Business Succession Case Study
Helping a producer write $IO million in new life insurance policies by designing a compelling BUSINESS SUCCESSION plan.
Facts of Case:
This case involved an entrepreneur who owned a very successful potato farm and business operation, Pleasant Farms, Inc., and the underlying farmland, First Properties, LLC. Pleasant Farms is an S corporation worth about $15 million in which the husband owns 80% of the stock. The remaining 20% is owned by his son, who is active in the business. There are also two key people in the business. Pleasant Farms, LLC is worth about $8 million and is wholly owned by the husband. In addition, the husband and his wife own a personal residence worth $1 million, IRAs totaling $100,000, a $500,000 life insurance policy on husband s life and cash and marketable securities totaling about $200,000.
The clients were concerned about several issues, including:
- Passing Pleasant Farms, Inc., to their son.
- Passing First Properties, LLC to his three children equally yet giving control to their son.
- Treating their three children equitably.
- Assuring the long-term viability of each of the businesses.
- Taking steps to minimize estate settlement costs at both the first and second death.
- Protecting the son’s assets from his family’s creditors and ex-spouses.
- Having sufficient cash to pay estate settlement costs.
We first discussed updating the clients’ estate planning documents and proper titling of assets to assure optimal use of both spouse’s unified credit at the first death.
We suggested that the client enter into a one way buy-sell agreement with his son for the stock of Pleasant Farms, Inc. where the client’s son would have the obligation to buy out the client’s interest at death at the stock’s fair market value. We explained how a cross purchase buy-sell agreement permits the son’s tax basis to be increased by the full amount of the purchase price. We also suggested that the buy out obligation be funded so that the son has the financial wherewithal to carry out the agreement.
It was suggested that the son be the owner and beneficiary of a $10 million policy on the husband s life and that the premiums be bonused to the son. Upon the husband s death, the son would collect the life insurance and purchase the shares from the husband s estate. In this way, the death proceeds indirectly pass to the surviving spouse as she is the primary beneficiary of the estate. The life insurance can provide the necessary cash to the wife who otherwise lacks sufficient non-business assets to maintain her lifestyle. To the extent that the proceeds from the buy-sell are still available at the wife s subsequent death and are not needed to pay estate settlement costs, these same funds can also be used to treat the inactive children in a fair and equitable manner.
GRAT (Grantor Retained Annuity Trust)
We also discussed ways to limit the future growth of the business in the husband s and his wife s estates. We suggested creating a grantor annuity trust (GRAT) for the son s benefit. Shares in Pleasant Farms, Inc. could be transferred to a GRAT to take advantage of various valuation discounts (i.e., lack of control, lack of marketability). Since the son will not receive the shares for a period of years, the value of the gift can also be discounted for the time value of money. At the end of the term of years, the remainder interest (i.e., the shares in the S corporation) passes to the son.
Retaining Key Employees
We also suggested that steps be taken to better ensure that the two key people stay with the business after the client’s death and during the critical transitional period. We suggested a nonqualified retirement plan whose terms include a graded vesting schedule and a substantial deferred benefit (i.e., “golden handcuffs”). The plan could be tied to individual performance or alternatively, to a formula that mirrors the growth of the business such as a phantom stock plan.
To provide equitably for the two inactive children, we also discussed creating a new dynasty trust. The existing $500,000 personally owned life insurance could be transferred to this trust in order to remove the death proceeds from both estates. We also suggested that this trust purchase a $5 million joint and survivor policy on the husband and his wife. The death benefit could provide income tax-free, estate tax-free and generation skipping tax-free proceeds to the couple s inactive children and their grandchildren. Funds to pay the premium could be lent to this trust using a note to lock in the appropriate AFR interest rate. Structured properly, the property in this trust would not be included in husband s or his wife s estate nor would it be included in the children’s estates.
Recapitalization of Voting and Non-voting Interests
Furthermore, we discussed how First Properties, LLC could be recapitalized into voting and non-voting interests. The voting interests could be gifted to the son and the non-voting LLC interests could be gifted to the dynasty trust to take advantage of potential discounts (i.e., lack of control and lack of marketability). The cash flow generated from the gifted LLC interests could be used to pay the interest, repay the note and exit from the loan arrangement. At the client s and the wife s death any unused applicable exclusion amounts, and GST exemption amounts could be used to transfer non-business assets and non-voting LLC interests to this GST trust.
Post Case Analysis:
The clients liked our recommendations but wanted to reduce the amount of insurance to fund the buy-sell agreement to $5 million. They believed that the insurance could be reduced by gifting shares to their son and by utilizing their remaining applicable exclusion amount at death. One did not feel the need to use a GRAT and take a chance that it might not work if he died early. The clients’ attorney decided to implement the recommendations over a two-year period. In the first year, we implemented the buy-sell agreement and purchased the $5 million individual policy to fund the agreement. In the second year, we established the dynasty trust and purchased the $5 million joint and survivor life insurance policy. We are still working on implementing the golden handcuffs for the key people and the various gifting programs.