Competing Concerns Ensuring Business Continuity, Preserving Owner - - PowerPoint PPT Presentation

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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 brian@anninolawfirm.com 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
• therwise 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 marty@iagforensics.com

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
• r 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 jhg@disinherit-irs.com 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

• f 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
• f 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

• f 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

• rders 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
• n 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
• n 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

• f 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 brian@anninolawfirm.com 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-
• wners requiring a departing owner to sell his

interests in a business and the remaining

• wner 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

• f

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

• nly 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

• btain, 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 brian@anninolawfirm.com 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