Planning for Business Owners

In our previous blog we touched on how planning for clients with a variety of assets can be more challenging, or at least provide the opportunity to make use of more interesting planning strategies. One situation where this is especially common is when the client owns a family business. When that is the case, the relationship between the business and the beneficiaries is a lynchpin in the planning.

Michael and Nancy own a series of businesses, originally inherited from Nancy’s parents and then expanded, that over the years have allowed them to provide very well for their three children Oliver, Pam, and Quinn. All three children are now adults with children of their own, and Michael and Nancy have assisted them with funding their grandchildren’s college costs. Pam is very active in the family businesses, ready to step in and take over control whenever her father is ready to retire. While Oliver and Quinn are not involved in the businesses, Oliver has become a successful CPA and is doing well on his own. Quinn on the other hand has struggled to find her way in the world. A recent divorce has left her in a precarious financial and personal situation.

Adding to the complexity of planning for Michael and Nancy is that a section of their business is very reliant on the work on a particular key employee without whom that portion of the business is likely to suffer. The employee also has expressed interest in owning part of the business. While the complexity of this situation cannot be explained in the confines of our normal word limits we will summarize how proper estate planning can be used to ensure that Michael and Nancy can provide for Oliver, Pam, and Quinn equally, address concerns about differing financial states, and avoid creating a competitor.

First, it is important to note that much of the planning for Michael and Nancy’s situation revolves around the use of a document called a Buy-Sell Agreement (Buy Sell). This document creates an obligation for the owners of a business to sell and a particular party to buy the business under certain predetermined circumstances. The Buy Sell will establish the triggering events (often Death, Incapacity, and/or Retirement of the seller), the sale price (or at least how that price will be determined), and the terms for paying the sale price. Depending on the relationship between the buyers and sellers, there may be a life insurance component to the Buy Sell that guarantees there will be funds for some, if not all, of the purchase price.

For Michael and Nancy we used two different Buy Sells to achieve their goals, one with their daughter Pam and one with their key employee. For the key employee the Buy Sell granted an initial sense of ownership in the part of the business in which he was involved, and guaranteed him the right to buy out that portion of the business when Michael and Nancy retired or passed away. The Buy Sell even included incentives to encourage the key employee to improve the business while Michael and Nancy remained the owners, increasing profits in the near term without significantly increasing the final purchase price. This Buy Sell was part of the planning to create sufficient liquid assets to allow Michael and Nancy to make Pam the sole owner of the remainder of the family business while still having assets to leave to Quinn and Oliver.

In addition to the funds from their key employee’s Buy Sell, Michael and Nancy created a Buy Sell with Pam which controlled the transfer of the majority of the remaining family business assets. Michael and Nancy funded this Buy Sell with the proceeds of a Second to Die Life Insurance policy on Michael and Nancy’s lives that provides the business with the funds to buy Michael and Nancy’s interest in the company from their Living Trust, leaving the Trust with liquid assets to distribute to Oliver and Quinn. In lieu of those liquid assets, Pam will receive her parent’s voting interest in the company, giving her complete control of that asset.

Since the liquid assets for Oliver and Quinn will pass through Michael and Nancy’s Living Trust, they were able to provide their Trustee with the discretion to hold distributions to Quinn in trust in the event the Trustee deemed that she needed additional assistance with the large influx of money. While this creates a situation fraught with potential problems because Michael and Nancy named Oliver as the first successor Trustee, the family dynamic between Oliver and his “baby sister” is strong and Michael and Nancy are comfortable with the situation.
This example touches on the simplest use of a Buy Sell and does not address many of the other strategies available to business owners for transferring wealth to their beneficiaries but clearly, the complexity of even this simple plan requires the involvement of other experienced professionals. As always, do not attempt to implement the strategies you read about here without consulting an attorney experienced in the estate planning field.

Matt and Al

Window Closing on Discounts for Intra-family Gifts

We've been quiet for a couple of weeks, something we intend to avoid in the future, however today's blog addresses the Proposed Regulations announced yesterday by the Treasury Department and the IRS with respect to the ability to claim a discounted valuation for Intra-family gifts. If you or your clients are considering transferring partial ownership of a family business on to children it may be beneficial to do so sooner, rather than later.

In previous blogs we discussed the strategy of using a Family Limited Partnership or Family L.L.C. to transfer interests in either family owned businesses or other types of assets, such as real estate, to children while allowing parents to retaining control of the entity during their lifetime. A major benefit of such transfers is the ability of the parent to claim a significant discount in the valuation of the transferred assets for the purposes of Gift Tax liability. On Tuesday August 2, 2016, the Treasury Department and the Internal Revenue Service announced Proposed Regulations that address this strategy and, if put into effect as written, will significantly reduce the ability of family business owners to take advantage of this strategy.

Under current regulations, it is possible for a parent to transfer interests in a family business to the other family members while retaining operational control of those businesses. The transferred interest does not contain voting rights and specifically indicates that the family member does not have the right to sell or otherwise alienate the interest. The lack of control over the operation of the business and inability to sell the interest reduces the value of the interest and allows for a discount in the value for purposes of gifting. This discount allows the client to transfer a greater value of assets to their loved ones at a lesser cost for gift tax purposes. When it has challenged transfers of this nature in court, the IRS has consistently argued against the size of the discounts. 

The Proposed Regulations generally provide that if a parent transfers an interest in a corporation that the parent controls to any other member of the family any "applicable restriction" shall be disregarded in valuing the transferred interest. The Internal Revenue Code defines “applicable restriction” as “any restriction that effectively limits the ability of the entity to liquidate, but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or any member of the transferor’s family, either alone or collectively.” In plain English, the Proposed Regulation provides that if a parent transfers an interest in a family owned business to their child with the restriction that the child cannot alienate their interest in the business without the parent’s permission, that restriction is ignored for purposes of valuing the transferred interest. The removal of such restrictions from consideration in valuing the interests transferred will have a significant impact on the strategy of transferring interests in family owned businesses.

While the Proposed Regulations will significantly limit the valuation discount available to clients when making transfers of family-owned businesses, it does not entirely eliminate the benefits of such transfers. Until these regulations go into effect and are tested in real-world situations, it is unclear what level of discount the IRS will argue is reasonable with respect to other restrictions placed on interests transferred to children that do not relate to the child's ability to alienate the interest. Additionally the strategy of transferring minority or non-controlling interests in family businesses to children is still very beneficial, especially when those business interests contain assets that are likely to appreciate significantly in coming years. Such transfers are also still relevant in the context of succession planning for family businesses, as an equity interest in the family business is often necessary to ensure that future generations are fully invested in the operation of that business before they are given control of the company.

There is still an opportunity to take advantage of the valuation discount, but the window for doing so may be closing. Before these Proposed Regulations can go into effect they must first go through a 90-day public comment period, after which there may be changes, but even if there are no changes, portions of the regulations will not take effect until 30 days after the government issues a final version of the regulations.

The strategy of using a Family L.L.C. to obtain a discount in the valuation of assets transferred to children is a complex legal strategy that business owners should not attempt without consulting an attorney and accountant who are familiar with the process. Avoiding significant issues with the IRS in implementing this strategy requires sound valuations of the business and working with advisors familiar with the process of justifying such valuations. If you have additional questions, concerns, or interest in discussing whether this strategy may be appropriate for your circumstances, or the circumstances of one of your clients, we encourage you to contact us quickly, as the time available to take advantage of this strategy is very limited.

Alan and Matt

Protecting Business Assets Through Buy-Sell Planning

In our last few blogs, we have discussed issues that arise following the death of a spouse. A significant concern for surviving spouses during this time is the impact of the death on the operation of a family business, especially when that business is a primary source of income.  This can be an especially thorny problem for the surviving spouse if they were not active in the operation of the business, because they may then be at the mercy of key employees, business partners, or even family members whose interests are very different from their own. The possibility of a surviving spouse facing this situation is the best reason for a business owner to consider Buy-Sell planning. 

    

     Business interests are frequently one of a client’s most valuable assets, so it is important to consider how to handle such assets following the client’s death. A direct transfer of the business interest to a surviving spouse or children, according to the provisions of a client's Will or Living Trust, has the potential to cripple the operation of the business and significantly reduce its value especially if the surviving spouse or children have not been active in the business. Lack of operational experience, conflicts with staff and business partners, or lack of interest in running a business can all reduce the business’ value quickly or even cause the business to collapse completely, rendering it valueless. This is where a well-drafted Buy-Sell Agreement can assist in making a smooth transition following the client’s death 

     The purpose of a Buy-Sell Agreement is to establish how business interests transfer following the death of a business owner. Buy-Sell Agreements can be made between co-owners, between parents and children, and even between a business owner and their key employees. Typically, a Buy-Sell Agreement provides that 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 also defines what constitutes a “triggering” event, including death, disability, desire to sell, or retirement, to eliminate questions about when a party’s obligation arises. Additionally the Agreement provides a method for determining the value of the business interest and the terms for the payment of the sale price over a time span fair to all the parties. This ensures that following a death, the people active in the operation of the business know what will happen, allowing them to continue operations uninterrupted, and maintain the value of the company. 

     Often the parties to the Buy-Sell Agreement purchase insurance on the life of the business owners in order to provide funds for the purchase of that owner’s interest at their death. This is especially useful when there are non-family co-owners who may be put in an untenable business situation if the family members have no interest or knowledge in running the business, or want cash now and are unrealistic about the real value of the business. Life insurance proceeds can also be used to ensure that surviving spouses, or other children, receive fair value for the business when only some of the client’s children are active in operations. This allows the active-children to continue running things, without worrying about their surviving parent’s welfare or non-active siblings creating problems with the operation of the business. 

     A well drafted Buy-Sell Agreement takes into account the myriad of unexpected circumstances that may arise following the death of a business owner and attempts to foster a situation where that death has a minimal impact on operations. This allows survivors to either continue operating the business as usual or easily transition of ownership of the business, for a fair price, to those people the client chose as the next owners. 

     As always, it is important to remember that engaging in business planning should not be done without having good advice. A Buy-Sell Agreement is a binding legal contract and thus it is important to discuss Buy-Sell planning with an experienced attorney who can explain the substantial operational, tax, and planning impacts that the Agreement imposes on a client’s business.

Using LLCs to Expand Lifetime Gifting

So far, our discussion regarding the use of gifting an estate plan has revolved primarily around cash gifts, it is important to understand that gifts can consist of any type of property, including interests in real estate and business entities. A family owned Limited Liability Company is an excellent tool for transferring a variety of assets from one generation to the next, often at a reduced value, while allowing parents to retain control of the assets during their lifetime.

     While the use of cash gifts provides clients with a tool for reducing their potential estate tax liability, clients may be able to gain greater benefits through by using a Limited Liability Company (LLC) in their estate planning. The client can establish an LLC with two classes of Membership Interest, voting and nonvoting, and can retain control over assets by keeping the voting interests and gifting the nonvoting interests to beneficiaries..

     To make use of this gifting strategy, clients first establish a LLC (or modify an existing LLC) with a 1% Voting Member Interest and a 99% Nonvoting Member Interest. This allows the owner of the 1% Voting Member Interest to control the company regardless of who owns the 99% Nonvoting Member Interest. Clients then transfer ownership of other assets, such as real estate or business interests, to the LLC. Now the client is able to make gifts of the Nonvoting Member Interest, without giving up control of the assets. This allows clients to begin transferring highly appreciating assets during their lifetime, reducing any potential estate tax liability because the appreciation of the assets is now out of the Estate, and providing a potential source of income to their loved ones. Clients can transfer these  Nonvoting Member Interests in the LLC using either their lifetime estate exemption and/or their annual gift tax exemption, further reducing potential tax liability. These nonvoting member interests can be given to adult children as well as minor children and grandchildren, with trust holding the interest for these minors. These trusts can then be used to provide funds for education for the minors as income is distributed from the LLCs

     Another benefit of including an LLC in an estate plan is the potential to receive a valuation discount when making gifts of Nonvoting Member Interests. The IRS recognizes that a member interest in an LLC which does not allow the owner control over the company and which restricts the owner's ability to sell or transfer the member interest has less value than an unrestricted interest. Thus, a properly structured LLC may allow clients to transfer larger portions of the Nonvoting Member Interest as part of an annual gifting plan. While using an LLC in this manner is a well-established practice, it is important to acknowledge that without proper appraisals and planning, and such transfers may be subject to IRS scrutiny.

     In order to comply with the law and IRS regulations is important to manage and operate the family-owned LLC as a separate entity, and not just an extension of the client’s own affairs. The LLC should not contain all of the client assets, especially not the client’s residence, because the IRS argues that the LLC is necessary to maintain the client’s lifestyle and therefore, under estate tax rules, the IRS may deem the LLC's assets part of the client’s estate.

     For many clients the use of an LLC as part of their estate planning is an excellent strategy to increase the value of annual gifting. It is also an excellent tool for transferring ownership of family-run businesses to the next generation while ensuring that the clients retain control of the business operation. It is important to remember that this is a complex planning technique that clients should not attempt without consulting qualified professionals for assistance in reviewing the tax and legal implications.

Using Non-Compete Clauses to Protect the Value of Business Assets

On Tuesday, we discussed how a Buy Sell Agreement keeps the value of a client’s business, frequently their most valuable asset, from evaporating following the owner’s death. While many business owners prepare for physical disasters though the use of insurance and some prepare for ownership transitions with Buy Sell Agreements, most fail to protect their business from a trusted employee who leaves to start a competing business.

Well-drafted, up to date, Non-Compete Agreements (or Non-Compete Clauses in Employment Agreements) can protect the business owner from losing valuable trained employees to competing ventures, but such documents must be narrowly tailored in order to be effective. While the courts enforce contractual agreements, there is a reluctance to enforce agreements when the employer does not compensate the employee in some manner for accepting the Non-Compete Agreement or where the restriction on competition is unreasonably broad.

Fortunately, acceptable compensation for assenting to a Non-Compete Clause/Agreement includes promotion to a new position or access to new information regarding the operation of a particular business. This allows the business owner to implement a Non-Compete Agreement with a small group of key employees whom the owner sees as potential successors without the worry that one of them will then leave to start a competing business.

In addition to requiring compensation to enforce a Non-Compete Agreement, the agreement must not be so broad as to restrict the employee from making a living. The breadth of restriction applies both to geography and to length of time. This means that an agreement that bars working in a similar business within thirty miles of an existing employer for two years is likely enforceable, while an agreement barring employment in a whole industry for ten years will likely be overturned. It is important that the agreement balance the scope of restriction against the time the business needs to recover from the employee’s departure. When considering whether to enforce a Non-Compete Clause courts also examine whether the clause serves a legitimate business purpose or appears to be purely punitive to limit the employee's ability to make a living.

Unfortunately, all too frequently employers only come to us after an employee leaves a business. The owner will want to stop the employee from using key business information, such as processes, client lists, or technological developments to compete in the absence of a Non-Compete Agreement. While Michigan law will protect the "trade secrets" of a business to a certain extent, only properly drafted documents before a problem arises will maximize that protection.

Our clients work hard to build valuable assets they hope will provide for them and their loved ones far into the future. It is important for us as advisors to work with our clients to protect their investment in the company during their ownership as well as establish a plan that provides the client, or their loved ones, with a smooth transition to new owners to best maintain the value of the business. 

Matt Ferrara