THE ESTATE PLANNING COUNCIL OF HAMPDEN COUNTY INC

THE ESTATE PLANNING COUNCIL OF HAMPDEN COUNTY, INC. PRESENTED BY Dana R. Barrows Estate and Business Planning Specialist for the Northwestern Mutual Financial Network Email Address: dana. barrows@nmfn. com Office Telephone: (413) 748 -6015 & Steven J. Schwartz, Esquire, Shatz, Schwartz and Fentin, P. C. On FEBRUARY 8, 2011 Held at the Colony Club located at Tower Square

DEFINITION OF EXIT PLANNING Exit Planning is the comprehensive approach to designing an exit strategy for a business owner. Why is an Exit Plan Important? n 50% of high net worth individuals are business owners n $3. 2 Billion in business assets will be transferred in the next 10 years. n 88. 6% of households that have over $50 million own a private business n 67% of those business owners do not have complete transition plans n 72% will seek advice of the sale of their business n 90% of U. S. businesses are family owned n Only 30% of such companies succeed in the second generation; and n Just 15% make it to the third generation.

R O A D M A P To encompass setting exit objectives, such as: When does the business owner want to retire? What are the business owner's financial requirements upon retirement? To whom will the business owner sell the business? What is the estimated fair market value of business? To assemble a “team” of trusted, professional advisors; To develop a written plan of ideas for each aspect of the transition sequence in the form of a "road map" that explains exactly the transitional steps to be taken, when each transitional step will be taken and why each transitional step is taken.

FACT FINDING n n Assemble with the client a "team" of advisors. n Lawyer n Certified Public Accountant n Financial/Insurance Advisor n Business Appraiser n Investment Banker n Business Adviser Establish responsibility of each team member. Produce an introductory exit plan. The Case Study is a result of the Fact Find

Case Study Family Circumstances n n n John and Ruth Successful are 65 years old and in good health. They have four children who are all married and have eight grandchildren. John and Ruth’s son, Rich, and their daughter, Sue, are working in the family business, namely High Tech, Inc. (the “Company”). Rich and Sue are successful in managing the business and have been primarily responsible for the growth of the business in the last five years. Jane and Robert are children who have independent careers. Rich is the Chief Executive Officer of the Company and Sue is Vice President and is in charge of sales and marketing of the Company’s products. Rich and Sue have a good working relationship and enjoy managing the business. They anticipate that their employment at the Company will be their sole careers and they are hopeful that the next generation of the family will also join them in operating the business.

Case Study (continued) Family Circumstances (continued) n n John and Ruth’s other children have careers of their own and are financially independent. John and Ruth give all their children the maximum annual exclusion gifts of $26, 000 each year. Their children invest their annual gifts. John and Ruth have established 529 Plans for each of their grandchildren, which are all fully funded at this time. Balance Sheet a) John is the sole owner of the shares of common stock of the Company which is an "S corporation". The Company has a book value of $3, 670, 000. John owns 120 Class A voting shares and 1080 Class B non-voting shares. His accumulated adjustment account is $2, 000.

Case Study (continued) Balance Sheet (continued) The earnings of the Company before interest, taxes, depreciation and amortization are consistently in excess of $2, 000. b) John wishes to retire from the Company at age 70. c) John feels the market value of the Company is $12, 000. John’s salary each year is $250, 000. d) e) John is the sole owner of High Tech, LLC (“Realty”) which owns the real estate leased to the Company. The real estate’s fair market value is $2, 000 and there is no mortgage outstanding. John's net distribution each year from Realty is $240, 000. f) John has a 401(k) plan of $1, 000 expected to be $1, 500, 000 when he retires.

Case Study (continued) Balance Sheet (continued) g) h) i) Ruth has stocks and bonds of $3, 000 invested in municipal bonds with a yield of 3% per annum which is expected to be $3, 500, 000 when John retires. Ruth owns their residence with a fair market value of $1, 000 (no mortgage). Ruth owns their vacation home with a fair market value of $600, 000 (no mortgage). Pertinent questions to ask John and Ruth: a) b) c) d) e) f) g) John and Ruth’s income and lifestyle objectives; John’s exit from the business; Estate equalization; John and Ruth’s post mortem objectives; Lifetime gifts; Lifetime charitable objectives; and Post mortem charitable objectives.

Case Study (continued) Goals: a) b) c) d) e) f) Disposable income need upon John's retirement is $350, 000. Transfer of 40 Class A voting shares and 540 Class B non-voting shares, to each of Rich and Sue as soon as possible using the most favorable tax structure. Jane and Robert are each to receive an inheritance of $3, 000 after estate taxes. John has asked for advice on the disposition of the real estate occupied by the Company. John and Ruth wish to use every tax strategy available to reduce estate taxes, provided, that they have financial security until the death of the surviving spouse. They would like to make charitable gifts of $500, 000 on the death of the survivor.

Case Study (continued) What plan due you recommend to John and Ruth to fulfill their objectives: n n Disposable Income Goals Transfer of business alternatives: i. Gift ii. Sale to a Grantor Defective Trust iii. Transfer to a Grantor Retained Annuity Trust iv. Conventional Sale n Estate Equalization, Life, Health and Long Term Care Insurance n Real Estate

DISPOSABLE INCOME GOALS for John and Ruth Net Income for Lifestyle Net Income for Insurance* $350, 000 $ 80, 000 Total Net Income: Age 65 – 70 John’s W 2 Salary John’s 3. 33% “S” Profit Rental Income Pre Tax $430, 000 $250, 000 $ 66, 667 $275, 000 $591, 667 After Tax Bond Income – Net $355, 000 $ 90, 000 Total Net Income $445, 000

DISPOSABLE INCOME GOALS for John and Ruth Age 71 & Up John’s W 2 Salary/SERP & Consulting John’s Continuing 3. 33% “S” Profit Rental Income 401 K RMD/Average Pre Tax $100, 000 $ 66, 667 $300, 000 $100, 000 $566, 667 After Tax Bond Income – Net $340, 000 $ 100, 000 Total Net Income $440, 000 Assumed $6 million second to die coverage $60, 000; $350 per day/lifetime benefit for long term care $16, 000; Supplemental Medical Insurance $4, 00080, 000 total annual premium.

Business Appraisal Valuation 1. Fair Market Value of the Business is $12, 000 2. LESS Minority Interest Discount of 20% ($2, 400, 000) $9, 600, 000 LESS Non-Marketability Discount of 20% ($1, 920, 000) $7, 680, 000 3. Assume Voting and Non-Voting shares have the same value of $6, 400 per share.

Revenue Ruling 93 -12 1993 -1 C. B. 202, 1993 -7 I. R. B. 13. Internal Revenue Service Revenue Ruling VALUATION; STOCK; INTRAFAMILY TRANSFERS; MINORITY DISCOUNTS Published: January 26, 1993 26 CFR 25. 2512 -1: Valuation of property; in general. Valuation; stock; intrafamily transfers; minority discounts. In determining the value of a gift of a minority block of stock in a closely-held corporation, the block should be valued for gift tax purposes without regard to the family relationship of the donee to other shareholders. Rev. Rul. 81 -253 revoked.

Transfer Goals John would like to retain one-third of the voting shares in the Company. John presently owns: n 120 shares of Class A Common Stock, and n 1080 shares of Class B Common Stock To accomplish John’s transfer goals, the following should occur. 1. 2. John will transfer 40 shares of Class A Voting Common Stock to each, Rich and Sue; and John will transfer 540 shares of Class B Non-Voting Common Stock to each, Rich and Sue.

Transfer Alternatives n Direct Gift n Sale to a Intentional Defective Grantor Trust (IDGT) n Transfer to a Grantor Retained Annuity Trust (GRAT) n Conventional Sale to a Third Party

Direct Gift n n n Value of each gift without Discount: Discounted Fair Market Value: Reported Gifts (no annual exclusion): Federal Unified Exemption: Tax on Gift: Remaining Exemption for Ruth: $5, 800, 000 $3, 712, 000 $7, 424, 000* $0 $3, 576, 000 * Ruth joined in the gift and allocated $2, 424, 000 of her Federal Unified Credit Exemption to eliminate any taxes due. NO step up in basis at death of Donor. NO Massachusetts Gift Tax.

Intentionally Defective Grantor Trust n Establish an Intentional Defective Grantor Trust n n n An IDGT is an estate planning tool used to freeze certain assets of an individual for estate tax purposes, but not for income tax purposes. The intentionally defective trust is created as a “grantor trust” with a purposeful flaw that ensures that the individual continues to pay income taxes, as income tax laws will not recognize the assets as having been transferred away from the individual. For estate tax purposes, however, the value of the grantor's estate is reduced by the amount of the assets transfer. The individual will "sell" assets to the trust in exchange for a promissory note of some length, such as 10 or 15 years. The note will pay enough interest to classify the trust as above market value, but the underlying assets are expected to appreciate at a faster rate.

What constitutes a “IDGT”? An IDGT can be created in one or more of the following ways: n n n The Trustor or his or her spouse retains the power to recover the trust assets (e. g. , the Trustor retains the right to reacquire property out of the trust in exchange for property of equal value); The Trustor or his or her spouse can or does benefit from the trust income (e. g. , the Trustor and/or a nonadverse Trustee can sprinkle income for the benefit of the Trustor's spouse) The Trustor or his or her spouse possesses a reversionary interest worth more than 5% of the value of the trust upon its creation;

What constitutes a “IDGT”? (continued) n The Trustor or his or her spouse controls to whom and when trust income and principal is to be distributed, or possesses certain administrative powers that may benefit the Trustor or his or her spouse (e. g. , a non-adverse Trustee may add beneficiaries of the trust income and/or principal); n n The Beneficiary has a power to withdraw income or principal to himself or herself (e. g. , a Crummey power); and/or The Trustor and/or a nonadverse Trustee has the power to apply trust income to the payment of premiums for insurance on the life of the Trustor or the Trustor's spouse.

Structured Sale to an “IDGT” n The IDGT need to be seeded by a cash gift or by the transfer of shares of common stock of the Company. a) b) Gift of Cash (Triple A Distribution) Gift of Shares $412, 445 - 4 shares of Class A - 61 shares of Class B $371, 200 Appraised Value n Sale Price of shares sold to each IDGT a) b) Gift of Cash Gift of Shares $3, 712, 000 $3, 340, 800

Structured Sale to an “IDGT” (continued) n n Issue a Promissory Note in the amount of $7, 680, 000 Note for a nine (9) year period with the applicable Federal interest rate annually of 1. 94%; or an annual long term interest rate of 2. 84%; or n Note for interest payments only n Right of Note Prepayment without penalty n Interest rate based on IRC Section 1294(a).

Important IRC Sections 1. Retention of certain powers under IRC Section 675(4)(c) will result in Grantor status. 2. Must not violate IRC Sections 2036 through 2038 which would result in the inclusion of the shares in John’s estate.

Grantor Retained Annuity Trust (“GRAT”) Definition of a “GRAT”: n n A GRAT is one of the most powerful and tax efficient wealth transfer tools available today. A GRAT allows a person to share the future appreciation of an asset with the next generation with virtually no gift tax. A GRAT protects the client if the 2010 tax laws change after two (2) years.

Definition of a “GRAT” (continued) n n A GRAT is a trust with a specific life or term, i. e. , 5 years, 8 years, etc. The grantor transfers assets to the GRAT and retains an interest in the trust. This income interest will be stated as an annuity percentage of the original assets transferred to the GRAT. Each year the GRAT will pay the grantor the required payment. At the end of the GRAT term, any remaining assets will be distributed to the named beneficiary of beneficiaries. The gift will be calculated using the subtraction method. The present value of the annuity payments to the grantor will be subtracted from the original value of the assets placed into the GRAT.

Establish the “GRAT” 1. Transfer 40 Class A shares and 540 Class B shares to the two individual trusts established for Rich and Sue. 2. The beneficiary for a term certain will be John. 3. Rich and Sue will be the owner of the assets of one trust at the end of the term certain. 4. Calculation

Establish the “GRAT” (continued) n Calculation: n n n Term: Transfer Date: 7520 Rate: Grantor’s Age: Income Earned by Trust: Total Number of Payments: Annual Annuity Payout: Initial Amount of Payment Period: Value of Term Certain Annuity Interest: Value of Grantor’s Retained Interest: Taxable Gift: 5 Years 01/2011 2. 40% 65 Years 0. 00% 5 742, 400 3, 458, 990. 08 $253, 009. 92

Other Benefits to a “GRAT” n Income Tax Benefits: n NO Capital Gains tax on proceeds from the sale n Grantor pays Income Tax on the IDGT earnings. This ingredient may be the best benefit of the IDGT in many cases. n Other than the 40 Class A shares of Common Stock, the shares are no longer included in John’s estate. If he survives a five (5) year term. n NO appreciation on shares transferred to the IDGT n n Generation Skipping Grantor’s payment of income taxes can be altered by provisions in the trust.

Negatives of using a GRAT n n Under Internal Revenue Code Section 2642(f)(1), the grantor of a trust cannot effectively allocate generationskipping transfer (“GST”) tax exemption to property transferred until the close of the estate tax inclusion period. Thus, it appears that in order for GRAT property passing to the GRAT remainderman to be exempt from GST tax, the grantor must allocate GST exemption to the remainder property at the end of the GRAT term rather than at the time the property is initially transferred to the GRAT.

Conventional Sale to Third Party n n A conventional sale for the shares could be done on the same basis as the transaction. However, the business owner/seller would have to pay a capital gain on all the payments received. Business owner/seller would have to pay ordinary income tax on the income generated by interest; and Business owner/seller would not be able to pay the taxes on the earned income of the corporation.

Conventional Sale (continued) n n n n n Sale Price Installment Payments Mid-Term Interest Rate Long-Term Interest Rate John’s Tax Basis John’s Capital Gains Tax Rate/20% Rich & Sue’s Earnings Rich & Sue’s Tax Rate/40% (individually) Payment on Notes (individually) 7, 424, 000 3, 712, 000 1. 95% 3. 88% 2, 000 5, 530, 667 1, 860, 133 12, 373, 333 3, 093, 333. 50

ESTATE EQUALIZATION AND INSURANCE SUMMARY $60, 000 $6, 000 Survivorship Second to Die life insurance; $60, 000 annual premium funded via annual gift to an ILIT. Open to traditional portfolio design or universal life policy design. Considerations: premium flexibility; short pay, importance of cash value Rationale – Guaranteed benefit for Jan and Robert. Income and estate tax free liquidity if needed for taxes.

ESTATE EQUALIZATION AND INSURANCE SUMMARY (continued) $16, 000 Long Term Care $350 per day, lifetime benefit, 3% inflation Rationale – prudent transfer of risk; preservation of assets for John and Ruth then heirs $4, 000 the $80, 000 Medical Insurance Supplement to Medical A & B – assumes John and Ruth stay in company plan Total annual premium

SUMMARY n In Depth Fact Finding n Advisor Team Work n Clear Focus on client Lifestyle Income Needs n Integration of Insurance and Tax Strategies n Questions and Answers