For Business Owners, Exit Planning Leads To Wealth Preservation

By Steve Parrish and John Brown

In our February 11 article, “Letting Business Owners Exit ‘In Style’,” we discussed the exit planning process–a seven-step system designed to help business owners grow their businesses so they can leave them in style.

This process is an organized way for owners to assess: personal needs, business value, likely purchasers, and tax-efficient transfer methods.

To review, the seven steps of the exit planning process are:

1. Setting exit objectives;

2. Determining value/ price;

3. Increasing business value;

4. Converting business value to cashselling to an outside party;

5. Transferring the business to children or employees for a promissory note;

6. Contingency planning for the business; and

7. Wealth preservation planning.

In the final step of the exit planning process, owners work to preserve wealth for their families or undertake what many refer to as “estate planning.” Principal Life Insurance Company’s focus group research of small and medium sized businesses reveals that owners associate the term estate planning with the very elderly or the very rich. It is perceived as either the writing of wills or tax schemes for the ultra rich. Owners rarely see estate planning as part of their own business exit plans.

When preserving wealth is presented as part of the overall exit planning process, however, owners are more willing to consider estate planning concepts and funding. Most importantly, owners feel greater immediacy regarding preserving wealth, thus enabling the financial representative to offer estate funding solutions to a receptive owner. As part of exit planning, estate planning answers a “what can it do for me?” question.

One note about the seven-step process: Some owners assume that because wealth preservation is the last step, they should exit their businesses before actively preserving wealth. As you know, if an owner waits until he converts the value of the business to cash, it is too late to realize all of the benefits of wealth preservation.

After determining exit objectives and the value of his or her business, implementing an owners exit plan often begins with the final step–wealth preservation. This is because the most significant claimant to a business owners wealth is the IRS–especially in the estate tax arena.

Lets look at how one of our fictional clients/owners worked through step seven:

George opened his meeting with us almost apologetically.

“I know Ive waited too long to begin gifting part of the company to my kids,” he said.

“My CPA told me that, based on the company’s pre-tax cash flow of $2 million per year, the company could be worth as much as $12 million to a third party,” he explained. “I had no idea!”

George continued, “Since I dont need that much, I want to transfer at least half the value–at a lower valuation of course–before any possible sale. I’m looking at millions in gift taxes.”

George hired a Certified Valuation Analyst (CVA) who valued the business at $9 million–a conservative but supportable valuation. The companys stock was recapitalized into voting and non-voting stock.

Based on current tax case law, the CVA knew that she could justify discounting the value of non-voting stock (or a gift of a minority interest of the voting stock). In her opinion, the minority discount was 35% of the full fair market value of the stock.

Even with the 35% discount, however, a gift of half of the company (now reduced to a gift of approximately $3 million) would cause the payment of a gift tax of approximately $500,000.

George was not particularly keen on paying a tax of $500,000. So he didnt. And he still gave away 50% of the company to his children. He did so by using the biggest lever in the wealth preservation transfer process: a Grantor Retained Annuity Trust, or “GRAT.”

A GRAT is an irrevocable trust into which the business owner (and the Trustee of the GRAT) transfers some of his stock. The GRAT must make a fixed payment (annuity) to the owner each year for a pre-determined number of years (in George’s case, four years). At the end of this period, any stock remaining is transferred to the owner’s children.

Stock transferred into a GRAT is treated as a gift–the amount of which is the value of the asset transferred minus the present value of the annuity that the owner will continue to receive.

George’s advisors made sure that the present value of the annuity paid out over four years equaled the value of the stock transferred into the GRAT–therefore no gift was made by George.

A key to maximizing the GRAT’s leverage is to transfer an underlying asset that appreciates in value and/or produces income in excess of the federal mid-term interest rate (currently about 6%). This way the asset has passed to the next generation at a low value for transfer tax purposes.

In summary:

1. George transferred one-half of the business with a fair market value of $9 million to $12 million to his children in four years using less than $10,000 of his lifetime exemption.

2. George continued to receive all of the income from the company during that four-year period, because the annuity payment to him was designed to equal the amount of income expected from the stock transferred into the GRAT.

3. At the termination of the trust (four years) the trust asset, consisting of one-half of the company, was transferred to trusts for Georges children, free of any gift tax.

4. Finally, George’s estate planning was substantially completed before he was ready to move forward with the sale of his business.

When the GRAT was created, George established these trusts containing his wishes regarding when, and if, the children were to receive money from those trusts.

Planning techniques such as GRATs and the careful use of minority discounts, as well as a variety of other estate tax avoidance techniques, are likely available to your clients and their families.

Exit planning gives life underwriters a framework for introducing complex estate planning tools to their business owner clients. A GRAT is just one example of the many estate planning techniques that help business owners complete successful exit plans.

When these techniques are presented to owners as exit planning tools, they see them as sound business planning with immediate benefits to themselves and to their families.


Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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