planning for Business.
• Contrast with: corporate merger; asset purchase transaction.
September 8, 2015 Overview of Buy-Sell Agreements 80
Types of Buy-Sell Agreements
• Cross-Purchase
– Remaining shareholders purchase shares (or membership interests) from departing shareholder.
• Redemption
– Corporation or LLC purchases shares or membership interests from departing owner.
• Hybrid
– Agreement includes provisions for different triggering events.
September 8, 2015 Overview of Buy-Sell Agreements 81
• Buy-Sell Agreements should be drafted by counsel in coordination with a CPA or tax counsel.
• Shareholders should negotiate key terms at the earliest possible stage, preferably before the business is incorporated or organized.
• Importance of Business Valuations.
• Ensure that there is a funding mechanism to fulfill the purpose of the Agreement!
September 8, 2015 Overview of Buy-Sell Agreements 82
What Triggers Action in a Buy-Sell Agreement?
• Whenever a co-owner departs the business.
• Examples: – Withdrawal of a co-owner at a time before
retirement.
– Retirement
– Disability
– Death
– Bankruptcy
– Divorce or Familial Separation
– Loss of necessary license
September 8, 2015 Overview of Buy-Sell Agreements 83
• Fundamentals of Buy-Sell Agreements:
– HOW will the shares or membership interests be sold?
– What is a triggering EVENT under the Buy-Sell Agreement?
– What is the VALUE of the ownership interest?
– How will parties FUND the Buy-Sell Agreement?
September 8, 2015 Overview of Buy-Sell Agreements 84
Importance of Funding Sources for Various Contingencies
• At a fundamental level, a Buy-Sell Agreement is inherently useless if there is no available method for the remaining owner to purchase the departing owner’s interest.
• A business owner should consider various sources of funding for the various contingencies that could trigger action under a Buy-Sell Agreement.
September 8, 2015 Overview of Buy-Sell Agreements 85
Funding Sources
• Savings – “Cash is King.” – Best source of funding because it can cover all triggering
events.
• Life Insurance Policies – Generally, each co-owner will own policy and pay
premiums. – Payable upon death, therefore is intended to assist with
only one of the triggering events. – Benefits may be distributed free from income tax. – Certain types of policies may generate cash-value, which
could be utilized for other triggering events.
September 8, 2015 Overview of Buy-Sell Agreements 86
Funding Sources
• Disability Insurance
– Generally, each co-owner will own policy and pay premiums.
– Payable upon occurrence of disability.
• Ensure that covered disabilities match definition in Buy-Sell Agreement.
September 8, 2015 Overview of Buy-Sell Agreements 87
Funding Sources
• Bank Loans – If co-owner is credit worthy, bank loans provide
flexibility to fund all triggering events.
– More difficult to obtain than in the past.
– Will likely require securitization of business and perhaps personal assets.
– A co-owner needs to re-visit his ability to obtain a bank loan on a yearly basis to ensure ability to obtain, or otherwise obtain and maintain a revolving line of credit.
September 8, 2015 Overview of Buy-Sell Agreements 88
Funding Sources
• Promissory Note/Installment Payments
– If allowed, terms should be set forth in the Buy-Sell Agreement.
– Beneficial to the remaining owner.
– May not be beneficial to remaining owner or remaining owner’s estate.
– Promissory Note should be secured with business and/or personal assets of remaining owner.
September 8, 2015 Overview of Buy-Sell Agreements 89
Federal Tax Considerations
• Buy-Sell Agreements requiring stock redemption – If transaction fails to qualify as IRC § 302 or 303
exemption (and treated as a non-liquidating corporate distribution, purchasing shareholder could be deemed to have received a taxable dividend.
– Ensure that FMV is paid for withdrawing shareholder’s stock.
• If too high, withdrawing shareholder may have received a gift from remaining shareholders.
• If too low, remaining shareholders may have received a gift.
• Importance of valuations!
September 8, 2015 Overview of Buy-Sell Agreements 90
Federal Tax Considerations
• Cross-Purchase or Hybrid Buy-Sell Agreements
– Be careful of potential constructive dividend issues.
• If remaining shareholders are required to purchase shares but purchase is made by corporation, IRS may determine existence of taxable constructive dividend.
• Possible solution: Shareholders have the option, but not obligation to purchase shares. This provides flexibility for corporation to redeem stock without constructive dividend issue.
September 8, 2015 Overview of Buy-Sell Agreements 91
What is a Business Valuation?
• A process by which the value of a business is determined.
• The concept of fair market value (FMV) is central to the process.
• A business valuation utilizes different and additional methodology than a financial statement in order to determine FMV.
• What will my business sell for in the market?
September 8, 2015 Overview of Buy-Sell Agreements 92
Why Conduct a Business Valuation?
• To prepare for a sale or transfer of business assets. – Asset Purchase Agreements – Mergers and Acquisitions
• To prepare for selling shares or membership interests in the business and drafting Buy-Sell Agreements.
• To prepare for retirement and/or winding down and dissolving the business.
• To plan and prepare for current and future income, gift, and estate tax.
September 8, 2015 Overview of Buy-Sell Agreements 93
Why Conduct a Business Valuation?
• To prepare for the future development of your business by tracking market value over time.
• To adequately determine insurance needs.
• To prepare for offering employee stock plans.
• To prepare for divorce.
• To prepare for litigation.
– External and Internal
• To prepare for compliance reporting.
September 8, 2015 Overview of Buy-Sell Agreements 94
Why Conduct a Business Valuation?
• What is common to all of these circumstances:
– Business valuations are utilized in the course of preparation and planning for the future of a business.
– Business valuations are in indispensable tool in planning the fundamental development of a business and preparing for key events, such as interest transfers and sales.
September 8, 2015 Overview of Buy-Sell Agreements 95
Methodologies of Business Valuations
Three Primary Approaches:
• Asset Approach
• Market Approach
• Income Approach
September 8, 2015 Overview of Buy-Sell Agreements 96
Asset Approach
• Adjusts assets and liabilities to FMV.
• Assets – Liabilities = Net Asset Value.
• Include all assets in determination. – Not just assets on financial statement.
– However, calculation of intangible assets is difficult.
• Perhaps not the best method for calculating going business concerns (value of business looking forward).
September 8, 2015 Overview of Buy-Sell Agreements 97
Market Approach
• Seeks to establish value of business by utilizing market comparisons.
• What have similar businesses sold for relative to a comparable variable (sales, net income, earnings, etc.)
• Requires the existence of other like-kind business for proper comparative calculations.
• Utilize database and trade organization information.
September 8, 2015 Overview of Buy-Sell Agreements 98
Income Approach
• Values company by estimating future earnings and converting the estimate into a present value. – Based upon investor’s required rate of return and
risk of investment.
– Net cash flow is typical measure of earning power.
• Attempts to quantify the concept that the true value of a business lies in part upon future earnings and wealth.
September 8, 2015 Overview of Buy-Sell Agreements 99
Preparing for a Business Valuation
• Allocate sufficient time prior to the need of the business valuation.
• Locate a certified and accredited professional. – Attorney – CPA – Certified Valuation Analyst
• Bookkeeping and accounting should be in order. • Be prepared to educate the professional regarding the
unique characteristics of the business. • Work with your professional in a transparent and
forthright manner.
September 8, 2015 Overview of Buy-Sell Agreements 100
Thank you. Please feel free to contact me if I can
assist you further. Brian M. Annino, Esq. Annino Law Firm, LLC
707 Whitlock Ave., Ste E16 Marietta, GA 30064
(404) 934-5978 [email protected] www.anninolawfirm.com
Licensed to practice in Georgia, South Carolina, and Massachusetts and admitted to U.S. Tax
Court.
101 Overview of Buy-Sell Agreements September 8, 2015