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PFP Guest Family Business Succession Planning January 1, 20XX Page 2 of 9 Transferring Your Family Business As a business owner, you’re going to have to decide when will be the right time to step out of the family business and how you’ll do it. There are many estate planning tools you can use to transfer your business. Selecting the right one will depend on whether you plan to retire from the business or keep it until you die. Perhaps you have children or other family members who wish to continue the business after your death.

Obviously, you’ll want to transfer your business to your successors at its full value. However, with income, gift, and potential estate taxes, it takes careful planning to prevent some (or all) of the business assets from being sold to pay them, perhaps leaving little for your beneficiaries. Therefore, business succession planning must include ways not only to ensure the continuity of your business, but also to do so with the smallest possible tax consequences. Some of the more common strategies for minimizing taxes are explained briefly in the following sections.

Remember, none are without drawbacks. You’ll want to consult a tax professional as well as your estate planning attorney to explore all strategies. This allows your beneficiaries more time to raise sufficient funds or obtain more favorable interest rates. The business must exceed 35 percent of your gross estate and must meet other requirements to qualify. Selling your business interest outright When you sell your business interest to a family member or someone else, you receive cash (or assets you can convert to cash) that can be used to maintain your lifestyle or pay your estate taxes.

You choose when to sell–now, at your retirement, at your death, or anytime in between. As long as the sale is for the full fair market value (FMV) of the business, it is not subject to gift tax or estate tax. But if the sale occurs before your death, it may be subject to capital gains tax. Transferring your business interest with a buy-sell agreement A buy-sell agreement is a legal contract that prearranges the sale of your business interest between you and a willing buyer.

A buy-sell agreement lets you keep control of your interest until the occurrence of an event that the agreement specifies, such as your retirement, disability, or death. Other events like divorce can also be included as triggering events under a buy-sell agreement. When the triggering event occurs, the buyer is obligated to buy your interest from you or your estate at the FMV. 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 you become ill or when you die.

Remember, you are bound under a buy-sell agreement: You can’t sell or give your business to anyone except the buyer named in the agreement without the buyer’s consent. This could restrict your ability to reduce the size of your estate through lifetime gifts of your business interest, unless you carefully coordinate your estate planning goals with the terms of your buy-sell agreement. There are many estate planning tools you can use to transfer your business. Selecting the right one will depend on whether you plan to retire from the business or keep it until you die.

You and your estate may get some relief under the Internal Revenue Code If you are prepared to begin transferring some of your business interest to your beneficiaries, a systematic gifting program can help accomplish this while minimizing the gift tax liability that might otherwise be incurred. This is done by utilizing your ability to gift up to $12,000 per year per recipient without incurring gift tax. By transferring portions of your business in this manner, over time you may manage to transfer a significant portion of your business free from gift tax.

Clearly, the disadvantage of relying solely on this method of transferring your business is the amount of time necessary to complete the transfer of your entire estate. In addition, Section 6166 of the Internal Revenue Code allows any estate taxes incurred because of the inclusion of a closely held business in your estate to be deferred for 5 years (with interest-only payments for the first four years and interest plus principal due in the fifth year), and then paid in annual installments over a period of up to 10 years.

See disclaimer on final page January 1, 20XX Page 3 of 9 Grantor retained annuity trusts or grantor retained unitrusts A more sophisticated business succession tool is a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). GRAT/GRUTs are irrevocable trusts to which you transfer appreciating assets while retaining an income payment for a set period of time. At either the end of the payment period or your death, the assets in the trust pass to the other trust beneficiaries (the remainder beneficiaries).

The value of the retained income is subtracted from the value of the property transferred to the trust (i. e. , a share of the business), so if you live beyond the specified income period, the business may be ultimately transferred to the next generation at a reduced value for estate tax or gift tax purposes. A more sophisticated business succession tool is a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). Self-canceling installment notes

A self-canceling installment note (SCIN) allows you to transfer the business to the buyer in exchange for a promissory note. The buyer must make a series of payments to you under that note. A provision in the note states that at your death, the remaining payments will be canceled. SCINs provide for a lifetime income stream and avoidance of gift tax and estate tax similar to private annuities. Unlike private annuities, SCINs give you a security interest in the transferred business. Family limited partnerships

A family limited partnership can also assist in transferring your business interest to family members. First, you establish a partnership with both general and limited partnership interests. Then, you transfer the business to this partnership. You retain the general partnership interest for yourself, allowing you to maintain control over the day-to-day operation of the business. Over time, you gift the limited partnership interest to family members. The value of the gifts may be eligible for valuation discounts as a minority interest and for lack of marketability.

If so, you may successfully transfer much of your business to your heirs at significant transfer tax savings. Private annuities A private annuity is the sale of property in exchange for a promise to make payments to you for the rest of your life. Here, you transfer complete ownership of the business to family members or another party (the buyer). The buyer in turn makes a promise to make periodic payments to you for the rest of your life (a single life annuity) or for your 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, it allows you to remove assets from your estate without incurring gift tax or estate tax. Until very recently, exchanging property for an unsecured private annuity allowed you to spread out any gain realized, deferring capital gains tax. Proposed regulations have effectively eliminated this benefit for most exchanges, however.

If you’re considering a private annuity, be sure to talk to a tax professional. See disclaimer on final page January 1, 20XX Page 4 of 9 Grantor Retained Annuity Trust (GRAT) Definition A grantor retained annuity trust (GRAT) is an irrevocable trust into which a grantor makes a one-time transfer of property, and in which the grantor retains the right to receive a fixed amount of principal and interest at least annually for a specified term of years. At the end of the retained nterest period or upon the death of the grantor, whichever is earlier, the property remaining in the trust passes to the remainder beneficiaries or remains in trust for their benefit. A transfer of property to an irrevocable trust is a taxable gift. The value of the gift on which gift tax is imposed is generally its fair market value. However, because the grantor retains an interest in a GRAT, the value of the transfer is discounted; gift tax is imposed only on the remainder interest (and any gift tax due may be sheltered by the grantor’s $1 million lifetime gift tax exemption).

This taxable value is calculated using an interest rate provided by the IRS (known as the discount rate or Section 7520 rate), which is based on current interest rates and changes monthly. This interest rate assumes the GRAT property will earn a certain rate of return during the annuity period. Any actual return that exceeds the assumed return passes to the remainder beneficiaries gift and estate tax free. Investment performance, therefore, is central to this strategy. Key tradeoffs If the GRAT property underperforms the Section 7520 rate, no tax savings is achieved (and if the GRAT is depleted, no property is transferred to the remainder beneficiaries) If the GRAT property underperforms the Section 7520 rate, gift taxes paid and/or any applicable exclusion amount used will be wasted (though the amounts would be minimal)

If the grantor does not outlive the term of years, any property remaining in the GRAT is includable in the grantor’s gross estate for federal estate tax purposes If the GRAT is unsuccessful, any costs incurred to create and maintain the GRAT will be wasted • • How is it implemented? • • • • Hire an experienced attorney to draft the GRAT document Have property that is transferred to GRAT professionally appraised Transfer property to GRAT (i. e. , retitle assets) File gift tax returns For a GRAT to be successful: • • • The grantor must outlive the term of years The GRAT property must outperform the Section 7520 rate The GRAT document must be properly drafted Potential tax advantages of a GRAT include: Because of the retained interest, the value of the transfer for federal gift tax purposes may be discounted Principal remaining in the GRAT at the end of the term of years is removed from the grantor’s gross estate for federal estate tax purposes Interest (i. e. , appreciation and/or earnings) remaining in the GRAT at the end of the term of years passes to the remainder beneficiaries federal gift tax free • • See disclaimer on final page January 1, 20XX Page 5 of 9 Grantor Retained Unitrust (GRUT) Definition

A grantor retained unitrust (GRUT) is an irrevocable trust into which a grantor makes a one-time transfer of property, and in which the grantor retains the right to receive a variable amount of principal and interest (based on a fixed percentage) at least annually for a specified term of years. At the end of the retained interest period or upon the death of the grantor, whichever is earlier, the property remaining in the trust passes to the remainder beneficiaries or remains in trust for their benefit. A transfer of property to an irrevocable trust is a taxable gift.

The value of the gift on which gift tax is imposed is generally its fair market value. However, because the grantor retains an interest in a GRUT, the value of the transfer is discounted; gift tax is imposed only on the remainder interest (and any gift tax due may be sheltered by the grantor’s $1 million lifetime gift tax exemption). This taxable value is calculated using an interest rate provided by the IRS (known as the discount rate or Section 7520 rate), which is based on current interest rates and changes monthly. This interest rate assumes the GRUT property will earn a certain rate of return during the annuity period.

Any actual return that exceeds the assumed return passes to the remainder beneficiaries gift and estate tax free. Investment performance, therefore, is central to this strategy. A GRUT is the same type of trust as a grantor retained annuity trust (GRAT), except that with a GRAT, the grantor receives a fixed annuity amount rather than a variable unitrust payment. Because of this, the grantor of a GRUT receives more income than with a GRAT, reducing the potential for tax savings. And, because the unitrust payment must be recalculated each year, the cost to administer a GRUT may be greater than with a GRAT.

Another important difference between these two trusts is that unlike a GRAT, a GRUT can’t be zeroed out, and therefore a taxable gift always results. Potential tax advantages of a GRUT include: • Because of the retained interest, the value of the transfer for federal gift tax purposes may be discounted Principal remaining in the GRUT at the end of the term of years is removed from the grantor’s gross estate for federal estate tax purposes Interest (i. e. , appreciation and/or earnings) remaining in the GRUT at the end of the term of years passes to the remainder beneficiaries federal gift tax free • • Key tradeoffs If the GRUT property underperforms the Section 7520 rate, there is no excess and no tax savings is achieved (and if the GRUT is depleted, no property is transferred to the remainder beneficiaries) If the GRUT property underperforms the Section 7520 rate, gift taxes paid and/or any applicable exclusion amount used will be wasted (though the amounts would be minimal) If the grantor does not outlive the term of years, any property remaining in the GRUT is includable in the grantor’s gross estate for federal estate tax purposes If the GRUT is unsuccessful, any costs incurred to create and maintain the GRUT will be wasted • • How is it implemented? • • • • Hire an experienced attorney to draft the GRUT document Have property that is transferred to the GRUT professionally appraised Transfer property to GRUT (i. e. , retitle assets) File gift tax returns For a GRUT to be successful: • • • The grantor must outlive the term of years The GRUT property must outperform the Section 7520 rate The GRUT document must be properly drafted See disclaimer on final page January 1, 20XX Page 6 of 9 Planning for Succession of a Business Interest

Business Succession Planning Alternatives Lifetime Gifts If you want to: Sell your business interest If you want to: Give business to your children If you want to: Sell business to your children If you want to: Bequest Lifetime Sale Estate Sale Buy-Sell Agreement Buy-sell agreement can be used to guarantee the sale of your business Not appropriate Not appropriate You may be able to sell your business outright-but there is no guarantee You can control the timing and size of the gifts You control the Not appropriate size of the gift through your will

Your estate may be able to sell your business outrightbut there is no guarantee Not appropriate Not appropriate Can be used in Not appropriate You can control conjunction timing of salebut sale is not with sale guaranteed You can control timing of salebut sale is not guaranteed Your child could buy from your estate-but sale is not guaranteed Value of business must be included in your estate Buy-sell can be used to guarantee your child’s option to buy your interest Value of business must be included in your estate, but the buy-sell can help establish that value

Can be used to Will not reduce the minimize value of your estate Minimize value value of your of your estate estate and maximize gift tax exclusion See disclaimer on final page January 1, 20XX Select Options for Preserving a Family Business for Children Private Annuity Self-Canceling Installment Note Lifetime Gifts Yes Generally, yes Yes, to the extent the fair value of the business does not exceed the present value of the annuity Yes No To the extent of the annual gift tax exclusion and the lifetime gift tax exemption

Family Limited Partnership Yes To the extent of the annual gift tax exclusion and the lifetime gift tax exemption Value of gifts may be discounted Yes, but not to the extent payments are received back into your estate • Generally, payments are return of basis and/or interest (ordinary income) • You pay income tax on interest ncome • You pay income tax on interest income Yes, but children do not receive a “step up” in cost basis Yes, but children do not receive a “step up” in cost basis Payments are return of basis, capital gain, and/or interest (ordinary income) • • Yes, but not to the extent payments are received back into your estate Yes, but not to the extent payments are received back into your estate You pay no income tax on annuity payments You pay taxes on all income earned by the trust Shifts future appreciation to children Yes Yes, to the extent the fair value of the business does not exceed the present value of the annuity

Grantor Retained Annuity Trust Provides liquidity? No Minimizes federal gift tax? • • Minimizes federal estate tax? Shifts future appreciation to children Minimizes federal income tax? • Shifts FLP income to children, who may be in lower tax brackets Minimizes federal capital gains tax? No, generally, for exchanges made after October 18, 2006 Capital gain can be reported over the period payments are received No No Yes, but children do not receive a “step up” in cost basis for gifted interests Lets you retain control of the business?

Yes Payments received are subject to creditors Yes Yes Yes No Provides lifetime income? Yes, if general partner is a corporation Limited partners have no personal liability for business debts • • You may die before receiving full payment The buyer’s obligation is unsecured Transfer title Execute agreement Can be costly • • To extent you receive FLP income Yes Payments received are subject to creditors No • • Your creditors cannot reach gifted interests Gifted interests are subject to your children’s creditors

Protection against creditors? • Payments received are subject to creditors • Any risk? No You may die before receiving full payment No No Formalities? • Many • Transfer title Execute note Can be costly • • Transfer title Execute trust Can be costly Transfer title Page 7 of 9 See disclaimer on final page January 1, 20XX Costly? Yes No Page 8 of 9 Overview of Buy-Sell Agreement Forms Agreement Form Wait and see Buyer Business entity, co-owner, or both Co-owner Transaction overseen by trustee Business entity Business entity Works Well With

Business with two or more owners Business with two or more owners Simplifies plan when large number of owners Business with two or more owners Business with two or more owners Business with two or more owners, especially family business Business with two or more owners, especially family business Business with two or more owners Unsuitable For Sole proprietor and single-shareholder corporation Sole proprietor and single-shareholder corporation Trusteed cross purchase Entity purchase (stock redemption) Section 302 stock redemption Section 303 stock redemption Reverse Section 303 stock redemption Cross purchase (crisscross) agreement

Most expensive type Sole proprietor and single-shareholder corporation Sole proprietor and single-shareholder corporation Sole proprietor and single- shareholder corporation Sole proprietor and single-shareholder corporation Large number of owners (gets complicated with four or more) Business entity Business entity Co-owner Option plan Business entity, co-owner, or any eligible third party Sale not guaranteed Business with any number of owners, including sole proprietorship and single-shareholder Business with any number of owners, including sole proprietorship and single-shareholder

Any scenario where guaranteed sale is needed One-way buy-sell Business entity, coowner, or any eligible third party Sole proprietor with no willing buyer See disclaimer on final page January 1, 20XX Page 9 of 9 PFP Guest Neither Forefield Inc. nor Forefield Advisor provides legal, taxation, or investment advice. All content provided by Forefield is protected by copyright. Forefield claims no liability for any modifications to its content and/or information provided by other sources. Copyright 2007 Forefield Inc. All rights reserved.