What Will Happen to Your Business When You Retire?

By Mark E. Battersby

Sooner or later, everyone thinks about retirement. For those who own a closely held or family business, retirement is more than just a matter of deciding not to go to work anymore. In addition to ensuring there will be enough money to retire, service center owners, shareholders and partners must decide what will happen to the business when they are no longer in control.

An effectively developed succession plan can involve selling the business to provide a retirement nest egg or continuation of the business with gradual changes in management or control to ensure a source of retirement income—or any combination thereof.

Planning basics
At its most basic, a succession plan is a documented road map to be followed in the event of the owner, partner or shareholder’s death, disability or retirement. This plan can include a program for distributing the stock of the service center and other assets, retiring the operation’s debt, obtaining life insurance policies, buy-sell agreements between partners and heirs, dividing responsibilities among successors, and any other elements that affect the business or its assets.

The tax component of succession planning addresses the minimization of taxes upon death. Tax law changes in 2001 contained a one-year elimination of the so-called “death tax.” The estate tax rose from the grave at the end of 2010, with a Bush-era top rate of 35 percent and an applicable exclusion amount of $5 million ($5.12 million in 2012). In 2013, the death tax will revert to its antiquated, pre-2001 form. The applicable exclusion amount will plummet to $1,000,000, and the top marginal rate will leap 20 points to 55 percent. A surtax of 5 percent also will return, to be levied on estates between $10 million and $17 million. This raises the top effective rate of the death tax to 60 percent.

Giving it away
Because a key way to reduce estate taxes is to lower the value of assets that are in the estate, gifting strategies can legitimately lower any owner, partner or shareholder’s tax liability. Fortunately, there are several ways to make gifts outright, and all serve to reduce the amount of the overall estate:
  • Annual gift tax exclusions: Currently, property valued at up to $13,000 per year per donee (i.e. person receiving the property) may be gifted without any gift tax consequence.
  • Other gift tax exclusions: Gifts for the purposes of the donee’s health or education are excluded from gift tax calculations (which is why parents could seemingly pay unlimited amounts for their children’s doctor appointments and, for some lucky ones, schooling expenses).
  • Lifetime gift tax exemptions: For 2011 and 2012, giving lifetime gifts totaling up to $5 million before any estate, gift or generation-skipping taxes are imposed is still possible.

Unfortunately, none of these gifting strategies directly benefits the metals distribution business. Other strategies for transferring a service center business do exist, however, strategies that frequently include retaining control.

Flipping for FLPS
By controlling the metal center business through a family limited partnership (FLP) or a family limited liability company (FLLC), everyone can get the added benefit of gifting shares at considerable discounts. An FLP or FLLC also can assist in transferring a business interest to family members.

First, a partnership with both general and limited partnership interests is created. Then, the business is transferred to this partnership. A general partnership interest is retained for the owner, allowing a continuation of control over the day-to-day operation of the business. Over time, the limited partnership interest is gifted to family members.

Buy/sell agreements
A buy-sell agreement, often called a “business pre-nup,” is a legal contract that prearranges the sale of a business interest between a seller and a willing buyer. A buy-sell agreement allows the seller to keep control of his or her interest until an event specified in the agreement occurs, such as the seller’s retirement, disability or death. Other events such as divorce can also be included as triggering events under a buy-sell agreement.

When the triggering event occurs, the buyer is obligated to buy the interest from the seller, or the seller’s estate, at its fair market value. The buyer can be a person, a group (such as co-owners), or the business itself. Price and sale terms are prearranged, which eliminates the need for a fire sale if the owner, partner or major shareholder becomes ill or dies.

Selling it to the employees
An Employee Stock Ownership plan (ESOP) allows the owner of an incorporated business such as a metals service center to sell his or her stock to the ESOP and defer the capital gains tax. Ownership can be transferred to the metal distribution operation’s employees over time, and the business can obtain income tax deductions for contributions to the plan. An ESOP provides a market for the shares of owners who leave the business, a strategy for rewarding and motivating employees, as well as benefitting from available borrowing incentives and acquiring new assets using pretax dollars.

An outright sale
To keep the income rolling in without having to show up for work every day, succession planning might look at selling an owner, shareholder or partner’s interest in the business outright. When the business interest is sold, the seller receives cash (or assets that can be converted to cash) that can be used to maintain the seller’s lifestyle or pay the estate taxes.

The time to sell is optional—immediately, at retirement, at death or anytime in between. As long as the sale is for the full fair market value of the business, it is not subject to gift tax or estate tax. Of course, a sale that occurs before the seller’s death may be subject to capital gains tax.

Liquidity Strategies = Cash
So-called “liquidity strategies” permit an owner to take cash out of the business in exchange for the transfer of assets to another individual. While liquidity options are most common when sales of the business are to a third party, they also can be used when the assets are being transferred to family members or business insiders (such as partners).

A private annuity involves the sale of property in exchange for a promise to make payments for the rest of the seller’s life. Here, ownership of the business is transferred to family members or another party (the buyer). The buyer, in turn, makes an unsecured promise to make periodic payments for the rest of the seller’s life (a single life annuity), or for the seller’s life and the life of a second person (a joint and survivor annuity).

A joint and survivor annuity provides payments until the death of the last survivor; that is, payments continue as long as either the husband or wife is still alive. Again, because a private annuity is a sale and not a gift, assets can be removed from an estate without incurring gift tax or estate tax.

A self-canceling installment note (SCIN) permits the transfer of the business to a buyer in exchange for a promissory note. The buyer must make a series of payments to the seller under that note. A provision in the note states that upon the owner’s death, the remaining payments will be canceled. SCINs provide for a lifetime income stream and avoidance of gift tax and estate tax in a manner similar to private annuities. Unlike private annuities, however, SCINs give a security interest in the transferred business.

Successfully planning succession
Developing a succession plan is a multi-phase process outlining in detail the who, what, when, why and how changes in ownership and management of the business are to be executed. At a minimum, a good plan should help accomplish the following:
  • Transfer control according to the wishes of the operation’s owner, shareholder or partner;
  • Carry out the succession of the business in an orderly fashion;
  • Minimize the tax liability of all involved;
  • And provide economic well-being after the owner, partner or shareholder steps aside.

Obviously, business owners seeking a smooth and equitable transition of their interests should seek competent, experienced advisors to assist them in this matter. No matter how talented and earnest those professional advisors are, their limited specialties should never dictate the choices for the business or the owner, shareholder or partner’s family.

A tax lawyer can make compelling arguments for strategies that can minimize estate and gift taxes. A CPA can be very convincing when suggesting strategies for controlling income taxes. And it is a similar story with financial planning and insurance professionals. In fact, tax planning should never control any business decisions.

Finally, succession planning isn't something that can done once and forgotten. To be complete and effective, a succession plan must be continually revisited, reviewed and updated to reflect changes in the value of the service center operation, market conditions, and the owner, shareholder or partner’s health, as well as the abilities and passion of the people who will take over the business.

Mark E. Battersby is a freelance writer and consultant on tax and financial issues based in Ardmore, Pa. He can be reached at 610-789-2480 or by e-mail at MEBatt12@Earthlink.net.
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Sunday, March 18, 2018