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Putting the "Success" in "Succession"

(November 2013) - by: Attorney Robert Travers


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Businesses don’t pass successfully from one generation to another by accident. To put the “success” in “succession,” business owners must develop succession plans.

Most don’t bother – and it’s no coincidence that most businesses don’t survive past the original owner. The U.S. Small Business Administration found that only 30 percent of businesses continue into a second generation.

Without a plan, the unexpected death or disability of an owner can cause the demise of the business. Heirs may squabble over who owns the business and who should manage it. They may have to sell the business to pay estate taxes. And if non-family partners are involved, they may not treat heirs of the deceased fairly.

A succession plan should consider:

  • An exit strategy
  • Management
  • Ownership
  • Taxes

Failure to approach these issues carefully could result in failure of the company.

An Exit Strategy

The first step in succession planning is to determine who should control and manage the business when you leave, whether you leave voluntarily or involuntarily.

Business owners should develop an exit strategy as early as possible. Death or disability can make retirement plans moot. Having a plan in place can help the business continue operating, regardless of why a change in leadership is needed.

The following are among the ways to change ownership:

Keep it in the family. The U.S. Small Business Administration estimates that 90 percent of U.S. businesses are family owned, so it’s not surprising that most owners leave their business to family members.

However, that works only if family members have the ability and desire to manage the business. The best way to find out is to involve them in the business. Experts advise that children work at other companies first, so they enter the business with experience and fresh ideas. They should learn the family business from the bottom up, and should be treated like other employees so they do not develop a sense of entitlement.

If several children are involved, do not give them equal authority and equal ownership. When too many family members make decisions, they rarely agree. Choose the best leader and even things out by leaving other assets to other children.

The owner should consider the liquidity needs of the business in case death or disability strikes before a planned transition. Life insurance is an excellent means to provide working capital to survive the loss of a key owner. The cash value may be used as a rainy day fund or to hire an experienced executive to run the business short term.

Finally, business owners should coordinate their estate plans and succession plans. Ownership of company stock, or membership interests in partnerships or LLCs, should be transferred to the owner’s revocable trust during the owner’s lifetime to avoid public probate of the business. The trust should dictate the ownership split of the stock to family members who are capable and willing to run the business.

Sell it to your partners. When there are multiple owners, a buy-sell agreement is needed to ensure that surviving shareholders have the first right to purchase shares of any owner who leaves.

The agreement keeps shares from unqualified heirs, disgruntled spouses and competitors. It also details how to value and purchase the interest of the person leaving, which is crucial to the success of the agreement. Typically, the company purchases life insurance, disability insurance or both on all owners, with the idea that the benefits or cash value from the insurance will be used to purchase the shares of the former owner. Two different structures are commonly used – the stock-redemption plan and the cross-purchase plan.

With a stock-redemption plan, the corporation is the owner and beneficiary of the insurance, and holds the cash value to fund the buyout. When a shareholder dies or leaves the company, the corporation purchases the stock and surviving shareholders are the only remaining owners.

The stock-redemption plan is simpler, but the cross-purchase plan has tax advantages. Using a cross-purchase plan, each shareholder owns an insurance policy on the life of every other shareholder. Upon death, a shareholder’s stock receives a “step up” in basis to its fair value. The surviving shareholders purchase the stock with its stepped-up basis, minimizing capital-gains taxes when the company is sold. It also avoids the alternative minimum tax. When a stock-redemption plan is used, there may be no step up in basis for the surviving owners.

Business owners should consult with an attorney experienced in succession planning to avoid unintended consequences. For example, most businesses fail to review their loan documents to ensure that repayment is not accelerated upon the death of an owner or the transfer of stock. When overlooked, minor details can cause major problems.

Sell it to your employees. An Employee Stock Ownership Plan (ESOP), which grants shares to employees based on length of service and other factors, is ideal for a business with no family heir to take over, especially if there is not a strong market for selling the business. An ESOP can create a market for the owner’s shares, provide tax advantages, and motivate and reward employees.

Sell it to outsiders. While many people are reluctant to sell their business to non-family members, doing so can provide the owner with financial security and plenty of wealth to pass on.

Tax Issues

Many business owners find it difficult to transfer ownership to the next generation without incurring a tax bill so large the business has to be sold to pay it.

Without Congressional action, the top federal estate tax rate will increase from 45 percent next year to 55 percent beginning in 2011. The amount of assets exempt from estate taxes is scheduled to increase from $2 million today to $3.5 million in 2009 before dropping to $1 million in 2011. In addition, individuals can make gifts valued at up to $1 million during their lifetime without incurring gift taxes. Gifts valued above that amount are taxed at a rate of up to 46 percent.

Regardless of rates and exemptions, it is beneficial to transfer as much wealth as possible to heirs while the owner is living.

It is especially worthwhile to pass on shares in a family business, because the value of minority shares can be discounted. Since minority shares lack voting control, they cannot easily be sold and are worth less than majority shares. The IRS has ruled that such shares may often be discounted by 25 to 35 percent.

Many strategies are available to transfer a non-controlling interest to the owner’s family, or in trust for the family’s benefit, while minimizing gift taxes. A business owner should also consider opportunity shifting when starting a new business or an offshoot of a current business. By initially putting some of the ownership interest in trust for family members, the future value of the business will not create a significant estate tax burden.

Most business owners recognize that their business can’t succeed without a business plan. They should also recognize that the business can’t succeed through another generation without a succession plan.

Robert Travers is an attorney specializing in wealth transfer and tax minimization strategies for high net worth families and business owners. His office is located in Westborough, Massachusetts, and he can be contacted at (508) 366-1903.

The contents of the article are for general education purposes only and are not to be relied upon as tax or legal advice. Please consult with your legal or tax advisor regarding your particular circumstances. This article is not intended or written to be used for the purpose of avoiding penalties under the Internal Revenue Code and cannot be used for that purpose.

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Venture Capital and Estate Planning: Importance of "Getting In" at the Ground Level"

(October 2013) - by: Attorney Robert Travers


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You’ve seen the projections from your financial adviser, accountant or estate planning attorney – million of dollars owed to the federal government through estate taxes when you die. You ask yourself – could I have done something different to minimize this potentially enormous tax? How can I stop it from getting even larger?

Unfortunately, most clients do not think about estate taxes until after they have amassed their fortunes. It’s natural to focus on accumulation of wealth – whether that is navigating the growth of a start-up business or purchasing investments with the best appreciation potential – rather than focus on the potential estate tax consequences in the future. But that is where the problem takes root.

A common misconception is that the federal estate tax is a tax on your assets when you die – it is not. The government taxes your right to transfer assets to others during lifetime or at death. The greater the value of the transfer, the greater the tax. The estate tax system treats a married couple basically as one unit, so transfers between husbands and wives do not trigger a tax.

Using this basic transfer tax premise, you can see that transferring (giving away) an asset when it is worth less can significantly reduce the amount of potential tax owed under the gift/estate tax system. This can have a dramatic effect on your overall tax liability. For instance, three principals of a software company, who are clients of mine, grew their company from virtually nothing to a $150 million enterprise (each owning $50 million). They are coming to me now asking how they can avoid paying millions of dollars in estate taxes upon their death. We are working on some advanced gifting strategies, but it would have been much easier if they came to me earlier.

The key is planning far in advance. Flashback to when my clients were creating their LLC. Each client gives a certain percentage of the business to a trust for the benefit of his family. The interests in trust are non-voting membership interests in the LLC, so that the clients retain absolute voting control of the operations.

What is the benefit? Each client is taxed on the nominal value of the LLC interest at the time it was gifted to the trust. My clients would not have paid any out of pocket tax, but would have used some of their lifetime gift exemption (up to $5 million) to cover the transfer. Let’s say each client gave 50% of his interest in the LLC to an irrevocable trust when establishing the LLC. Now that the interest in the business has grown to $50 million, the LLC interests in trust (valued at $25 million) will not be part of my client’s estate for tax purposes. With a top federal estate tax rate of 40%, each could have saved roughly $10 million of tax dollars by removing part of the business from their ownership early in the game. The trust could be structured to last for generations, avoiding estate tax at their children’s deaths as well.

The same reasoning holds true for a speculative investment that has home run potential. If a client invests in a few speculative companies, he may want to consider gifting some percentage of the shares to an irrevocable trust while the stock value is extremely low. If the stock appreciates 5x, all the growth is out of the client’s taxable estate and is available for his family’s financial security. What if the company tanks? The client has used a small amount of his/her $5 million dollar gift exemption for an asset that is worthless. The client lost that bet, but the downside is minimal. As speculative investors know, it only takes a few home runs to make up for the losers.

I always tell clients never to let a tax issue compromise their non-tax objectives regarding estate planning. However, if one of your objectives is to minimize estate taxes while planning for the financial security of your family, involving your estate planning adviser early in the game can reap great net returns for your family.

Robert Travers is an attorney specializing in wealth transfer and tax minimization strategies for high net worth families and business owners. His office is located in Westborough, Massachusetts, and he can be contacted at (508) 366-1903.

The contents of the article are for general education purposes only and are not to be relied upon as tax or legal advice. Please consult with your legal or tax advisor regarding your particular circumstances. This article is not intended or written to be used for the purpose of avoiding penalties under the Internal Revenue Code and cannot be used for that purpose.

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Common Misconceptions and Excuses Used to Delay Estate Planing Decisions

(June 2010) - by: Attorney Robert Travers


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Everyone I talk with seems to lead a busy life – longer hours at work, children on sports teams competing around the state, household improvement projects and general upkeep – and the list goes on and on. In order to budget our precious time, we attempt to prioritize our projects. Dealing with the more complex projects, we tend to “trick” ourselves by finding excuses to delay the start of them. Such is the case with estate planning. I talk with so many couples who confess, “We’ve been meaning to address/update our estate plan, but we put it off because … Below are some common misconceptions and excuses used by couples to justify putting off planning for the security of their families.

Misconception #1: “If I die without a Will, everything will pass to my spouse anyway.”

Reality: Under the laws of Massachusetts, property titled in your individual name at the time of your death (your “probate estate”) will pass one-half to a surviving spouse and one-half to your surviving children. This comes as a shock to an uninformed widow or widower at a time when he/she doesn’t need more bad news, and usually results in unnecessary expenses and complexity during settlement of the estate. By having a valid will in place at the time of your death, you, and not the laws of the state, determine who receives your property. (Please note that assets held in jointly with right of survivorship or assets naming a designated beneficiary are not part of your “probate estate”.)

Misconception #2: “I will never pay any estate tax – my estate is too small.”

Reality: Many clients are unpleasantly surprised when learning that their estates would owe Massachusetts and/or federal estate tax if something happened to them tomorrow. A person’s “gross estate” that is subject to tax includes all assets that the person owns, or has an interest in, at time of death – the value of the residence, retirement accounts, any second homes or investment properties, annuities, death proceeds of life insurance, etc. Death proceeds payable from a life insurance policy is the asset that causes the estate value to soar. For instance, if a person has a $1 million term life insurance policy, either through work or a separate policy, such person is well on their way to having an estate that is taxable under state and/or federal law. Under present law, Massachusetts taxes estates having a value exceeding one million dollars, unless such assets are passing to a spouse who is a U.S. citizen (which amount is unlimited). The federal law allows you to shelter up to two million dollars with the same unlimited deduction to a surviving spouse. However, with the right type of planning, a couple can use each of their exemption amounts in order to shelter a maximum of two million dollars under Massachusetts law and four million dollars under federal law. By using a simple planning strategy involving revocable trusts, a person can maximize the amount that can be sheltered from estate tax while providing for the surviving spouse and children. A tax efficient estate plan will then ensure that your assets pass to your family rather than to the government.

Misconception #3: “Everyone knows that I want _____________ (fill in the blank with your brother, sister, parent, friend) to care for my minor children if something happens to me.”

Reality: One of the most difficult decisions during the estate planning process is the selection of a person to act as guardian for your minor children if something happens to you prematurely. No one can take your place as a parent. However, by failing to nominate someone to fill this role, your decision of who best to care for your children will never be known. Even worse, both your side and your spouse’s side of the family may wage battle in court to be appointed as guardian. Your children, already dealing with the loss of a parent, could be subject to conflicts among family members at a time when continuity and compassion are necessary for their well-being. Unfortunately, the lure to control substantial sums of money for the benefit of the minors may induce ill-intentioned parties to enter the guardian competition. Why not avoid such a potential nightmare by nominating someone you trust to serve as guardian, along with a back-up candidate, under your Will? It may make a terrible situation a bit more manageable for your kids.

Misconception #4: “We don’t need a trust – we’re not the Rockefellers.”

Reality: Trusts are no longer just for the ultra-wealthy. Revocable trusts can address a number of issues that plague the uninformed. First, the assets that you transfer to your trust during your lifetime avoid the delay, expense and public disclosure of “probate” – the court-governed, public process for the distribution of your estate upon your death. Second, couples can use the flexibility within a trust instrument to minimize the amount of their estate tax liability and still have the estate available for the use and benefit of the surviving spouse (See Misconception #2, above). Third, a trust can appoint a person or entity (trust department) to oversee the investment and distribution of trust assets. This is especially important if young children are beneficiaries. You can design the trust so that the principal is held for the benefit of the child until he/she reaches certain ages, such as distribution in thirds at ages 25, 30 and 35. Without such planning, a child may have control of substantial sums of money at too young an age – such as 18 or 21. Just think back when you were 18 – buying shots for the entire bar might have seemed rational. Children always need guidance from their parents, at any age, and you can continue to provide such advice through the provisions of your trust. Finally, the trust is protection for your heirs against judgment creditors and divorcing spouses. You can give your trustee the discretion to make distributions as the trustee deems appropriate, even to the extent of making no distributions to a child-beneficiary who has creditor problems, in the middle of a bad divorce, or has strayed down the wrong path (substance abuse problems).

Robert Travers is an attorney specializing in wealth transfer and tax minimization strategies for high net worth families and business owners. His office is located in Westborough, Massachusetts, and he can be contacted at (508) 366-1903.

The contents of the article are for general education purposes only and are not to be relied upon as tax or legal advice. Please consult with your legal or tax advisor regarding your particular circumstances. This article is not intended or written to be used for the purpose of avoiding penalties under the Internal Revenue Code and cannot be used for that purpose.

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