At some juncture, the owners of the business reach a point where it’s time to slow down to pass the baton to a new leader, a successor in the wings anxious to run the show. The owner really has no interest in selling out. Here, she just wants to continue to pull money regularly out of the company to fund a desirable lifestyle and investments, to keep a hand at the operation to make sure things continue to function well and to provide strong incentives for the new leader.
This article shares a few ideas on how the company might be restructured to help with this challenge. This article has only one purpose – to help educate all those who want and need more information.
We’re going to use a simple case study to help illustrate the ideas. The case study involves a family business but the ideas may work for the owner of a non-family enterprise who wants to phase out and have a person who is not a relative run the show.
Earl and Betty Wilson own 90% of the outstanding stock of a C Corporation that has been in a specialized distribution business for 26 years. Earl Wilson (he’s aged 65) is the founder and president of the company and historically has been the principle force behind the company. Betty, his wife (she’s 60 years old), serves on the board but spends no serious time in the business.
The other 10% of the stock is owned by Jeff Wilson. Now, Jeff is Earl and Betty’s oldest son. He is married and he has been actively involved in the business for years. Jeff is considered the second-in-command behind Earl. In addition to having a strong financial background, Jeff has a proven knack for sales and marketing and is really skilled in dealing with people. Jeff is anxious to take over the reins and he wants to aggressively grow and expand the business.
Earl and Betty have 2 other children, Kathy and Paul. Both are grown and married but neither of them work in the business. Paul is a doctor. Kathy works in commercial real estate. Earl and Betty have 4 grandchildren and they hope that they’re going to have 1 or 2 more.
Earl estimates that the business is worth approximately $10 million. That’s the price that he believes the business could be sold for today. Earl and Betty’s total estate inclusive of their share of the business is valued at about $18 million. Earl and Betty are anxious to move forward. They’re looking forward to their retirement. They would like to develop a plan that will accomplish a variety of objectives:
Number 1: Earl would like to phase out of the business over the next year and continue to receive payments from the business that will enable he and Betty to ride off into the sunset and enjoy their retirement for the rest of their lives.
Two: Jeff will take over the control and the management of the business. Earl wants some ongoing involvement as a hedge against the boredom of retirement and to ensure that the financial integrity of the business is protected for the sake of his retirement and Betty’s welfare.
Three: Jeff will have the freedom to diversify and expand the business, and ideally, the value of all future appreciation will be reflected in Jeff’s estate and will not continue to build Earl and Betty’s estates or the estates of other family members, specifically Kathy and Paul.
Four: Earl and Betty want to make sure that at their passing, each child receives an equal share of their estate. They appreciate that the business represents the bulk of their estate right now. They want Jeff to control and run the business, but they want to make certain that Kathy and Paul are treated fairly.
Five: Earl and Betty want to minimize taxes consistent with their other objectives and their overriding desire to be financially secure and independent.
And finally, above all, Earl and Betty always want to make certain that they are financially secure. They never want to be placed in a position of having to depend on their children and they always want to know that their estate is sufficient to finance their lifestyle for the duration. They are willing to pay some estate taxes for this peace of mind.
Earl and Betty have explored various business transition options, none of which have appealed to them. They do not want to start gifting stock or other assets to Jeff or any of the other children at this point. They figure the future is uncertain, that they each have a long time to live, and who really knows what they will need or want for themselves in the future. The idea of selling their stock to either the corporation or to Jeff in return for a long-term note really doesn’t work for them. Given their low tax basis and their stock, any such sale would just trigger a big long-term double tax because all principal payments on the note would have to be funded with after-tax dollars.
Plus, any sale to the corporation to make any tax cents would require that all of the stock be sold in one transaction and that Earl have no further dealings with the company. He couldn’t be an employee, a director, a consultant or anything. None of this works for earl. And any sale to Jeff would create a difficult burden, a real tax killer. The challenge would be to get enough corporate funds into Jeff’s hands so that he could make the payments required by the note, much of which would be with after-tax dollars. And then, on top of that, you’d have to cover all the associated tax burdens.
And there’s another problem. Wilson Inc. is a C Corporation. Earl has regularly drawn a salary of between $350,000 and $450,000 a year and he would like to continue drawing at that pace as he transitions out of the business. But if he’s out playing and no longer working full-time for the enterprise, all or a major portion of any such payments may end up being taxed as dividends which would produce no deduction to the company. This would be an expensive double income tax burden.
So let’s take a look at a few ideas for Earl and Betty to consider.
Often, some simple business restructuring can help immensely in the design of a family transition plan. It’s phasing out without selling out.
Suppose, for example, that Wilson Inc. is restructured to take advantage of 2 basic realities. First, the distribution of S Corporation earnings presents no double tax issues. Second, Jeff’s desire to expand into new markets and to garner all of the benefits of the expansion for himself can be accomplished by having him form and operate a new business that finances the expansion, takes the risks of the expansion, and realizes all the benefits. This restructuring might be implemented as follows:
Wilson Inc. would make an S selection. The shareholders of the company would remain the same, at least for the time being. Earl and Betty would keep their stock for now. Early would retire now and ride off with Betty. The company as an S Corporation would make regular distributions of its earnings to Earl and Betty, none of which would be subject to double tax fears or payroll taxes. Jeff would form a new company. This new company would be structured to finance and manage the growth and expansion of the business. It would take the risks; it would reap the benefits. The old company would either employ Jeff as its CEO or it would contract with Jeff’s new company to provide top level management for the old company. Appropriate provisions would be drawn to ensure that the new company does not adversely affect Wilson Inc.’s present operation and that it has the latitude to enhance the existing markets and expand into new markets. Preferably, the new company would be a pass-through entity, an S Corporation or a limited liability company. Jeff would select the entity form that works best for him. Earl and Betty would structure a gifting program to transfer to their children stock in the company and possibly other assets if and when they determine that they have sufficient assets and income to meet their future needs. These gifts, when they’re made, would be planned to maximize use of their annual gift tax exclusions and the unused gift tax unified credits of both spouses.
Earl and Betty’s wills or living trusts would be structured to leave each child an equal share of their estate. Jeff would have a preferred claim to the Wilson stock, and Kathy and Paul would have a priority claim to the other assets in the estate. If it becomes necessary to pass some of the Wilson’s stock to Kathy and Paul in order to equalize the values, the will or living trust would include a buy-sell provision that would give Jeff the right to buy the stock passing to Kathy and Paul under stated terms and conditions. Jeff’s management rights would remain protected by the existing employment management contracts.
This simple restructuring would offer a number of potential benefits. First, since Earl and Betty retain their stock they would have an income from the business for life, and if that income grows beyond their needs, they would have the flexibility to begin transferring stock and the related income to their children and grandchildren as they choose. Since the cash distributions would be stock-related distributions, there would be no unreasonable compensation risk nor would there be any payroll tax burden.
Second, by virtue of the company having made the S selection, the income distributed to Earl and Betty each year would be pre-tax earnings, free of any threat of double taxation. So as long as the corporation has sufficient current earnings to cover these distributions, this income would be taxed only once. No longer would a party be forced to make payments with after-tax dollars to another family member.
Third, Jeff’s management and control rights would be protected by the employment and management agreements. Earl could play as much or littlest role in the business as he chooses. The parties could scope their control and management agreement in any manner they may choose free of any tax restrictions or limitations.
Fourth, Jeff would be the primary beneficiary of the future growth in the business through the new business entity. The operating lines between the old company and the new company would need to be clearly defined. The goal would be to preserve the existing operation for the old company and its owners, primarily Earl and Betty, and to allow any new operations and opportunities to grow in the company that would be owned, financed, and operated by Jeff.
Fifth, stock owned by Earl and Betty at their deaths receive a full step up in income tax basis.
Sixth, future increases in the value of Earl and Betty’s estate could be limited and controlled by 3 elements: First, the incentive employment management contracts with Jeff. Two, the new company owned, financed, and operated by Jeff. Three, a controlled gifting program implemented by Earl and Betty.
Finally and hopefully, the income stream for Earl and Betty would be insulated for some or all of the financing risks taken by Jeff to expand into new markets. These financing risks would be in the new company, not the old company.
There are limitations and potential disadvantages with such a restructuring approach that would need to be carefully evaluated and may require some creative solutions. First, Jeff may need the operating and asset base of the old company in order to finance the expansion efforts. Various factors could influence the issue including the historical success pattern of the old company, the likelihood of future success, Jeff’s track record and expertise, and other assets owned by Jeff. If this situation exists, it may significantly complicate the situation. Workable alternatives usually are available depending upon the flexibility of the lenders and Earl and Betty’s willingness to take some risks to help with the new financing. But clearly, this may be a complication depending on the circumstances.
The second potential disadvantage is the possibility that the value of Earl and Betty’s common stock in the old company may continue to grow with a corresponding increase in their estate tax exposure. There would be no automatic governor, no automatic limitation on the stock’s future growth and value. Hopefully, this growth fear could be mitigated or entirely eliminated with a carefully implemented gifting program, the operation of Jeff’s new company, and special incentives under the employment or management contracts.
Third, conversion to S Corporation status likely would create additional tax challenges that often are regarded as serious nuisances, not reasons for rejecting the strategy. Converting out of C Corporation’s status is not a free lunch. There are various issues to deal with in the conversion process. But usually, the biggest issue is the potential impact of what’s called the “built-in gains tax,” the big tax. This tax applies when an S Corporation disposes off assets that it owned at the time of its conversion to S Status if the sale occurs within 10 years of the conversion. It’s an entity level tax imposed at the maximum corporate rate on the built-in gain on the asset at the time of the conversion. This tax is an addition to the tax that is realized and passed through to the S Corporation shareholders on the sale. Its purpose is to preserve at least in part and for a period of 10 years the double tax burdens of the corporation’s C existence.
So, the planning challenges for those who decide is to convert early and put as much distance as possible between the conversion date and any sale of corporate assets. But note in Earl’s situation where the goal is to start pulling dividends out of the company on a regular basis that will not be subject to double taxation, the S Corporation will work from day one for this purpose so long as the current earnings of the S Corporation are sufficient to cover the dividend distributions.
Also, often when this issue of S Corporation conversion surfaces, the question is raised as to whether it’s possible to convert the C Corporation to a limited liability company that would be taxed as a partnership. It just can’t be done. The tax costs of such a conversion are prohibitive for almost everyone. The only option in almost all cases is an S Corporation conversion.
The bottom line, often the plan design process should include an evaluation of business restructuring options that address specific family objectives and allow a parent to phase out without selling out. This may allow the parents to rethink or slow down their actual stock transitions to other family members or to target those transitions to occur at key times such as on the death of the first parent.