Succession Planning for the Entrepreneur

Tools and Techniques to make the transition

by: Jonathan Chapman
Originally published in the Journal of Construction Accounting and Taxation

It is not uncommon for thoughts of succession to occur at about the time when succession is just around the corner.  Often, a sense of urgency at last-minute planning results in uncompleted plans, analytical paralysis, and emotional family dynamics, which, in turn, results in doing nothing (well, I can always come back to this ... perhaps next year).  Of course, there is the option to simply let the family sort things out when "something happens." Decisions left to loved ones at the worst possible time can be disastrous. There are many horror stories where a family has had to dispose of a business at fire-sale prices to simply pay the estate tax.   All too often, poor decisions are made under considerable stress.

This article addresses some of the easier parts to a succession plan, describing tools and techniques frequently used in executing a succession plan for a closely held business that, properly structured, will result in tax efficiency.  However, it is important that tax-planning techniques do not take on a life of their own, resulting in a tax-efficient plan that doesn't accomplish the underlying family goals.

Although outside advisors such as estate planning attorneys, CPAs, and insurance and investment advisors are a very important part of succession planning, bringing in the advisors too early can create unnecessary complexity resulting in analysis paralysis.  The process begins at the family level, where decisions are made as to what goes where, to whom, and when?  Another common mistake is to attempt to execute the plan in its entirety, which can be overwhelming and result in nothing accomplished.

Typically, the succession plan begins with a series of questions, such as what role, if any, the founder will take in the business after retirement (e.g., advisor, consultant).  Will the owner continue in an ownership capacity so as to not lose control of the business? Will the owner retain voting control in the case of a corporation? What happens when the founder is no longer able or willing to continue in the business? Will the business be gratuitously transferred to the successors and, if so, on what schedule, or will the business be sold to family members, to a key man, or on the market? If sold, how will it be financed? Seller financed? Bank financed? How comfortable is the business owner that the successor will sustain/grow the business sufficiently to financially secure the owner and spouse (e.g., to pay off any seller financing)? What is the business worth? Frequently, at the top of the list is: what are the projected cash needs of the founder and spouse to support an anticipated lifestyle, and how will this be funded?

Once the plan is created, it will likely change as life circumstances change.  A key man in the business who is looked at as the ideal successor may not end up being a successor in the business.  Family circumstances may change, such as divorce, marriage, death, or the birth of grandchildren.  Flexibility is important; that lovely future daughter-in-law could end up owning the business as a result of a divorce property settlement and may not turn out to be so "lovely." How do you protect against that (e.g., by retaining a call option or through restrictions in corporate by-laws, trusts)? And, although hard to imagine, tax laws may change. Who knows, someday Congress could simply repeal the estate and gift tax (any bets?), making succession planning considerably easier.  In view of the dynamics of change, the succession plan isn't a set of documents to be created, executed, put into a file, and forgotten.  Instead, it should be reviewed on a regular basis.

A few commonly used tools

The tax environment has changed recently and continues to change, creating considerable uncertainty.  Congress recently passed legislation that increased the gift and estate exemption to $5 million, reduced both tax rates to 35 percent, and introduced "portability" for unused exemptions, such that a decedent spouse's unused exemption is added to that of the surviving spouse.   In effect, the surviving spouse's exemption can be as high as $10 million.   Things become considerably simpler from an estate/gift tax planning perspective for married couple estates under $10 million.   However, these changes are temporary in that they expire at the end of 2012.  Without further Congressional action, gift/estate tax rates and exemptions will revert to pre-2001 levels of 55 percent and $1 million, respectively.  Proposals have been made to change these rates and exemptions to 45 percent and $3.5 million.   Additionally, although an estate may be well below the exemption amount, further appreciation can change all of that.  With all of this uncertainty, 2011 and 2012 may be the opportune years to execute gift-planning strategies.  One of the goals from an estate tax-planning perspective is to freeze values, such that property appreciation subsequent to the gift is excluded from the donor's estate, which, again, can be at significantly higher rates after 2012.  Annual gift tax exclusion

One such strategy is to simply make maximum use of the annual gift tax exclusion of $13,000.   A married couple can make up to $26,000 tax-free gifts to an individual without using any of their exemption.  Over a period of time this can be a very efficient strategy.  Many family-owned businesses are structured as S corporations.  Where the founder would like to keep control of the business, a common strategy is to recapitalize the S corporation into voting and non-voting stock, using the nonvoting stock to make gifts.  Valuation discounts for minority interests and lack of marketability (although generally challenged by the IRS) make this a particularly effective technique in transferring ownership, maintaining control, and removing future appreciation from the donor's estate.  With a combined exclusion of $10 million and the very real possibility that the exclusion could be significantly lower after 2012, there is a body of thought that taxpayers should take maximum advantage of this exclusion before 2013 by accelerating gifts.  Again, we come back to the question: does this make sense in the context of the overall succession plan?

The GRAT

Another technique is the use of what is known as a grantor retained annuity trust, or GRAT.  Properly executed, this technique has the effect of freezing asset values and passing subsequent appreciation to heirs free of any gift or estate tax.  Here, the grantor makes a transfer into a trust for a period of years.  During the term of the trust, the grantor receives an annuity of a given amount, and at the end of the trust term, the assets remaining in the trust are transferred to the trust beneficiaries (e.g., the children).

When the grantor transfers property to a trust and retains a "qualified annuity interest," a gift will result equal to the value of the remainder interest.  A qualified annuity interest is an irrevocable right to receive a fixed amount each year during the term of the trust.  This fixed amount may increase each year up to 120 percent of the amount payable in the preceding year.  Additional contributions to the trust are prohibited once the trust is funded. ¹

The value of the remainder interest is generally computed under what is known as the "residual method," where the gift is equal to the entire fair market value of the property transferred to the trust reduced by the value of the income interest retained by the grantor.  The value of the income interest is based on IRS valuation tables,² which in turn, are based on current applicable federal interest rates.  The lower the interest rate, the greater the value of the income interest and the lower the value of the remainder interest and the taxable gift. Currently, the applicable interest rates are at all-time lows, making this an opportune time to consider using the GRAT technique.  These rates are referred to as the "7520 rates" after the code section under which the rate is determined.

For example, a transfer of S corporation stock valued at $1 million to a GRAT with an annuity to the grantor of $50,000 per year for five years and a 7520 rate of 2.5 percent (approximate rate as of June) will result in a present value for the annuity of approximately $232,000 and a gift of $768,000 (i.e., $1,000,000-232,000).  Those same facts with a 7520 rate of 6 percent would result in a gift of approximately $790,000.

The key to avoiding a disastrous result is ensuring that a qualified annuity interest is retained by the grantor.  In the case of gifts in trust to family members,³ the value of the retained interest is treated as zero, resulting in a taxable gift equal to the fair market value of the entire amount transferred in trust.⁴ An important exception to this rule is where the grantor retains a qualified interest.  A qualified interest includes a qualified annuity interest described above.⁵ Where the trust earns a rate of return in excess of the 7520 rate, the amount passing to the remainder beneficiaries will exceed the amount treated as a taxable gift, resulting in excess value free of any gift or estate tax at the end of the trust term.  Again, the lower the applicable federal interest rate, the lower the taxable gift and potential to transfer subsequent appreciation free of estate tax. 

The trust must specify the term of the GRAT.  This term can be for the life of the grantor,⁶ for a specified term of years, or the shorter of the two periods.⁷ This creates a bit of a dilemma in that the longer the GRAT term, the greater the value of the qualified annuity interest and the lower the taxable gift but the greater the risk of the grantor dying during the GRAT term, resulting in the entire GRAT being included in the grantor's estate.  Conversely, the shorter the GRAT term, the lower the value of the qualified annuity interest and the higher the taxable gift, but the risk of the grantor dying during the GRAT term is reduced.  One planning consideration is sometimes referred to as laddered GRATs, where multiple trusts with different terms are set up, thus reducing the risk of an all or nothing inclusion in the grantor's estate upon a death during the GRAT term.⁸

To end the GRAT discussion on a cautionary note, care must be taken where S corporation stock is transferred to a GRAT.  Specifically, it would be "unfortunate" (other descriptions not suitable for publication may be used) if, as a result of transferring S corporation stock, the S election were to terminate.⁹ Specifically, the GRAT as a trust must be a qualified shareholder of the S corporation.  As a GRAT, it must qualify as a grantor trust.  The grantor must be treated as owning all the assets and income of the GRAT.¹⁰ There are several provisions that would cause the GRAT to qualify as a grantor trust and, thus, qualify as an S corporation shareholder.  For example, a provision in the GRAT allowing the grantor a non-fiduciary power to substitute assets of equal value for assets in the GRAT would cause the GRAT to qualify as a grantor trust.¹¹ As a grantor trust, GRAT taxable income is taxable to the grantor.  Thus, S corporation taxable income allocated to the stock contained in the GRAT is taxed at the grantor level.  From an estate tax planning perspective, the tax paid by the grantor further reduces the grantor's taxable estate.  Care must be taken, however, in ensuring that GRAT distributions are sufficient to enable the grantor to pay the income tax. 

In summary, the GRAT provides significant benefits including:

• The potential for the value transferred to the remainder beneficiary exceeding the value treated as a gift, resulting in such excess transferred free of gift or estate tax.  This is premised on the rate of return on the GRAT assets exceeding the 7520 rate.  Again, with the 7520 rate being at all-time lows and the potential change in the law requiring a minimum 10-year GRAT term, this may be the opportune time to set up a GRAT;
• Asset appreciation after the GRAT term excluded from the grantor's estate;
• Guaranteed income stream to the grantor-in addition to the required annuity, the GRAT may provide for additional income distributions. 

The IDGT

The intentionally defective grantor trust (IDGT) is an effective technique in selling an interest in an S corporation or other income producing assets that, for example, are used in the business and leased to the S corporation.  As the name implies, the IDGT is a grantor trust, such that income generated in the trust is taxed at the grantor level.  Similar to the GRAT, the IDGT will violate one of the grantor trust provisions, causing the owner to be treated as the owner of the S stock (and any other assets) for income tax purposes but not for estate and gift tax purposes, thus removing subsequent appreciation from the grantor's estate free of any gift or estate tax.  In other words, the IDGT is effective for estate tax purposes but defective for income tax purposes.

Mechanically, the IDGT is created by the grantor contributing "seed money" to the trust generally equal to 10 percent of the value of the property sold to the IDGT.  For example, stock with a value of $8 million would generally require seed money of $800,000.  The seed money is intended to create additional equity in the trust in the event the IRS asserts that the note taken by the grantor when the stock is sold is really equity, thus increasing the amount of the gift.  In other words, the seed money adds weight to the sale as an arm's length transaction comparable to what a third party lender would require as equity on a loan. 

The sale is then made by the grantor to the IDGT in return for an installment note.  Under the grantor trust rules, a properly structured IDGT results in the sale being ignored for income tax and capital gain purposes but recognized as a transfer for estate and gift tax purposes.  The note must bear an adequate rate of interest under the below-market loan rules of IRC Sec. 1274.  These interest rates are lower than the 7520 rates required of a GRAT.  As a result, the appreciation rate under an IDGT necessary to transfer appreciation to the beneficiaries tax-free is lower than that of a GRAT.  The result, all other considerations being equal, is that more value can be transferred free of estate or gift tax consequences with an IDGT than with a GRAT.

It is important to sell income-producing assets to the IDGT to generate sufficient cash flow to make annual interest payments under the installment note (i.e., S corporation stock that makes distributions to the IDGT or, as mentioned earlier, real estate and other assets leased to the corporation for use in its business).   The importance of generating sufficient cash flow is to avoid a forced sale by the trust, enabling it to make required annual interest payments to the grantor.  Such a sale would be treated as sold by the grantor, and the grantor would recognize any taxable gain.  Said another way, the grantor would effectively have to sell assets and generate taxable gains to enable him to pay interest to himself.

There should be no gift tax consequences on the sale of the property to the IDGT if the sales price is at least equal to the fair market value of the property sold and the interest rate is equal to or greater than the applicable federal rates under IRC Sec. 1274.  As to estate tax consequences, the fair market value of the installment note plus interest accrued to the date of death is included in the grantor's estate.  However, a lower amount may be included in the grantor's estate if the executor establishes that the value is lower or that the notes are worthless.¹²

The grantor may consider purchasing life insurance on the life of the IDGT beneficiary to ensure the remaining amount due on the installment note is paid upon the beneficiary's death.  Alternatively, or in combination, the beneficiary's spouse may consider purchasing life insurance on the beneficiary's life to cover estate taxes on the appreciation in the property and/or make the promised installment payments under the note.

In comparing the IDGT to the GRAT, the IDGT does have certain advantages.  For example, in the event the grantor dies before the note is paid, the estate includes only the unpaid balance of the note, and all appreciation in the underlying property from the date of sale to date of death is excluded from the grantor's estate.  This is in contrast to a GRAT, where such an interim death will result in the underlying property at date of death value being included in the grantor's estate.

In addition, there is considerably more flexibility in structuring payments in the IDGT than in the GRAT, such that payments in the IDGT may consist of interest only for a period of years with a balloon principal payment at some future date.  A GRAT is more restrictive in that annuity payments cannot exceed 120 percent of the prior year's payment.  As mentioned earlier, the required interest rate in an IDGT is lower than that of the GRAT, resulting in additional value transferred out of the grantor's estate.

One of the primary disadvantages of the IDGT is the required seed money to fund the trust.  At 10 percent of the value of the property sold to the trust, this can be a severe impediment.  Seed money is not required of a GRAT.  Another disadvantage of the IDGT is that the grantor may find the interest rate on the note inadequate.

Other considerations

In financing a sale of the business, there are several alternatives.  In addition to installment sale arrangements, where the business owner takes back a note and spreads the taxable gain over the note's term, there are arrangements like self cancelling installment notes (SCINs) and private annuities, typically found in sales to family members.  In both of these cases, the obligation terminates upon the seller's death.

One of the requirements is that the term of the SCIN not extend beyond the seller's life expectancy.  The SCIN requires a premium to reflect the possibility that the seller will die during the SCIN term.  Also, where the balance of the note is cancelled upon the death of the seller and the seller and oblige are related persons (e.g., children), the U.S. Tax Court has held that the installment sale results in realization of taxable gain reported in the decedent's final return.¹³ This decision was reversed by the 8th U.S. Circuit Court of Appeals only by holding that the gain would be taxable to the decedent's estate as income in respect of a decedent and not on the decedent's final income tax return.¹⁴ Also, careful consideration must be given to the gift tax consequence to a SCIN.  Specifically, the actual value of the SCIN will be less than its face value because the risk of death affects the value of the note.  This could result in a bargain sale and, therefore, a gift.  There are a couple of ways to avoid this, such as increasing the interest rate or the selling price of the SCIN, each of which can create its own problems.

Another financing technique is the private annuity.  The private annuity typically provides an annuity to the seller for the seller's life, although it can be set up for the seller's life plus the life of the spouse.  The private annuity is often used by the business owner who is retiring and wishes to shift control of the business to a family member or a key employee.  The selling business owner may be concerned with having an adequate stream of income for his life (or his and his wife's life, in the case of a joint annuity).  The annuity would be based on the fair market value of the business, the business owner's age, and the 7520 rate (discussed above) at the date the transaction is executed.  Typically, the asset sold will be income-producing property (e.g., S corporation stock).  There are certain technical requirements that must be considered in order to avoid negative tax consequences.¹⁵ Typically, the private annuity is used by someone in a high estate tax bracket and requiring a lifetime income stream.

As mentioned earlier, one of the difficulties for a business owner with children active and inactive in the business is providing for an equitable distribution to the children and adequate protection and support for the surviving spouse.  This is an especially challenging task when substantially all of the business owner's assets are tied up in the family business.  Although each case is unique and requires customized asset allocation bequests and gifts, there are a few somewhat generic planning considerations.  As discussed, there are advantages in transferring business ownership during the owner's lifetime, such as removing asset value appreciation from the owner's estate.  In many cases, the business owner transfers the business to children who are active in the business during the owner's lifetime or at his death.  However, transferring non-business assets to children who are inactive in the business may create liquidity and support problems for the surviving spouse.  In many cases, the business owner chooses to maintain some level of ownership until death.  In this context, there are multiple goals, such as minimizing estate tax, providing income to the surviving spouse, and the eventual transfer of the business to the children.

One approach in both providing for the surviving spouse and, upon her/his death, assuring provision for the children is through a qualified terminal interest property trust (QTIP).  A QTIP is often used by a business owner with children from a former marriage.  In that case, the business owner wants to ensure that his surviving spouse receives an income interest in the business for life and, upon the surviving spouse's death,  the business is transferred to his children.  Alternatively, the surviving spouse may be given a limited power of appointment in passing ownership among the children upon her death.  This would allow flexibility to consider the children’s' future changes in circumstances. 

One of the benefits of a QTIP is that it qualifies for the marital deduction, such that the estate tax is postponed until the surviving spouse's death.  The QTIP requires that all income is payable to the surviving spouse at least annually.  Although the surviving spouse can be permitted to appoint the property upon death via a will, the principal reason for the QTIP is to allow the business owner to designate who will receive the trust property upon the surviving spouse's death.

On the surface, the QTIP seems to meet the business owner's goals in providing for his spouse and assuring that the business passes to his children.  However, upon closer examination, this may not be the case.  For example, the business within the QTIP may not produce sufficient income.  Although the QTIP may hold unproductive assets (not currently producing income), the trust document must either require or permit the surviving spouse to require that either the property be made productive or be converted to productive property within a reasonable time.¹⁶ This can create tension between the surviving spouse, who is in need of income, and children, who are involved in the business and are taking income through compensation or feel that any income should be reinvested in the business rather than distributed.

A possible solution to this problem is through shareholder agreements that provide for compensation and debt limitations, as well as distributions.  One approach that could satisfy these competing interests is a buy-sell agreement funded through adequate life insurance.  This would enable the children to purchase the spouse's interest, thus providing liquidity to the surviving spouse in the form of sales proceeds funded by the life insurance and allowing the children to retain the business.

Speaking of life insurance, a critical component of the estate plan is to determine the estate's liquidity needs.  An all-too- common crisis occurs when the business comprises a significant portion of the estate, and the estate is illiquid.  There is a special provision that allows for the estate tax attributed to an interest in a closely held business to be paid over a period of up to 14 years with interest only over the first four years.  This provision only applies if the closely held business is included in the gross estate of a decedent who was a U.S.  citizen or resident at the time of his death and if the value of the closely held business is more than 35 percent of the decedent's adjusted gross estate.¹⁷

The increase in the estate tax exclusion amounts to $5 million, and its portability to the surviving spouse may provide some flexibility-possibly temporarily through 20 12-in allowing the business owner to structure a trust that doesn't qualify for the marital deduction and ensures both adequate income to the surviving spouse and business continuity to the children.   In any case, where a trust is used as a repository for S corporation stock, it is critical that the trust qualifies as an S corporation shareholder.¹⁸

In summary, there are a number of tools and planning ideas to efficiently execute a succession plan, but these are only tools.  There are many other techniques and tools in addition to those discussed in this article.  The most important part is the succession plan itself, the tools being just techniques to execute the plan in the most efficient manner possible.  Bringing in the right advisors at the right time will result in a tax-efficient succession plan that accomplishes the family succession goals.

Please contact Feeley & Driscoll's Boston Accounting team for help with your succession plan by Email or call us at 1 (888) 875-9770 .

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