Business Succession Planning Morgan Stanley Smith Barney LLC. Member SIPC

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1 2011 Morgan Stanley Smith Barney LLC. Member SIPC 2011-PS-541 Expires: February 2012 Date of First Use: February 2011 Updated/Reviewed: February 2011

2 Overview Why Succession Planning is Important Common Concerns and Goals of Business Owners Planning and Operational Needs of a Business Common Business Structures Factors in Developing a Successful Succession Plan Owner Options for Transferring a Business during Life Strategies for Transitioning the Business at Death or Disability Valuation of a Business Federal Estate and Gift Taxes 2

3 Why is Succession Planning Important? Family companies are responsible for 78% of new jobs created. 1 Family businesses in the U.S. generate approximately 50% of the GDP and employ approximately 60% of the U.S. workforce 2 Approximately 40% of the family companies that will transition within the next five years have no succession plan in place 3 1,2 Gaebler.com; Blueprintforbiz.com;

4 Why is Succession Planning Important? Seven out of 10 new employer firms survive at least 2 years Half at least 5 years A third at least 10 years A quarter stay in business 15 years or more

5 Common Concerns and Goals of Business Owners 1. Family Harmony 2. Preserving the Business 3. Financial Security for Retirement 4. Financial Security for Younger Family Members 5. Reducing Taxes 5

6 Planning and Operational Needs of a Business Ownership and Management Active involvement Inactive Involvement Liquidity Valuation 6

7 Planning and Operational Need of a Business (cont d) Ownership and Management Active involvement Inactive Involvement Liquidity Valuation 7

8 Planning and Operational Needs of a Business (cont d) Asset Protection General concerns include protection against creditors and liability claims. Continuation or Succession Key questions include how and when does a business owner want to transition out of the business. Choices include: Sale to a third party, to business partners, to employees Gift or sale to family members 8

9 Planning and Operational Needs of a Business Appropriate Business Structure Typical structures include: Sole-proprietorships Partnerships Family Limited Partnerships (FLP) Limited Liability Companies (LLC) C-Corporations and S-Corporations 9

10 Common Business Structures Sole Proprietorships A sole proprietorship is the simplest and most common form of business structure. Unlike business entities designed to provide owners with limited liability and creditor protection; a sole proprietorship does not afford its owner with such protection. For income tax purposes, the owner pays personal income taxes on the profits of the sole proprietorship; there is no double taxation as with certain corporate entities. 10

11 Common Business Structures (cont d) Partnerships: Family Limited Partnership (FLP) A FLP is a partnership established under state law, typically, by and between two or more family members. The income realized by the FLP flows through to the individual partners. There are two types of FLP partners: General Partner Limited Partner 11

12 Common Business Structures (cont d) Partnerships (continued) Limited Liability Partnership (LLP) A partnership that also has limited liability characteristics similar to a corporation. All LLP partners have the right to manage the business entity. All LLP partners have a form of limited liability. For tax purposes, LLPs allow for pass-through taxation. Typically designed for members of specific professions (e.g. attorneys, accountants, architects). 12

13 Common Business Structures (cont d) Limited Liability Company (LLC) A business entity offering limited liability to all of its owners (i.e. members). An LLC with multiple members may choose to be treated for federal income tax purposes as a partnership, as a C-Corporation, or as an S-Corporation. An LLC can elect to be managed by its members or by a manager. 13

14 Common Business Structures (cont d) Corporations C-Corporation Legal business entity, authorized under State law, separate from its ownershareholders. Provides its owner-shareholders protection against personal liability. Management, and not the shareholders, oversees the day-to-day operations and affairs of the corporation. Typically, no limit on the number of shareholders. In certain circumstances, corporate profits can be subject to double taxation. 14

15 Common Business Structures (cont d) Corporations (cont d) S-Corporation A corporate business entity, authorized under State law, which may provide its owner-shareholders with protection against the corporation s debts and creditors of the company. Management oversees the day-to-day operations and affairs of the corporation. Can elect special tax treatment that may avoid double taxation of the company s profits. 15

16 Common Business Structures (cont d) Entity Comparison Table Entity Characteristics Sole Proprietorship Family Limited Partnership (FLP) Limited Liability Partnership (LLP) Limited Liability Company (LLC) S-Corporation (S- Corp.) C-Corporation (C-Corp.) # of Owners One Unlimited Unlimited Unlimited Up to 100 Unlimited Liability to Parties Involved Unlimited liability Unlimited for general partners. Limited partners are not personally liable for debts of FLP. None of the partners are personally liable for debts of LLP. No personal liability for any of the members. Shareholders typically not personally responsible for debts of corporation. Shareholders typically not personally responsible for debts of corporation. Entity Management Characteristics Sole proprietor is the manager and operator. General partner(s) responsible for management of FLP. All LLP partners have the right to manage the business entity. An LLC can elect to be managed by its members or by a manager. An S-Corp. is managed by the officers and the board of directors. A C-Corp. is managed by the officers and the board of directors. Taxation Issues Sole proprietor pays taxes in the form of income taxes. Partners pay taxes on their share of the income and deduct losses against other sources of income. Partners pay taxes on their share of the income and deduct losses against other sources of income. Members can elect to be taxed as a corporation or as a partnership. Taxes are paid on an individual income tax level by the shareholders. The C-Corp. is taxed as well as the individual shareholders. Taxation Method Income tax on the sole proprietor. Income tax on partner s share of partnership income. Income tax on partner s share of partnership income. Can elect taxation method. Typically no tax on the company level. Typically no tax on the company level. Profits subject to double taxation. 16

17 Things to Consider When Developing a Succession Plan Will the Owner sell or transfer the business while living or have it transfer after death? Are the children interested? How will ownership be divided among the children? Which child will manage the business? If there are no children active in the business, who will manage? If there are no children, to whom will the business be sold? 17

18 Transferring a Business during Owner s Lifetime Sale or Gift to Family Members Installment Sale Sale of stock in the business at a gain, where at least one payment is to be received after the year of sale. Each installment payment includes a return of basis, capital gain, and interest. Allows for payment in installments over an extended period of time. If the Seller dies before full payment, the balance on the note is included in the Seller s estate. 18

19 Transferring a Business during Owner s Lifetime (cont d) Sale or Gift to Family Members (cont d) Intentionally Defective Irrevocable Trust (IDIT) Sale of appreciating property to a trust that is irrevocable for transfer tax purposes, but is defective for income tax purposes. Grantor sells the property to the IDIT, usually in exchange for a promissory note at fair market value. The note usually bears interest at an Applicable Federal Rate (AFR) Repayment period is usually within the Grantor s actuarial life expectancy. 19

20 Transferring a Business during Owner s Lifetime (cont d) Sale or Gift to Family Members (cont d) Self-Canceling Installment Note (SCIN) An installment sale with a note that is cancelled if the seller dies before receiving full payment. To compensate for risk of the note s cancellation, the SCIN must include a premium either on the sales price or interest rate on the note. A SCIN may be exchanged for property sold to an IDIT. 20

21 Transferring a Business during Owner s Lifetime (cont d) Sale or Gift to Family Members (cont d) Grantor Retained Annuity Trust (GRAT) Gift of property to an irrevocable trust Grantor retains an annuity payment for a specified term of years. Gift is discounted to the value of the remainder interest Appreciation may be excluded from Grantor s estate. Should the grantor die prior to the expiration of the GRAT term, a portion of the property s value may be included in the grantor s estate. 21

22 Transferring a Business during Owner s Lifetime (cont d) Sale or Gift to Family Members (cont d) The Use of a FLP or LLC to Transfer Interests in the Business FLP or a LLC may protect personal assets from potential creditors of the business. FLP and LLC interests also may be gifted to heirs, possibly, at discounted values, for gift-tax purposes. Discounts for lack of control and lack of marketability 22

23 Transferring a Business during Owner s Lifetime (cont d) Sale or Gift to Family Members (cont d) Gifting non-voting shares or interests in the Business (S- or C-Corporation) When gifting interests in a business, typically, the owner will want to maintain control over the business. One way to accomplish this is to create two classes of stock (i.e. voting and non-voting stock). 23

24 Transferring a Business during Owner s Lifetime (cont d) Sale to Employee Stock Ownership Plan (ESOP) Owner of a C-Corporation can sell stock to an ESOP under IRC 1042 Must be a domestic ( C ) corporation; Has no stock outstanding that is readily tradable on an established securities market; and Owner must have held the stock for at least three years prior to sale. Can defer capital gain if the ESOP; owns at least 30% of stock after sale and reinvests proceeds in qualified replacement property. 24

25 Transferring a Business during Owner s Lifetime (cont d) Third-Party Sale Taxable sale of incorporated business Stock Sale: Beneficial capital gain tax rate for Seller. Asset Sale: Purchaser avoids assumption of business liabilities. 25

26 Transferring a Business during Owner s Lifetime (cont d) Third-party sale (cont d) Tax-free exchange Seller receives stock in acquiring corporation in exchange for his company stock. Seller receives stock in exchange for assets of his corporation. Liquidation Liquidate and sell the assets of the business Corporation sells assets to a third party. Corporation then uses cash to settle all debts. Corporation redeems remaining stock of shareholders for all remaining cash. 26

27 Strategies for Transitioning the Business at Death or Disability Buy-Sell Agreements An arrangement, typically established for closely held corporations or partnerships. May name co-owners, family members, or third parties to take over or buy (at a pre-determined price) an owner s interest in the business. May ensure stability for the business May minimize potential disputes among the remaining owners and family members over the business. May be funded with life insurance on the owners 27

28 Strategies for Transitioning the Business at Death or Disability (cont d) Types of Buy-Sell Agreements Cross-Purchase Agreement The owners of the business purchase life insurance policies on the other owners Age or insurability can cause there to be a sizable difference in the cost of premiums Surviving owners can use the death proceeds from policies to buy the deceased owner s interest from his/her estate. Surviving owners will receive a step-up in basis 28

29 Strategies for Transitioning the Business at Death or Disability (cont d) Types of Buy-Sell Agreements (cont d) Entity-Purchase Agreement Company purchases an insurance policy on each owner. At owner s death, company can purchase the deceased owner s interest in the company with the insurance proceeds. Any disparity in the cost of premiums, due to difference in ages of owners, will be born by the company and not by the owners. No step-up in basis for surviving owners 29

30 Strategies for Transitioning the Business at Death or Disability (cont d) Types of Buy-Sell Agreements (cont d) Stock Redemption Agreement Company (i.e. a corporation) redeems the shares of a withdrawing stockholder. Retirement, death and disability tend to be the three most common withdrawal events. Redemption is typically funded by company using the proceeds of a life policy insuring each stockholder. 30

31 Strategies for Transitioning the Business at Death or Disability (cont d) Key-Person Life and Disability Insurance Policy is owned by the business and insures the life of an owner and/or key employee for the benefit of the business. Provides protection to offset financial loss to the business occurring by reason of an owner s or key employee s premature death or disability. 31

32 Strategies for Transitioning the Business at Death or Disability (cont d) Income Continuation Agreement Works in conjunction with a buy-sell agreement Provides that for a given number of years the business will share a percentage of its profits with a deceased owner s heirs or pay a fixed sum for a period of time. Owner s Last Will and Testament Business is transferred pursuant to the terms of the Business Owner s Will and not the succession plan. Each owner s Will and their business succession plan should compliment each other. 32

33 Valuation of a Business Earnings. Independent Third-Party Appraisal.. Book Value. Multiple of Book Value. Specific Price. 33

34 Valuation of a Business (cont d) The following factors are commonly looked to when determining the value of a business: The business earnings and income history Comparing the business to other similar businesses The business economic outlook The business earning capacity The book value of the business stock The business good will and other intangibles 34

35 The Tax Relief Act of 2010 Reality for the time being (New) Two Years of Protection ( ) Estate Tax Exemption Gift Tax Exemption Portability Decrease in Maximum Estate and Gift Tax Rates Sunset Provision 35

36 The Tax Relief Act of 2010 (cont d) Estate and Gift Tax Exemption Amounts and Maximum Tax Rates Calendar Year 2011 Estate and Gift Exemption Amount ($) 5,000,000 Highest Estate and Gift Tax Rate (%) ,000,000 1,000,

37 Federal Estate and Gift Taxes (cont d) The Federal Gift Tax Annual gifts made by a donor to a recipient are not considered income to the recipient and, generally, are not tax deductible to the donor. For 2011, The annual exclusion gifting amount is $13,000 per donee. Gift-Splitting: Married couples, generally, can gift up to $26,000 combined. 37

38 Federal Estate and Gift Taxes (cont d) The Federal Gift Tax (cont ) Gifts made to a Donee in excess of the annual exclusion amount will be considered taxable gifts. Donor would need to file a federal gifttax return (IRS Form 709) in that year. Annual Exclusion Gifts are considered to be present interest gifts. Future interest gifts are considered to be taxable gifts and do not qualify under the annual exclusion limits. Individuals can make up to $5,000,000 of non-annual exclusion gifts during their lifetimes without paying federal gift tax (in Effect in ). 38

39 Tax Relief Act of 2010 (cont d) Carryover Basis Rule Change (Can still be used for Decedents who died in 2010) Assets transferred at death not stepped up to fair market value. Asset s cost basis is carried over at death, thus perpetuating built-in capital gains. Some built-in capital gains can still be eliminated at death: $1,300,000 on transfers to anyone Additional $3,000,000 on transfers to spouse 39

40 Tax Relief Act of 2010 (cont d) Step-Up Cost Basis Rule Change (Choice in 2010, In Effect in ) Assets transferred at death stepped up to fair market value. New cost basis will be either date of death value or value on alternate valuation date. Does not apply to retirement plan assets and annuities IRAs Qualified Plans, e.g. 401k, 403b, Profit-Sharing Plans, Defined Benefit Plans Non-Qualified Deferred Compensation Plans Annuities 40

41 Disclosure This material is based on generally available public information and is provided free of charge for general informational and educational purposes only. The information contained in this material is subject to change without notice. Morgan Stanley Smith Barney LLC undertakes no obligation to update this material. This material does not take into account your personal circumstances and we do not represent that this information is complete or applicable to your situation. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters 2011 Morgan Stanley Smith Barney LLC. Member SIPC 41