Protecting the Business Owner

A client's business is often the largest asset in their estate. Yet, despite spending years growing the business and making it successful, some clients think their business has nothing to do with their estate planning. The payoff of all that hard work is a high-value asset that will support the client during their retirement and provide for their loved ones in the event they pass away unexpectedly. Unfortunately, clients often fail to protect that asset because they neglect to plan for future transitions.

Clients work hard to grow a business, yet fail to implement plans to maintain the value of that business in the event of an unexpected death. While a business have significant value while the business owner is alive, if the strength of that business is the owner, it may have little or no value because of his or her sudden death. It is not enough to have a successful business. Owners must develop employees that are willing and able to take over the business. A buy-sell arrangement can solidify the value and longevity of the business by guaranteeing that key employees are buyers for the business in the event the owner decides to retire, becomes incapacitated or dies. In addition to creating a succession plan, Buy Sell Agreements can help protect the value of the business by requiring that the future owners purchase a life insurance policy on the current owner to guarantee purchase funds are available at death.

It is important that a well-drafted Buy Sell Agreement not only be in place, but that clients update that agreement as appropriate. Often terms that seemed reasonable in the initial agreement fail to reflect events and changes that occur as a business grows. Key provisions of a Buy Sell Agreement should include:

• Triggering events when the buyer must purchase the business, such as death, disability, or retirement. 
• An initial value for the business as well as a method for redetermining that value at the time of sale. 
• Payment terms that are fair to the seller, but are not so onerous to the buyer that there is an eventual default

      We are encouraged to have annual check-ups to maintain our health. We are now engaging some of our business clients in a "business health audit" to determine if all of their business documents are up to date and protect their business value. I would encourage all business owners to consider similar steps with their professionals to protect the biggest value in their estate. Later this week we will discuss how clients protect their business from employees who become competitors, using Non-Compete Clauses/Agreements.

Alan Ferrara

Buy Sell Planning As an Important Part of Estate Planning

When assessing a client's estate planning needs, it is important consider any business interests owned by the client. Business interests are frequently one of the client’s most valuable assets and absent other planning, pass according to the provisions of a client's Will or Living Trust. Unfortunately, often a direct transfer of the business interest to beneficiaries is not optimal for the operation or continuation of that business after the death of the client.

For example, if the surviving spouse or children have not been active in the business, their lack of operational experience can cause reduce the business’ value quickly or even cause the business to collapse completely, rendering it valueless. If the business is a large part of the client's assets and provides a good income stream, this scenario will pose a serious problem for the spouse and minor children if the business is lost. Another potential issue arises when only some, but not all, of the client’s children, are active in the business. If all the children receive equal shares of the business, the non-active children may try to manage the business without knowledge, again causing the value the business to decrease significantly. Alternately, the non-active children may demand the purchase of their interest by the children active in the business, creating substantial cash-flow problems.

However, by engaging in Buy Sell planning it is possible to significantly reduce the likelihood that such problems will arise. Buy Sell planning is also important when the client is not the sole owner of the business. In situations where a portion of the business is owned by a nonfamily member, but the deceased client's interest now goes to beneficiaries a Buy Sell Agreement can protect the nonfamily member and the business from new owners who,

• Have no interest in being a part of the business;
• Want to be part of the business but have no idea how to run it; or
• Are unrealistic about the value of the business.

All of these situations can decrease the value of the business, create cash flow problems if the beneficiaries demand a salary, or simply wish for cash in exchange for their interest.

All of these situations are common, however by executing a Buy Sell Agreement the business owners can proactively limit the chance that a sudden change of circumstance for one owner can bring down an entire business.

The primary benefit of a buy sell agreement is the protection provided to the health of the businesses. A Buy Sell Agreement typically provides that under certain circumstances, one of the parties has the right or obligation to purchase the interest of the other party for whom a triggering event occurred. The agreement typically provides for specific events, such as death, disability, desire to sell, or retirement that trigger the parties’ obligations to one another. Additionally the Buy Sell Agreement provides provisions for determining the value of the business interest and terms for the payment of the price over a fair time span to all the parties. Further, beneficiaries can receive fair value for their business interest over a reasonable period, without adversely affecting the health of the business. It is important to review and update the buy sell agreement periodically as the situation changes.

In circumstances where the potential for conflict exists between siblings or with non-family owners, the parties will "fund" the agreement with life insurance, to be paid in the event of the death of one of the parties. The life insurance proceeds pay the deceased's estate for the deceased’s share of the business and beneficiaries involved in the business operation or the non-family owner are free to run the business without interference. To the extent that the value of the business exceeds life insurance, the Agreement provides for the payment of the remaining value over a reasonable time, with reasonable terms.

I often meet resistance when I discuss a buy sell agreement with some of my business clients. That resistance usually melts away when faced with one of two questions:

1. "Do you want to be partners with your partner's spouse, if your partner passes away?
2. Will your children’s collective efforts result in the continued success of the business?

While client’s may like a partner’s family members, they are generally not interested in being partners with them and when they truly take the time to consider their children’s interests most clients acknowledge that ownership is better passed to particular children.

A business interest is often a large part of a client’s assets. A properly drafted Buy Sell Agreement is important to insure that beneficiaries benefit from that asset in the best possible manner. Having a Buy Sell Agreement allows a client's family to be treated fairly as part of the purchase agreement and allows the remaining parties to continue running the business with no management interference while purchasing the business interest for a fair price and at reasonable terms. This is why any complete discussion of estate planning issues is not complete without addressing the client’s business interests.

Using an LLC in your Estate Plan

While trusts of various kinds are important in estate planning, other entities, standing alone or used in conjunction with trusts, are useful in achieving estate planning goals. One such entity is a Limited Liability Company.

A Limited Liability Company (LLC) is a business entity often used instead of a corporation or partnership. It is a hybrid entity that provides the benefit of limiting liability against personal assets for its owners (just like a corporation) as well as the benefits of being taxed for income tax purposes like a partnership.

By establishing an LLC with a "voting interest" component (typically 1%) and a "non-voting interest" component (99%) clients can give away assets, while maintaining substantial control over the administration of those asset during the client’s lifetime. The client (typically a parent) can keep the voting interest and give part or all of the nonvoting interest to children, grandchildren, or other beneficiaries. By retaining the voting interest, the parent maintains control of the operation of the LLC and the assets owned by it, yet is giving away value and future appreciation on the gift portion to others. I liken this to the client sitting in the front seat driving the car and his beneficiaries sitting in the backseat coming along for the ride. By giving away the majority of the non-voting interest during their lifetime (ideally using their Lifetime Gift Tax Exemption), the client reduces the total value of their estate and any potential Estate Tax liability. Another benefit of using the LLC strategy is a potential reduction in the client’s annual income taxes. If the LLC earns annual income, the LLC allocates that income in proportion to the owned interests. Thus instead of the client paying taxes on all of the income, the beneficiaries pay (presumably in a lower bracket) the tax on their share of the income.

The client can transfer any type of asset to the LLC, including cash. Transferring closely held businesses and real estate to an LLC provides additional planning opportunities:

1.    If structured properly, the LLC can take advantage of valuation discounts for minority interests and lack of control. In addition, assets such as real estate and closely held businesses tend to have a range of value rather than a specific value, and the client can take advantage of the lower range of the value in order to make more gifts under the Annual Gift Tax Exclusion or the Lifetime Exemption. It is important, if an LLC desires to take advantage of these valuation discounts, that a valuation expert determines the assets themselves and the valuation discount.

2.   Using an LLC offers the ability for business succession planning and provides a platform for determining who will operate entities in the future.

3.    An LLC provides protection against creditors, both for the client and the succeeding generations.

4.    The LLC offers an ability to plan for estate liquidity by purchasing life insurance in the LLC on the life of the client to eventually purchase the un-gifted client interests at the client's death or simply to replace the "client's wisdom and experience" with cash at death.

Clients can transfer an LLC interest as a gift to an individual or as a gift to a trust set up for the benefit of the individual. This is especially beneficial if a beneficiary has creditor issues, marital issues that may result in divorce, or spendthrift issues and an inability to control spending habits. In addition, gifting an LLC interest to a trust for the benefit of a minor allows for protection well beyond the minor's 18th birthday. The trust can specifically provide for income and principal distributions for the benefit of the minor with the eventual distribution at stated ages or certain events.

While the concept and use of an LLC for estate planning purposes is well-established, it is subject to IRS attack if not properly valued or if not appropriately established:

1.    The LLC must comply with all state law rules for establishing such an entity and must continue to maintain all the required documents. The LLC must be managed and operated as a separate entity and not just another "pocket of the client".

2.    With an LLC, the concept of "if some is good, more is better" is not necessarily a good idea. Clients should not transfer all of their assets to an LLC, because the IRS will argue that the client needs the LLC to maintain their lifestyle and therefore under estate tax rules the assets are deemed to be part of the client’s estate. Based on case law it is an especially bad idea to place the client's residence in the LLC.

3.    When making gifts, valuations are necessary to substantiate the amount of the gift. To the extent the gift is in excess of the $13,000 annual exclusion, a Gift Tax Return is required.

4.    Certain specific provisions must be included in the LLC to protect its integrity, ensure that gifts will be recognized, and allow gifts to be claimed as a "present gift" using the Annual Exclusion.

Use of an LLC for estate planning purposes is an excellent strategy in the right situation. It may be especially appropriate for any clients still interested in making large gifts before December 31, 2012 to take advantage of the $5,120,000.00 lifetime exemption, which may be going away in 2013. However, before taking any steps to include an LLC in an estate plan, clients should carefully review all tax and legal requirements with qualified professionals.