It’s not often that one gets to turn back the clock. But this rarest of privileges was afforded to a hypothetical business owner whose business succession and estate planning needs tested the expertise of a trio of experts at the Financial Service Forum, held here October 15-17.
During the final general session of the Society of Financial Service Professionals’ annual conference, the 3 advisors–an accountant, a life insurance agent and an estate planning attorney–detailed what they would have recommended for the imaginary entrepreneur, Fred, before he died unexpectedly at age 65, leaving behind a successful company but an estate up for grabs.
The 2-hour case study featured a cast of characters ready-made for the tabloids: 2 children and a former spouse from a first marriage (Betty Jo) who stood to inherit interests in Fred’s business, “Big Deal,” an oil and gas production company valued at $30 million; a second wife (Susan) who laid claim to Fred’s $5 million split-dollar life insurance policy; plus a third wife (Donna) whose prenuptial contract called for paying her $2 million and $1 million to each of her two children by Fred (see related charts).
There was, too, a “mystery woman” (Candi) who possessed a hand-written note from Fred bequeathing her a previously unknown downtown condominium (value: $500,000), a Porsche automobile and $2,500 per month for life; and another hand-written note entitling her to Fred’s post-retirement benefits.
Among these was a pension plan account holding a balance of $2.5 million and a supplemental executive retirement plan of $600,000 per year with guaranteed payments for 15 years. Also in Fred’s estate were ranching operations valued at $6 million, several residential and resort properties collectively worth $7 million, and a stock/bond portfolio totaling $10 million.
To prepare Fred for his inevitable retirement and death, his financial advisors (the session panelists) agreed to address estate planning issues only after developing a business succession plan, thereby permitting a more streamlined process.
“The business succession plan we established gives us the needed liquidity upon death,” said Terence Stanaland, a principal at Teague, Rosenstreich & Stanaland, PC, Greensboro, N.C., and the panelist who played Fred’s estate planning attorney. “If you focus on the business assets first, the rest of the estate plan starts to fall into place.”
To that end, the team agreed to recommend revoking the subchapter S election of Big Deal, converting the business to a C Corp. (thereby permitting streamlined retirement and estate planning) and recapitalizing the business’s debt structure to create $25 million in privately held preferred stock at $1 per share. Of the total, $5 million in non-voting shares ultimately went to Fred’s first wife, Bettie Jo, thus securing for her a claim on the company when sold, plus dividends.
To free up cash needed to fund a business transition, the advisory team established an employee stock ownership plan. Sam Torolopoulos, president of ATI Capital Group, Irving, Tex., and the panelist who played the accountant, said the ESOP is advantageous in part because it’s the only qualified plan under ERISA that can borrow money.
“The ESOP lets us create a large liquidity event that will allow Fred to have the cash necessary to do the personal planning,” said Torolopoulos. “Also, because the [ESOP] trust is acquiring shares in the business through a series of transactions, Fred can remain in control of Big Deal while grooming other executives who will be taking over the corporation.”
The transaction called for a third-party lender to loan $10 million to the ESOP trust, yielding for the business a $10 million tax deduction. And, in exchange for the sale of a 30% ownership interest, the $10 million provided Fred with cash to invest in stocks and bonds, thereby generating replacement income as he phased out operational control of the business.
Torolopoulos additionally advised implementing a stock-based incentive plan that allows executives (including children in the business) the right to earn shares based on their performance. The plan also gave Fred preemptive rights to maintain his equity position in the event additional shares were issued and provided phantom stock (or non-voting shares) to children who were not in the business.
Terry Altman, a panelist and director of insurance services at Rehmann Financial, Troy, Mich., said an ESOP transition represents a “substantial insurance [sales] opportunity” for agents because the plan creates unfunded liabilities (i.e., money the ESOP needs as collateral for the $10 million loan and cash to buy back shares from departing employees).
“For the insurance professional, it’s not hard to see that the most efficient way for the ESOP to fund its liabilities is through the use of corporate-owned life insurance,” said Altman. “Life insurance can also be used to fund the stock incentive plan, which is essentially a non-qualified deferred compensation plan.”
He added the plan can be structured in one of several ways, depending on the level of corporate control desired: (1) as a COLI-funded plan, wherein the company owns the policy and pays the premiums; (2) as a section 162 executive bonus plan (the employee owns the policy, but the company pays the premiums); (3) as a restrictive executive bonus plan that’s restricts access to a policy’s cash value for a term of years; (4) as an endorsement split-dollar plan (the company owns the policy, but premium payments and policy benefits are divided between the employer and employee or beneficiary); and (5) as a loan regime split-dollar plan, wherein the employee owns the contract and is responsible for retiring the loan to covered premiums paid.
Altman also counseled using life insurance to fund a one-way buy-sell agreement that would enable Tex–Fred’s ranch foreman–to purchase the ranch from Fred’s estate in the event of his death. Altman further advised purchasing a first-to-die policy to cover Fred’s estate taxes.
“The leverage created by insurance clearly makes it a superior asset to stocks and bonds for paying off the estate taxes,” said Altman. “And there are a number of ways to fund the premiums, including the use of premium financing.”
Stanaland closed the panel discussion by advocating the creation of a revocable grantor trust from which to distribute estate assets (including Fred’s pension funds) to the various claimants; a qualified terminal interest property trust (QTIP) that would provide income to his third wife, Donna, until her remarriage; and an irrevocable life insurance trust, funded with the Fred’s split-dollar life insurance policy, to settle his second wife’s claims.