Presentation on theme: "Estate and Business Succession Planning For Farmers and Ranchers Steve R. Akers Managing Director and Fiduciary Counsel, Southwest Region Lauren Y. Detzel."— Presentation transcript:
22 Pop Quiz for the Business Owner 1.Will you be able to retire when you want to? 2.Will your spouse be able to enjoy his or her lifestyle independent of the business? 3.Will you be able to treat your children equitably without hard feelings? 4.Should your family risk keeping the business? Can the family run the business? Does any of the family want to continue the business? 5.Will the business pass to the child / children who are active in the business? 6.Will the family need outside help in running the business? 7.Is there liquidity to pay estate taxes so the family will not lose the business or have the business financially crippled? 8.Have you minimized estate and income taxes that will be payable at your death?
33 Family Farms About 98% of all farms in the US are family farms. 85% of the nations agricultural output comes from family farms. Although 70% of the countrys farmland will change ownership in the next two decades, only 11% of farmers have a transfer plan. --U.S. Department of Agriculture A USA Today article on July 10, 2012 entitled, Keeping Farm in Family Requires Strategy states that: The average age of a farmer in the US is 57. In any other industry, that would bother everyone.
44 Business Succession Planning Surveys of family business owners reflect the following: Only 30% of businesses succeed in the transition to management by children. Only 12% of family businesses make it to the grandchild – generation. More than 2/3 of owners say they plan to pass the family business to their relatives within the next 10 years. But only 25% of those have a written succession plan. – 34% have an unwritten plan – 40% have no plan at all Source: The Center for the Study of Taxation, Federal Estate and Gift Taxes: Are They Worth the Cost? Pg. 2 (1996)
55 Business Succession Planning 40% of business owners who plan to retire in the next five years have not chosen a successor. Less then 30% of all businesses have a buy-sell agreement. Why devote a career to building the business without bottom-line strategic planning to transfer the fruits? Do I make these decisions alone or in collaboration with other family members? (Influence vs. control) These can be very difficult issues to face within the family. Its very easy to procrastinate.
66 Vulnerability of Business During Succession Planning There is no time when a business is more vulnerable to failure than during a succession transition. Vulnerability factors: Taking your eye off the business operation during this most vulnerable time Lots of change: family, business, ownership Owners are often secretive: Successor must play investigator to find out what the deceased owner knew Tremendous uncertainty: Customers, suppliers, key employees and lenders
77 Failure Factors Factors for the failure of most businesses during the succession transition including: Failure to name a successor to run the company and a timetable for the succession Family squabbles that divert attention away from the core focus of the business Poor estate planning – resulting in a forced sale of assets (or the company) to pay estate taxes or other liquidity needs (But countries with no estate tax or much lower estate taxes have similar failure rates) Unwillingness to take risks that fuel company growth; Family owned companies often stay with decades-old practices rather than integrate new services, products and approaches
88 Business Succession Planning Without proper succession planning, the business is subject to the ultimate GOTCHHA.
99 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
10 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
11 Cash Flow Cash Flow for Owners Life Cash Flow for Spouses Life As a practical matter, the owner will be reluctant to entertain succession planning as long as the owner and owners spouse are tied to the business for living expenses. The Concern: Loss of Compensation and Perks Elements of Possible Solution Deferred compensation Wage continuation plans Outside investment assets Rental payments for farmland used in the farm operation Note payments from sale or redemption of some of owners stock Life insurance proceeds for spouse
12 Cash Flow Cash Flow for Children: Are childrens living expenses tied to the business? Can children earn the same amount elsewhere? Do children have an expectation of a funded endowment from the business? Are childrens services worth what they are being paid? Are there disparities between levels of compensation to the children? These cash flow issues impact many of the remaining issues. Wheres the money?
13 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
14 Governance – Family Issues Tough questions for the owner: Should every family member be entitled to a job? Does everyone start at the bottom? What if some of my children are not qualified – Can I tell them? Should family members be required to work outside the business first? How do I assign titles? What criteria do I use: – Age? – Experience? – Interest Level? – Competence? Will the chosen business leader also be the family leader?
15 Governance – Family Issues Can my children get along with key non-family members? Should non-family members be chosen to run the business? Are there legitimate roles in the business for children who will not lead it? What if my children dont have the experience or are too young? Will intra-family rivalries spill over into the business? Are siblings obsessed with fairness? (They often are.) Do spouses of children have an intense sense of competition with each other? Are there Queen Bees who will destroy the business? Do my children want to pursue new activities that I think are too risky? Are children angry at the business for taking all of my attention?
16 Governance – With an Eye to Management Transfer Entrepreneurs – by their nature – are reluctant to give up control Developing, motivating, training and nurturing successors Dealing with unmotivated children Separating personal from business goals Outside directors / advisors – Only 12% of family firms have directors outside the family Equitable compensation (family / non-family; active / inactive shareholders) Plan for delegation of responsibility and authority to successors
17 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
18 Ownership Transfer Planning 1.Decide whether business will be sold or liquidated, or whether to perpetuate it for children 2.Decide who will be successor owner(s) Voting / nonvoting Debt / equity Class ownership 3.Mechanics of ownership transfer Farmland ownership may be different than entity that operates the farm Gifts Sale Redemption by business Bequest Buy-sell agreement
19 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
20 Treating Family Equitably Most of the time, the factors that cause a family business to come to an end are not the business issues, but the family issues.
21 Treating Family EquitablyCommunication Issues Research shows that succession failures occur because of a breakdown in communication between generations. Finances matter, the business matters, but this is the key. Each generation must define its own vision and decision-making process The longer you wait, the higher the probability of conflict. Family conflict typically is not about personalities. It is about a lack of structure and preparation for change. --Dr. Marion Hampton (Banyon Family Business Advisors)
22 Treating Family Equitably Family System vs. Business System Gut-wrenching Family pride associated with family business Childrens perspective – parents pride and joy Even if ownership is equal, management and control will probably not be equal Proper valuation is first step to dividing equitably What if non-business assets are not large enough to give pro rata value to non-active children?
23 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
24 Can the Business Survive the Liquidity Crunch? 1.Estate taxes 2.Living expenses for owners surviving spouse 3.Funding purchases of owners stock under buy–sell agreement 4.Special business needs during transition (such as extra expenses to address uncertainties and anxieties of customers, vendors, lenders, etc.)
25 Can the Business Survive Taxes? Federal estate tax in 2009: $3.5 million exemption in 2009; 45% Rate Federal estate tax in 2010: None, carryover basis applies Federal estate tax in 2011-2012: $5.0 million estate, gift and GST exemption in 2011; $5.12 million in 2012 35% Rate Federal estate tax after 2012 if no legislation: $1.0 million exemption and 55% Top Rate (with 5% extra for some estates) The federal estate tax can be deferred until the second spouses death (with proper use of the marital deduction) In some states (but not Florida), there are state estate taxes in addition to the Federal estate taxes described above.
26 Estate Tax System 1.2012: Estate, Gift and GST Exemption = $5,120,000; Rate is 35% 2.If Congress does not act in 2012, the estate and gift tax exemptions become $1,000,000 on 1/1/13, with a maximum rate of 55% plus a 5% surtax on par of the estate. (The GST exemption is $1.0 million, indexed since 1997) 3.Many planners think Congress will not address the estate tax in 2012, but will do so in 2013. Whenever compromise is reached, it will likely be retroactive to 1/1/13
27 The Bottom Line Excess Net Estate $5,120,000 (in 2012) IS Subject to TAX at 35% rate (in 2012) ITS A HUGE TAX !!
28 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
29 How to Reduce Taxes 1.Transfer planning during life can dramatically reduce the overall transfer taxes. Future appreciation is not subject to estate tax Fractionalization discounts Grantor trusts (grantor pays income taxes so more value removed from estate) $5.12 million gift exemption this year may disappear 2. Every dollar removed from the estate yields a 35% (or more) present value savings to the ultimate bottom line.
30 Estate Tax System 1.2012: Estate, Gift and GST Exemption = $5,120,000; Rate is 35% 2.If Congress does not act in 2012, the estate and gift tax exemptions become $1,000,000 on 1/1/13, with a maximum rate of 55% plus a 5% surtax on par of the estate. (The GST exemption is $1.0 million, indexed since 1997) 3.Many planners think Congress will not address the estate tax in 2012, but will do so in 2013. Whenever compromise is reached, it will likely be retroactive to 1/1/13
31 Reducing Estate TaxesGift Planning Advantage: Individual may wish to transfer assets to children or to trusts for children to reduce estate taxes or (within limits) to shield assets from the individuals creditors. Future appreciation and income from the gift is out of the estate for tax purposes. Annual exclusion: $13,000 (indexed, probably $14,000 next year) per donee per year for present interest gifts. Medical/tuition expense exclusion--for payments of tuition or to a medical care provider paid on behalf of any individual. This exclusion is unlimited in amount. Marital/charitable deduction-A deduction is available for gifts to spouses or to charity. Applicable Exclusion Amount gifts-Gifts that are not excluded or deducted as described above effectively use up part of the donors $5.12 million (in 2012) lifetime applicable exclusion amount.
32 Reducing Estate TaxesGift Planning Excess gifts-Cumulative lifetime gifts (that are not excluded or deducted as described above) over $5,120,000 generate gift taxes at ratio of 35% (in 2012) Income tax effects of gifts-Gifts are not taxable income to the donee. The donee has a carryover basis in the assets equal to the lesser of (1) the donors basis, or (2) fair market value of the property at the date of the gift. Defined value transfers: transfer of set dollar value worth of units to limit gift tax exposure. IRS objects to these clauses. Some cases have recognized them where excess value over dollar value amount passes to charity
33 Reducing Estate Taxes – Gift Planning Case Study #1 Steve, a widower, owns 3,000 acres of property in Florida upon which he runs a large cattle and citrus operation with a total value of $10,000,000. Steves son, Jack, also works in the business and expects to take over the business when his father dies. The property is now very valuable, although it is probably worth less than it was a few years ago. Steve is worried about estate taxes and whether Jack will be able to continue the farm after his death. If Steve does nothing and dies next year (and Congress has not acted) then the first $1,000,000 will be estate tax free and the rest will be subject to estate tax. Estate: $10,000,000Estate Tax in 2013: $4,795,000
34 Reducing Estate Taxes – Gift Planning Case Study #1 Suggestion: Steve transfers his land and business into an LLC which has voting and nonvoting interest: 1% of the interests are voting and 99% are nonvoting. Steve creates an irrevocable grantor dynasty trust for Jack and gifts to the trust nonvoting interest of the LLC that equals $5,120,000 in 2012. Because the gift is of a nonvoting interest and it is not readily marketable, the value of the gift can be discounted. Using a 35% discount on the gift, 79% of the nonvoting interests can be gifted to Jacks trust with no tax. Steve is in control of the business which means that he can increase his salary as need be to provide for his expenses during his lifetime.
35 Reducing Estate Taxes – Gift Planning Case Study #1 Business Steve 79% nonvoting interest No gift tax Allocate GST exemption 79% interest valued as follows: 9,900,000 x.65 = 6,435,000 (35% discount) x 79% = $5,083,650 Farm LLC 1% voting 99% nonvoting Steve Irrevocable Dynasty Trust for Jack and descendants
36 Reducing Estate Taxes – Gift Planning Case Study #1 At Steves death he owns: 21% of Farm LLC nonvoting $2,100,000 using 35% discount is valued at 1,365,000 And 1% voting 100,000 no discount Total Value:$1,465,000 Estate tax in 2013:$ 805,750 Tax if no gift in 2012 $4,795,000 Tax if gift in 2012 805,750 Savings:$3,989,250
37 Reducing Estate Taxes – Gift Planning Case Study #2 Same as above except that Steve has a daughter, Jill, that does not work in the business and Steve wants her to be treated equally with Jack, although, he wants Jack to be in control of the farm when he dies. Instead of transferring all of the business assets to one LLC now Steve creates two LLCs, one that owns the land and another that runs the farm business which leases the land from the first LLC. Steve creates two irrevocable dynasty trusts and gifts 49% of the Farm LLC to Jacks irrevocable trust and gifts as much of the Property LLC as can be gifted with the remaining gift tax exemption to the two irrevocable grantor trusts but gives more of the Property LLC to Jills trust to make up for the gift of the Farm LLC to Jacks Trust. When Steve dies, Steve gives the remaining Farm LLC to Jack and the remaining Property LLC to Jack and Jills trusts, again equalizing for the gift of the Farm LLC to Jack.
38 Reducing Estate Taxes – Gift Planning Case Study #2 Farm LLC Owns cattle, equipment, hires employees Property LLC Owns farmland 100% Steve 100% Steve Jacks Irrevocable Trust Jills Irrevocable Trust 49% of Farm LLC Remainder of $5,120,000 minus value of 49% of Farm LLC – more to Jills Trust to equalize No gift tax Allocate GST exemption to both trusts Lease
39 Reducing Estate Taxes – Gift Planning Case Study #2 Steve dies in 2013, owning 51% of Farm LLC and small percentage of Property LLC, both valued at $1,465,000. Estate Tax is $805,750, same as in case study #1. Jack has control of the Farm business and Jill has a steady stream of income from the lease payments.
40 Reducing Estate Taxes – Gift Planning Case Study #3 Spousal Lifetime Access Trust (SLAT) The facts are the same as in case study #2 except that Steves wife, Lauren, is still alive and Steve is concerned that Lauren will not have sufficient income if she survives him. Hes nervous about giving away all of this value to the trusts for his children. A solution can be to simply add Lauren in as a beneficiary as each of the irrevocable trusts, which would then provide for the Trustee to make distributions to Lauren during her lifetime if she needs funds, but doesnt have to. When Lauren dies the irrevocable trusts are not included in her estate. In addition, instead of leaving Steves remaining estate when he dies to his two children, he would leave it in a marital trust for the benefit of Lauren which would defer the estate tax that would have to be paid on his remaining assets until Laurens later death. Assuming no change in the ultimate value of the assets the estate tax would be the same as above – a savings of almost $4,000,000 and Lauren has access to the gifts.
41 Benefits of GST Exempt Trust (Dynasty Trust) Florida trusts can last for up to 360 years. If allocate GST exemption to irrevocable grantor trust, then trust can continue for many generations avoiding transfer tax (estate, gift and GST taxes) the entire time. In addition to saving transfer tax, the trust is also free from creditors of trust beneficiaries and generally free from a divorce settlement of a trust beneficiary.
42 Reducing Estate Taxes at Death § 2032A Special Use Valuation 1. Qualifying real property (QRP) used in a family farm or closely held business may be valued at its current use instead of its highest and best use 2.The aggregate reduction in the fair market value of the QRP from its highest and best use cannot exceed $1,040,000 for 2012 decedents. This amount is adjusted annually for COLA. Estate tax savings in 2012 = 35% x $1,040,000 = $364,000 3.This reduction is taken against FMV of the property after considering other applicable valuation discounts
43 Reducing Estate Taxes at Death § 2032A Special Use Valuation Qualifications Decedent is a U.S. resident or citizen and property is located in the U.S. Property must be devoted to a farm or farming purposes or in a trade or business QRP must pass to a qualified heir (i.e., spouse; ancestor; lineal descendants of decedent, decedents spouse or decedents parents; spouse of any such lineal descendant) Decedent or family member must have owned the property and materially participated in the business for 5 of the 8 years preceding death Value of real and personal property used in the business must be at least 50% of the adjusted value of the gross estate Value of the real property used in the business must be at least 25% of the adjusted value of the gross estate QRP designated in written agreement consenting to recapture tax.
44 Reducing Estate Taxes at Death § 2032A Special Use Valuation 1.Recapture Tax Some or all of the tax benefits may be recaptured if the QRP is transferred outside the family or ceases to be used as a farm or closely held business during the 10 year period following the decedents death Recapture tax is generally equal to the tax that would have been due had §2032A not been elected Tax is due 6 months after qualified use ends Qualified heir is personally liable for recapture tax 2. IRS will have a lien on a portion of the QRP in an amount equal to the tax savings, unless IRS accepts other security
45 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Survive Taxes? 6.How to Reduce Taxes? 7.How to Pay Taxes? 8.Act
46 Payment of Estate Taxes 1.Estate tax is due 9 months after date of death 2.Can request extension of time to pay estate tax for reasonable cause, such as illiquidity or hardship Extensions for 1 year are almost automatic Additional extensions can be granted, but the IRS may require distributions to beneficiaries or creditor payments be withheld 3.Election to Pay Estate Tax in Installments (§6166) Must qualify Estate can pay interest only for the first 5 years on unpaid tax attributable to a closely held business interest and then principal and interest over the next 10 years
47 Payment of Estate Taxes§6166 Extension 1.Qualifications Decedent must be a U.S. resident Value of decedents interest in a closely held business exceeds 35% of adjusted gross estate 2.Interest in closely held business includes: Interest in a trade or business carried on as a proprietorship Interest in a partnership carrying on a trade or business if the partnership has 45 or fewer partners, or at least 20% of total capital interest is included in the decedents gross estate Interest in a corporation carrying on a trade or business if the corporation has 45 or fewer shareholders or at least 20% of the voting stock is included in the decedents gross estate 3.20% ownership requirements can be met through direct and indirect ownership 4.Interests in 2 or more closely held businesses can be aggregated for purposes of satisfying 35% test if the decedent owns 20% or more of the total value of each business 5. If a §6166 election is made, the IRS will place a lien on §6166 property sufficient to cover the deferred tax and interest
48 Payment of Estate Taxes§6166 Extension 1. Election will terminate and payment of the deferred estate tax will be accelerated upon the occurrence of any of the following: A disposition of any portion of the closely held business interest or a withdrawal of money or property from the business, which, in the aggregate, equals or exceeds 50% of the value of the decedents closely held business interest Failure to timely pay interest or principal 2. Interest Rate on installments: 2% on the tax on the first $1,000,000 (adjusted for inflation) of assets (using the highest marginal rate) 45% of the current underpayment rate for the excess. Current underpayment rate is 3%; 45% of that is 1.35%
49 Business Succession Planning 1.Cash Flow 2.Governance with an Eye to Succession 3.Ownership Transfer 4.Treating Family Equitably 5.Can the Business Service Taxes? 6.How to Reduce Taxes? 7.How to Pay Estate Taxes? 8.Act
50 Business Succession Planning 8. Act Insanity is doing the same thing again and again – and expecting a different result.
Selected Planning Techniques for Business Succession Planning
52 One Way to Start: Family Mission Statement Characteristics: Overriding principles that will not be compromised Unwavering aspiration Achievable Timeless
53 Buy-Sell Agreement Provides purchaser Eliminates friction Prevents hostile third-party shareholders Avoids income, gift and estate tax traps (and there are many) Plans for funding
54 Buy-Sell Agreement: Major Terms 1.Purchaser Entity purchase Purchase by other shareholders / partners Hybrid
55 Buy-Sell Agreement: Major Terms 2.Events Triggering Purchase Death of owner Disability of owner Owners withdrawal from employment Foreclosure Bankruptcy Retirement Sale to third parties
56 Buy-Sell Agreement: Major Terms 3.Funding 4.Payment method (coordinate with funding) 5.Valuation
57 Buy-Sell Agreement: Example Approaches Leave stock equally to children – Buy-sell agreement addresses purchase of stock from children not involved with the business Mandatory purchase for a note at owners death – To provide cash flow for spouse
58 Summary 1.Planning is vital to successful succession 2.Addressing family issues is central to the process 3.Road map for the process: CASH FLOW GOTCHHA 4.Buy-sell agreements
Additional Selected Planning Techniques for Business Succession Planning Appendix
60 Tax Apportionment in Will If business interest is not left equally to all children, estate taxes on the business interest generally should not be borne equally by children.
61 Lifetime Transfers Every dollar removed from estate has 35% present value savings (assuming there is a 35% estate tax) Gift / Sale of non-voting stock Grantor Trusts No gain recognition Parent pays trusts income taxes
62 Grantor Retained Annuity Trust – 6% Growth *Assumes Internal Revenue Code §7520 rate of 1.0%. (The rate for September 2012 is 1%.) ** Assumes trust assets grow at 6% per year. If assets grow at 10%, remainder would be $741,900. Stock $5,000,000 Step 1 Remainder after 2 years: $ 402,215 ** (no gift tax) Step 3 Annuity Step 2 Year 1: $2,307,870 Year 2: $2,769,443 Parent Trust for children GRAT trust value $5,000,000 Amount transferred$5,000,000 Value of annuity 9,999,999* Value of remainder (Gift)1
63 GRAT Advantages Certainty Valuation formula clause No up front gift Transfer all appreciation above low hurdle rate Income tax neutral Annuity payments do not have to be made in cash GRAT assets in excess of a specified amount can be return to parent if desired Can have continuing trust for spouse / children Short term vs. long term – A series of 2-year GRATs is preferable to a single long-term GRAT for a stock portfolio
64 GRAT Disadvantages Actuarial risk – If die before end of trust term, GRAT assets probably included in estate for tax purposes No GST exemption allocation when GRAT is created No valuation formula clause for funding annuity payments with in-kind assets
65 Installment Sales Irrevocable Grantor Trust Child or Trust Parent 1 3 2 Gift (10%) Sell property for note No further gift tax
66 Installment Sale – Partnership or S Corp. Parent To Pay Income Tax IRS Overall Effect: 1. Parent sells interest in partnership or S Corporation to Trust for Note. 2. Note payments can be satisfied (in part or maybe even fully) with distributions to pay income taxes. Irrevocable Grantor Trust Partnership or S Corporation $ $ $
67 Installment Sales to Grantor Trust Summary Requires gift Grantor trust: – No gain on sale if note paid before death – Grantor pays income taxes on trust income (Revenue Ruling 2004-64) Interest only / Balloon note Low interest rate (about 0.84 for 9-year note in September, 2012) Shifts appreciation above interest rate Can be GST exempt
68 Installment Sales to Grantor Trust Summary But No specific code section or regulation Asset value may decline below note, wasting the gift No clear way to have valuation formula clause but some cases have recognized formula clause where excess value passed to charity