In this month's column, we explore succession planning, a key service that wealth advisors can — and should — provide for clients whose fortunes are tied up in closely held businesses. We give you the hypothetical case of Charlie and Sally, a couple in their 60s. Charlie owns Jones Construction, which has a book value of $10 million. Charlie and Sally also have other assets worth about $5 million.
Charlie has three children from his first marriage: Abby, Barbara and Carl. All three are married, but Abby's marriage is not happy. Charlie would like to pass on the business to Abby, who works for the company, “but not too soon,” he says. He wants about $500,000 per year to live on comfortably. He also wants to be sure that if he dies first, Sally is well taken care of. Finally, he wants to be sure that all three children receive equal amounts from his estate at his death. Charlie currently has a simple will leaving everything to Sally and, if Sally does not survive him, the total estate will be divided among his three children. Here are the issues presented in Charlie's plan:
Issue #1: How to provide adequate cash flow and control for Charlie?
There are three basic methods for Charlie to pass on the business to Abby.
Charlie could bequeath the business to Abby at his death. This provides ultimate cash flow and control protection for Charlie, but it doesn't do much for Abby, who may become impatient and leave the business. It is also tax inefficient, because the business will be part of his taxable estate at his death.
Charlie could gift the business to Abby. If Charlie were to gift the business outright, he would remove any growth in value of the business from his taxable estate. But he would lose access to the cash flow and he would pay a significant gift tax. So, an outright gift does not make sense. But Charlie could achieve a similar effect with a grantor retained annuity trust, defective trust sale or a freeze partnership. All three of these techniques allow him to retain some cash flow from the business, while gifting a portion of the growth in the value of the business to Abby.
Or, if the business were recapitalized to include both voting and nonvoting stock, Charlie could retain control by transferring only the nonvoting stock to Abby during his lifetime.
Charlie could sell the business to Abby. There are a number of techniques available to accomplish this, including a deferred-gain installment sale, a bootstrap redemption, a private annuity sale and a sale for a self-canceling installment note. All of these techniques allow Charlie to retain a portion of the cash flow and, if they are used in conjunction with a voting-nonvoting recapitalization of the company, Charlie could retain control as well.
Issue #2: How to provide continuing income for Sally?
Charlie could simply bequeath his entire estate, including the business, to Sally. As the surviving spouse, she would not pay estate tax, but would control the entire estate. But this is a second marriage and Sally is not the mother of the eventual beneficiaries. Charlie might do better, then, to bequeath assets to Sally in a Marital Trust, giving her income for life with the principal passing to Charlie's children at Sally's death.
Issue #3: Estate Tax and Liquidity.
Under Charlie's current simple will, there will be an approximately 50 percent estate tax at the death of the second survivor on all of the assets in excess of $1.5 million (in 2005). Charlie can do a number of things to ameliorate the estate tax problem, including:
Revise his will to ensure that he sets aside an amount equal to the estate tax exemption in a “bypass” trust for Sally, rather than leaving those funds outright. This will ensure that Charlie's estate tax exemption is fully utilized at his death. Sally then has her own $1.5 million exemption, meaning that together the couple can shelter up to $3 million from estate taxes. With their existing simple wills, they shelter only $1.5 million.
Establish a program of gifting to remove value from his estate.
Ensure that adequate liquidity exists to pay estate tax. For example, Charlie could enter into a buy-sell agreement with Abby, whereby Abby is required to purchase the business from Charlie's estate for its fair market value. Abby could purchase insurance on Charlie's life to fund this purchase. Any portion of the purchase price not paid via the insurance could be paid through Abby's promissory note.
Even if there is no buy-sell agreement, Charlie should consider purchasing life insurance to pay estate tax. This would avoid a forced sale to pay estate taxes. Since no tax should be due until both Charlie and Sally die, Charlie and Sally should consider using second-to-die life insurance, and should be sure that it is owned in a properly structured second-to-die life insurance trust.
Issue #4: Fairness to the Other Children.
If Charlie sells the business to Abby for a fair price, then the fairness issue ought to be solved because Barbara and Carl will receive an equal share of the sale proceeds, if the business is sold at Charlie's death. If selling the business is not a good option, Charlie should investigate the use of other assets, and the purchase of additional second-to-die insurance in order to “equalize” the other two children.
Issue #5: Liability.
In our hypothetical, we have placed Charlie in a relatively high risk business — construction. To limit his liability and protect his assets, Charlie should be sure to review all of his insurance coverage. In addition, he should operate his business through a liability-shielding entity such as a C corporation, S corporation or LLC.
Charlie also needs to structure his succession plan to protect the business from Abby's bad marriage. He can do this by ensuring that any bequest, gift or sale of the business to Abby is made instead to a “spendthrift” trust for Abby's benefit. Such a trust can be structured to provide a large degree of protection from the claims of Abby's creditors, including those of a divorcing spouse.
Planning for the business owner is a complex subject covering many different areas of law, finance and even psychology. It can be a daunting task. Done correctly, however, a good succession plan can ensure that the business transfers to the intended beneficiaries, that the business owner retains adequate control and cash flow for as long as desired, that family members are treated fairly and that the business survives, even thrives, for generations to come.