Estate and Business Succession Planning For Farmers and Ranchers Steve R. Akers Managing Director...

Estate and Business Succession Planning For Farmers and Ranchers

Steve R. AkersManaging Director and Fiduciary Counsel, Southwest Region

Lauren Y. DetzelDean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A., Orlando, FloridaCopyright © 2012 by Bessemer Trust, N.A. All Rights Reserved

22

Pop Quiz for the Business Owner1. Will you be able to retire when you want to?

2. Will your spouse be able to enjoy his or her lifestyle independent of the business?

3. Will you be able to treat your children equitably without hard feelings?

4. Should your family risk keeping the business?

• Can the family run the business?

• Does any of the family want to continue the business?

5. Will the business pass to the child / children who are active in the business?

6. Will the family need outside help in running the business?

7. Is there liquidity to pay estate taxes so the family will not lose the business or have the business financially crippled?

8. Have you minimized estate and income taxes that will be payable at your death?

33

Family Farms

• About 98% of all farms in the US are family farms.

• 85% of the nation’s agricultural output comes from family farms.

• Although 70% of the country’s farmland will change ownership in the next two decades, only 11% of farmers have a transfer plan.

--U.S. Department of Agriculture

• A USA Today article on July 10, 2012 entitled, “Keeping Farm in Family Requires Strategy” states that:

“The average age of a farmer in the US is 57. In any other industry, that would bother everyone.”

44

Business Succession Planning

Surveys of family business owners reflect the following:

• Only 30% of businesses succeed in the transition to management by children.

• Only 12% of family businesses make it to the grandchild – generation.

• More than 2/3 of owners say they plan to pass the family business to their relatives within the next 10 years.

• But only 25% of those have a written succession plan.

– 34% have an unwritten plan

– 40% have no plan at allSource: The Center for the Study of Taxation, Federal Estate and Gift Taxes: Are They Worth the Cost? Pg. 2 (1996)

55


• 40% of business owners who plan to retire in the next five years have not chosen a successor.

• Less then 30% of all businesses have a buy-sell agreement.

• Why devote a career to building the business withoutbottom-line strategic planning to transfer the fruits?

• “Do I make these decisions alone or in collaboration with other family members?” (Influence vs. control)

• These can be very difficult issues to face within the family.It’s very easy to procrastinate.

66

Vulnerability of Business During Succession Planning

There is no time when a business is more vulnerable to failure than during a succession transition.

Vulnerability factors:

• Taking your eye off the business operation during this most vulnerable time

• Lots of change: family, business, ownership

• Owners are often secretive: Successor must play investigator to find out what the deceased owner knew

• Tremendous uncertainty: Customers, suppliers, key employees and lenders

77

Failure Factors

Factors for the failure of most businesses during the succession transition including:

• Failure to name a successor to run the company and a timetablefor the succession

• Family squabbles that divert attention away from the core focusof the business

• Poor estate planning – resulting in a forced sale of assets (or the company) to pay estate taxes or other liquidity needs (But countries with no estate tax or much lower estate taxes have similar failure rates)

• Unwillingness to take risks that fuel company growth; Family owned companies often stay with decades-old practices rather than integrate new services, products and approaches

88


Without proper succession planning,

the business is subject to the ultimate

GOTCHHA.

99


1. Cash Flow

2. Governance with an Eye to Succession

3. Ownership Transfer

4. Treating Family Equitably

5. Can the Business Survive Taxes?

6. How to Reduce Taxes?

7. How to Pay Taxes?

8. Act

1010


1.Cash Flow







8. Act

1111

Cash Flow

Cash Flow for Owner’s Life

Cash Flow for Spouse’s Life• As a practical matter, the owner will be reluctant to entertain succession

planning as long as the owner and owner’s spouse are tied to the business for living expenses.

The Concern: Loss of Compensation and Perks

Elements of Possible Solution• Deferred compensation• Wage continuation plans• Outside investment assets• Rental payments for farmland used in the farm operation• Note payments from sale or redemption of some of owner’s stock• Life insurance proceeds for spouse

1212

Cash Flow

Cash Flow for Children:

• Are children’s living expenses tied to the business?

• Can children earn the same amount elsewhere?

• Do children have an expectation of a funded endowment from the business?

• Are children’s services worth what they are being paid?

• Are there disparities between levels of compensation tothe children?

• These cash flow issues impact many of the remaining issues.

Where’s the money?

1313


1. Cash Flow

2.Governance with an Eye to Succession






8. Act

1414

Governance – Family Issues

Tough questions for the owner:

• Should every family member be entitled to a job?

• Does everyone “start at the bottom?”

• What if some of my children are not qualified – Can I tell them?

• Should family members be required to work outside the business first?

• How do I assign titles?

• What criteria do I use:– Age?– Experience?– Interest Level?– Competence?

• Will the chosen business leader also be the family leader?

1515

Governance – Family Issues

• Can my children get along with key non-family members?• Should non-family members be chosen to run the business?• Are there legitimate roles in the business for children who will

not lead it?• What if my children don’t have the experience or are too young?• Will intra-family rivalries spill over into the business?• Are siblings obsessed with “fairness?” (They often are.)• Do spouses of children have an intense sense of competition with

each other?• Are there “Queen Bees” who will destroy the business?• Do my children want to pursue new activities that I think are too

risky?• Are children angry at the business for taking all of my attention?

1616

Governance – With an Eye to Management Transfer

• Entrepreneurs – by their nature – are reluctant to give up control

• Developing, motivating, training and nurturing successors

• Dealing with unmotivated children

• Separating personal from business goals

• Outside directors / advisors – Only 12% of family firms have directors outside the family

• Equitable compensation(family / non-family; active / inactive shareholders)

• Plan for delegation of responsibility and authority to successors

1717


1. Cash Flow


3.Ownership Transfer





8. Act

1818

Ownership Transfer Planning

1.Decide whether business will be sold or liquidated, or whether to perpetuate it for children

2.Decide who will be successor owner(s)• Voting / nonvoting• Debt / equity• Class ownership

3.Mechanics of ownership transfer• Farmland ownership may be different than entity that operates the

farm• Gifts• Sale• Redemption by business• Bequest• Buy-sell agreement

1919


1. Cash Flow



4.Treating Family Equitably




8. Act

2020

Treating Family Equitably

Most of the time, the factors that cause a

family

business to come to an end are not the

business issues, but the family issues.

2121

Treating Family Equitably—Communication Issues

• “Research shows that succession failures occur because of a breakdown in communication between generations. Finances matter, the business matters, but this is the key.”

• “Each generation must define its own vision and decision-making process”

• “The longer you wait, the higher the probability of conflict.”

• “Family conflict typically is not about personalities. It is about a lack of structure and preparation for change.”

--Dr. Marion Hampton (Banyon Family Business Advisors)

2222

Treating Family Equitably

• Family System vs. Business System

• Gut-wrenching

• Family pride associated with family business

• Children’s perspective – parent’s pride and joy

• Even if ownership is equal, management and control will probably not be equal

• Proper valuation is first step to dividing equitably

• What if non-business assets are not large enough to give pro rata value to non-active children?

2323


1. Cash Flow




5.Can the Business Survive Taxes?



8. Act

2424

Can the Business Survive the Liquidity Crunch?

1.Estate taxes

2.Living expenses for owner’s surviving spouse

3.Funding purchases of owner’s stock under buy–sell agreement

4.Special business needs during transition (such as extra expenses to address uncertainties and anxieties of customers, vendors, lenders, etc.)

2525

Can the Business Survive Taxes?Federal estate tax in 2009:

• $3.5 million “exemption” in 2009; 45% Rate

Federal estate tax in 2010: None, carryover basis applies

Federal estate tax in 2011-2012:

• $5.0 million estate, gift and GST “exemption” in 2011; $5.12 million in 2012

• 35% Rate

Federal estate tax after 2012 if no legislation:

• $1.0 million exemption and 55% Top Rate (with 5% extra for some estates)

The federal estate tax can be deferred until the second spouse’s death (with proper use of the “marital deduction”)

In some states (but not Florida), there are state estate taxes in addition to the Federal estate taxes described above.

2626

Estate Tax System

1.2012: Estate, Gift and GST Exemption = $5,120,000; Rate is 35%

2.If Congress does not act in 2012, the estate and

gift tax exemptions become $1,000,000 on

1/1/13, with a maximum rate of 55% plus a 5% surtax on par of the estate. (The GST exemption is $1.0 million, indexed since 1997)

3.Many planners think Congress will not address the estate tax in 2012, but will do so in 2013. Whenever compromise is reached, it will likely be retroactive to 1/1/13

27

The Bottom Line Excess Net Estate — $5,120,000 (in 2012)

IS

Subject to TAX at 35% rate (in 2012)

IT’S A HUGE TAX !!

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1. Cash Flow





6.How to Reduce Taxes?


8. Act

2929

How to Reduce Taxes

1.Transfer planning during life can dramatically reduce the overall transfer taxes.

• Future appreciation is not subject to estate tax

• Fractionalization discounts

• Grantor trusts (grantor pays income taxes so more value removed from estate)

• $5.12 million gift exemption this year may disappear

2. Every dollar removed from the estate yields a 35% (or more) “present value” savings to the ultimate bottom line.

3030

Estate Tax System

1.2012: Estate, Gift and GST Exemption = $5,120,000; Rate is 35%

2.If Congress does not act in 2012, the estate and

gift tax exemptions become $1,000,000 on

1/1/13, with a maximum rate of 55% plus a 5% surtax on par of the estate. (The GST exemption is $1.0 million, indexed since 1997)

3.Many planners think Congress will not address the estate tax in 2012, but will do so in 2013. Whenever compromise is reached, it will likely be retroactive to 1/1/13

3131

Reducing Estate Taxes—Gift Planning• Advantage: Individual may wish to transfer assets to children or to

trusts for children to reduce estate taxes or (within limits) to shield assets from the individual’s creditors. Future appreciation and income from the gift is out of the estate for tax purposes.

• Annual exclusion: $13,000 (indexed, probably $14,000 next year) per donee per year for “present interest” gifts.

• Medical/tuition expense exclusion--for payments of tuition or to a medical care provider paid on behalf of any individual. This exclusion is unlimited in amount.

• Marital/charitable deduction-A deduction is available for gifts to spouses or to charity.

• Applicable Exclusion Amount gifts-Gifts that are not excluded or deducted as described above effectively use up part of the donor’s $5.12 million (in 2012) lifetime “applicable exclusion amount”.

3232

Reducing Estate Taxes—Gift Planning

• Excess gifts-Cumulative lifetime gifts (that are not excluded or deducted as described above) over $5,120,000 generate gift taxes at ratio of 35% (in 2012)

• Income tax effects of gifts-Gifts are not taxable income to the donee. The donee has a “carryover basis” in the assets equal to the lesser of (1) the donor’s basis, or (2) fair market value of the property at the date of the gift.

• “Defined value” transfers: transfer of set dollar value worth of units to limit gift tax exposure. IRS objects to these clauses. Some cases have recognized them where “excess value” over dollar value amount passes to charity

33

Reducing Estate Taxes – Gift PlanningCase Study #1

Steve, a widower, owns 3,000 acres of property in Florida upon which he runs a large cattle and citrus operation with a total value of $10,000,000. Steve’s son, Jack, also works in the business and expects to take over the business when his father dies. The property is now very valuable, although it is probably worth less than it was a few years ago. Steve is worried about estate taxes and whether Jack will be able to continue the farm after his death. If Steve does nothing and dies next year (and Congress has not acted) then the first $1,000,000 will be estate tax free and the rest will be subject to estate tax.

Estate: $10,000,000 Estate Tax in 2013: $4,795,000

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Suggestion:

Steve transfers his land and business into an LLC which has voting and nonvoting interest: 1% of the interests are voting and 99% are nonvoting. Steve creates an irrevocable grantor dynasty trust for Jack and gifts to the trust nonvoting interest of the LLC that equals $5,120,000 in 2012. Because the gift is of a nonvoting interest and it is not readily marketable, the value of the gift can be discounted.

Using a 35% discount on the gift, 79% of the nonvoting interests can be gifted to Jack’s trust with no tax. Steve is in control of the business which means that he can increase his salary as need be to provide for his expenses during his lifetime.

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Business

Steve• 79% nonvoting interest• No gift tax• Allocate GST exemption

79% interest valued as follows:

9,900,000 x .65 = 6,435,000(35% discount)

x 79% = $5,083,650

Farm LLC

1% voting

99% nonvotingSteve Steve

Irrevocable Dynasty Trust for Jack and descendants

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At Steve’s death he owns:

21% of Farm LLC nonvoting $2,100,000 using 35% discount is valued at 1,365,000

And

1% voting 100,000 no discount

Total Value: $1,465,000

Estate tax in 2013: $ 805,750

Tax if no gift in 2012 $4,795,000Tax if gift in 2012 805,750

Savings: $3,989,250

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Same as above except that Steve has a daughter, Jill, that does not work in the business and Steve wants her to be treated equally with Jack, although, he wants Jack to be in control of the farm when he dies. Instead of transferring all of the business assets to one LLC now Steve creates two LLCs, one that owns the land and another that runs the farm business which leases the land from the first LLC. Steve creates two irrevocable dynasty trusts and gifts 49% of the Farm LLC to Jack’s irrevocable trust and gifts as much of the Property LLC as can be gifted with the remaining gift tax exemption to the two irrevocable grantor trusts but gives more of the Property LLC to Jill’s trust to make up for the gift of the Farm LLC to Jack’s Trust. When Steve dies, Steve gives the remaining Farm LLC to Jack and the remaining Property LLC to Jack and Jill’s trusts, again equalizing for the gift of the Farm LLC to Jack.

38


Farm LLC

Owns cattle, equipment, hires employees

Property LLC

Owns farmland

100%Steve

100%Steve

Jack’sIrrevocable Trust

Jill’s Irrevocable Trust

49% of Farm LLC

Remainder of $5,120,000 minus value of 49% of Farm LLC – more to Jill’s Trust to equalize

• No gift tax• Allocate GST exemption to both trusts

Lease

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Steve dies in 2013, owning 51% of Farm LLC and small percentage of Property LLC, both valued at $1,465,000.

Estate Tax is $805,750, same as in case study #1.

Jack has control of the Farm business and Jill has a steady stream of income from the lease payments.

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Spousal Lifetime Access Trust (SLAT)

The facts are the same as in case study #2 except that Steve’s wife, Lauren, is still alive and Steve is concerned that Lauren will not have sufficient income if she survives him. He’s nervous about giving away all of this value to the trusts for his children. A solution can be to simply add Lauren in as a beneficiary as each of the irrevocable trusts, which would then provide for the Trustee to make distributions to Lauren during her lifetime if she needs funds, but doesn’t have to. When Lauren dies the irrevocable trusts are not included in her estate.

In addition, instead of leaving Steve’s remaining estate when he dies to his two children, he would leave it in a marital trust for the benefit of Lauren which would defer the estate tax that would have to be paid on his remaining assets until Lauren’s later death. Assuming no change in the ultimate value of the assets the estate tax would be the same as above – a savings of almost $4,000,000 and Lauren has access to the gifts.

41

Benefits of GST Exempt Trust (“Dynasty Trust”)

• Florida trusts can last for up to 360 years.

• If allocate GST exemption to irrevocable grantor trust, then trust can continue for many generations avoiding transfer tax (estate, gift and GST taxes) the entire time.

• In addition to saving transfer tax, the trust is also free from creditors of trust beneficiaries and generally free from a divorce settlement of a trust beneficiary.

4242

Reducing Estate Taxes at Death—§2032A Special Use Valuation

1. Qualifying real property (QRP) used in a family farm or closely held business may be valued at its “current use” instead of its “highest and best use”

2. The aggregate reduction in the fair market value of the QRP from its “highest and best use” cannot exceed $1,040,000 for 2012 decedents. This amount is adjusted annually for COLA.

• Estate tax savings in 2012 = 35% x $1,040,000 = $364,000

3. This reduction is taken against FMV of the property after considering other applicable valuation discounts

4343


Qualifications

• Decedent is a U.S. resident or citizen and property is located in the U.S.

• Property must be devoted to a farm or farming purposes or in a trade or business

• QRP must pass to a “qualified heir” (i.e., spouse; ancestor; lineal descendants of decedent, decedent’s spouse or decedent’s parents; spouse of any such lineal descendant)

• Decedent or family member must have owned the property and materially participated in the business for 5 of the 8 years preceding death

• Value of real and personal property used in the business must be at least 50% of the adjusted value of the gross estate

• Value of the real property used in the business must be at least 25% of the adjusted value of the gross estate

• QRP designated in written agreement consenting to recapture tax.

4444


1. Recapture Tax

• Some or all of the tax benefits may be “recaptured” if the QRP is transferred outside the family or ceases to be used as a farm or closely held business during the 10 year period following the decedent’s death

• Recapture tax is generally equal to the tax that would have been due had §2032A not been elected

• Tax is due 6 months after qualified use ends

• Qualified heir is personally liable for recapture tax

2. IRS will have a lien on a portion of the QRP in an amount equal to the tax savings, unless IRS accepts other security

4545


1. Cash Flow






7.How to Pay Taxes?

8. Act

4646

Payment of Estate Taxes

1. Estate tax is due 9 months after date of death

2. Can request extension of time to pay estate tax for reasonable cause, such as illiquidity or hardship

• Extensions for 1 year are almost automatic

• Additional extensions can be granted, but the IRS may require distributions to beneficiaries or creditor payments be withheld

3. Election to Pay Estate Tax in Installments (§6166)

• Must qualify

• Estate can pay interest only for the first 5 years on unpaid tax attributable to a closely held business interest and then principal and interest over the next 10 years

4747

Payment of Estate Taxes—§6166 Extension

1. Qualifications

• Decedent must be a U.S. resident

• Value of decedent’s interest in a closely held business exceeds 35% of adjusted gross estate

2. “Interest in closely held business” includes:

• Interest in a trade or business carried on as a proprietorship

• Interest in a partnership carrying on a trade or business if the partnership has 45 or fewer partners, or at least 20% of total capital interest is included in the decedent’s gross estate

• Interest in a corporation carrying on a trade or business if the corporation has 45 or fewer shareholders or at least 20% of the voting stock is included in the decedent’s gross estate

3. 20% ownership requirements can be met through direct and indirect ownership

4. Interests in 2 or more closely held businesses can be aggregated for purposes of satisfying 35% test if the decedent owns 20% or more of the total value of each business

5. If a §6166 election is made, the IRS will place a lien on §6166 property sufficient to cover the deferred tax and interest

4848

Payment of Estate Taxes—§6166 Extension

1. Election will terminate and payment of the deferred estate tax will be accelerated upon the occurrence of any of the following:

• A disposition of any portion of the closely held business interest or a withdrawal of money or property from the business, which, in the aggregate, equals or exceeds 50% of the value of the decedent’s closely held business interest

• Failure to timely pay interest or principal

2. Interest Rate on installments:

• 2% on the tax on the first $1,000,000 (adjusted for inflation) of assets (using the highest marginal rate)

• 45% of the current underpayment rate for the excess. Current underpayment rate is 3%; 45% of that is 1.35%

4949


1. Cash Flow




5. Can the Business Service Taxes?


7. How to Pay Estate Taxes?

8.Act

5050


8. Act

Insanity is doing the same thing again and again –

and expecting a different result.

Selected Planning Techniques for Business Succession Planning

5252

One Way to Start: Family Mission Statement

Characteristics:

• Overriding principles that will not be compromised

• Unwavering aspiration

• Achievable

• Timeless

5353

Buy-Sell Agreement

• Provides purchaser

• Eliminates friction

• Prevents hostile third-party shareholders

• Avoids income, gift and estate tax traps (and there are many)

• Plans for funding

5454

Buy-Sell Agreement: Major Terms

1.Purchaser

• Entity purchase

• Purchase by other shareholders / partners

• Hybrid

5555


2.Events Triggering Purchase

• Death of owner

• Disability of owner

• Owner’s withdrawal from employment

• Foreclosure

• Bankruptcy

• Retirement

• Sale to third parties

5656


3.Funding

4.Payment method (coordinate with funding)

5.Valuation

5757

Buy-Sell Agreement: Example Approaches

• Leave stock equally to children

– Buy-sell agreement addresses purchase of stock from children not involved with the business

• Mandatory purchase for a note at owner’s death

– To provide cash flow for spouse

5858

Summary

1.Planning is vital to successful succession

2.Addressing family issues is central to the process

3.Road map for the process: CASH FLOW GOTCHHA

4.Buy-sell agreements

Additional Selected Planning Techniques for Business Succession Planning

Appendix

6060

Tax Apportionment in Will

If business interest is not left equally to all children, estate taxes on the

business interest generally should not be borne equally by children.

6161

Lifetime Transfers

Every dollar removed from estate has 35% present value savings(assuming there is a 35% estate tax)

Gift / Sale of non-voting stock

Grantor Trusts

• No gain recognition

• Parent pays trust’s income taxes

6262

Grantor Retained Annuity Trust – 6% Growth

* Assumes Internal Revenue Code §7520 rate of 1.0%. (The rate for September 2012 is 1%.)** Assumes trust assets grow at 6% per year. If assets grow at 10%, remainder would be $741,900.

Stock $5,000,000Step 1

Remainder after 2 years: $ 402,215 **(no gift tax)

Step 3

Annuity

Step 2

Year 1: $2,307,870Year 2: $2,769,443

Parent

Trust for children

GRAT trust value $5,000,000

Amount transferred

$5,000,000Value of annuity

9,999,999*Value of remainder (Gift)

1

6363

GRAT Advantages

• Certainty• Valuation “formula clause”• No up front gift• Transfer all appreciation above low “hurdle rate”• Income tax neutral• Annuity payments do not have to be made in cash• GRAT assets in excess of a specified amount can be

return to parent if desired• Can have continuing trust for spouse / children• Short term vs. long term – A series of 2-year GRATs is

preferable to a single long-term GRAT for a stock portfolio

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GRAT Disadvantages

• Actuarial risk – If die before end of trust term, GRAT assets probably included in estate for tax purposes

• No GST exemption allocation when GRAT is created

• No valuation “formula clause” for funding annuity payments with “in-kind” assets

6565

Installment Sales

IrrevocableGrantor

Trust

Child or Trust

Parent

1

3

2

Gift (10%)

Sell property for note

No further gift tax

6666

Installment Sale – Partnership or S Corp.

Parent

To Pay Income Tax

IRS

Overall Effect:

1. Parent sells interest in partnership orS Corporation to Trust for Note.

2. Note payments can be satisfied (in part or maybe even fully) with distributions to pay income taxes.

Irrevocable Grantor Trust

Partnership or S Corporation

$

$

$

6767

Installment Sales to Grantor Trust Summary

• Requires gift

• Grantor trust:

– No gain on sale if note paid before death

– Grantor pays income taxes on trust income(Revenue Ruling 2004-64)

• Interest only / Balloon note

• Low interest rate (about 0.84 for 9-year note in September, 2012)

• Shifts appreciation above interest rate

• Can be GST exempt

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Installment Sales to Grantor Trust Summary

But

• No specific code section or regulation

• Asset value may decline below note, “wasting” the gift

• No clear way to have valuation “formula clause” but some cases have recognized formula clause where “excess value” passed to charity

Estate and Business Succession Planning For Farmers and Ranchers Steve R. Akers Managing Director...

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