Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-1 Exit Planning – Family and Big Fishes Option 1: Sell Out For Real Money Option 2: Transition to Next Generation Option 3: Divide and Do Some of Each The All-Important “Keep vs. Sell” Decision

Copyright 2008 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-2 Hard Facts 80% of businesses in U.S. family dominated Family businesses account for more than 50% of U.S. employment and nearly 50% of GNP. Over next 15 to 20 years, 43% of American’s family businesses will change leadership. Succession is dream: 80% of old say they want succession, yet less 30% have plan. Only 30% survive through second generation. Only 15% survive through third generation

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-3 Problem 8-A: The Crane Company Sellout Math: Assume asset sale with basis of net assets valued at $4 million. Sale Proceeds $14 million Stock Basis 4 million Gain on Sale 10 million Tax on Sale 1.5 million After-Tax Proceeds $12.5 million

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-4 Problem 8-A: The Crane Company Future Math: Assume following sale: Pre-tax investment long-term yield 7% Marginal tax rate 35% Live style annual expenditures (750k) growth rate 2% How much value left after 20 years (Mark age 80)?

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-5 Problem 8-A: The Crane Company Bottom Line Numbers Remaining balance after 20 years if sell: $ 3,461,047 Keep Comparison – Company Value grows 5% per year: $ 30,070,707 (After Payment of income taxes)

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-6 So Why Even Consider Sale? Pressure is gone Nest Egg Assured Exit a winner The vulnerabilities (demons) are gone Time to play and stop worrying Down deep I know: “Kids can’t cut it” The world is scary and getting scarier

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-7 Advisors Role Brutal honesty: Not a time for client appeasement Encourage confrontation of the tough issues Emotional Ties Risk World Trapped Child Syndrome Qualified Heir Apparent? Bona Fide Sellout Option In-law Factor Key Business Indicators

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-8 Key Business Indicators Strategically v. Relationship Based Institutionalization Process; Brand development Margin Tolerance Uniqueness of asset base Low Tech v. High Tech; Permanence Industry Barriers to Entry; Competition Adaptability of Business and Market Capital Structure and Wealth Concentration

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-9 Marble Planning Daughter Trust Son Trust Daughter Trust GC Trust – 1 GC Trust – 2 GC Trust – 3 GC Trust – 4 GC Trust – 5 GC Trust – 6 Duncan and Sandy Living Trust Personal Residence Trust Family L.L.C. (Growth) Family L.L.C. (New) Dynasty Insurance Trust Charitable Remainder Trust C Corporation Holding S Corp (Parent) Alma Mater Qualified Retirement Plan QSSS Corp (One) QSSS Corp (Two) Income Charitable Deduction Assets Remainder Contributions Distributions Compensation Distributions Home Term Use Assets Cash Remainder Income Units Income, support

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Family Business Mountain Challenge 8-10

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Timing Factors  Both Parents Living  First Parent Death  Surviving Parent Death - Moment of Truth 8-11

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Targeted First Death Planning  Community Basis Step-Up. 1014(b)(6)  No Estate Taxes with Marital Deduction  Control Surrender Easier  Life Insurance at Its Best 8-12

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 35% Hurdle Relief 303 Redemption Qualification: - Death taxes (Fed & State) plus funeral & admin expenses - Tax-Free vs. Taxable Dividend = Big Deal - Only hope with 318 attribution 6166 Estate Tax Payment Option: - Fed estate burden - Payment term up to 14 years - Favored interest rate break 20% Owned Biz: May be included in 35% factor. Spouses community interest may be included for 20% hurdle, but not 35% hurdle 8-13

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Valuing the Business  Use an Expert  Better - An Expert Expert  Don’t Get Too Cute or Aggressive 8-14

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Exciting Discount Math 100 / 11 = Something Less Than 6 Trap: Control Premium Math 8-15

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Discount Strategy  Transfer Minority Interests  Always Die Owning a Minority Interest  Control Value: A Disappearing Act 8-16

C Corp to LLC or Partnership? Prohibitively tax expensive Full recognition of all asset gains at corporate level Full recognition of capital gains at shareholder level Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-17

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com LIFO Inventory Trap – LIFO inventory reserve recaptured over four years 2.C Corp E & P Trap – Post-conversion distributions in excess of S corp accumulated adjustment account will trigger taxable dividends to shareholders to extend of C corp E & P 3.The Passive Income Trap of The BIG Tax Trap of 1374 Potential S Conversion Tax Traps

Minority Discount 2056 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-19 Parent Estate Family Corp Control Minority Stock Credit Trust, Others Estate Control Value - Minority QTIP Value = Estate Tax Liability Minority Stock QTIP Trust

Buy Sell 2056 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-20 Parent Estate Family Corp Stock Other Family Estate Value > Buy/Sell Price = No QTIP Marital Deduction Family Stock QTIP Trust Family Stock Cash, Note Per Buy/Sell

Stock Compensation Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-21 Family Corp Stock & Gross Up Cash Inside Child  Child Income per 83  Corp 162 Deduction  Zero Net Inc. Tax Cost  Child Basis = Full FMV  No Gift Tax Costs (Actual or Opportunity

8-22 Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Compensation “Gross-Up” Game Assume: 1. Stock for services equal 150k 2. Corporation tax rate 34% 3. Executive tax rate 33% Straight recognition transaction: - Executive pays taxes of 50k - 33% of 150k. - Corporation saves taxes of 51k – 34% of 150k Gross up amount formula: [Stock value / (1 - Executive tax rate)] – Stock Value = Gross-Up Bonus [ 150k / ( =.67)] – 150k = 74k - Corp tax savings: (150k + 74k) x 34% = 76k (More than Gross-up) - Employee tax bill: (150k + 74k) x 33% = 74k (Paid by Gross-up)

Unrelated Party Common Stock Sale Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-23 Family Corp $ 3 Mill Common $ 2 Mill Non-cum Preferred Parent Parent Income Tax = $ 3 mill less common stock basis Common Stock Unrelated Party $ 3 Mill Cash, Notes

Preferred Stock 2701 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-24 Family Corp $ 3 Mill Common $ 2 Mill Non-cum Preferred Parent Parent Income Tax = $ 3 mill less common stock basis Plus Taxable Gift of $2 million. Plus - Parent still owns preferred Common Stock Related Party $ 3 Mill Cash, Notes

2036(b) Voting Stock Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-25 Controlled Corp Voting Stock Parent Stock Taxed in Parent’s Estate Per 2036(b) Note: Nonvoting Stock Works Voting Stock Trust, LLC Partnership, Corp Voting Rights - Direct or Indirect

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-26 Problem 8-B: Olson Consolidations Jason’s Objectives: Be assured control of business, not accountable to siblings Begin sharing in value growth now Stop building more growth value for siblings Make sure siblings (both insiders and outsiders) know the deal Minimize taxes and disruption to business

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-27 Problem 8-B: Olson Consolidations Mom and Dad’s Objectives Financially secure and free for rest of lives Keep business strong with Jason running show Continue oversight of business with some authority Keep harmony in the family Give each child an equal share of estate Minimize taxes and disruption to business

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-28 Problem 8-B: Olson Consolidations Gift Transition Strategy Parent’s use 2 mill gift tax unified credits to give Jason his 3 mill share of estate now in stock. Use minority interest and lack of marketability discounts to get there. Parents use annual exclusions (for Jason and spouse) to gift with discounts additional 72k stock each year (72k discounted value 48k) Parents make similar offsetting annual gifts to other children to tax- protect insurance through ILIT and to transition other assets through one or more family LLCs. Parent’s estate (living trusts, wills) designed to eliminate any further interest of Jason until others have received transfers (after-transfer tax) of same 3 mill value. Then Jason and each sibling shares 1/5 of excess. If there s cumulative shortfall, no adjustment from Jason because Jason took risk of stock.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-29 Parents C Corporation Jason Stock Ownership 78.5% and dropping Gift up to 3 mill stock now Problem 8-B: Olson Consolidations Gift Transition Strategy Annual stock gifts – up to 72k Stock Ownership 21.5% and rising

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-30 Gifting Annual Exclusion Math 4 Kids, 4 Kid Spouses, 4 Grandkid Trusts Dad: 12k per year x 12 = 144k per year Mom: 12k per year x 12 = 144k per year Total Annual Before Discounts: 288k Discount 40%: $480,000 per year Total value moved in 10 8%: $ 7.5 million Total value moved in 20 8%: $ 23.7 million

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-31 Gifting Pros & Cons Pros Value growth on gifted stock out of parents estate No transfer tax on gift tax if beat 3 year pullback Income tax shift Leverage annual exclusions & unified credits Cons Value growth still in parents’ estate Unclear when / how inside children get control Low basis transfer under 1015 C corp double tax on dividends to parents down road Parents’ financial security potentially compromised

Grantor Retained Annuity Trust Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Trust Annuity Term of Years Parent & Estate  Fixed Annuity Amount  Fixed Annuity Term  Annuity Paid Annually  No Debt, Etc.  No additions or others  Mortality Risk of Deal  Yield Risk of Deal  A “Darling” Children Property Remainder 8-32

GRAT Something For Nothing Example Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Trust Annuity $ 336,291 yr. Term - 5 Yr Parent & Estate  7529 Rate 5.4%  Zero Remainder Value  Annuity Funded Heavily From Principal  5 Yr Mortality Risk  Any Remainder Pass Transfer Tax Free Children Property $ 1.44 Mill Remainder 8-33

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com The GRAT & Family Stock Factors Will work with S or C stock - just make grantor trust Best to Use Nonvoting Stock Negative impacts of corp earnings distributions Yield risk at odds with other value strategies? Opportunity cost of gift tax exclusions & credits Gift tax payments with mortality risks - hard sell Zero Out Play Fund annuity with stock transfers back? Valuation boomerangs & costs Impacts on health of business Big costs and risks v. how much real benefit Screwy message to inside kids 8-34

Preferred Stock Freeze Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Family Corp Common Stock Cumulative Preferred Parent  No hope with S corp - One Class of Stock Requirement  Double tax hit on preferred dividend  Real Killer - preferred value under 2701 based sole on market value of cumulative yield. All other value in common under 2701  Hence, strategy only works with extreme annual growth rate Gift Common Stock Children 8-35

3 YEAR GRIT Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Trust All trust income Term - 3 Yr Parent  Term value zero  Remainder Value 100%  Parent pays gift taxes  Gift taxes in parent estate if death within 3 yr  Parent death within 3 yr term triggers basis step-up  Trade-off is appreciation included in estate  Nullity if parent survives 3 yr term Children Property Remainder 8-36

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-37 Parents C Corporation Jason Balance of Stock Gift up to 3 mill stock now Problem 8-B: Olson Consolidations Gift With Redemption Strategy Stock Ownership 100% Installment Note

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-38 Problem 16-B: Olson Consolidations Gift with Redemption Strategy Pluses: Jason gets all stock now. Note to parents reflect balance of stock value. Negatives: Exchange treatment to parents only if qualify under 302(b)(3) as complete redemption with no family attribution. Parents role limited to creditors. Note principal payments funded with after-tax dollars. All payments on note at parents’ death income in respect of decedent. Full income tax burden to heirs. Tremendous debt burden for company now. Jason gets no basis step-up for all payments to parents.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-39 Parents C Corporation Jason Problem 8-B: Olson Consolidations Cross Purchase Strategy 100% of stock Installment Note Stock ownership 100%

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-40 Problem 8-B: Olson Consolidations Cross Purchase Strategy Pluses: Jason gets all stock now. Note to parents reflect balance of stock value. No big gifting required now to spook other kids. Parents can retain any role – no creditor limitation. Jason gets stepped-up basis on all stock. Negatives: Note payments funded with Jason after-tax dollars. All payments on note after parents’ death income in respect of decedent. Full income tax burden to heirs. Tremendous debt burden on Jason. Jason interest deduction. Investment interest tough. How does Jason get money out of corp to fund payments?

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parent Family Corporation Grantor Trust Intentional Defective Grantor Trust Installment Sale “IDGT” Stock Installment Note Stock ownership Other asset Gift Children Beneficiaries Dream Scenario  No gain on sale  No gift tax impacts  Stock outside parent’s estate  Trust income taxed to parent  No mortality risk  Asset substitution pre-  death for basis step-up  Works with C and S stock 8-41

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com IDGT Issues What we think we know: Dual status possible No gain on sale to grantor trust No gift tax on income tax payments by parent No estate inclusion under 2036 if parent outlive note What we are not sure of: Gift tax impact going in if interest rate is applicable federal rate Estate inclusion under 2036 if death before note paid Debt v. retained equity on note – need for other assets equal to 10% What we don’t know Tax treatment on note payments post death – IRD? Gain recognition on note on grantor trust status termination Basis impacts on death with grantor trust termination 8-42

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com IDGT & Family Stock Key questions: Is cross purchase strategy best option? Parent’s capacity to gift other assets? Has stock basis been stepped-up at first death? Impact on business? Client’s stomach for tax uncertainty? 8-43

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Self – Canceling Installment Note (“SCIN”) Pluses: All note payments canceled on death of parent No residual note balance in parent’s estate Minuses Actuarial premium calculation required If parent lives, premium will result in gift tax cost (actual or opportunity) or child paying more May conflict with objectives for other children 8-44

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-45 Parents Old Corp Now S Jason 100% of Stock Stock gifts over time Problem 8-B: Olson Consolidations S Election – New Corp Strategy Service/Management Contract Distributions - No double tax New Corp Planned post mortem stock buyout Employment/Stock Equivalency ILIT Ins. on Parents Cash for premiums Death benefit

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-46 Problem 8-B: Olson Consolidations S Election – New Business Strategy Pluses: Parents have income for life. No double tax or payroll issues on income to parents. Jason’s control rights protected by contract. New corp’s growth all belongs to Jason. Full basis step-up in parent’s stock at death. Tools to control parents’ future estate growth. Parents insulated from growth risks of new corp. Negatives: Operates and assets of old may be needed for new. Estate growth may occur for parents. Watch S Corp reasonable comp rules of 1366(e). Normal S Corp conversion issues.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-47 Problem 8-B: Olson Consolidations Other Potential Strategies (Some complementary) Split off of separate company to Jason under 355 after he has been gifted stock and has become an historic shareholder. Transfer real estate rented to company to LLC and use as gifting tool for other children. Have agreements (either now or triggered at death) to protect employee rights of inside children.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 8-48 Problem 8-B: Olson Consolidations Other Potential Strategies (Some Complementary) Insurance funded trade-off with other children with equalizing ILIT policy. May couple with capital restructuring. Voting and non-voting common shares with S Corp conversion. Non-voting can pass to other children at death subject to buy-sell when Jason can swing purchase. Tax-free recapitalization at death of parents: common stock to Jason, preferred to others.