CASE INFORMATION FOR FAMILY BUSINESS:
  OVERCOMING OBSTACLES
IN THE
OWNERSHIP TRANSITION PROCESS OF A
 SUCCESSFUL FAMILY OWNED BUSINESS 
  A CASE STUDY 
  Presented by Joseph F. Blum, CLU, TEP
"The Wealth Pre$ervation Company" ™

 

CAVEAT 

Since this article was written, there have been changes in the gift tax rules and Social Security requirements which are not reflected in the text.

Note: On the “Tax News” link on this website you will find a summary of the Economic Growth and Tax Relief Reconciliation Act of 2001, which phases out the Estate Tax and raises the limits of the annual exclusion and gift tax exemption all of which would affect this case study. While this is now the law of the land, the consensus of most practitioners is that many of its provisions will never survive to their proposed effective dates. 

Writings on tax laws must be viewed as a “moving target”, since rules and regulations change frequently. 

Before adapting any planning devices discussed herein, one should seek counsel from one’s advisors as to its applicability for their particular situation. 

Respectfully,

Joseph F. Blum, CLU, TEP

The Family Business case we are going to look at can best be summarized with a question that is simple to state but emotionally and legally complex to resolve:
 
"How can the founder of an FOB create an Estate Plan that treats all of his children equally when:
 
a.               The business is the largest single asset in the Estate,
 
b.               Its President and heir apparent is the founder's son-in-law ... and
 
c.                None of the other children are, or will ever be, involved in the Family Business!

FACT PATTERN

 
 
1.             Parent's Mr. & Mrs. E are 66 & 59, respectively.
 
2.             They have 4 children: 2 boys age 37 & 39 and 2 daughters ages 29 and 34.
 
3.             None of the children are in the business but one daughter's husband is President of the FOB and is its designated heir apparent. During his 7-year employment stint, he has grown the company 15% annually; sales now stand at 9.5 million, with net profit margins of 9.85%.
 
4.             Mrs. E is active in the business and is considered an accomplished businessperson. She sits on the board with her son-in-law and 4 outside directors.
 
5.             The 4 children and the son-in-law have received gifts of Co. stock as part of the Parents Estate Plan. Each currently owns 9.9% with the exception of the youngest son. His stock was redeemed when he left the employ of the Company after a brief stint in management.
 
6.             The parents retain a total of 50.4% of the stock, evenly divided between them, 25.2% each. This is a C Corp. (as distinguished from an S Corp.), it has only one class of stock and it has never paid a dividend.

7.             Mr. E states that he will reconsider his retirement in 5 years, and is adamant about retaining control of the Co. to that point and possibly beyond.
 
8.             The balance of the assets rounding out the parents estate consist of:
 
a.               A $2,000,000 stock portfolio
b.               2 homes valued at $1,500,000
c.                Miscellaneous assets valued at $400,000
 

Mission Statement 

If this were my case, my approach would be as follows:             
a.               I would look at what we know, as expressed by this family's mission statement.
 
1.      Maintain long-term profits
 
2.      Live well but not extravagantly
 
3.      Have a strong balance sheet.
 
4.      Keep cash equal to 40% of short-term liabilities (those due in one-year).
 

Quality of Life for All. 

They will probably go to great lengths to prevent family "train wreck". 

Family Harmony and a "United Front" are What Promote Long-term Customer Relationships. 

Ethical Values Further Reinforce the Probability of Family Members Treating Each Other Equally and Respectfully. 

b.               I would then look at the family tree to see what each person's present position looked like.

POSITION OF EACH FAMILY MEMBER AT START OF CASE

 
Perhaps you are wondering how Mr. and Mrs. E. were able to get 1 $1,837,200 of company values over to the children without paying gift taxes, up to this point in time.
 
Well, they did it by taking advantage of the 2 major provisions of the I.R.C., which allow us to make tax-exempt gifts of $600,000 once in a lifetime, PLUS $10,000 per year per parent to as many people as one chooses, whether related or not.
 
Lets see how Mr. and Mrs. E. have utilized this tax code provision. They started their gifting program of company stock 7 years ago when their son-in-law entered the family business. They made gifts under both the Annual Exclusion and the-Unified Credit as follows:

Daughter & Son-in-law				Son, Age 39			Daughter, Age 34			Son, Age 37
		A.E.		U.C.			A.E.	U.C.		A.E.		U.C.
Year 1		$40,000		$157,466	$0		$20,000	$78,733		$20,000		$78,733
Year 2		$40,000			$0		$20,000			$20,000
Year 3		$40,000		$157,466	$0		$20,000	$78,733		$20,000		$78,733
Year 4		$40,000			$0		$20,000			$20,000
Year 5		$40,000			$0		$20,000			$20,000
Year 6		$40,000		$157,466	$0		$20,000	$78,733		$20,000		$78,733
Year 7		$40,000			$0		$20,000			$20,000
Yearly Total		$280,000		$472,400	$0		$140,000	$236,200*		$140,000		$236,200
Grand Total		$752,400			$0		$376,200					$376,200
*Mr. and Mrs. E. still have $255,200 of U.C. left NOTE: (UC was $600,000 at time of case study.)

 
*Mr. and Mrs. E. still have $255,200 of U.C. left
       NOTE: (UC was $600,000 at time of case study.)
 
 
ESTATE TAXES

Given the growth rate of this company (5.38% on an after-tax basis) and two key touchstones in the life of this couple (his proposed retirement in five years an d Mrs. E's life expectancy of approximately 23 years), combined with their present estate tax liability of approximately $3,500,000 should they die simultaneously, it behooves this couple to do some serious planning to further their wishes regarding their children and to lower their estate taxes.
 
The two challenges we face in this case are:
 
1.      Creating equity for all four children in- an estate valued, for Estate Tax purposes, at $7,300,000 today.
 
2.      Reducing estate tax liabilities.
 
We will approach these problems en masse and with no particular order but as you will see we will wind up hopefully with the desired result.
 
1.      The Two sons age 37 and 39 need cash for their new business that has already been started.

One possible solution would be have dad convert his $400,000 of other assets to cash and makes gifts to each of these boys in the amount of $200,000. The loan would be a debt of his estate and would reduce its taxable value at the time it passes to his spouse.
 
The "C" corporation could be converted to an "S" corporation. Once the S election is taken, Mom and Dad could gift 40% of the Corporation's stock (80% of their interest) to their three children not involved in the business. Since this is less than a controlling Interest in the company, it could receive a discounted value of as much as 40%. The gifting value would therefore be $912,000 even though the market value is $1,520,000. There would be a gift tax payable on these 2 gift transactions of $369,170. If these gifts are not made now, however, and the full value of these assets were taxed in the Estate of the last of Mr. & Mrs. E. to die, and further assuming no growth in their value, the Estate tax would be $629,960. There would be no minority discount available since this stock represents a majority interest in the parent's Estate.
 
That not withstanding, as S Corporation shareholders, these 3 children will be entitled to a proportionate share of the 1994, $570,000 profit, and greater amounts if the current growth pattern continues.
 
Simple mathematics reveals that once this 40% gift is made the parents interest in the Company will be reduced to a 10.4% interest. The combined interests of the children will therefore be greater than those of their parents. This would make any founder of a family-owned business very insecure.
 
There is, however, a valuable option available in the structure of an S corporation. We call it the peace of mind option. While S corporations cannot have two classes of stock, their one class of stock may contain both voting and non-voting shares. - We would strongly suggest that the shares involved in the parents'40% gift contain no voting rights. This would leave 100% of the voting rights in the 10.4% interest retained by the parents.
 
Under the terms of the parents' respective wills, each would leave their stock interest, to the other-. This would guarantee that the survivor would still exercise control over the Corporation until -his/her death. This kind of security is critical to parents involved in this situation since their greatest fear is having to go to one or more of their children on a Friday to ask for a check. This 10.4% interest would be entitled to $57,000 of income. Obviously, retention of this interest, given the bright prospects of this Corporation provides a significant measure of security/income to a surviving spouse in his/her later years.
 
To reduce Estate taxes even further, the two residences could be put into a QPRT with the children not involved in the business as beneficiaries. We would suggest a period, of ten years for this QPRT. This is less than one-half the life expectancy of these parents and provides surety that should they outlive the ten-year period and, should the real estate grow in value to $2 million; $1.5 million in value will be out of their Estate. Once the QPRT has ended, they could pay rent to the children who are the beneficiaries, and that rent could be used to subsidize the children's living costs or, hopefully, to facilitate the payment of life insurance premiums on their parents' lives.
 
While their real estate has a market value of $1,500,000, the gifting value (once again we see the discount leverage available in these arrangements) is only $784,000. A gift tax of $340,000 would be payable on this discounted gift of the residences to the QPRT.
 
Once again, had this property remained in the Estate of the last of Mr. & Mrs. E. to die, an incremental Estate tax of $753,970 would have been due on these residences.
 
If Mr. & Mrs. E. both die during the 10 year period of the QPRT, the property reverts back to their Estate and a tax is payable. Should they both survive the 10-year period of the QPRT, the property would belong to the children who are the trusts' beneficiaries.
 
 A long term occupancy agreement or lease, entered into simultaneously with the QPRT arrangement, would add a measure of security to the arrangement. The parents' rent payments are usually tied to taxes and upkeep of the properties.
 
Once all of these planning devices have been implemented, here is what the respective positions of each party would look like:
 
 

POSITION OF EACH FAMILY MEMBER AT START OF CASE 
The Parents’ Joint Assets

 

Daughter & Son-in-Law  9.9% of FOB share each $752,400 Total Value8				Son, 39 0% of FOB Share		Daughter, 34 9.9% of FOB Share $376,200 Capital Stock		Son, 37  9.9% of FOB share $376,200 Capital Stock
40%  GIFT		(10% $380,000)		(10% $380,000)		(10% $380,000)		(10% $380,000)
CASH GIFT		$0		$200,000		$0		$200,000
CORP STOCK INHERITIANCE PARENTS		(10.4%) $395,200		$0		$0		$0
REAL ESTATE (GRIT)		$0		$500,000		$500,000		$500,000
INVESTMENTS		$302,400		$750,000		$573,800		$373,800
TOTALS		$1,830,000		$1,830,000		$1,830,000		$1,830,000

 You might ask "Why would Mr. & Mrs. E. pay $1,153,000 in gift taxes during their lifetimes as the price for giving away property, when the same tax would be due on the same property on their death"?
 
And ... where would they get the $ to pay the gift taxes?
 
The first question has a 2-part answer:
 
1.It actually costs less to make lifetime gift than the-tax cost of leaving those same properties to be taxed on death in the decedents estate.
 
2. Assets have a way of appreciating. The company stock is obviously growing rapidly in value. At the present growth rate (15%) the currently gifted stock will have a value on Mrs. E's death (assuming she lives her normal life expectancy of 23 years) of $38,000,000, on which the Estate tax would be $23,000,000!
 
To raise the cash to pay the gift taxes due on the proposed lifetime gifts, Mr. E could:
 
a.               Borrow against his stock portfolio
b.               Borrow from the Corporation
c.                Allocate some of the children's S Corporation income to loan payments.
 
An infinite variety of choices exist for financing the taxes of such lifetime gifts.
 
Dad states that he intends to "revisit" his active role in the Company five years hence at his age of 71. We, therefore, need to look at his income picture at retirement, in view, of how these planning changes have affected it. Basically, this is what his income will look like:
 

1. Sub S Income at 1994 level	$ 57,000
2. Dividend Income	$ 100,000
3. Social Security	$ 25,000
TOTAL	$182,000

I would doubt that this income, net after taxes, would be sufficient for Mr. & Mrs. E. to maintain the lifestyle they have become accustomed to during their working years.
 
Supplementary income would undoubtedly be required and to that end we would suggest the following:
 
1)        Defer the date of retirement one-year to the age of 72. This would allow Dad to collect his Social Security without the earned income limitation. (As of 1999, this deferral was no longer required. The income test for Social Security eligibility was abandoned)
 
2)        We would suggest that the Corporation immediately install a Salary Continuation agreement providing for the payment of $100,000 for 20 years to Dad or to Mom should she survives Dad. When one looks at the humble beginnings of this Company (the manufacture of plastic bird feeders) and projects a line to its present position as a fabric manufacturer with volume approaching $10 million, it is easy to draw the conclusion that Dad drew very little out of this Company to the point when his son-in-law took it over. That history is but 7 years old. It should, therefore, not be difficult to support the contention that Dad's salary during his working lifetime, when combined with the payments made under the proposed Deferred Compensation plan, do not in total represent "unreasonable compensation" from the IRS prospective.
 
This would bring the couple's income to $282,000 per year; undoubtedly a more reasonable sum.
 

WHAT’S LEFT

  
Following the implementation of these planning devices, the taxable estate of Mr. & Mrs. E. look like this:
 

1.          Investment Portfolio	$2,000,000
2.          Stock in Corporation	395,200

HERE'S WHERE LIFE INSURANCE COMES IN

To cover the tax liability of the remaining estate and to replace the cash dissipated on Mr. & Mrs. E.'s lifetime gift taxes, we would suggest the purchase of a $1.5 million Survivorship Life Policy. During Dad's lifetime we would suggest that the policy be purchased, owned, and payable to an Irrevocable Life Insurance Trust. Upon issue, the Trust would assign the policy to the Corporation for the purpose of premium payment and enter into a Split Dollar Agreement. The parents would write a check each year for only the PS38 amount. That check would be written to the Irrevocable Trust and paid over to the trustees. This small payment would represent 100% of the parents' gift to the Trust. The double leverage this provides is that the premium, as paid, $37,395 would go out of their Estate for tax purposes forever. The only direct cost to the parents in this case is the tax on the so-called PS38 ($1,000)'and the tax on 10.4% of the premium ($3,889) in a 46% tax bracket. Mr. & Mrs. E's total tax cost is $2,253 on a $37,395 premium.
Reason: At this point, Dad would not be a majority shareholder of the Corporation (he only owns 10.4%). It therefore follows that only his proportionate share of the split-dollar premium (10.4%) would be taxed as income.
 
The Irrevocable Trust receives $1,500,000 of the insurance upon the death of the survivor of these parents on an estate and income tax free basis. The Trust would buy from Mom's Estate her 10.4% stock interest in the FOB and, perhaps, some securities from her investment portfolio. The estate would then have the cash to pay the tax. At that point the Trust would disband, and spray its assets to its beneficiaries; the three children not involved in the business.
 

Mr. & Mrs. E Irrevocable Life Insurance Trust

How it works!
I. During Mr. E’s Lifetime

A. Part of the Sub-S income from ABC is deposited in the SILT.  These are considered "gifts" from John and Jane to their children.  While $10,000 per child may be given each year, only $38,549 is required  (for the insurance premium). 

B.  The trustee uses these funds to pay the insurance premiums

 
A second problem presents itself by the fact that the son-in-law who will succeed dad to ownership of the business, really doesn't want his brothers-in-law and his sister-in-law as minority shareholders sharing the income stream of this growing corporation: an entity in which he bears all of the risk but has entitlement to only 39.6% of the income.
 
As part of the insurance planning package, we would suggest a buy and sell agreement between son-in-law and three other children, funded by a life insurance policy, insuring Dad's life, applied for and owned by son-in-law naming him as beneficiary
Upon dad's death, the insurance proceeds would be received by son-in-law, tax-free and would in turn be used to buy out the minority shareholder interest of his brothers-in-law and sister-in-law. Should these minority shareholders sell their interest at the discounted value at which it was given, they would pay no capital gain tax on the transaction. They would simply be converting their shares for cash. If, however, the sale was at market value (40% higher), then capital -gains tax would be due on the difference between the gifted values and the market values at the point of sale. The "Bottom Line would be the son-in-laws 100% ownership of the FOB.
 
The Buy and Sell Agreement between the son-in-law and the other children cannot be a matter of choice. The Agreement must mandate the sale of their stock to the brother-in-law upon the death of the father. If the parties choose that the stock should be sold at the death of Mother, in the interest of a probable longer stream of Sub S income payments to these minority shareholders, then a SWL policy may be used.
 
Here's How It Works! 

During Dad's Lifetime:

·        Tax Treatment - On Death:

·        Corporation receives check for it's cumulative premium

·        Son-in-law receives balance of proceeds

·        Children receive buyout purchase, in cash

All on an income tax free basis, assuming children sell their stock for its purchase price
 
IN SUMMARY, LET'S NOW MEASURE THIS PLANNING PROCESS AGAINST THE PARENTS' INITIAL OBJECTIVES:
 
1.      We have reduced estate taxes from $3,800,000 to $1,683,170 (a 45% reduction):  $1,153,000 payable during lifetime & $530,000 payable on the last to die of Mr. & Mrs. E.
 
2.      Through the use of life insurance policies, we have paid that reduced death tax at a discount of approximately 65-90% (depending on the specific contract used).
 
3.      We have accomplished the parents' goal of leaving exactly equal legacies to each of their four children.
 
4.      We have allowed the parents to maintain control while letting go, with daughter and son-in-law ultimately owning the Company when both parents are deceased.
 
5.      We have allowed them to meet the mandates of their company mission statement:
 
a.      Harmony and equity among the family stockholders which equates to security for their employees.
 
b.      Unity in the family promotes good customer relationships allowing the company and in this case the surviving brothers-in-law to focus on providing exceptional value and service to customers.
 

c.      The entire job has been done professionally, ethically, and with planning devices that have allowed the family to remain independent within its own unit. There are no new shareholders outside of the family, no bank debt of any kind, and no danger of an unfriendly takeover by dissident investors or competitors.
…… and they all lived happily ever after!

THE END
 
QUESTIONS!                 For further discussion, call 1(800)-444-BLUM