Owners of privately held businesses often have competing concerns when designing their own exit plans. Especially if there are family members involved in the business, the owner may be conflicted as to what to do with the firm. Should the owner sell to children involved in the business, thus assuring those children act as owners, not just as heirs?

Or, to avoid exerting cash flow pressure on the children, should the business interest be gifted to them? Further, few business owners want to give up control. Should the owner stay in the business, making sure it is well run? In sum, should the owner sell, gift, or stay?

Using a combo approach

In some cases, the business owner can do all three. As will be shown, a carefully crafted combination of all 3 exit strategies can help to assure a successful exit by the owner and a profitable transition to the children. Assume, for example, the case of Brandon.

? Brandon is the owner of a $10 million S corporation, is 55 years old and wants to retire at 65.

? Brandon wants his children in the business to start acting like owners, not heirs.

? The company yields, on average, a 6% after-tax rate of return.

Brandon’s primary exit planning goals are to maximize the value going to the children, minimize the taxes incurred, continue to maintain control until retirement, and assure his exit plan is adequately funded.

Working with his exit planning team, Brandon can accomplish his goals. The following exit plan involves a sale of the business and a gift of assets to the children while allowing the owner to stay in control. The exit plan involves the following steps:

(1) Value the business. It is important that Brandon determine the true value of the business (i.e., what a reasonable buyer would pay to a reasonable seller). The transaction must be based on a value that will pass muster for tax purposes.

(2) Apply for life insurance. Funding the buyout with life insurance is a key aspect of the transaction, and it is important to determine Brandon’s insurability upfront. Once the trust is created, the insurance will be issued to the trust.

(3) Create and seed a grantor trust. A grantor trust, otherwise known as an Intentionally defective irrevocable trust (“IDIT”) is drafted by counsel to place the assets of the trust outside of the estate for federal estate tax purposes while assuring the income from the assets is paid to the grantor. The attribution of income to the grantor is intentional, and must be carefully designed. To assure legitimacy from a tax perspective, it is often suggested that the trust be seeded with some gifted assets (probably at least 10%). Brandon could gift stock or other discounted assets.

(4) Create voting and nonvoting stock. This will assure that Brandon maintains control of the business because he will continue to own the voting stock in the business.

(5) Sell the nonvoting stock to the IDIT for an interest-only note. Brandon will sell his ownership of the nonvoting stock to the IDIT, the financing terms being that the trust must annually pay interest on the note for a period of time (say 20 years), and then pay the principal at the end of the note, or at Brandon’s death.

(6) Use dividends from the business to pay the interest on the note and to fund the life insurance premiums. The S Corp. dividends paid to the trust on the nonvoting stock will be available to pay both the interest on the note to Brandon and the premiums on the life insurance the trust is purchasing on Brandon’s life.

Putting this example to numbers (see Chart 1), Brandon’s business is worth $10 million, and he will establish 90% of the stock as nonvoting. In valuing the nonvoting stock for purposes of the sale to the IDIT, Brandon will be able to take a discount for lack of control and lack of marketability. At a 33% discount, Brandon will sell the $9 million business interest for $6 million. The trust must pay a minimum annual interest rate to avoid the transaction being considered a gift from Brandon to the trust.

Though government minimum rates are currently much lower, assume a 5% interest rate on the note, thus $300,000 per year. In addition to the interest payment back to Brandon, the trust should also pay for life insurance on Brandon’s life. The death proceeds from the life insurance will be used to pay the principal on the note to Brandon’s estate.

How can the trust afford to make these payments? We established above that the company makes a 6% rate of return. Now that the trust owns 90% of the business, it will receive approximately $540,000 of the $600,000 annual return being made by the company. This allows the trust to pay the $300,000 per year to Brandon on the note, leaving well over $200,000 to pay for the life insurance premiums.

The results

What have we accomplished with this transaction? First, Brandon has avoided paying capital gains on the sale. Recall that the trust is “defective” for income tax purposes, and the income attributes back to Brandon. In effect, he has sold the company to himself, and so no income tax applies. Second, although Brandon pays income tax on the business’s income, in reality this is a planning advantage. Brandon has wealth, and his estate will likely be subject to estate taxes. It is better to reduce his taxable estate through the payment of yearly income taxes than to have the trust pay the income taxes and net less wealth to the trust beneficiaries.

From an estate planning perspective, Brandon both discounted and froze the value of the stock for estate tax purposes. At death, his estate will only get the $6 million back on the note, even if the company is worth far more. The bottom line is that Brandon remains in control during his lifetime (he owns the voting stock), but his children start acting like owners (they benefit from any appreciation in the stock value).

Further, the transaction is adequately funded. The income from the stock, plus any seed money, should be enough to pay both the note interest and the life insurance premium. And the life insurance provides the estate liquidity to pay off the note.

Focusing on the life insurance, the proper amount to purchase will depend on the estate’s expected size and Brandon’s insurability. To pay off the note, the face amount should be at least $6 million. The estate, however, will likely be subject to estate tax, hence it may be advisable to secure an additional face amount.

The key is to determine how much life insurance the annual trust income can afford to buy. Considering there is an expected annual net cash flow well in excess of $200,000, this should, assuming insurability, purchase a sizeable amount of insurance on Brandon’s life.

Through this transaction, Brandon has accomplished his exit planning goals. And, he did it through a sale, a gift, and staying on in the business.

Steve Parrish, JD, CLU, ChFC, RHU, is a national advanced solutions consultant with the Principal Financial Group, Des Moines, Iowa. You can e-mail him at parrish.steve@principal.com