SUCCEEDING IN BUSINESS MARKETS BUSINESS CONTINUATION BUYSELL ETC

SUCCEEDING IN BUSINESS MARKETS BUSINESS CONTINUATION (BUY-SELL, ETC. ) Mike Halloran 1

Business Continuation – general § Sooner or later, the day will come when the current owner of the business no longer owns it. § What will happen to the business then? ► Cease/liquidate? ► Continue? 2

Business Continuation – who, when, how If want business to continue, some things to ask/determine are: § Who. . . who should take over business (or each owner’s portion of it)? § When. . . what event should trigger the transfer (death, disability, retirement. . . even sooner)? § How. . . ► ► By gift or bequest? Sale? 3

Business Continuation – more Qs Some additional things to ask/determine: § What’s value of business (or each owner’s portion of it)? § If selling, what are terms of sale (lump sum v. pay over time)? 4

Lack of Planning by Business Owners § Very few privately-held businesses have a written succession plan § If no preparation is done, what happens with the business? let’s see the results. . . 5

Effect of Doing Nothing Corp A spouse 50 Shs B now in business with A’s spouse 6

Buy-Sell Agreement – what is it? Agreement to buy a business interest, and sell a business interest, upon a certain triggering event, such as … § Death § Disability § Retirement or termination of employment 7

Types of Buy-Sell Agreements § Business buys Entity Purchase § Other owner(s) buy Cross Purchase § Option to buy Wait & See 8

B buys A’s shares (cross purchase) Corp A spouse 50 Shs $ B 50 Shs B now owns all 100 shares; A’s estate/spouse has $ 9

Corp buys A’s shares (entity purchase) Corp $ spouse A 50 Shs B owns all 50 remaining outstanding shares; A’s estate/spouse has $ 10

How to Finance the Buy Out § Where to come up with the money to buy ? ► ► Cash on hand / existing funds ? Save for it ? Payments over many years? Life insurance and disability insurance ! 11

Buy-Sell Agreement … if funded with insurance Cardinal rule (or semi-cardinal). . . Whoever is supposed to buy the business interest upon triggering event should be § applicant, § owner, and § beneficiary (loss payee if disability ins. ) on insurance policy insuring the other 12

Buy-Sell Agreement … if funded with insurance (cont. ) Effect of Cardinal rule. . . § Entity purchase – business owns policy and is beneficiary (or loss payee) § Cross purchase – other owns policy and is beneficiary (or loss payee) 13

Cardinal Rule - illustrated A B Life Ins Entity Purchase C Corporation A B 14

Cardinal Rule - illustrated C Corporation A Cross Purchase B B A Life Ins 15

So …which is “better” … Cross Purchase ? or Entity Purchase ? 16

Cross Purchase v. Entity Purchase …some factors 1. Survivor’s Basis With cross purchase, remaining owners (survivors) more easily get high basis in newly acquired stock 2. Relative tax brackets If business is C Corp and in lower tax bracket than individual owner, might be cheaper to do entity purchase 3. Number of owners The more owners there are to be insured, the more likely entity purchase is easier 4. Related parties If parties are related, cross purchase avoids “attribution” problems 17

Cross Purchase v. Entity Purchase …some factors 1. Survivor’s Basis With cross purchase, remaining owners (survivors) more easily get high basis in newly acquired stock § can be important for survivors, especially if plan on selling the business in the future. § with pass-through entities (e. g. , S Corps and Partnerships), survivors receive some basis increase when death proceeds are paid to pass-through entity. 18

Buyer’s tax effects. . . paying premiums C Corporation A B Insurance Co. $ A Life Ins B’s payment of premiums not deductible for B 19

Buyer’s tax effects. . . death benefit $1 M C Corporation A B Insurance Co. A Life Ins B receives death benefit income tax free 20

Buyer’s tax effects. . . buying the stock C Corporation A $1 M Insurance Co. B Purchase of stock not deductible for B 21

Survivor’s basis (in cross purchase) FMV = $1 M Basis Newly Bought C Corporation A $1 M B FMV = $1 M Original Basis = $100 k B’s stock: FMV $1 M, . . . and basis $1 M 22

Survivor’s basis (in entity purchase) C Corporation A B FMV = $1 M Original Basis = $100 k 23

Survivor’s basis (in entity purchase) FMV = $2 M C Corporation A $1 M B Original Basis = $100 k B’s stock: FMV $1 M, . . . but no basis increase 24

Survivor’s basis. . . effect on later sale § Cross Purchase: $2 M - $1. 1 M = $ 900, 000 gain § Entity Purchase: $2 M - $100 K = $ 1, 900, 000 gain Pro-cross purchase 25

Survivor’s Basis with Pass-Through Entities. . . if funded with insurance § § Entity purchase plans funded with life insurance pay death proceeds to entity With pass-through entity (S Corp, P Ship, most LLCs), surviving owners receive basis increase pro rata to ownership Basis increase for deceased owner is “wasted” because already has basis step-up But owners may think this is small downside, if prefer entity purchase for other reasons 26

Cross Purchase v. Entity Purchase …some factors 2. Relative tax brackets If business is C Corp and in lower tax bracket than individual owner, might be cheaper to do entity purchase 27

Relative Tax Brackets C Corporation $12 k 15% $10 k prem. B $18 k 40% $10 k prem. Pro-entity purchase (with C corporation) 28

Cross Purchase v. Entity Purchase …some factors 3. Number of owners The more owners there are to be insured, the more likely entity purchase is easier 29

Number of Owners A B C Business A A B C C B n B C A B n (n - 1) Pro-entity purchase 30

Cross Purchase v. Entity Purchase …some factors 4. Related parties If parties are related, doing cross purchase avoids “attribution” problems 31

Related Parties ? Corporation Smith Jones Johnson Unrelated ? Then no attribution problem Dad Mom Son Related ? Entity purchase might have attribution problem 32

Normal tax effect on A’s estate While A is still alive … FMV $1 M Basis $100 k 33

Normal tax effect on A’s estate At A’s death … Basis $1 M FMV $1 M Estate’s Stock Basis = FMV at death (“Step-Up”) 34

Effect when A’s estate sells stock. . . ? A’s estate Basis $1 M FMV $1 M 35

If A’s estate sells to B via cross-purchase A’s estate $1 M B Basis $1 M Amount received – Basis $1 M – $1 M = = Estate’s Gain $0 36

If A’s estate sells to Corp via entity purchase A’s estate $1 M Corporation Basis $1 M The $1 Million received could be treated as taxable dividend, unless A’s Estate sells all its stock. . . not easy to do because of “attribution” 37

Related Owners (Estate Attribution) Dad’s ESTATE is considered to own stock that is owned directly or indirectly by a beneficiary of Dad’s estate Corporation $ Dad Mom Son Mom and/or Son probably are beneficiaries of Dad’s estate, and they still own stock 38

Related Owners (Family Attribution) Dad is considered to own stock that is owned by his FAMILY (parents, spouse, children and grandchildren) Corporation $ Dad Mom Son Dad sells while alive. . . Mom and Son are his family, and they still own stock 39

Other factors. . . § Transfer for Value Rule. § Unintended shifts in control. Not every remaining/surviving owner must buy from a departing owner. If want to sell to just one of several remaining owners (e. g. , to Child only), then don’t do entity purchase. § Disability Policies. Disability Buy-Out underwriting rules and policy provisions can differ greatly from life insurance. Call home office before promising anything. 40

Even more considerations. . . § Accounting. § AMT. Alternative Minimum Tax potentially could affect C Corporations. § IRC § 101(j). Notice and Consent. 41

Thank You 42

This presentation is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by The Northwestern Mutual Life Insurance Company. Representatives. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. 43