Business Succession: The No Tax Solution
Tim Jochim, Attorney and Counselor at Law
Business Succession
Business succession relates
to the process by which the owners and executives of closely-held companies
undertake the following: (1) Sell or
transfer ownership interests; (2) Develop successor management; (3) Optimize
wealth and liquidity.
Ownership transfers may
include cross purchase agreements with other owners, family trusts or limited
partnerships, redemption agreements among owners and the companies, sales to
successor management, sales to outside parties, stock for stock exchanges, initial
public offerings or employee stock ownership plans. Quality successor management will assure business continuity and
survival. Effective financial planning
can assure that company owners will realize personal financial security upon
the sale or transfer of their ownership interests by minimizing taxes (capital
gains, gift and estate, personal).
Over the past several years,
certain interest groups have promoted the perception that business succession
for the owners of closely held and family-owned companies has become untenable
primarily because of the burdens of federal estate taxes and, secondarily,
because of taxes applicable upon the sale of a company. This article will summarize the methods by
which the following can be achieved by the owner of closely-held companies:
* Sell the business and pay
no taxes on the gains
* Pay substantially no estate
taxes regardless of the value of the business
* Sell the business and
retain family control
* Operate the business with
no federal or state income taxes on the profits
All of these methods have
been available prior to the recent enactment of the Economic Growth and Tax
Relief Reconciliation Act of 2001 (AEGTRRA@). Further, to
obtain the optimum tax benefits, these methods must be used in specific
combinations under specific circumstances.
Employee Stock Ownership
Plans
Company owners who sell their
stock to an employee stock ownership plan (AESOP@) sponsored by the company may defer or exclude
capital gains taxes (and related state income taxes) on gains from the stock
sale by investing the sale proceeds in the securities of any U.S. operating
company. Certain conditions and restrictions apply. Owners or managers can direct the voting of stock in the ESOP and
employees benefit from the continued existence of the Company and from the
opportunity to share in its equity value.
If a bank loan (or internal
loan) is used by the ESOP to purchase the stock, loan principal payments are
pretax up to 25% of eligible compensation. Dividends of a reasonable amount on stock in an ESOP are also
pre-tax. Further, if it is prudent to
do so, an existing pension plan, such as a profit sharing plan (or 401(k)
plan), can be restated as a ESOP (or
KSOP) and a prudent amount of the plan assets from company contributions can be used to acquire stock. It is not uncommon for a family-owned
company to establish an ESOP enabling
the owner-founder to realize liquidity from his years of company-building
while, at the same time, retaining control of the company in the hands of
family members, even if a majority of the stock is sold to the ESOP. It may also be good business practice to
provide key employees (family members or outsiders) an additional equity
incentive by means of a stock bonus or stock option plan.
As the owner of the stock of
a Subchapter S corporation, an ESOP has a special exemption from taxes that
would normally apply to the owners of Sub S corporations. Thus, a 100% Sub S ESOP would pay no federal
(or Ohio) income taxes at either the company or at the shareholder level. Again, certain conditions apply and owners
selling to the ESOP of a Sub S corporation are not eligible for the gains tax
deferral or exemption cited above.
Family Limited
Partnerships
A family limited partnership
(AFLP@) is a
financial planning tool that can assure the orderly and controlled transfer of
an asset, such as company stock or real estate, to family members free from attachment
by creditors and at a discounted value for gift and estate tax purposes.
At least one year prior to
death, the company owners (parents) establish a limited partnership and serve
as the general partner (either directly or through a limited liability company
), while the children, as the limited partners, would own substantially all the
assets of the FLP. Thereafter, the
owners transfer by gift all or a majority of their company stock to the FLP.
The company could also
establish an ESOP to purchases a majority of the company stock from the FLP at
controlling interest price. If the FLP
held the company stock for three years prior to the sale to the ESOP, the
partnership should be eligible to defer, or be exempt from, capital gains (and
Ohio income) taxes on any gains.
For federal estate and gift
tax purposes, the FLP interests are subject to a discount because the interest
holders, the limited partners, do not exercise control over the FLP and do not
have a controlling interest in the FLP.
Thus, either a lack of marketability discount or a minority interest
discount, or both, would be applicable.
Charitable Remainder
Trusts
Transfers of interests in a
closely-held business to a charitable organization can achieve significant
benefits, such as an immediate charitable deduction and an income stream if a
trust is utilized in connection with the donation. In order to be effective for both the charity and the donor
shareholder, a donation of stock, whether direct or through a charitable
remainder trust (ACRT@), should be
followed by a sale or Acash in@ of
the stock by the CRT.
Although there are a number
of methods through which a CRT can Acash
in@ the stock of a closely-held company, (e.g., sale to
other shareholders or redemption by the company), the CRT cannot be required to
sell the donated stock nor be compelled to invest in other assets. Unlike other disposition methods, an ESOP
creates a market for the closely-held stock in the CRT using pre-tax
dollars. As with a CRT, an ESOP cannot be
required to purchase the stock from the CRT nor can either be compelled to sell
any other assets.
A CRT can be designed as a
unitrust, which permits flexibility in planning donations and income
targets. Distributions are based on
performance as a fixed percentage with permissible Amake-up@
contributions (preferable for non-liquid investments). The higher the unitrust payment, however,
the lower the charitable deduction.
Irrevocable Life Insurance
Trust (ILIT)
Normally, proceeds from life
insurance are included in the estate of the insured if (a) the estate is the
beneficiary or (b) the insured has incidents of ownership such as the power to
change the beneficiary, change the ownership of or cancel the policy or
withdraw the cash value. At the corporate
level, life insurance premiums are paid with after tax dollars and the death
benefit is subject to the alternative minimum tax (AMT). At the individual level, premiums are paid
with after tax dollars and named beneficiaries generally pay no income taxes on
the proceeds.
The solution is a perfected
irrevocable life insurance trust that owns the policy with the proceeds payable
to the trust upon the death of the insured.
The ILIT could own a new policy or an existing policy could be
transferred at least three years prior to the death of the insured. Premiums are generally paid with after tax
dollars and may be subject to the gift tax.
Because there are no incidents of ownership and control, the proceeds
will not be included in the taxable estate of the insured. An ILIT is frequently used as a family
wealth restoration vehicle in connection with a charitable remainder trust
(CRT) or to pay estate taxes of the insured.
Jochim Co.,
L.P.A.
673 S. Mohawk St.,
4th Flr.
Columbus, Ohio
43206
614-444-1190