Pre-Sale Planning for Business Owners Facing Liquidity Events

Transcription

1 Pre-Sale Planning for Business Owners Facing Liquidity Events Prepared by Richard Watson, CFP Senior Director of Planning Business Advisory Services Timothy Throckmorton Chief Philanthropic Officer, Philanthropic Services In this white paper 1 Overview of the William and Susan Blaine case study 2 Transfer XYZ shares to an intentional defective grantor trust prior to the sale to Boston Capital 5 Evaluate charitable planning opportunities prior to the sale to Boston Capital 6 Contribute patent to a charitable remainder unitrust 7 Contribute manufacturing facility to a charitable lead annuity trust 9 Summary

2 Pre-Sale Planning for Business Owners Facing Liquidity Events For many business owners, the business itself represents the single largest asset on his or her personal balance sheet. This fact, combined with the heightened emotions that are often associated with business transitions, leaves many business owners feeling uneasy about their long-range retirement, estate, and wealth transfer planning. In addition to the dynamics of the sale itself, business owners anticipating liquidity events often have three closely related pre-sale planning goals: n To minimize income taxes at the entity or corporate level (especially if the company is a C corporation, which can be subject to two layers of tax at the time of sale 1 ), and at the shareholder or partner levels n To determine post-transaction cash flow or retirement income needs n To implement pre- and/or post-sale wealth transfer planning strategies The case study below illustrates how a business owner may analyze the financial, tax, and estate planning impact of these three pre-sale planning goals, prior to the sale of a business. Overview of the William and Susan Blaine case study XYZ Manufacturing, Inc., founded over 20 years ago by William Blaine, manufactures patented electrical components that are mainly used in aviation. William and Susan Blaine have been married for 30 years and have three adult children, Pat, Sarah, and Tim, all of whom are in their 20s. XYZ operates out of a single facility, with a 20-year triple net lease, which is owned by William and Susan personally. XYZ has a long history of slow and steady growth, and has recently attracted the attention of a few key industry buyers and private equity groups, several of whom could be an ideal strategic fit with XYZ. One group, Boston Capital, has expressed the strongest interest in acquiring XYZ in a possible asset purchase for $30 million within the next year or so. As William and Susan contemplate a potential acquisition by Boston Capital, they have decided to contact their legal and financial advisors including their Wells Fargo relationship manager, for advice on specific pre-sale planning steps to consider in light of a potential sale of XYZ. Like many business owners, William and Susan s pre-sale planning goals involve coordination across three broad pre-sale planning themes: Determine Cash Flow Needs Minimize Income Taxes Evaluate Wealth Transfer Planning Opportunities Minimize income taxes on the sale transaction William and Susan would like to minimize any income taxes at the entity level (i.e., at the XYZ level), that would result from the sale of their company. Since XYZ is currently an S corporation, it is generally subject to only one layer of tax, a more favorable treatment than the two layers of taxation associated with C corporations. However, as XYZ s S-election occurred less than five years ago, selling assets with built-in gain could result in corporate level capital gains tax. 2 In reviewing XYZ Manufacturing s balance sheet for assets with built-in capital gains, the couple s advisors determine that a key patent, worth approximately $2 million, represents their most significant built-in capital gains tax exposure. Their advisors determine that the total income tax exposure to the Blaines as a result of an asset sale to Boston Capital would be approximately $5 million. William and Susan would, therefore, net $25 million after taxes to meet their long-term financial and retirement planning objectives. Pre-Sale Planning for Business Owners Facing Liquidity Events 1

3 XYZ Manufacturing, Inc. $5 million tax liability Sale proceeds Asset sale $30 million Boston Capital (private equity group) In terms of the prospective deal with Boston Capital, they will also need to consider whether William will want to negotiate either a consulting agreement for a period of years, a non-compete agreement, an earn-out agreement, or other options, all of which would have an impact to their future cash flow. 3 William and Susan In discussing their charitable planning objectives, William and Susan s advisors determine that they have two favorite charities they would like to support with some of the proceeds from the prospective transaction. The couple is also interested in learning about both pre- and post-sale opportunities to both benefit charity and help save on income and transfer taxes. Additionally, they are interested in any estate planning strategies that could help avoid capital gains tax on any prospective transfers. Determine post-transaction cash flow needs They have determined that they will require an annual income of $400,000 post-sale (in pre-tax dollars). As a consequence, the impact that any prospective wealth transfers planning may have to their long-term cash flow needs will need to be closely reviewed. As a result, the Blaines would like to review exactly what sources of income will be available to meet their post-sale income/cash flow needs. Sources of Income Pre-Sale William s salary S corporation distributions Portfolio and rental income Sources of Income Post-Sale Portfolio income Income from various trusts Consulting or non-compete agreements? Prior to the sale, for example, the Blaines have relied on William s XYZ salary, S corporation distributions from XYZ, portfolio income, and rental income to maintain their standard of living. Portfolio income, in particular, has averaged $250,000 annually. Post-sale, however, they will need to consider which sources of income (portfolio income, income from various trusts, etc.) will continue to be available to meet their post-sale cash flow needs. Evaluate wealth transfer planning opportunities One of Blaines most important goals is to provide a legacy for their three children, Pat, Sarah, and Tim. In addition to providing for their children, they may also wish to provide for future generations. Previously, the couple has considered gifting a portion of XYZ to the next generation; however, they also wish to ensure that William retains 100 percent control of the company, especially prior to any prospective sale to Boston Capital. William and Susan would like any wealth transfer planning strategy to help reduce potential gift and estate taxes. In particular, they would like to leverage their current $5 million (or $10 million per couple) lifetime exemption equivalent for gift tax planning purposes in This represents the amount of money or property that can be gifted without incurring a gift tax. Stated differently, gifts above this amount are subject to a gift tax. 4 Finally, William and Susan would like to consider how charitable contributions could be interwoven into their other pre-sale planning goals, as they want to devote a portion of their new found extra time and money to making a significant impact in their community and beyond. Transfer XYZ shares to an intentional defective grantor trust prior to the sale to Boston Capital After discussing several wealth transfer planning strategies with their advisors, William and Susan decide that a sale of XYZ to an intentionally defective grantor trust (sometimes referred to as an IDGT) may offer the most compelling tax and wealth transfer planning benefits for them. Design of the pre-sale strategy In its basic form, a sale to an intentionally defective grantor trust (IDGT) is an estate planning technique that is designed to freeze the value of an appreciating asset, such as a business interest, for estate tax planning purposes at its current value. The sale to IDGT transaction typically involves six steps, which are discussed separately below. 2 Pre-Sale Planning for Business Owners Facing Liquidity Events

4 Step 1: Recapitalize XYZ manufacturing stock into voting and non-voting shares Voting Stock 10% Equity 100% Control XYZ Manufacturing, Inc. Non-Voting Stock 90% Equity 0% Control The first step in the transaction involves recapitalizing the stock of XYZ into voting and non-voting shares. Recapitalizing XYZ serves three important planning purposes: n William will retain all of XYZ s voting shares, which will ensure that he continues to control the company, one of the couple s pre-sale planning goals and objectives. n A secondary benefit of transferring non-voting shares to family members (or to trusts for the benefit of family members) is that the transfer can qualify for valuation discounts, which can help to reduce wealth transfer taxes. n In most circumstances, recapitalizing corporate stock into voting and non-voting shares is not a taxable event 5 and will not impact XYZ s S election. 6 Step 2: Create a grantor (dynasty) trust William Creates grantor trust Grantor (Dynasty) Trust Income earned on assets taxed to William during his lifetime Assets excluded from William s estate at his death Next, William creates an irrevocable (grantor) trust to hold assets for the benefit of Susan, their children, and/or possibly future generations. The grantor trust will be designed to be complete for gift and estate tax purposes, but defective for income tax purposes. This means that assets held by the trust will be excluded from his gross estate for estate tax purposes, 7 but taxed to him during life for income tax purposes. There are several benefits to this trust arrangement: n The grantor trust is disregarded as a separate entity for income tax purposes, meaning that if William sells an asset, such as non-voting stock, to the trust, the sale does not result in a capital gain or loss for income tax purposes. 8 n Having William continue to pay the trust s tax liability will help further reduce his gross estate for estate tax purposes and is not considered an additional gift for gift tax purposes. 9 Since trust assets are not reduced by income taxes, they can grow at a faster pace for the next generation. n The trust avoids probate, providing the couple with more assurance that trust financial matters and named beneficiaries can be kept private. n A grantor trust can be an S corporation shareholder, 10 so the S election is not terminated. n The trust can be established as an asset-protected trust, such as a spendthrift or discretionary trust, in regards to the Blaines children (Pat, Sarah, and Tim) and future beneficiaries, should a creditor judgment or divorce become a concern for the next generation. n Finally, the trust can also be established in a jurisdiction that permits a dynasty or legacy trust. 11 A dynasty trust is designed to benefit multiple generations. Trust assets can be excluded from a child s gross estate for estate tax purposes, allowing the trust to grow free of gift and estate taxes for the benefit of future generations. Step 3: Fund grantor trust with cash or property William Fund trust with cash or property Grantor Trust In order to ensure that the trust has some equity prior to the sale, it is recommended that the trust own assets independent of the sale assets (i.e., non-voting shares of XYZ will be sold to the trust in step 5 below). 12 Therefore, William transfers $2,030,000 of cash into the trust as a gift. Since William has not previously used any of his $5 million exemption equivalent for gift tax purposes, this gift does not result in a gift tax obligation. 13 As a consequence of this (seed) gift, William has $2,970,000 of unused gift and estate tax exemption remaining. Pre-Sale Planning for Business Owners Facing Liquidity Events 3

5 Step 4: Have non-voting shares appraised by a qualified appraiser XYZ is appraised by an independent, qualified appraiser. 14 At the time the appraisal was completed, XYZ did not have a letter of intent or purchase agreement with Boston Capital, although William had begun preliminary conversations with them. This information was disclosed to the appraiser. The purchase price of non-controlling stock in a closelyheld corporation is adjusted to reflect the stock s lack of marketability and lack of control. As a consequence, if William sells non-voting shares to the grantor trust, the shares will qualify for valuation discounts. The appraiser determines that the enterprise value (i.e., going concern value for the entire company) of XYZ is worth $30 million, that a pro rata interest in 90 percent of the non-voting stock is worth $27 million, and that XYZ s non-voting shares should be discounted approximately 25 percent for lack of marketability and lack of control (or $6.7 million). William s non-voting shares are, therefore, worth approximately $20.3 million. 100% interest (enterprise value of XYZ Manufacturing, Inc.) $30 million 90% pro rata interest of non-voting shares $27 million 25% discount for lack of marketability and lack of control for non-voting shares FMV of non-voting stock $6.7 million $20.3 million Note that while this valuation adjustment impacts the valuation of XYZ for gift tax purposes, it does not impact income or cash flow distributions of the company, which are based on the percentage of stock ownership, because XYZ is a S corporation. This means that while the gift the underlying stock is discounted for gift tax purposes, the expected cash flow distributions flowing to the trust are not reduced. 15 Step 5: Sell non-voting shares to grantor trust William Sale of nonvoting shares Grantor Trust Now that William knows what the value of the non-voting shares are worth (i.e., $20.3 million), he can sell $20.3 million worth of non-voting stock to the trust. While William likely has low basis in his XYZ stock, the sale of his non-voting shares to a grantor trust does not generate a capital gain on the sale transaction, because William and the grantor trust are considered a single unit for income tax purposes in other words, for income tax purposes, it is as if William is selling shares to himself, which does not result in gain or loss recognition. 16 In addition, since a grantor trust is an eligible S corporation shareholder, William s grantor trust is eligible to hold S corporation stock, without terminating the S election. 17 Furthermore, it is recommended that William and the trustee formalize their agreement with a written purchase and sale agreement. Step 6: Trust issues a promissory note in consideration of the non-voting shares William Promissory note Grantor Trust As payment for the non-voting shares, the grantor trust issues William a nine-year promissory note for the amount of the purchase price ($20.3 million), 18 which reflects the lack of marketability and lack of control valuation discounts previously discussed. The promissory note is often structured to be interestonly (with a balloon payment due at the end of the loan term) or amortized as principal and interest, 19 bearing interest at the applicable federal rate (AFR). 20 Since the note is for nine years, the mid-term AFR is used. Since the grantor trust now owes William a $20.3 million note, which requires making payments to pay off the promissory note (i.e., approximately $284,000 annually, with a $20.5 million balloon payment due in year nine), a question arises as to how the trust will generate the income or cash flow to be able to do this. However, because XYZ is a flow-through entity (i.e., an S corporation), the trust, as the new owner of the stock, receives a pro rata share of XYZ s distributions. 21 If Boston Capital purchases XYZ, the grantor trust would receive the pro rata value for the non-voting shares that it owns (i.e., $27 million versus the discounted value of $20.3 for gift tax purposes), which the trust could then use to pay off the $20.3 million installment obligation due to William. 4 Pre-Sale Planning for Business Owners Facing Liquidity Events

6 The diagram below illustrates how XYZ s distributions are used to help the grantor trust make promissory note payments owed to William. Any excess cash flow distributions can be used to pay down the promissory note, used for investment purposes, used to purchase a life insurance policy on the life of William, accumulated for the benefit of the couple s beneficiaries (usually their children or grandchildren), and/or distributed outright to the beneficiaries by the trustee. XYZ Manufacturing, Inc. Tax liability William Cash flow distributions (including pro rata sale proceeds) Promissory note payments Grantor (Dynasty) Trust Discretionary trust distributions Susan and Children (Pat, Sarah, and Tim) Results of implementing the IDGT strategy prior to the sale Selling non-voting shares to an IDGT produced the following financial, tax, and estate planning benefits for William and Susan: n Estate tax savings. William and Susan have removed $6.7 million worth of XYZ share value from their gross estate for estate tax purposes as a result of the valuation discounts, producing approximately $2.3 million in estate tax savings, while only using $2,030,000 of William s exemption equivalent for gift tax purposes. 22 n Control. William continues to retain 100 percent control of XYZ via the voting shares, giving him full control unless or until he completes the sale transaction with Boston Capital. n Cash flow. The grantor trust owes William $20.3 million in installment payments, which can be used to supplement William and Susan s cash flow needs in retirement. The trust would have the option of paying off the note early (i.e., after Boston Capital purchases XYZ, which would include all of the newly issued non-voting shares), though this may reduce the wealth transfer benefit accruing to the grantor trust. n Indirect gift. Since William will be liable for the income taxes on the grantor trust, the trust will not be reduced by the gain on the sale of XYZ s non-voting shares to Boston Capital, which is not considered an additional gift for gift tax purposes. 23 This is a considerable wealth transfer benefit, since the income tax liability was estimated by William and Susan s advisors at nearly $5 million. n Spousal access. William can also consider naming Susan as a beneficiary of the trust, should access to the trust be necessary to meet their cash flow needs in later years. n Wealth transfer. If the grantor trust does not pay down the installment note until the end of the nine-year note term, even if XYZ is sold to Boston Capital earlier, the value of the grantor trust will be approximately $25 million at the end of the note s term. 24 n Dynasty trust. The grantor trust can be created as a perpetual dynasty trust, meaning that it could benefit not only the next generation (i.e., Pat, Sarah, and Tim), but also future generations, and not be reduced by future gift, estate, and generation skipping taxes at each generational level, producing significant wealth transfer savings over time. 25 n Asset protection. Finally, the trust is designed to provide asset protection benefits for William and Susan s children and beneficiaries. Evaluate charitable planning opportunities prior to the sale to Boston Capital Creating a legacy is often an important goal for many successful business owners. They are often very interested in passing on their life lessons and values to their family and other heirs. The style, flavor and meaning underlying their philanthropic plans and actions can speak volumes to their family, community and the world for generations to come. William and Susan Blaine have achieved very tangible dreams in their lives and are successful by any worldly standard. Their next challenge is to move from success to significance, whatever significance means to them personally. Philanthropy can be a way to create this significance by making a bigger impact in the world. Pre-Sale Planning for Business Owners Facing Liquidity Events 5

7 Balancing how much to give to family and how much to leave to charity is an important question to answer for any charitably-inclined family, like the Blaines. With each dollar left to charity, Uncle Sam becomes a smaller estate beneficiary. There are various strategies available to William and Susan to balance their desire to benefit charity, reduce taxes, and provide for their family. Some of these strategies should be implemented prior to the sale of the business to maximize the economic benefit, while others could be created after the sale proceeds have been received. In addition, there are certain assets that are better suited to use in philanthropic planning to, among other reasons, help maximize tax savings. Specifically, William and Susan have decided to implement the following two philanthropic strategies, each of which are discussed in more detail below: n Donate the patent on XYZ s balance sheet to a Charitable Remainder Unitrust (CRUT); n Donate the manufacturing facility to a Charitable Lead Annuity Trust (CLAT). Contribute patent to a charitable remainder unitrust Design of the pre-sale strategy For William and Susan s first charitable planning strategy, they decide that XYZ will establish a charitable remainder unitrust (CRUT), and then contribute the $2 million patent to the CRUT, which will provide payments to the children (Pat, Sarah, and Tim) for a term of 20 years. The diagram below illustrates how the charitable contribution of the patent to a CRUT would work: XYZ Manufacturing, Inc. Income tax deduction Charitable contribution of patent CRUT Remainder St. Mary s Hospital and UCI (public charities) Annual payments Children (Pat, Sarah, and Tim) Because William s patent was acquired while he was an employee of XYZ, the patent is considered a capital asset owned by XYZ, 26 qualifying for capital gains treatment when sold. 27 Since the patent is now worth $2 million, it has appreciated significantly from the value assigned to it at the time of creation of the patent many years ago. The tax basis is essentially zero due to depreciation taken over the years. Consequently, there would be a sizeable gain (i.e., $300,000 of income tax due or more, depending on the level of depreciation recapture and built-in-gain) incurred if the patent were to be sold with the other assets of the company before placing it in some sort of charitable solution. The IRS has specifically ruled that a Subchapter S corporation can give an appreciated asset to a charitable remainder trust, such as a CRUT, without incurring a current capital gain at the time of the gift. 28 If William and Susan have XYZ contribute the patent to a CRUT well in advance of a business sale contract being consummated, 29 the patent could subsequently be sold at the time of the business sale. The value of the patent ($2 million) would remain in the CRUT to meet the payment obligations of the CRUT to the children over the next 20 years. The payments to the children would be taxed based on the worst-out-first (which is technically known as the 4 tier approach) income tax reporting structure of a CRUT, a portion of which would be capital gain. If there is not currently sufficient income from the patent to make the 5 percent annual payments to the children, the CRUT could be established as a FLIPCRUT, which would not begin making payments to the children until the patent is sold. William and Susan, as the shareholders of XYZ, would receive a current income tax deduction in the amount of $723,520, since XYZ s charitable contribution would pass-through to them personally. Ideally, if the business sale happened in the same year as the contribution of the patent to the CRUT, they could use this deduction to partially offset the capital gain incurred at that time. Otherwise, they can carry over any unused charitable income tax deduction into the next five years, until it is exhausted. The actual amount of this deduction could vary significantly, depending upon the type of charity named to receive the remainder. If a public charity were named as the remainder beneficiary, the up-front charitable income tax deduction would be $723,520. As the asset being contributed is not cash or an appreciated publicly traded security, the deduction would be substantially 6 Pre-Sale Planning for Business Owners Facing Liquidity Events

8 reduced if the named beneficiary was a private foundation. In that case, the starting point before splitting out the remainder portion for calculating the amount contributed would be the tax basis of the patent (i.e., nearly zero), as opposed to the fair market value ($2,000,000) allowed to a public charity. Consequently, to obtain the higher tax deduction they choose St. Mary s Hospital and the University of California at Irvine (Susan s alma mater), both public charities, in this case. Another option could be to establish a donor advised fund, which is also considered a public charity. Finally, William and Susan will be using a portion of their $5 million ($10 million per couple) gift and estate tax exemption equivalent to fund the CRUT, since the remainder going to their children will be a taxable future interest gift. The gift tax annual exclusion, which is reserved only for present interest gifts, cannot be used to offset the gift. Therefore, they will need to use a total of $1,276,480 of their lifetime gift and estate tax exemption. 30 Results of implementing the CRUT strategy prior to the sale Contributing the patent to a CRUT produced the following tax, estate, and charitable planning benefits for William and Susan: n Income tax deduction. XYZ received a current income tax deduction (approximately $720,000), which is passed through to the Blaines personal tax returns. n No built-in-gains tax. XYZ and the Blaines were not subject to $2 million of gain on the sale of the patent (saving approximately $300,000 in capital and built-in-gains taxes at the time of sale). n Estate tax savings. The value of the patent is removed from William and Susan s gross estates for estate tax purposes. n Cash flow to children. Pat, Sarah, and Tim receive a payment stream for a term of 20 years (based on 5 percent of the CRUT valued annually). n Benefit charity. The remainder is distributed to St. Mary s Hospital and the University of California at Irvine, one of William and Susan s charitable planning goals. Contribute manufacturing facility to a charitable lead annuity trust Design of the pre-sale strategy Finally, to help maximize their up-front income tax deductions and transfer tax benefits in the long run, William and Susan decide to give the manufacturing facility and land, worth approximately $2 million, to a 20-year defective grantor charitable lead annuity trust (CLAT), with the annual payments over the 20 years paid to St. Mary s Hospital and the University of California at Irvine, Susan s alma mater. The remainder would be distributed to William and Susan s newly created dynasty trust (see above) at the end of a 20-year term. The diagram below illustrates how the charitable contribution of the manufacturing facility to a CLAT would work: William and Susan Income tax deduction Charitable contribution of facility CLAT Remainder Dynasty Trust for Children and Grandchildren Annual payments St. Mary s Hospital and UCI (public charities) Many years ago, the Blaines, upon the advice of their accountant, purchased the XYZ headquarters building and property and leased it back to the company under a long-term triple net lease. As there are currently 20 years of lease payments remaining, and there is no outstanding debt against the building or land, the net cash flow on this $2 million asset is seven percent or $140,000 per year. As discussed above with the CRUT example, there will be a higher up-front income tax deduction if a public charity, such as St. Mary s Hospital or the University of California at Irvine, instead of a private foundation, is named to receive the annual lead payments over the 20-year term. 31 The dynasty trust will be named the remainder beneficiary to receive the remaining assets (i.e., the manufacturing facility and excess cash) of the CLAT at the end of the 20 years. If the property appreciates and most of the two percent difference in Pre-Sale Planning for Business Owners Facing Liquidity Events 7

9 cash flow (7 percent net income paid from the triple net lease less 5 percent paid to charity each year) is reinvested, there will likely be a substantial sum added to the dynasty trust in 20 years. William and Susan will receive an up-front income tax deduction of $1,733,900 if the transfer is made to a CLAT naming St Mary s Hospital or the University of California at Irvine 32 in time to take advantage of the historically low interest rate (1.4 percent April 2012 AFR) used to calculate these types of gifts. This charitable income tax deduction can be used to offset the gain on the sale transaction with Boston Capital. If Boston Capital is comfortable continuing to pay the lease payments to the CLAT and has no desire to own the manufacturing facility, the annual net taxable rental income (i.e., 7 percent annually) would be taxed to William and Susan as the grantors of the CLAT. This essentially will result in an additional gift to the dynasty trust in the amount of the annual tax paid, as the annual income tax liability does not reduce the CLAT assets, leaving more to pass to the dynasty trust at the end of the 20-year term. An alternative strategy would be for Boston Capital to purchase the manufacturing facility from the CLAT, at which point the capital gain would be recognized by William and Susan, again not reducing the assets of the CLAT. The sale proceeds would then be reinvested and the CLAT would continue for the remaining portion of the 20-year term. While this may not be the preferred alternative, because Susan and William would likely have to pay a substantial capital gain, the assets would still benefit charity and go on to the dynasty trust, and Susan and William would have benefited from a significant up-front income tax deduction. As with the CRUT described above, this scenario would result in using a portion of the $5 million ($10 million per couple) gift and estate tax exemption equivalent, based on the present value of the gift to the dynasty trust at the end of the 20-year term. Specifically, William and Susan would use a total of $266,100 of their combined gift and estate tax exemption by funding the CLAT with the property. A final consideration for William and Susan is when the transfer of the manufacturing facility should occur. Unlike the CRUT transaction with the patent above, there is no requirement to complete this transaction before the business sale, and, in fact, it might be wise for them to wait until they have know whether Boston Capital s long-term intentions are to assume lease payments and stay in the current facility. Since a business sale can take 9 12 months to close, this also helps to ensure that a resulting income tax charitable deduction occurs in the same calendar year as the business sale. Results of implementing the CLAT strategy prior to the sale n Estate tax savings. The manufacturing facility, worth approximately $2 million, is removed from William and Susan s gross estate for estate tax purposes. n Income tax deduction. William and Susan receive an up-front income tax deduction of $1,733,900. They also pay the income tax liability on the CLAT s income each year, so that the CLAT is not reduced by income taxes. This additional amount of tax paid is not considered a gift for gift tax purposes. n Benefit charity. St. Mary s Hospital and the University of California at Irvine receive fixed annual payments of $100,000 (combined), which is based on 5 percent of the original $2 million gift for the 20-year term of the trust. n Wealth transfer. The remainder (approximately $3.6 million) goes to the dynasty trust at the end of the CLAT term. Create a private family foundation While all types of charitable gifts can potentially create a family legacy, one in particular has been the gold standard for many generations: the private family foundation. The Rockefeller, Ford and Gates foundations have made philanthropic marks on the world that are arguably commensurate with their industrial prowess. A family foundation can be a wonderful vehicle to pass along personal values and name recognition, while still offering the income and estate tax benefits associated with gifting a highly appreciated asset to such an entity. Cash and marketable securities are generally the best types of assets to give to a family foundation as they offer a charitable income tax deduction similar to giving to a public charity. The family foundation can also be a receptacle for current lead or remainder payments from charitable trusts. William and Susan may wish to consider making additional contributions of cash sale proceeds or other assets to the private foundation in the year of the business sale to obtain additional income tax deductions and offset the tax due to the sale of the business. 8 Pre-Sale Planning for Business Owners Facing Liquidity Events

10 The Blaines children can also be involved in the philanthropic activities of their family foundation. As the William and Susan have expressed interest in making a difference in their community and beyond, their foundation can be used as a parking lot where the assets can be managed until specific public charity grant decisions are made. There are very creative ways business owning families have made significant improvements in their communities through grants from family foundations. Summary As William and Susan continue to contemplate the potential acquisition of XYZ Manufacturing by Boston Capital, they have also reviewed their pre-sale planning goals and objectives with their advisors. The pre-sale planning questions that especially resonated well for them were the following: n How can they help minimize the income tax burden on a prospective sale transaction? n What are their long-term cash flow needs post-sale? n Should they consider implementing any specific wealth transfer planning strategies prior to the sale? Minimize income taxes on the sale transaction William and Susan s advisors determined that an asset sale to Boston Capital for $30 million would produce approximately $5 million in income taxes, because of built-in-gain taxes, depreciation recapture, capital gains, etc. From an income tax perspective, contributing the patent on XYZ s balance sheet to a CRUT produced approximately $300,000 in capital gains and built-ingains tax savings, and the CRUT and CLAT strategies produced a combined charitable income tax deduction of $2.4 million, which could be used to offset the tax liability from the asset sale. This reduces the income tax liability from the asset sale from $5 million to approximately $2.3 million, which was one of the couple s planning objectives. 33 They could also consider using a portion of the proceeds from the sale to fund a private foundation, should they wish to consider an additional charitable income tax deduction. Determine post-transaction cash flow needs William and Susan had performed a pre- and post-sale cash flow analysis with their advisors and determined that they would need approximately $400,000 annually (in pre-tax dollars) post-sale to maintain their standard of living. Fortunately, since they have already accumulated a portfolio of marketable securities, a portion of their post-sale cash flow goal can be met by their existing portfolio, which has consistently generated net income of $250,000 or more annually. The IDGT strategy also provides the flexibility to make interest-only payments to William (i.e., $284,000 annually for eight years and then a balloon payment of $20.5 million in year nine) or with payments that amortize principal and interest (i.e., $2.4 million annually for nine years), both of which provide William and Susan with the additional cash flow to meet their long-term retirement cash flow needs. They would also received $3 million in proceeds from the sale of their voting shares to Boston Capital, which could be used to help meet their remaining income tax obligation as a result of the sale or to meet their cash flow goal. Should cash flow be a concern in the future, the grantor feature of their dynasty trust, which shifted the income tax liability of the grantor trust to William, can be designed to be discontinued or toggled off. This has the effect of shifting the income tax liability of the dynasty trust back to the trust itself, 34 leaving William and Susan with more cash flow. If, in the event of William s premature death, cash flow for Susan would be inadequate, they could also consider naming her as a beneficiary of the trust. As neither of the Blaines has expressed any real concerns about their post-sale cash flow, they have focused much of their planning attention on meeting their wealth transfer planning goals, which are discussed below. Evaluate wealth transfer planning opportunities The most important long-term goals for the couple were leaving a legacy for their three children, Pat, Sarah, and Tim, and providing an impact on their community through philanthropy, especially to their two favorite charities. Implementing the IDGT, CRUT, and CLAT strategies pre-sale has allowed them to meet both of these goals in meaningful and significant ways. Beginning with the IDGT strategy, they created a dynasty trust for their children, which will manage a substantial amount of wealth for the children over the term of the IDGT. If the trust is created in a certain justifications, the trust will provide asset protection benefits and not be subject to either state income taxes, or federal gift, estate, and generation-skipping taxes. Under current tax law, the IDGT strategy produced Pre-Sale Planning for Business Owners Facing Liquidity Events 9

11 $2.3 million in estate tax savings immediately. This amount could be even greater if the estate tax rate increases and as the value of the trust grows, since it is not considered part of William and Susan s gross estate for estate tax purposes. 35 The CLAT strategy provides payments of $100,000 for a term of 20 years to two of William and Susan s favorite charities, St. Mary s Hospital and the University of California at Irvine, 36 with the remainder interest going to the dynasty trust for the benefit of the children. Assuming a 7 percent rate of a return from the triple net lease and a 5 percent fixed payout to the charities, it is estimated that the remainder interest would be worth approximately $3.6 million at the end of the CLAT term. The CRUT strategy also produces a significant income benefit for the children. The CRUT produces a payment, which is based on 5 percent of the CRUT balance valued annually, to the children for a term of 20 years, with the remainder interest going to William and Susan s two favorite charities. The initial payment to the children would be $100,000, but could increase based on the investment performance of the CRUT. The children could use the payments to pay the premiums in a life insurance program on the lives of William and Susan or to meet their own particular financial planning goals. In addition to the income tax charitable deduction previously discussed, the CLAT and CRUT strategies also produce estate tax savings of $1.4 million. Finally, while William and Susan have made significant progress attaining their many wealth transfer planning goals, they have only used approximately $3.5 million of their lifetime exemption equivalent for gift and estate tax planning purposes. Therefore, they will continue to monitor their wealth transfer goals annually, revisiting with their advisors whether they should pursue any additional tax and wealth transfer planning opportunities in the future, especially as the tax laws change. Note: The tax impacts referred to in this paper are to Federal taxes unless otherwise noted. 10 Pre-Sale Planning for Business Owners Facing Liquidity Events

12 End notes 1 C corporations are subject to two layers of tax in asset sales, once at the entity level and a second time at the shareholder level, when the proceeds are distributed out to the shareholder. 2 IRC 1374(d). 3 Often sellers attempt to minimize consulting agreements and non-compete agreements, because they are taxed at ordinary income rates (35 percent in 2012 and 39.6 percent in 2013). Buyers tend to favor consulting agreements, however, because they can deduct compensation expense immediately, whereas non-compete agreements must be amortized over 15 years. 4 The gift tax rate is 35 percent in 2012 and is scheduled to increase to 55 percent in See generally IRC IRC 1361(c)(4). S corporation are permitted to have voting and non-voting stock. 7 If the grantor is treated as the owner (donor) of any part of the trust under IRC , then items of income, deductions, and credits attributable to that part of the trust will be used in computing the taxable income of the grantor (donor). IRC Rev. Rul , C.B Rev. Rul , IRB , 7 10 A wholly-owned grantor trust can be a S corporation shareholder under IRC 1361(c)(2)(A)(i). 11 Several states have abolished the rule against perpetuities and permit dynasty trusts to benefit future generations, including, for example, Delaware and South Dakota. 12 In PLR , the IRS required the applicants to commit equity of at least 10 percent of the installment purchase price. 13 William could gift other assets, such as marketable securities, in place of or in addition to cash. Some practitioners also favor the use of beneficiary guarantees as a mechanism to help substantiate the trust. See, for example, PLR , where the IRS permitted a beneficiary guarantee with a private annuity sale, provided that the guarantor had sufficient personal assets to make good on the guarantee. 14 In analyzing the weight to accord an appraisal, tax authorities generally first examine the credentials and qualifications of the appraiser. Therefore, working with a knowledgeable and experienced business appraiser is critical. An appraiser with a specialized designation, such as from the American Society of Appraisers (i.e., the appraiser has ASA accreditation), may be a helpful starting place. 15 William could also use a defined value clause, particularly with one of the charitable beneficiaries discussed below, to help minimize any valuation risk, due to the proximity of the subsequent sale to Boston Capital. 16 Rev. Rul , C.B IRC 1361 (c)(2). 18 Less any down payment. 19 The note can also be structured as a private annuity or as a self-cancelling installment note (SCIN) to prevent inclusion of the promissory note for estate tax purposes. 20 IRC 1274(d). Using the AFR also avoids having to rely on the below market loan rules of IRC William and Susan also continue receive pro rata distributions for their voting shares, which is not represented here. 22 The estate tax rate in 2012 is 35 percent and is scheduled to increase to 55 percent in The estate tax savings produced by the IDGT strategy in 2013 and beyond would be approximately $3.6 million. 23 Rev. Rul , IRB , 7 24 Assumes a 6 percent net growth rate. 25 Assuming the value of the grantor trust is valued at $25 million after William s installment note is paid off in year nine, this amount would no longer be subject to gift, estate, or generation skipping taxes for William and Susan s children and possibly future generations. 26 IRC 197(d) 27 This means the patent would be taxed at 15 percent. Any depreciation recapture, for any portion of the patent previously depreciated, would be taxed at 35 percent. 28 PLR This is true even if the corporation was formerly a Subchapter C corporation which had converted to a S-corporation within the last 10 years. 29 The suggestion to complete this transaction well before a buyer has committed to purchase the business is designed so that the IRS could not re-characterize the transaction and tax XYZ Manufacturing for the capital gain due at the time of sale of the patent, which can occur under the so called pre-arranged sale doctrine if the two transactions are closely connected. 30 This is $638,240 each from their respective $5 million exemption equivalents for gift and estate tax purposes. 31 A donor advised fund would be another example of a public charity that could be named to receive the lead payments. 32 St Mary s Hospital and UCI are two examples of public charities. 33 Note that this summary ignores possible itemized deduction limits for the charitable income tax deduction because of the alternative minimum tax (AMT). 34 This reduces the effectiveness of the IDGT as a wealth transfer planning device, however. 35 The estate tax rate in 2012 is 35 percent and is scheduled to increase to 55 percent in The estate tax savings produced by the IDGT strategy in 2013 and beyond would be approximately $3.6 million. If the value of the trust is $25 million in year nine, which assumes a 6 percent growth rate, the estate tax savings to William and Susan is actually closer to $13.7 million (assuming a 55 percent estate tax rate). 36 To be clear, the CLAT generates a payment of $100,000, which is then split by or divided among the two charities, based on the way that William and Susan structure the CLAT. Pre-Sale Planning for Business Owners Facing Liquidity Events 11

13 Disclosures Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A., and its various subsidiaries and affiliates. Investment products and brokerage services are available through Wells Fargo Advisors, LLC, (member SIPC), a non-bank affiliate of Wells Fargo & Company. Insurance products are available through insurance subsidiaries of Wells Fargo & Company and underwritten by non-affiliated Insurance Companies. Not available in all states. This information is provided for education and illustration purposes only. The information and opinions in this report were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the strategies mentioned. The strategies discussed or recommended in the presentation may be unsuitable for some clients depending on their specific objectives and financial position Wells Fargo Bank, N.A. All rights reserved. Member FDIC. NMLSR ID TPB01148 ( /12)