The Three Levels of Business Succession Planning

1. The Three Levels of Business Succession Planning Sponsored by: Tuesday, May 17, 2016 Greensboro, North Carolina Presented by: Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver Road, 10th Floor Troy, Michigan 48084 (248) 457-7200 jhg@disinherit-irs.com www.disinherit-irs.com

2. Wealth Transfer Strategies Over Lifetime Annually Transfer of wealthexcluded fromany gift tax Transfer of wealththrough GST, estate,and gift tax exemptions Transfer of wealth utilizing discount strategies Transfer of wealth utilizing freeze strategies(appreciation-only gifts) Transfer of wealththroughtaxable gifts • $14,000 per individual ($28,000 gift splitting with spouse) per donee • Direct payments to educational institutions and health care providers1 • Irrevocable life insurance trusts (ILIT)2 • Gift tax exemption of up to $5.45M per individual3 • GST and estate tax exemptions of $5.45M per individual3 • Generation-skipping transfer trust (GST) • Family limited partnership (FLP) • Family limited liability company (FLLC) • Non-voting shares in family corporation (C or S corporation) • Grantor retained annuity trust (GRAT) • Intentionally defective grantor trust (IDGT) • Qualified personal residence trust (QPRT) • Intra-family loan • Statutory freeze partnership (FLP or FLLC)4 • Pay gift tax now rather than paying estate tax later • Converting traditional IRA to Roth IRA5 Charitable planning: CRTs and CLTs. 1 To qualify for exclusion, gifts of tuition and medical expenses must be made directly to the provider. 2 Often can be structured to use annual exclusion gifting. 3 Adjusted annually for inflation ($5.45M for 2016). 4 Can serve to both utilize discount and transfer wealth utilizing freeze strategies. 5 Paying the income tax in converting a traditional IRA to a Roth IRA is essentially a tax-free gift. 2

3. CaseStudy John James is the founder, president and sole owner of JJ Enterprises, Inc. (JJ), a successful manufacturer of machine tools. John is 65 years old. His wife Mary is also 65. JJ has two key executives. 3

4. CaseStudy • Their son, Bradley (age 35) is vice president of marketing at JJ. • Aspires to succeed John as president and controlling owner. • John generally concurs, but has concerns about Bradley’s wife. • John and Mary have another son, Blaze (age 30), who is not and does not want to be involved in the business. • Bradley has two minor children; and Blaze has three minor children. 4

5. CaseStudy • JJ is worth $10M to the right buyer. • John’s annual salary and bonus is $300K. • JJ is an S corporation with taxable income averaging $1M over the last four years. • JJ has a profit-sharing plan. • No equity or nonqualified retirement plans for key executives. • No other retention plans for key executives. 5

6. CaseStudy John and Mary own the business real estate, which has an estimated value of $5M. They own it jointly to avoid probate. Their residence and vacation homes are valued at $2M and $1.5M and are owned jointly. The mortgages have been paid off. John and Mary have personal investments of $1.5M, most owned jointly. John has a $5M life insurance policy owned by an irrevocable life insurance trust (ILIT). 6

7. CaseStudy John’s profit-sharing account is $1M; Mary is the beneficiary, and Bradley and Blaze are the contingent beneficiaries. John and Mary have pour-over wills, living trusts with the usual “A/B” structure, powers of attorney, healthcare directives, and John has an ILIT. 7

8. John & Mary’s Balance Sheet Value Residence (Joint) $2,000,000 Vacation Home (Joint) $1,500,000 Business (S corp) (John) $10,000,000 Building (Joint) $5,000,000 Non-Qualified Investments (Joint) $1,500,000 Profit-Sharing Plan (John) $1,000,000 Life Insurance (ILIT) ($5,000,000) Gross Estate $21,000,000 1 2 1 Cost basis of $500,000; assume 10% distributions and 4% principal appreciation. Annual renewal term policy. 2 8

9. John & Mary’s Objectives • Retain control of the S corporation until John’s death, disability or retirement. • Pass the entire business to Bradley at John’s death. • Retain the two key employees to assist in the transition period. • Treat both sons fairly, if not equally. • Guarantee retirement income (which may have to come from the business). • Reduce or eliminate estate taxes. 9

10. Projected Estate Tax Liability in 2031 No federal estate taxes at first death Current Net Estate $44,000,000 Life Insurance $ 5,000,000 Total Estate $49,000,000 ILIT$5,000,000 By-Pass Trust $6,000,000 Marital Trust / Surviving Spouse $38,000,000 After-Tax Estate $28,850,000 Federal Taxes $15,200,000 Distribution to Heirs After-Tax Estate $22,800,000 By-Pass Trust 6,000,000ILIT 5,000,000 Total $33,800,000 Distribution to Family: 69% Assumes 4% after-tax growth through 2031. Assumes the estate tax exemption is $6M and the estate tax rate is 40%. 10

11. Options to Pay the Estate Tax if John & Mary Do Nothing • Liquid assets in estate. • IRC Section 303 (redemption of stock to pay death taxes). • IRC Section 6166 (5-year deferral; 10-year installment payment of estate tax). • Irrevocable Life Insurance Trust. • Discounted dollars. • Can purchase assets from estate. • Can loan monies to estate. 11

12. Sources of Liquidity to Pay Estate Taxes • Cash accounts of the deceased (checking, savings, etc.). • If in sole name of deceased – frozen by bank and subject to probate. • If titled as joint tenants with rights of survivorship, then available to surviving heir and can be used for liquidity needs. 12

13. Sources of Liquidity to Pay Estate Taxes • Sale of highly liquid assets (stock and bonds) can provide liquidity for estate. • Issues with taxable basis for estate. • Typically sold at fair market value. 13

14. Sources of Liquidity to Pay Estate Taxes • Sale of non-marketable assets. • Quick sale may be well below fair market value, thereby reducing estate. • Past and potential appreciation of asset important. • Tax Advantage Accounts. • “Cashing In” tax deferred accounts usually triggers a tax. • Taxes are incurred upon “withdrawing” funds. • Taxes may be postponed if account is distributed to spouse and/or heirs who pay as they withdraw. 14

15. IRC Section 303 • Redemption of closely-held stock. • Sell stock back to corporation (treasury stock purchased by corporation). • General rule: Proceeds treated as “dividend” and taxable to estate. 15

16. IRC Section 303 • Exception to general rule (IRC Section 303). • Stock’s value must exceed 35% of the adjusted gross estate, and redemption must occur within four (4) years of shareholder’s death. • Treated as capital gain, which can be offset by the shareholder’s stepped-up basis in the stock. • Limited to sum of state and federal death taxes, costs of estate administration, and funeral expenses. 16

17. IRC Section 303 • Advantages of a Section 303 redemption funded by corporate owned life insurance (“COLI”) on the shareholder’s life: • Keeps the family business in the family. • Heirs are assured of funds to pay estate settlement costs. • Corporate dollars can be used to make a tax favored redemption. • For C corporations, COLI may be subject to the alternative minimum tax unless the business qualifies as a “small business corporation”. IRC Section 55(e). 17

18. Section 303 RedemptionDuring John’s Lifetime Insurance Company Pays Premiums JJ Enterprises Obtains Life Insurance John If stock interest is more than 35% of adjusted gross estate, the estate will qualify for a partial redemption. Insured 18

19. Section 303 RedemptionAt John’s Death Insurance Company Pays Death Benefits JJ Enterprises Cash John • Partial redemption is not treated as a dividend. • Family continues to retain an ownership interest. Stock Transferred Some Stock John’s Living Trust 19

20. IRC Section 6166 • Section 6166 – For closely-held business. • Business interest must be at least 35% of the adjusted gross estate. • Estate must elect Section 6166 on a timely-filed estate tax return (Form 706). • Election only applies to the FET due on the proportional value of the business. • Decedent must be U.S. resident. 20

21. IRC Section 6166 • Interest only for 5 years and then 10 equal annual installments after the deferral (14 years to pay). • Installment payments include interest expense at: • 2% compounded daily on the first $588,000 of tax deferred (for 2016); and • At 45% of the current regular tax underpayment rate on the balance of the tax deferred. • Interest expense is not deductible. 21

22. IRC Section 6166 • 20% ownership requirements can be met through direct and indirect ownership. • 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. • If a Section 6166 election is made, the IRS will place a lien on Section 6166 property sufficient to cover the deferred tax and interest. 22

23. IRC Section 6166 • “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 decedent’s 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 decedent’s gross estate. 23

24. IRC Section 6166 • 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 decedent’s closely-held business interest. • Failure to timely pay interest or principal. 24

25. Life Insurance

26. Life Insurance • Basis Step-Up. • An ILIT can be used to pay the FET on assets held until death to obtain a basis step-up. • Liquidity. • An ILIT can be used to provide estate liquidity to avoid forced asset sales. • Family Harmony. • Life insurance can be used to provide for a second spouse or children from a prior marriage. • Life insurance can be used as an equalization tool for those children not active in the business. 26

27. Life Insurance • Private Pension. • Cash values can be accessed income tax free through loans or withdrawals up to basis. • Flexibility. • Policies can be transferred between grantor trusts without triggering the transfer-for-value rule. • Premiums for policies held in an ILIT can be paid with annual exclusion gifts, the grantor’s gift tax exemption, premium financing, split-dollar arrangements, and/or with income-producing assets held in the ILIT. 27

28. Life Insurance • Freeze Planning. • An ILIT can be used as a hedge in case of a premature death in connection with a GRAT or QPRT. • Excess cash flow in connection with an installment sale to an IDGT can be used to purchase life insurance to “leverage” the grantor’s GST exemption. 28

29. Life Insurance • Life Insurance Policies – generally distributed outside of estate if held by an ILIT. • Discounted dollars. • Proceeds can be used to purchase assets from, or loan funds to, business owner’s estate. 29

30. Life Insurance How much is John willing to spend on life insurance? Term insurance will be less expensive than permanent insurance in the short run. But should consider permanent insurance for a permanent need. Who will be the insured – John, Mary, or both? To protect Mary, John should be the insured. For estate liquidity or equalization for Blaze, Mary could be the insured (assuming she has the longer life expectancy), or a survivorship policy could be used. 30

31. Who will be the policy owner and beneficiary? Given the size of the estate, an irrevocable life insurance trust should be the owner and beneficiary. Who will pay the premiums and under what type of arrangement? Gifts from John and Mary using their $28,000 annual gift tax exclusions per child / grandchild. Loan regime split-dollar with the Corporation. Life Insurance 31

32. The Three Levels of Business Succession Planning

33. The Three Levels of Business Succession Planning • Selecting Management and Retaining Key Employees. • Transitioning Ownership and Securing Retirement for the Founders. • Selecting a Transfer Strategy to Minimize Gift and Estate Taxes. 33

34. Selecting Management and Retaining Key Employees • Will Bradley be ready to manage the business upon John’s death, disability or retirement? • If not, what options are available to retain the two key employees during the transition period: • Employment agreements with profit-sharing provisions. • Stock option plans (but this dilutes the family’s equity). • Change of control agreements. • Non-qualified deferred compensation (NQDC) plans. 34

35. Non-Qualified Deferred Compensation (“NQDC”)

36. Overview: If executive remains a general unsecured creditor of the employer, the amounts deferred are not subject to taxation. The amounts distributed will be ordinary income to the executive and deductible by the employer at the time of payment (not the time of deferral like qualified plans). This is particularly important to discuss with S corps, like JJ. NQDC 36

37. NQDC • Overview (cont.): • The group of employees covered by the plan must be a select group of management or highly-compensated employees. • The employer’s obligation to make benefit payments may not extend beyond a simple unsecured promise to pay money at some time in the future. 37

38. NQDC • Overview (cont.): • The plan must be “unfunded” for executives to achieve tax deferral on plan contributions. • The plan is “unfunded” if all plan assets are paid from the general assets of the employer, which remain subject to the claims of the employer’s general creditors. 38

39. NQDC • Overview (cont.): • Accountant should decide whether or not plan benefits are material and, if they are, which accounting method should be used (APB12 or FASB 87). • Must notify the Department of Labor of the plan’s existence. 39

40. NQDC • Potential advantages: • Rewards a select group of highly-compensated employees or management employees. • Supplements existing retirement programs. • Allows executives to defer taxes on contributions. • Provides “golden handcuffs” to retain key employees. • Introduces a plan exempt from Title 1 under ERISA. • Gives the employer control over plan benefits. 40

41. NQDC • Potential disadvantages: • Subject to IRC Section 409A rules. • Benefits subject to ordinary income taxes. • Funding asset is subject to claims of employer’s creditors. • Timing of payments must be “fixed” when plan is adopted; no flexibility. 41

42. NQDC • Plan Design Options. • Type of plan (Defined Benefit or Defined Contribution or Phantom Stock). • Type of payout (lump sum or annuity). • Benefit for surviving spouse? • 100% vesting for change in control or termination without cause? • Reasonable compensation. • Impact on the value of the business and lenders. • Funding. • Section 409A requirements. 42

43. NQDC • Distributions can only be made upon one of six circumstance (IRC Section 409A): • Separation of service. • Disability. • Death. • Fixed time specified in plan. • Change in control. • Unforeseen emergency. • No haircuts. 43

44. NQDC • Funding Options. • Pay-as-you-go: • Benefits are paid from the general assets of the employer, so employer maintains use of funds. • But executive is at risk for payment. • Sinking fund: • Plan assets are placed in a designated account or fund (with after-tax dollars). • Employer controls, but at least there is an identifiable asset for satisfaction of future liabilities, subject to risks. • Requires time to accumulate funds. 44

45. NQDC • Funding Options (cont.) • Business Owned Life Insurance (BOLI); • Employer is owner, beneficiary and premium payer of policies on the key executives. • Premium is not deductible, but generally: • Cash value builds on tax-deferred basis. • Cash value can be accessed on tax-free basis (if done properly). • Death benefit is not taxable when received by the company (but C corporations are subject to a 15% AMT). 45

46. NQDC • Use Life Insurance for Plan Security: • An executive depends on the employer’s unsecured and unfunded contractual promise to pay the future benefit. • The purchase of BOLI to “informally” fund the NQDC plan will make the executive more confident that the future obligation will be met. 46

47. NQDC • Use Life Insurance for Plan Security (cont.): • Allows the plan to make payments to an executive who is disabled prior to retirement. • Allows the plan to make payments to a named beneficiary in the event of the death of the executive. • Life insurance plan may provide contractual guarantees that give added security to the deferred arrangement. • Life insurance provides for cost recovery for employer. 47

48. NQDC • Use Life Insurance for Plan Security (cont.): • The life insurance policy should be a permanent policy for several reasons: • Cash values that can be accessed to help the employer pay retirement or disability benefits. • The cash value growth avoids current income taxation. • Assures that death benefits will be available to enable the employer to recover costs even if the executive lives for many years after retirement. 48

49. NQDC • Rabbi Trust: • A “Rabbi Trust” may be used to prevent assets under the plan from being threatened by changes in the employer’s ownership or management. • The funds in the trust are still subject to the employer’s creditors, but not for other business uses. 49

50. JJ purchases life insurance to “informally” fund benefits. 2 Asset values help pay benefits and/or recover costs. 3 Benefits are paid based on contractual specifications. 4 NQDC 2 JJEnterprises Insurance Company 3 1 4 Key Employees JJ promises to provide a death, disability or retirement benefit. 1 50