Pre-Sale Planning for Business Owners; The Benefits of an Integrated Approach A Case Study Example

The sale of a business can be one of the most

Case Study - Meet the E Family

significant events for families of wealth. Often, family

Mr. Entrepreneur (Mr. E) is a co-founder of The

members have devoted substantial time and resources

Widget Corporation, a C corporation, formed 15

to building a successful enterprise. This dedication

years ago with a business partner. A recent company

and sacrifice have made a meaningful difference in

appraisal has valued the company at $100 million.

creating value and it is doubtful they want to sell

Mr. E, who is married with two teenage children,

the business without maximizing this value for the

ages 16 and 18, owns 1,000 shares of the outstanding

benefit of their family.

stock of Widget Corporation. His business partner

While the sale of the business may be viewed as the successful culmination of years of work, it may also cause concern for the owner, who feels there is not enough time to initiate effective wealth transfer planning. In fact, many owners considering a sale don’t even know what kind of planning to consider. All is not lost, however, and GenSpring’s experience has shown that instituting the proper planning process before a sale has a material impact on the after-tax sales proceeds received and provides peace of mind for the owner, who can be assured they are making thoughtful and beneficial decisions for future

owns the remaining 500 shares, which are valued at $50 million, however, Mr. E controls the decision on whether to sell Widget Corporation. Mr. E has been in discussions with a potential acquirer who made a preliminary offer of $150 million for all of the company stock. At this price, Mr. E would receive $100 million for his stock. At a dinner party, a friend of Mr. E’s suggests that if a potential sale is on the near horizon, Mr. E will need to “do some planning” to ensure that the E family will be able to enjoy their windfall in both the short and longer term. The friend put Mr. E in touch with GenSpring Family Offices.

generations.

The GenSpring Approach: A Four Phase Process

The following case study illustrates the value of sound

In our 25 years of experience working with clients

pre-transaction planning prior to the sale of a family

like Mr. E we’ve learned that a coordinated process

business.

around wealth planning for the future is essential

Sustaining Family Wealth

upon their multi-disciplinary backgrounds and prior experiences with similar families to help deliver maximum value for the family. Thoughtful pre-sale planning typically involves the following elements: Taxes, Estate Planning, Philanthropy, Investments,

In

GOVERNANCE

Fi

ESTATE

PHILANTHROPY

INVESTMENTS

GOVERNANCE

FIDUCIARY

ESTATE

Es

Ph

Go

In

Throughout each phase, GenSpring advisors draw

Go

PHILANTHROPY

Fi

TAXES

Ta

Administration. (Figure 2.1)

Ph

Es

INVESTMENTS

TAXES

FIDUCIARY

phases: Discovery, Planning, Implementation and

Ta

Ed EDUCATION EDUCATION

family. Our approach is divided into four distinct

Ed

to yield the best results for the client and his

to the family’s particular situation. In order to best customize planning for each individual family, we typically engage in a comprehensive discovery process to fully understand both the potential transaction at hand and the family’s near and long-term estate planning and financial goals and objectives. During this Discovery phase, we engage Mr. and Mrs. E

Governance, Fiduciary and Education.

in a process that looks beyond the sale to help

GenSpring can help integrate these key elements

them articulate and prioritize their broader financial

and coordinate with Mr. E’s other expert advisors

planning goals and objectives.

(attorney, CPA and the like) to ensure all involved

At the same time, we recommend that Mr. and Mrs.

parties work to help achieve the desired results for

E engage both an attorney and a CPA with strong

the E family.

backgrounds in navigating the intersection of income, gift, estate and generation-skipping tax planning.

Phase 1: Discovery Wealth transfer planning is not one-size-fits-all. To be effective for Mr. and Mrs. E, their children and their future generations, planning must be tailored

In the event the couple does not have attorneys and CPAs who are appropriately qualified to help with this type of planning, GenSpring is able to help select an

GenSpring Family Offices Coordination of Pre-Sale Planning Process

Discovery

• Wealth Priorities • Goals & Objectives • Document Review

Planning

• Capital Sufficiency • Advisor Selection • Assessment & Modeling

Implementation

• Advisor Coordination • Facilitate Planning • Portfolio Construction

Administration

• Wealth Management • Trust & Entity Administration • Family Governance & Education Figure 2.1

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advisory team that will ensure the family is getting

In order to make well-informed decisions, we establish

the most effective, timely and coordinated advice.

a tax baseline against which alternatives can be

In our case study, the immediacy of the potential

measured. In our case study, if Mr. E has a zero

business sale necessitates that our first priority is

tax basis in his stock and proceeds with the sale

to request any legal documents that might restrict

without any planning, his federal income tax would

the transfer of company stock to third parties (such

be approximately $23,800,000. Upon his death, the

as charities or trusts). Any transfer restrictions

after-tax proceeds received by Mr. E will also be subject

in the company or shareholders’ agreements that

to federal estate tax, approximately $30,480,000.

might jeopardize pre-transaction planning must be

Now that we have helped Mr. and Mrs. E understand

addressed with Mr. E and the company attorneys as

the potential after-tax sale proceeds and future estate

soon as possible.

tax liabilities, we turn our focus to the feasibility

Additionally, we must gather and review all Mr.

of accomplishing the goals and objectives they are

and Mrs. E’s estate planning documents. Our initial

envisioning for the wealth.

review of their current plan will provide important

In order to understand what portion of the sale

context for our discussions that reveal the family’s goals and concerns.

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proceeds Mr. and Mrs. E will need to be able to live the life they are imagining, we determine if they are

The Discovery phase is a critical first step for effective

planning a one-time large purchase (such as a jet

wealth transfer planning. We do not want to get

or a yacht) in the near future. Will they be making

far along in the planning process only to discover a

a large real-estate purchase or upgrading current

problem that could jeopardize the pre-transaction

residences? Will they have other sources of income

planning.

outside of investment income, or will they live on

Phases 2 and 3: Planning & Implementation

investment income alone? What are their day-to-day

The foundation of pre-transaction planning in this context is the transfer of company stock. Through the

living expenses? How much can be set aside to fund these expenses and how much can be set aside for

planning phase important questions like the amount

long-term growth?

and to whom or what entities transfers will be made

The answers to these questions allow us to prepare a

must be explored and resolved.

detailed Capital Sufficiency analysis that shows how

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$100 million X 23.8%, which represents the long term capital gains rate of 20% + 3.8% for the Medicare surtax put in place by the Affordable Care Act. This assumes the stock is not eligible for any income tax exclusions as Qualified Small Business Stock and puts aside any alternative minimum tax and state income tax considerations.

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$76,200,000 X 40%, the current highest federal estate tax rate, assuming that Mr. and Mrs. E use their $10.5 million 2013 federal estate tax exclusion to transfer or shelter other assets. For illustration purposes only. Actual results may vary.

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long their capital will last based on a myriad of tax,

is that the IRS could apply the “assignment of income”

spending and income projections. This analysis gives

doctrine to assert that the entire gain on the sale of

Mr. and Mrs. E confidence that their needs will be met

company stock is recognized by Mr. E, even though

and they can objectively focus on the decisions for

he transferred shares to charity. The greater the

sizing their charitable and family transfers.

certainty of sale and the shorter the time between

After reviewing the Capital Sufficiency analysis, Mr.

the transfer and sale, the higher the risk that the IRS

and Mrs. E feel comfortable in giving away $5 million to charity. During the Discovery process, we learned that Mr. and Mrs. E’s daughters are top-notch athletes who will attend and play softball at their parents’ alma mater. Knowing this, we might recommend a pre-sale

might successfully challenge the transfer and deem all gains taxable to Mr. E. We believe the best defense against this risk is to make sure the transfer occurs well in advance of any contract to sell and the actual sale itself. Increasing the lead time of

charitable contribution of a portion of Mr. E’s company stock (either outright or in trust) that will fulfill the couple’s desire to make a large contribution to build and endow the operation of a new softball stadium at the university. Mr. E would

“By making a charitable contribution of shares that should generate $5 million of proceeds, Mr. E could save approximately $1,190,000 ($5,000,000 x 23.8%) in federal income tax.” 3

any charitable transfer of stock, however, can create another set of problems. What happens if the sale does not occur after the charitable transfer takes place? The company would find themselves with charity

receive a charitable income tax deduction for the value

as a potential long-term shareholder and the charity

of his contribution and, as the Capital Sufficiency

would own an operating business that it likely has

analysis revealed, the transfer could reduce the

no desire to own. Working with legal counsel to give

federal income tax he will incur as a result of the sale.

shareholders a right to sell their interest back to the

By making a charitable contribution of shares that

company or a right of first refusal in the shareholder’s

should generate $5 million of proceeds, Mr. E could

agreement can help mitigate this risk.

save approximately $1,190,000 ($5,000,000 x

The need to transfer company stock to charity sooner

23.8%) in federal income tax.

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rather than later also may give the donors less lead

The overall planning process involves the discussion

time before the transfer to work with the university to

and careful consideration of different risks. One

design a detailed plan for the building of the stadium.

primary risk of engaging in pre-transaction transfers

The use of a donor-advised fund (DAF), which can

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Note that the valuation of the stock may be less than the purchase price depending on when the transaction occurs so this tax savings may vary. If the business owner lives in a high income tax state, then the tax savings may be even greater.

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direct disbursements over time to build and operate

Mrs. E will have access to the trust, whether the trust

the stadium, might present a good solution. Using a

income will be taxed to Mr. E, and how the trust

DAF also affords Mr. and Mrs. E some level of control

should operate if the sale does not occur.

of the sales proceeds if the school chooses to back out

Mr. and Mrs. E should also consider certain estate

of its commitment. The funds cannot be returned to Mr. and Mrs. E but can be used for other charitable purposes. We routinely work with charities that establish these types of funds for our clients.

of their estate. One popular technique is the use of a family limited partnership (FLP) or family limited liability company (FLLC). If correctly structured and

During the discovery process, we also identified Mr.

implemented, an FLP or FLLC can provide both tax

and Mrs. E’s desire to transfer some stock to or for

and non-tax benefits. One possible structure begins

the benefit of their children and future descendants.

with Mr. E contributing company stock to a FLP or

After reviewing the Capital Sufficiency analysis, Mr.

FLLC in exchange for units in the FLP/FLLC and then

and Mrs. E decide that they can afford to transfer $15

transferring the units to a trust for the benefit of the

million by gift.

children and future generations.

The structure of any gift must be carefully considered.

Utilizing an FLP/FLLC can provide the following two

Mr. and Mrs. E are concerned about the impact of

benefits:

such significant wealth on their children, and thus do

1. Centralized management by the general partner or

not want them to receive financial resources outright. Consequently, it is important to discuss with Mr. and Mrs. E the advantages of using a trust as the recipient of the gift. These advantages include: •

Protection of the trust assets from unwise actions of the beneficiaries

• • •

Protection of the trust assets from former spouses

managing member, who may often be Mr. E or other experienced business advisor 2. Asset protection, because limited partner/member rights are restricted under terms of the entity’s operating agreement, providing very limited transferability and little or no access to cash or assets

or other creditors of the beneficiaries

These legal benefits also impact the valuation of the

A structured disposition of trust income and

ownership interests in the FLP/FLLC. Because of the

principal

significant restrictions on the limited partnership

Flexibility to account for changes in circumstances

or member interest, a valuation expert may assign

Additional trust issues to discuss with Mr. and Mrs. E

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planning techniques that “freeze” or reduce the value

a discount to the value of the FLP/FLLC unit when

include who should serve as trustee, whether a trust

compared to the value of the underlying assets.

protector or other trust advisors should be used, how

For example, assume Mr. E funds an FLLC with stock

long the trust should last, the coordination of the

worth $15 million in exchange for FLLC units. A week

trust with other estate planning documents, whether

later he makes a gift of all of his FLLC units to a trust

for the benefit of his children and their descendants.

approach, but the IRS continues to litigate the issue.

An appraisal of the FLLC units might conclude that

Mr. and Mrs. E might consider using other techniques

they should be discounted by 33% so that the value of

in addition to or in lieu of a FLP or FLLC to hedge

the units gifted is approximately $10 million, which

some of the risk (such as a grantor retained annuity

is just under Mr. and Mrs. E’s combined federal gift

trust or a sale to an intentionally defective grantor

tax exemption, resulting in no gift tax owed. The

trust).

federal transfer tax potentially saved is $1.8

The complexity of the planning discussed above

million ($15 million - $10.5 million) x 40%,

requires the careful coordination of financial, tax

which is the highest federal estate tax rate) . In

and legal considerations. GenSpring advises business

addition, no appreciation in value of the partnership

owners on the type of planning discussed and is

units will be included in Mr. E’s estate and therefore

able to coordinate advice from the business owner’s

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subject to federal estate tax, which could save millions more in federal estate tax. The transfer also may be designed to eliminate future estate and generation skipping

attorneys, CPA and other

Effective pre-transaction planning is complex and requires the careful coordination of financial, tax and legal considerations.

facets are addressed. Phase 4: Administration After going through an intensive discovery and

transfer taxes.

planning process, many

As with many planning techniques, the FLP or

wealthy families pay the professional fees, place the

FLLC involves risks. A primary risk is that the IRS

documents on a shelf and quickly forget about them.

successfully disregards the valuation discount,

However, proper ongoing administration of the plan

resulting in a taxable gift of $15 million. If the IRS

and consistent follow up on open items are critical to

were to prevail in establishing the $15 million value,

achieve successful results.

Mr. E will pay $1.8 million of federal gift tax (plus

Given the planning put in place in our case study,

interest and penalties) since only $10.5 million of the

ongoing care and attention must be given to:

gift is sheltered from federal gift tax. This risk may be

•

mitigated by the use of a defined value formula clause in which a set amount (usually equal to the remaining federal gift tax exemption) is transferred to the FLP or FLLC with any excess amount as determined by the IRS on audit either passing to charity or back to the donor. In a few cases, courts have approved this 4

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advisors to make sure all

For illustration purposes only. Actual results may vary.

• • •

Mr. and Mrs. E, who will receive $80 million sales proceeds The FLLC, which will receive $15 million The Trust, which owns an FLLC interest The Donor-Advised Fund, which will receive $5 million

Once the sale of the business has been completed, the

next order of business is to coordinate the payment

Mrs. E that considers financial goals, both short and

of federal and state income taxes with the CPA.

long term, so that they can feel secure that their

Estimated tax payments will need to be adjusted to

needs will be met and their overall planning is fully

prevent penalty payments and the CPA will want to

integrated.

evaluate whether or not to pay the state income tax by year end. With the creation of the FLLC and trust, existing estate planning documents should be reviewed and

Conclusion After working through GenSpring’s Pre-Transaction Planning Process, Mr. and Mrs. E agreed that the sale of the Widget Corporation was in their best interest

updated as needed. Additionally, a valuation expert

and the sale proceeded. They are currently enjoying a

will need to appraise the value of the LLC units

life of travel and following their daughters’ collegiate

transferred by gift to the trust.

successes, both on and off the softball diamond.

Once the DAF receives its $5 million of sale proceeds,

We believe GenSpring’s approach to delivering a

we will assist Mr. and Mrs. E in determining how

timely and thoughtful process to pre-transaction

to structure a gift from the DAF to the university.

planning allows families to unlock additional value

For example, Mr. and Mrs. E may want to require a

in a sales transaction. Our experience over 25 years

matching gift program or additional commitments

has shown that, while every family and transaction

of support from the school as a condition of funding

is unique, they can all benefit from the objectivity,

the project. The GenSpring Discovery and Planning

integration and coordination we deliver throughout

process uniquely positions us to serve Mr. and Mrs.

our four-phase Pre-Transaction Planning Process.

E and the FLLC manager as investment advisor for the liquid sales proceeds. Applying a goals-based approach to portfolio construction, Mr. and Mrs. E’s portfolio may be compartmentalized into multiple sub-allocations designed to solve for their nearterm income and longer-term wealth accumulation objectives. Additionally, the unique requirements and objectives of the family LLP/LLC, Trust and donor advised fund must also be considered in the design and management of those specific portfolios. Through the Planning process, GenSpring also considers tax sensitivity and takes a best-fit approach when deciding which investments to locate across the different family entities and portfolios. Our goal is to create an investment plan for Mr. and

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Authored by GenSpring Wealth Advisory Center, with contribution from: Tim Tallach, JD, CPA, Head of Wealth Advisory Center; David Neubert, CPA, Partner and Jay Cloud, JD, Family Wealth Advisor

Disclaimers The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. Investment decisions should always be made based on the investor-s specific financial needs, objectives, goals, time horizon, and risk tolerance. The statements herein are based upon the opinions of GenSpring and third party sources. Information obtained from third party resources are believed to be reliable but not guaranteed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

To know more, please call 866.506.1989 or visit us on the web at www.GenSpring.com

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