Issue 27: 2014

Special Section — Your Business

Fine Tuning Your Business

You started it, you manage it every day. Now make sure you’re prepared for tomorrow.

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Most private business owners know that creating a business succession plan is important, even if — in the all-consuming crush of managing and growing their businesses — they sometimes tend to put it off longer than they probably should. They are often less aware, however, of the many other early steps they can take to help protect and grow their business and personal wealth. According to Andrew Tanner, head of U.S. Trust’s Specialty Asset Management Private Business group, “implementing a few often-overlooked business and personal wealth planning strategies early in the life of your business, long before you sit down with transaction attorneys and investment bankers, can make a meaningful difference in the amount of wealth you create and ultimately retain for yourself and your family.”

Protecting Your Business

Retaining talent: equity compensation

For private companies, retaining key employees is critical. “Replacing talent and getting new people up to speed in private companies is tough because typically private businesses don’t have staff moving up the ranks,” Tanner says. “This is especially true when business owners become older, and they’ve been counting on their number one or number two at the company to step up.” The problem is that private companies can find it difficult to compete with their larger public counterparts when it comes to compensation, particularly regarding equity-based compensation. Most private companies tend to offer annual salaries and cash bonuses and avoid equity and long-term compensation entirely. “You obviously can’t offer public stock, but you might consider providing key management personnel some form of long-term equity compensation. Not only does it align everyone’s interests, which is good for the business; it can help to preserve capital because cash payouts can be lower, and perhaps most important, it can allow you to compete more effectively with public companies when it comes to both recruiting and retaining top talent,” he says.

 

The sticking point for most business owners is giving up control and having to account to others when it comes to managing their business, or evaluating a change-of-control transaction. However, Tanner says “there are ways of giving equity to key personnel without giving away control.” Here are some examples:

  • Real equity: Direct stock awards, options, restricted stock (employees keep the stock only if certain conditions are met, such as meeting performance goals), stock purchase plans and equity bonuses can all be effective ways of retaining top talent and aligning the interests of management and owners. But these entail granting a real, though small, ownership stake in the company. “You can avoid even that much loss of control by simply issuing nonvoting shares,” says Tanner. “Also, you probably don’t want these shares being transferred to third parties, so you might also consider making the stock callable, establishing resale restrictions or requiring employees to sell their shares back to the company in certain situations — if they leave the company, for instance.”
  • Stock appreciation rights (SARs): Another effective way to go that cedes no control, but still provides an incentive for employees to stay with your firm, is to offer stock appreciation rights that are settled in cash. SARs don’t carry a voice in company affairs, but they do provide an upside stake that is based on the appreciation of the company’s stock (based on an appraisal of the company’s value). “You can think of them as being similar to equity options, with the same potential for financial gain, but with no cash required to exercise them,” he says.
  • Phantom equity: Phantom stock, sometimes referred to as shadow stock, allows employees to receive a stock-like equity stake that inures to their benefit while they are with the company. They are like a long-term cash bonus linked to company performance and valuation. Again, these shares can be nonvoting. One other consideration is that these shares are dilutive to other shareholders in certain circumstances, which must be evaluated carefully.

While these compensation options can be critically important tools in retaining top talent, business owners must work closely with advisors to ensure that these structures are carefully implemented and maintained.

The buy/sell agreement

Not all companies have a sole owner. What happens if your business partner suddenly dies? Is your partner’s spouse, or your partner’s child, the new co-owner — even if he or she has no knowledge of the business? Are you obligated to buy them out? Can you afford to buy them out? In turn, are they obliged to sell to you, or can they entertain other suitors? In any case, how much should it cost? How should it be paid? And what if you happen to die? If your surviving business partner refuses (or cannot afford to) purchase the inherited shares, will your spouse be left without any liquidity? Or what happens if your partner simply decides to retire? Or divorces, and your partner’s shares end up in the ex-spouse’s hands as part of the settlement?

There are many early steps Business Owners can take to help protect and grow their business and personal wealth

“Any one of these events, and many others, can put the continuity of your business — your greatest financial asset — at risk,” says Tanner. “But a buy/sell agreement can help to address these and other potential issues long before they actually occur, so a clear plan can be enacted immediately when they do, thereby helping to prevent damage to the company’s operations or its value.”

Tanner says that buy/sell agreements can make good sense for any type of business — corporations, partnerships or LLCs with multiple owners. They put in place a clear procedure if certain things happen. “Think of the buy/sell agreement as a kind of ‘prenup’ for business owners,” says Tanner. "While it’s definitely preferable to create a buy/sell agreement as early as possible, it can actually be accomplished at any point in a company’s lifecycle.”

“The buy/sell agreement has several basic components,” he says. “The first are the parties involved, the owners of the business, and the underlying asset that is the basis of the buy/sell agreement is their respective equity interest in the company. Often there are two owners, but there can be more, and the ownership percentages can vary considerably. I’ve seen 50/50 partners, 60/40, 70/30. I’ve even seen 1/99 buy/sell agreements where a 1% owner was going to buy out a 99% owner.”

“And then there are the triggering events — the specific occurrences that will trigger the buy/sell agreement,” he says. They usually include what are commonly known as the 5 Ds:

  1. Death of a co-owner (with provisions for dealing with inheriting shareholders, such as the deceased owner’s spouse).
  2. Disability (How long should salary and sharing in the company’s profits continue?)
  3. Departure (retirement or resignation)
  4. Divorce (What happens when an ex-spouse receives a chunk of stock in the business? Should the spouse be forced to sell the stock back to the company?)
  5. Default/Insolvency (When a financial calamity overcomes your co-owner and obligor under the buy/sell)

These agreements often address many other eventualities as well.

The next component is pricing. This can be a prearranged price or even a prearranged formula — book value, say, or some multiple of earnings. “This is where things can go horribly wrong if they aren’t handled properly,” Tanner cautions. Let’s say two owners agree they’ll buy each other out at book value if one of them dies. And what so often happens in business owners’ busy lives is that 15 years go by, during which they never give a single thought to the terms they’ve established. They’ve taken the company down a number of paths in that time, and book value — or whatever pricing mechanism they’ve agreed upon — makes absolutely no sense anymore. Now, if a triggering event occurs, somebody is going to wind up greatly enriched and somebody is going to end up greatly diminished. Along with regular review of the buy/sell agreement, Tanner advises that provisions be included that rule out this sort of unjust enrichment. “I’ve personally been involved in a number of estates that dealt with fixed and formulaic buy/sell agreements with extremely unintended consequences,” he says. “To ensure an equitable solution, I usually advise business owners that pricing be established by an appraisal that is done at the time of the triggering event and with all information on the table.”

it’s preferable to create a buy/sell agreement as early as possible.

And then, of course, once pricing is established, funding mechanisms need to be addressed. The most basic method is simply for the purchasing owner to pay cash at the appraised price for the number of shares the departing owner has in the company. However, this is not always practical or possible. Another approach is to pay a fraction of the appraised price at the time of the triggering event, and put the rest in a promissory note that is paid off over time and a certain rate of interest.

Often, in the case of the death of an owner, cash to fund the buyout is obtained via life insurance. That is, co-owners take out life insurance policies on each other and agree to use the payouts to finance the buyout. A key here is to maintain the synchronization of the value of the business and the death benefit of the life insurance policies. This eliminates surprises from cropping up at the worst possible time. This structure is referred to as a cross-purchase agreement. Another common structure is company-owned life insurance whereby the company is the obliged purchaser and repurchases the shares in the event of an owner’s death.

Other funding mechanisms include borrowing or using personal assets, which may or may not be feasible. Using cash from the business itself, even if the business can support it, can be problematic, since the cash being used for the purchase is already partially owned by the owner being paid.

“One thing to remember,” Tanner says, “is that buy/sell agreements don’t have to be forever.” If the co-owners come to a point where they all agree that they are tired of running the business, they can simply decide to sell the company, at which point the buy/sell agreement terminates. In fact, owners can agree to terminate a buy/sell agreement at any time. (The buy/sell agreement — including the life insurance policies — is not, however, designed to be unilaterally canceled.) One thing that needs to be resolved — via simply swapping policies or some other method — is what will happen to any life insurance policies in force. With no business arrangement, owners no longer have a mutual obligation to each other, and therefore, no longer have an insurable interest in each other’s lives.

One of the biggest issues with these agreements — beyond not having one — is not reviewing and revising it on a regular basis. Says Tanner: “It can be a good working practice, for instance, to pull the owners together to review the agreement at the company’s annual meeting. These annual reviews should probably also include regular appraisals of the company’s value, if they’re not done already.”

Typically, a company’s legal advisor is the point person for drafting a buy/sell agreement for the owners. Co-owners should work closely with legal, accounting, valuation and insurance advisors when evaluating or modifying these structures.

 

Protecting Your Personal Assets

Pre-transaction tax strategies

Two potentially effective asset transfer strategies for business owners include the grantor retained annuity trust (GRAT) and the intentionally defective grantor trust (IDGT). With a GRAT, the grantor is essentially transferring assets into a trust and gradually taking back an annuity (akin to principal plus an assumed amount of interest at a rate specified by the government1) over the life of the GRAT, says Jim Welch, wealth strategies division executive at U.S. Trust. If the investments in the GRAT outperform the annuity paid back to the grantor, the assets remaining in the trust may be transferred to heirs free of estate and gift taxes. This, of course, assumes the GRAT is zeroed out, which means that the annuity consists of repayment of the initial amount plus interest paid back to the grantor at the assumed rate of interest. “In the case of a three-year $1 million GRAT, the grantor would receive $333,333 back each year plus interest (for three years),” says Welch. “ The grantor is paid back the initial amount contributed to the GRAT ($1 million) plus interest, but the excess appreciation remaining in the GRAT (following the sale of your company) is able to be transferred out of the grantor’s estate without any gift or estate tax ramifications.”

A sale to an IDGT functions much like a GRAT. The IDGT essentially deals with two sets of IRS rules — individual income tax rules and IRS transfer tax rules (e.g., estate, gift, generation-skipping). “Generally, these two sets of rules work well together, but occasionally some gaps appear. The IDGT attempts to take advantage of those gaps,” says Welch. “The theory is that it’s impossible to sell an asset to yourself and have it be a taxable transaction for income tax purposes. However, it is possible for someone to sell an asset to a trust, and if that trust has some special provisions for transfer tax purposes, that sale is a real and recognized event. But, as noted, it’s still a nonevent for income tax purposes.” For example, if you were to sell $1 million worth of your company’s stock to a defective trust, you would receive a note worth $1 million. As with the GRAT, you would eventually receive your $1 million back plus interest, but any appreciation (again, above the low hurdle rate) could be transferred out of your estate.

Using cash from the business itself can be problematic.

Should you choose a GRAT or an IDGT? “Although they behave in similar ways, there are differences,” says Welch. “The GRAT is an effective tool, but it has two main disadvantages: first, if you die during the GRAT’s term, all of the GRAT’s assets return to your estate; and second, multigenerational planning (for grandchildren and future generations) cannot generally be done as effectively with a GRAT.”

With an IDGT, on the other hand, the death of the grantor during the trust’s term does not end the trust. Also, you can name grandchildren and future generations as beneficiaries of the trust. “In fact, in practice, family business owners tend to prefer the IDGT to the GRAT,” says Welch. “GRATs are usually more popular when it involves publicly traded company stock or pre-IPO planning.”

GRATs may be zeroed out if structured appropriately, resulting in no gift or estate tax, according to Welch. IDGTs typically are funded with a 10% gift of the entire value of the trust, resulting in gift taxes paid, use of a portion of the lifetime credit or use of annual exclusion gifting.

 

He points out that one key difference between a GRAT and an IDGT is that the GRAT is an annuity, which carries out principal on a periodic basis back to the grantor. There are some creative methods of structuring GRATs where the payments of principal are less in the early period of the GRAT term and larger in the later period (e.g., a back-end-loaded GRAT). However, the IDGT is usually preferable in this situation since it can be structured as a loan with a balloon payment at the end and only interest being paid to the grantor periodically (e.g., yearly). Says Welch: “Therefore, more of the value of the initial transferred amount may remain in the IDGT for a longer period of time, allowing for the potential of a more favorable outcome if the underlying asset (in this case, usually the private company) appreciates above the interest rate.”

The grantor may pay a lower interest rate on IDGTs compared to GRATs, Welch adds, since the rate is set at the midterm applicable federal rate (AFR). The rate of GRATs, however, is 120% of the midterm AFR. Therefore, the hurdle rate for IDGTs may be lower than that of a GRAT. This is more beneficial for the grantor and the recipient of the remainder value since more of the assets will pass out of the estate with the lower hurdle rate on the IDGT.

Early Planning Can make all the difference.

Lastly, the one drawback to using an IDGT is that it has not been codified by the IRS. Since it is a non-statutory technique, the likelihood of it being challenged by the IRS is greater than that of a GRAT. Since GRATs are statutory, assuming the grantor follows the appropriate protocol, there is significantly less risk of the IRS challenging a GRAT than if the IDGT were utilized for the asset transfer.

Among the many other options, transferring company stock into a charitable remainder unitrust (CRUT) can also be an effective way to move future appreciation (and resultant federal tax consequences) out of your estate, according to Welch. With a CRUT, the remainder beneficiary of the trust is a charity and the income beneficiary of a CRUT is typically an individual. The mechanics are complicated, but basically the CRUT strategy allows you to sell your business assets, while maximizing the post-tax money received on the sale and enabling you to reinvest your proceeds at 100 cents on the dollar, as opposed to using after-tax proceeds. The grantor may choose himself or another individual as the income beneficiary of a CRUT. The grantor will then choose a prespecified payout rate, which he will receive on an annual basis. Statutorily, this rate must be at least 5% but no more than 50% of the fair-market value of the donated assets; however, in practice the rate is most often in the 5% to 8% range. The amount received by the income beneficiary on an annual basis is taxed to the beneficiary at their personal tax rate but based on the tax character experienced within the trust. For instance, if the trust produced all long-term capital gains (LTCG), the income beneficiary would be taxed at their own capital gains tax rate. However, if the payout consisted of LTCG and qualified dividend income, short-term capital gains (STCG), interest income and corpus, then the income beneficiary would be taxed first on income, then on STCG, then on dividends, then on LTCG, and finally, the beneficiary would receive corpus (with no tax on corpus).

“Another reason CRUTs can be an attractive strategy,” says Welch, “is that the donor/grantor of the CRUT receives an up-front charitable deduction for the present value of the remainder interest of the gift to charity. The gift to charity is assumed to occur upon the termination of the trust, at which time the remaining assets in the CRUT will flow directly to the prespecified charity. Lastly, it is important to note that for this strategy to work and be permitted by the IRS, the CRUT needs to be in place long before any purchase agreement for a company is finalized.”

Protection from creditors and state income taxes

Although business owners are concerned about spouses or family members being hit with huge tax bills or being pursued by creditors in the event of their death, they often don’t have provisions in place to handle these events effectively. Cash on hand may well not be sufficient. Term insurance or an insurance trust can help, but other, potentially more effective methods are worth considering.

“One popular strategy is to keep assets outside of your estate via a gift to a trust or installment sale to a trust in Delaware, Alaska or several other states,” says Welch. “In these states, creditors of beneficiaries have no access to the trust’s assets. It’s even possible to create a trust and name yourself its beneficiary, and thereby shield trust assets from creditors for yourself, and also, if you want, receive distributions from the trust.”

Perhaps even more important, states such as Alaska and Delaware impose no state income tax on trusts with non-state-resident beneficiaries. This could be especially meaningful to business owners. If they reside in high-tax states like New York or New Jersey, the potential savings can be substantial.

As with other trust strategies, it’s important to get it in place as early as possible — at least 12 months before your anticipated transaction date, or if that’s not possible, in a different calendar year.

Trusts don’t have to mean loss of control

For business owners, hesitation to consider these strategies sometimes has to do with a perceived loss of control. “But it’s important to distinguish between legal ownership of an asset and control of that asset on a functional day-to-day basis,” says Tanner.

Not all wealth planning strategies will be appropriate for all business owners.

There are many ways to make your influence felt in the trust process, through trustee selection (including at times selecting yourself as trustee of the trust you’re creating) and future trustee selection. Preferences can be reflected and concerns addressed with careful drafting of trust provisions. “Moreover, with a revocable trust, you don’t have to make all decisions immediately, and the decisions you do make are modifiable. They can even be canceled,” Tanner adds.

Early planning can make the difference

Not all of these wealth planning strategies will be appropriate for all business owners, but knowing about them and considering them in the context of your own situation allows for informed and intentional decision making. “Also, it’s important to remember that these strategies are not mutually exclusive, and none of them requires the commitment of all of your assets. In many instances, it may be preferable to use a combination of different types of trusts to achieve what are likely to be multiple goals,” says Welch.

 

But one thing that all of these strategies have in common is that they work better the earlier they’re established, both Welch and Tanner agree. So often, owners wait to plan until there’s a deal pending, or they’ve had a health scare, or some other event occurs that forces them to want to plan. But entrepreneurs who engage in this process earlier rather than later will have many more options available to them and a greater likelihood of achieving their long-term goals.

1Per Internal Revenue Code §7520, the interest rate for a particular month is equal to 120% of the applicable federal midterm rate (AFR) (compounded annually) for the month in which the valuation date falls. The rate is rounded to the nearest two-tenths of 1%.

PHOTO CREDITS: Violin Opener: Getty Images, Piano insides: Joseph Pulitano/Getty Images, Tuner: Michael Stuart, Piano Bridge: Mark Laita/Gallery Stock, Tuning Fork on Cello: Bojan Kontrec/Getty Images, Row of Violins: Westend61/Getty Images, Piano Tuner: Hal Bergman/Getty Images, Tuning a Guitar: Pat LaCroix/Getty Images, Violin Bridge: JordanPhoto/Getty Images

IMPORTANT INFORMATION

Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

Most private business owners know that creating a business succession plan is important, even if — in the all-consuming crush of managing and growing their businesses — they sometimes tend to put it off longer than they probably should. They are often less aware, however, of the many other early steps they can take to help protect and grow their business and personal wealth. According to Andrew Tanner, head of U.S. Trust’s Specialty Asset Management Private Business group, “implementing a few often-overlooked business and personal wealth planning strategies early in the life of your business, long before you sit down with transaction attorneys and investment bankers, can make a meaningful difference in the amount of wealth you create and ultimately retain for yourself and your family.”

Protecting Your Business

Retaining talent: equity compensation

For private companies, retaining key employees is critical. “Replacing talent and getting new people up to speed in private companies is tough because typically private businesses don’t have staff moving up the ranks,” Tanner says. “This is especially true when business owners become older, and they’ve been counting on their number one or number two at the company to step up.” The problem is that private companies can find it difficult to compete with their larger public counterparts when it comes to compensation, particularly regarding equity-based compensation. Most private companies tend to offer annual salaries and cash bonuses and avoid equity and long-term compensation entirely. “You obviously can’t offer public stock, but you might consider providing key management personnel some form of long-term equity compensation. Not only does it align everyone’s interests, which is good for the business; it can help to preserve capital because cash payouts can be lower, and perhaps most important, it can allow you to compete more effectively with public companies when it comes to both recruiting and retaining top talent,” he says.

 

The sticking point for most business owners is giving up control and having to account to others when it comes to managing their business, or evaluating a change-of-control transaction. However, Tanner says “there are ways of giving equity to key personnel without giving away control.” Here are some examples:

  • Real equity: Direct stock awards, options, restricted stock (employees keep the stock only if certain conditions are met, such as meeting performance goals), stock purchase plans and equity bonuses can all be effective ways of retaining top talent and aligning the interests of management and owners. But these entail granting a real, though small, ownership stake in the company. “You can avoid even that much loss of control by simply issuing nonvoting shares,” says Tanner. “Also, you probably don’t want these shares being transferred to third parties, so you might also consider making the stock callable, establishing resale restrictions or requiring employees to sell their shares back to the company in certain situations — if they leave the company, for instance.”
  • Stock appreciation rights (SARs): Another effective way to go that cedes no control, but still provides an incentive for employees to stay with your firm, is to offer stock appreciation rights that are settled in cash. SARs don’t carry a voice in company affairs, but they do provide an upside stake that is based on the appreciation of the company’s stock (based on an appraisal of the company’s value). “You can think of them as being similar to equity options, with the same potential for financial gain, but with no cash required to exercise them,” he says.
  • Phantom equity: Phantom stock, sometimes referred to as shadow stock, allows employees to receive a stock-like equity stake that inures to their benefit while they are with the company. They are like a long-term cash bonus linked to company performance and valuation. Again, these shares can be nonvoting. One other consideration is that these shares are dilutive to other shareholders in certain circumstances, which must be evaluated carefully.

While these compensation options can be critically important tools in retaining top talent, business owners must work closely with advisors to ensure that these structures are carefully implemented and maintained.

The buy/sell agreement

Not all companies have a sole owner. What happens if your business partner suddenly dies? Is your partner’s spouse, or your partner’s child, the new co-owner — even if he or she has no knowledge of the business? Are you obligated to buy them out? Can you afford to buy them out? In turn, are they obliged to sell to you, or can they entertain other suitors? In any case, how much should it cost? How should it be paid? And what if you happen to die? If your surviving business partner refuses (or cannot afford to) purchase the inherited shares, will your spouse be left without any liquidity? Or what happens if your partner simply decides to retire? Or divorces, and your partner’s shares end up in the ex-spouse’s hands as part of the settlement?

There are many early steps Business Owners can take to help protect and grow their business and personal wealth

“Any one of these events, and many others, can put the continuity of your business — your greatest financial asset — at risk,” says Tanner. “But a buy/sell agreement can help to address these and other potential issues long before they actually occur, so a clear plan can be enacted immediately when they do, thereby helping to prevent damage to the company’s operations or its value.”

Tanner says that buy/sell agreements can make good sense for any type of business — corporations, partnerships or LLCs with multiple owners. They put in place a clear procedure if certain things happen. “Think of the buy/sell agreement as a kind of ‘prenup’ for business owners,” says Tanner. "While it’s definitely preferable to create a buy/sell agreement as early as possible, it can actually be accomplished at any point in a company’s lifecycle.”

“The buy/sell agreement has several basic components,” he says. “The first are the parties involved, the owners of the business, and the underlying asset that is the basis of the buy/sell agreement is their respective equity interest in the company. Often there are two owners, but there can be more, and the ownership percentages can vary considerably. I’ve seen 50/50 partners, 60/40, 70/30. I’ve even seen 1/99 buy/sell agreements where a 1% owner was going to buy out a 99% owner.”

“And then there are the triggering events — the specific occurrences that will trigger the buy/sell agreement,” he says. They usually include what are commonly known as the 5 Ds:

  1. Death of a co-owner (with provisions for dealing with inheriting shareholders, such as the deceased owner’s spouse).
  2. Disability (How long should salary and sharing in the company’s profits continue?)
  3. Departure (retirement or resignation)
  4. Divorce (What happens when an ex-spouse receives a chunk of stock in the business? Should the spouse be forced to sell the stock back to the company?)
  5. Default/Insolvency (When a financial calamity overcomes your co-owner and obligor under the buy/sell)

These agreements often address many other eventualities as well.

The next component is pricing. This can be a prearranged price or even a prearranged formula — book value, say, or some multiple of earnings. “This is where things can go horribly wrong if they aren’t handled properly,” Tanner cautions. Let’s say two owners agree they’ll buy each other out at book value if one of them dies. And what so often happens in business owners’ busy lives is that 15 years go by, during which they never give a single thought to the terms they’ve established. They’ve taken the company down a number of paths in that time, and book value — or whatever pricing mechanism they’ve agreed upon — makes absolutely no sense anymore. Now, if a triggering event occurs, somebody is going to wind up greatly enriched and somebody is going to end up greatly diminished. Along with regular review of the buy/sell agreement, Tanner advises that provisions be included that rule out this sort of unjust enrichment. “I’ve personally been involved in a number of estates that dealt with fixed and formulaic buy/sell agreements with extremely unintended consequences,” he says. “To ensure an equitable solution, I usually advise business owners that pricing be established by an appraisal that is done at the time of the triggering event and with all information on the table.”

it’s preferable to create a buy/sell agreement as early as possible.

And then, of course, once pricing is established, funding mechanisms need to be addressed. The most basic method is simply for the purchasing owner to pay cash at the appraised price for the number of shares the departing owner has in the company. However, this is not always practical or possible. Another approach is to pay a fraction of the appraised price at the time of the triggering event, and put the rest in a promissory note that is paid off over time and a certain rate of interest.

Often, in the case of the death of an owner, cash to fund the buyout is obtained via life insurance. That is, co-owners take out life insurance policies on each other and agree to use the payouts to finance the buyout. A key here is to maintain the synchronization of the value of the business and the death benefit of the life insurance policies. This eliminates surprises from cropping up at the worst possible time. This structure is referred to as a cross-purchase agreement. Another common structure is company-owned life insurance whereby the company is the obliged purchaser and repurchases the shares in the event of an owner’s death.

Other funding mechanisms include borrowing or using personal assets, which may or may not be feasible. Using cash from the business itself, even if the business can support it, can be problematic, since the cash being used for the purchase is already partially owned by the owner being paid.

“One thing to remember,” Tanner says, “is that buy/sell agreements don’t have to be forever.” If the co-owners come to a point where they all agree that they are tired of running the business, they can simply decide to sell the company, at which point the buy/sell agreement terminates. In fact, owners can agree to terminate a buy/sell agreement at any time. (The buy/sell agreement — including the life insurance policies — is not, however, designed to be unilaterally canceled.) One thing that needs to be resolved — via simply swapping policies or some other method — is what will happen to any life insurance policies in force. With no business arrangement, owners no longer have a mutual obligation to each other, and therefore, no longer have an insurable interest in each other’s lives.

One of the biggest issues with these agreements — beyond not having one — is not reviewing and revising it on a regular basis. Says Tanner: “It can be a good working practice, for instance, to pull the owners together to review the agreement at the company’s annual meeting. These annual reviews should probably also include regular appraisals of the company’s value, if they’re not done already.”

Typically, a company’s legal advisor is the point person for drafting a buy/sell agreement for the owners. Co-owners should work closely with legal, accounting, valuation and insurance advisors when evaluating or modifying these structures.

 

Protecting Your Personal Assets

Pre-transaction tax strategies

Two potentially effective asset transfer strategies for business owners include the grantor retained annuity trust (GRAT) and the intentionally defective grantor trust (IDGT). With a GRAT, the grantor is essentially transferring assets into a trust and gradually taking back an annuity (akin to principal plus an assumed amount of interest at a rate specified by the government1) over the life of the GRAT, says Jim Welch, wealth strategies division executive at U.S. Trust. If the investments in the GRAT outperform the annuity paid back to the grantor, the assets remaining in the trust may be transferred to heirs free of estate and gift taxes. This, of course, assumes the GRAT is zeroed out, which means that the annuity consists of repayment of the initial amount plus interest paid back to the grantor at the assumed rate of interest. “In the case of a three-year $1 million GRAT, the grantor would receive $333,333 back each year plus interest (for three years),” says Welch. “ The grantor is paid back the initial amount contributed to the GRAT ($1 million) plus interest, but the excess appreciation remaining in the GRAT (following the sale of your company) is able to be transferred out of the grantor’s estate without any gift or estate tax ramifications.”

A sale to an IDGT functions much like a GRAT. The IDGT essentially deals with two sets of IRS rules — individual income tax rules and IRS transfer tax rules (e.g., estate, gift, generation-skipping). “Generally, these two sets of rules work well together, but occasionally some gaps appear. The IDGT attempts to take advantage of those gaps,” says Welch. “The theory is that it’s impossible to sell an asset to yourself and have it be a taxable transaction for income tax purposes. However, it is possible for someone to sell an asset to a trust, and if that trust has some special provisions for transfer tax purposes, that sale is a real and recognized event. But, as noted, it’s still a nonevent for income tax purposes.” For example, if you were to sell $1 million worth of your company’s stock to a defective trust, you would receive a note worth $1 million. As with the GRAT, you would eventually receive your $1 million back plus interest, but any appreciation (again, above the low hurdle rate) could be transferred out of your estate.

Using cash from the business itself can be problematic.

Should you choose a GRAT or an IDGT? “Although they behave in similar ways, there are differences,” says Welch. “The GRAT is an effective tool, but it has two main disadvantages: first, if you die during the GRAT’s term, all of the GRAT’s assets return to your estate; and second, multigenerational planning (for grandchildren and future generations) cannot generally be done as effectively with a GRAT.”

With an IDGT, on the other hand, the death of the grantor during the trust’s term does not end the trust. Also, you can name grandchildren and future generations as beneficiaries of the trust. “In fact, in practice, family business owners tend to prefer the IDGT to the GRAT,” says Welch. “GRATs are usually more popular when it involves publicly traded company stock or pre-IPO planning.”

GRATs may be zeroed out if structured appropriately, resulting in no gift or estate tax, according to Welch. IDGTs typically are funded with a 10% gift of the entire value of the trust, resulting in gift taxes paid, use of a portion of the lifetime credit or use of annual exclusion gifting.

 

He points out that one key difference between a GRAT and an IDGT is that the GRAT is an annuity, which carries out principal on a periodic basis back to the grantor. There are some creative methods of structuring GRATs where the payments of principal are less in the early period of the GRAT term and larger in the later period (e.g., a back-end-loaded GRAT). However, the IDGT is usually preferable in this situation since it can be structured as a loan with a balloon payment at the end and only interest being paid to the grantor periodically (e.g., yearly). Says Welch: “Therefore, more of the value of the initial transferred amount may remain in the IDGT for a longer period of time, allowing for the potential of a more favorable outcome if the underlying asset (in this case, usually the private company) appreciates above the interest rate.”

The grantor may pay a lower interest rate on IDGTs compared to GRATs, Welch adds, since the rate is set at the midterm applicable federal rate (AFR). The rate of GRATs, however, is 120% of the midterm AFR. Therefore, the hurdle rate for IDGTs may be lower than that of a GRAT. This is more beneficial for the grantor and the recipient of the remainder value since more of the assets will pass out of the estate with the lower hurdle rate on the IDGT.

Early Planning Can make all the difference.

Lastly, the one drawback to using an IDGT is that it has not been codified by the IRS. Since it is a non-statutory technique, the likelihood of it being challenged by the IRS is greater than that of a GRAT. Since GRATs are statutory, assuming the grantor follows the appropriate protocol, there is significantly less risk of the IRS challenging a GRAT than if the IDGT were utilized for the asset transfer.

Among the many other options, transferring company stock into a charitable remainder unitrust (CRUT) can also be an effective way to move future appreciation (and resultant federal tax consequences) out of your estate, according to Welch. With a CRUT, the remainder beneficiary of the trust is a charity and the income beneficiary of a CRUT is typically an individual. The mechanics are complicated, but basically the CRUT strategy allows you to sell your business assets, while maximizing the post-tax money received on the sale and enabling you to reinvest your proceeds at 100 cents on the dollar, as opposed to using after-tax proceeds. The grantor may choose himself or another individual as the income beneficiary of a CRUT. The grantor will then choose a prespecified payout rate, which he will receive on an annual basis. Statutorily, this rate must be at least 5% but no more than 50% of the fair-market value of the donated assets; however, in practice the rate is most often in the 5% to 8% range. The amount received by the income beneficiary on an annual basis is taxed to the beneficiary at their personal tax rate but based on the tax character experienced within the trust. For instance, if the trust produced all long-term capital gains (LTCG), the income beneficiary would be taxed at their own capital gains tax rate. However, if the payout consisted of LTCG and qualified dividend income, short-term capital gains (STCG), interest income and corpus, then the income beneficiary would be taxed first on income, then on STCG, then on dividends, then on LTCG, and finally, the beneficiary would receive corpus (with no tax on corpus).

“Another reason CRUTs can be an attractive strategy,” says Welch, “is that the donor/grantor of the CRUT receives an up-front charitable deduction for the present value of the remainder interest of the gift to charity. The gift to charity is assumed to occur upon the termination of the trust, at which time the remaining assets in the CRUT will flow directly to the prespecified charity. Lastly, it is important to note that for this strategy to work and be permitted by the IRS, the CRUT needs to be in place long before any purchase agreement for a company is finalized.”

Protection from creditors and state income taxes

Although business owners are concerned about spouses or family members being hit with huge tax bills or being pursued by creditors in the event of their death, they often don’t have provisions in place to handle these events effectively. Cash on hand may well not be sufficient. Term insurance or an insurance trust can help, but other, potentially more effective methods are worth considering.

“One popular strategy is to keep assets outside of your estate via a gift to a trust or installment sale to a trust in Delaware, Alaska or several other states,” says Welch. “In these states, creditors of beneficiaries have no access to the trust’s assets. It’s even possible to create a trust and name yourself its beneficiary, and thereby shield trust assets from creditors for yourself, and also, if you want, receive distributions from the trust.”

Perhaps even more important, states such as Alaska and Delaware impose no state income tax on trusts with non-state-resident beneficiaries. This could be especially meaningful to business owners. If they reside in high-tax states like New York or New Jersey, the potential savings can be substantial.

As with other trust strategies, it’s important to get it in place as early as possible — at least 12 months before your anticipated transaction date, or if that’s not possible, in a different calendar year.

Trusts don’t have to mean loss of control

For business owners, hesitation to consider these strategies sometimes has to do with a perceived loss of control. “But it’s important to distinguish between legal ownership of an asset and control of that asset on a functional day-to-day basis,” says Tanner.

Not all wealth planning strategies will be appropriate for all business owners.

There are many ways to make your influence felt in the trust process, through trustee selection (including at times selecting yourself as trustee of the trust you’re creating) and future trustee selection. Preferences can be reflected and concerns addressed with careful drafting of trust provisions. “Moreover, with a revocable trust, you don’t have to make all decisions immediately, and the decisions you do make are modifiable. They can even be canceled,” Tanner adds.

Early planning can make the difference

Not all of these wealth planning strategies will be appropriate for all business owners, but knowing about them and considering them in the context of your own situation allows for informed and intentional decision making. “Also, it’s important to remember that these strategies are not mutually exclusive, and none of them requires the commitment of all of your assets. In many instances, it may be preferable to use a combination of different types of trusts to achieve what are likely to be multiple goals,” says Welch.

 

But one thing that all of these strategies have in common is that they work better the earlier they’re established, both Welch and Tanner agree. So often, owners wait to plan until there’s a deal pending, or they’ve had a health scare, or some other event occurs that forces them to want to plan. But entrepreneurs who engage in this process earlier rather than later will have many more options available to them and a greater likelihood of achieving their long-term goals.

1Per Internal Revenue Code §7520, the interest rate for a particular month is equal to 120% of the applicable federal midterm rate (AFR) (compounded annually) for the month in which the valuation date falls. The rate is rounded to the nearest two-tenths of 1%.

PHOTO CREDITS: Violin Opener: Getty Images, Piano insides: Joseph Pulitano/Getty Images, Tuner: Michael Stuart, Piano Bridge: Mark Laita/Gallery Stock, Tuning Fork on Cello: Bojan Kontrec/Getty Images, Row of Violins: Westend61/Getty Images, Piano Tuner: Hal Bergman/Getty Images, Tuning a Guitar: Pat LaCroix/Getty Images, Violin Bridge: JordanPhoto/Getty Images

IMPORTANT INFORMATION

Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.