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To further expand on my blog post Planning for Succession in your Business dated June 26, 2013, I have outlined the seven steps to a successful business succession plan.
I FAMILY RELATIONSHIP PLANNING
Understanding family issues plays a key role in the implementation of a business succession plan. The business owner must decide who, if any, of the family members will be involved in and potentially become leaders in the business and to what extent such family members should be rewarded differently than other family members because of their contribution of “sweat” equity to the business. It is important to recognize that children who sit on the sidelines will often develop distrust of their siblings working for the business and will desire to be “cashed out” of the business on an equal basis to obtain their fair share of their parents’ estates. If not properly planned for, that desire may place an unreasonable burden on the business. The business owner must also decide the extent of participation of his or her spouse, often of a second marriage, in the business, both financially and as part of management. With an understanding of these planning issues, the owner can proceed with creating the strategic business succession plan.
II BUSINESS STRUCTURE AND OWNERSHIP PLANNING
The foremost planning area involves the structure of the business itself. The business should be structured to facilitate succession planning and to minimize liquidity concerns and potential income and transfer taxes. While an owner may believe that an ongoing business is precluded from changing its structure and ownership due to tax consequences or business considerations, this is not always the case. A business will consider the following vehicles in formulating its preferred structure and ownership for purposes of its strategic business succession plan:
- Is the business structured as a limited liability company, limited partnership, S corporation or other favorable entity and how can the business be restructured, if necessary, without significant adverse tax consequences?
- Do the ownership interests consist of voting interests and nonvoting interests for purposes of control? Even an S corporation can have both types of interests. Is the business owner providing family members that are not active in the business with nonvoting interests, debt instruments, fixed assets subject to a long-term lease or other similar assets that do not provide such members with control of the business?
- Do the minority interest owners or the family members not active in the business have any rights of control over the other participating family members or have rights to “cash out” their ownership interests? These rights must be documented in a shareholders agreement, operating agreement or partnership agreement to which all owners and family members are subject. The agreement should also provide for the rights of family members to acquire ownership interests in the event of divorce, death or termination of employment and should fix a value for the interests.
III BUSINESS MANAGEMENT PLANNING
The business succession plan should contain a strategic plan for the future management of the company. The plan should identify the key employees, whether or not family members, who will contribute to the successful growth of the company as future leaders. The business should obtain their participation in the formulation of the business succession plan and should attempt to secure the continued employment of these key leaders through employment agreements and through incentive compensation vehicles, such as stock options, bonuses, deferred compensation and partial ownership of the business entity. The owner should take such steps as are necessary to ensure that management can continue operating the company without being required to surrender to the demands of family members unrelated to the business.
The owner may also decide not to give management unfettered control of the business. This may be especially true if management consists of certain children who would have the ability to pay themselves significant compensation to the exclusion of the remaining children. If family members were not ready for control, the business owner could designate a transition management group, through a voting trust, family trust or similar vehicle, for the period of time the owner feels is necessary for such members to mature into responsible business managers.
IV RETIREMENT PLANNING
The family should not implement the business succession plan unless it creates a mechanism to provide the owner with financial security for his or her retirement. This aspect of the plan should normally take on greater significance if the founder transfers control of the business during his or her lifetime. To achieve financial security, the family should consider nonqualified retirement arrangements, such as an executive deferred compensation retirement plan, or qualified arrangements, such as pension or profit sharing plans or an ESOP. The owner should also consider installment sales of ownership interests in the business, potentially with a self-canceling feature, and leases of real and personal property necessary to operation of the business, as additional sources of retirement income.
V LIQUIDITY PLANNING
Liquidity issues arise both for the business itself and for the family members who are involved in the business. Liquidity is necessary for the business to meet future contingencies and to create reserves for ongoing capital needs. It may be necessary for either the business or the business partners to meet obligations under a buy/sell agreement. It may also be necessary for the family of the owner at his or her death to meet estate tax obligations and after his or her death to provide additional security and liquidity for other needs. The strategic business succession plan will incorporate planning to meet each of these objectives. If the owner has entered into a buy-sell, operating or partnership agreement with the other business partners, they as a group should consider funding these obligations with key-man life insurance. However, the owner must ensure that any buy-sell provisions in such agreements, which are just as important as the liquidity itself, facilitate the transition of ownership so as to prevent the disruption of the business.
In deciding upon the level of additional liquidity necessary for the family, the owner should estimate the liquidity that will be available after his or her death. This liquidity may arise from the sale of assets other than the family business or from other income-producing assets. This liquidity may also arise from life insurance. The family should also consider implementing an irrevocable life insurance trust (“ILIT”) or a life insurance partnership (“LIP”) as the vehicle to hold the life insurance policies for the benefit of the family. With an ILIT or LIP, the family can shield the life insurance itself from estate taxes (and avoid paying potentially half of the insurance to Uncle Sam) to further increase the liquidity needs arising when they are needed most – the death of a loved one. The ILIT or LIP should be an integral consideration in formulating every business succession plan.
VI TAX PLANNING
Taxes are an important area of discussion for every business succession plan. The family business owner must consider the federal and state income and transfer taxes applicable to the business and the family in creating and implementing the plan. As discussed in the section below, there are several vehicles available to reduce or potentially eliminate estate taxes.
VII ESTATE PLANNING
As a final stage of its business succession planning, the family should revisit its estate plan. The estate plan should serve to compliment the objectives of the business succession plan. It should first contain the standard family and marital shares to take into account the remaining available exclusion from estate and gift tax at death. It may also include trusts or gifts utilizing the federal generation-skipping transfer tax. This latter planning is implemented to pass $5,000,000 of property to future generations without subjecting such property to transfer taxes in those generations.
The estate plan should carry through with the business objectives of transferring ownership during life or at death in a manner that causes minimal disruption in the operation of the business. If the transfers will take place during life, the business owner should determine the optimal manner of gifting business interests, whether outright, in trust or through a family business entity. The estate plan could also be used by the business owner to equalize, whether with business interests or other assets, the “fair” shares of the children of the owner.
The family business owner should also consider more advanced planning techniques, such as a family business entity. This is an excellent vehicle to create a structure for the selective control of assets while allowing all family members to realize income from such assets. The owner should also consider installment sales of business interests and other assets, including sales to trusts, and grantor retained annuity trusts.
Finally, if charitably inclined, a family business owner might consider the charitable remainder trust. This vehicle is a powerful tool that has estate and income tax benefits for the grantor of the trust. The business owner may also consider charitable lead trusts and a family private foundation to further enhance their philanthropic interests.
It is well-known that in Florida, a great way to own your home is in your individual name so that the home can qualify for homestead protection. Florida’s homestead laws are among the broadest in the country, and exempt homestead property from levy and execution by judgment creditors.
However, homestead laws extend only to your principal, permanent residence. What happens if you want to purchase a beach condo, an office building, or a piece of land to potentially build on in the future? How you title this property can have a significant effect on your business and your other assets.
Generally, holding each piece of real property in a separate limited liability company (“LLC”) owned by a revocable trust is an effective way of ownership with a number of business and estate planning advantages:
- Asset Protection. Owning property through an LLC maximizes the protection for your personal assets. Because there is an inherent risk of liability that goes along with property ownership, you, as a property owner, could potentially be subject to tort claims stemming from activities that occur on the property. If the property were held in your individual name or in the name of your revocable trust at the time a tort claim was made and the claim resulted in a judgment against you or your trust, your personal assets or the assets of your revocable trust could be attached to satisfy the judgment. However, if the property is held in an LLC and is the only asset of the LLC, only this property can be used to satisfy the judgment. The same principal applies if you hold a number of real properties, each with a significant value. Generally, each such property should be placed into a separate LLC for these purposes.
- Estate Planning. Having each piece of real property in a separate LLC has advantages from an estate planning standpoint in that it makes it simple to transfer ownership to family members. The ownership of real estate held by an LLC is represented proportionately by a member’s shares of an LLC. Rather than filing a new deed, the owners can transfer ownership of the property to their children by simply issuing them membership interests in the LLC. This makes gifting away interest in the real estate very simple and cost effective. Further, the LLC could also be structured with voting and nonvoting units. The owner can preserve control over the property during his or her lifetime and, at the same time, move some of the value of the property out of his or her estate, by gifting only the nonvoting units to family members. The owner could then prescribe how the property is to be controlled at his or her passing by devising the voting interests in the LLC to one or more beneficiaries of the owner’s estate.
- Avoidance of Probate. Owning real property through an LLC that is in turn owned by a revocable trust enables one to avoid the difficult probate process with respect to that property, which in turn eases the administration of your estate in the event of your passing.
A less effective, yet still a better way of owning real property than in your individual name, is placing the property into a revocable trust. This type of ownership does not have the asset protection and estate planning benefits described above, but it does remove the property from the probate process at your passing.
If property has already been purchased, it is still possible to take advantage of some of the protections discussed above by transferring the property into the appropriate holding structure. A major consideration as to whether to transfer the property into a revocable trust or an LLC is whether the real property is encumbered by a mortgage. If the property is unencumbered, it should be transferred into a newly formed LLC to take advantage of the LLC’s asset protection attributes. If there is a mortgage on the property, however, a transfer into an LLC would trigger documentary stamp taxes in the amount of $.70 on each $100 of the mortgage payable to the state of Florida. So, for example, on a $500,000 mortgage, the documentary stamp taxes payable to the state at the time of the transfer would be $3,500, which, for some, may not be worth the benefits of the transfer in the first place. If this property is transferred into a revocable trust, however, nominal documentary stamp taxes would be due on the transfer.
While the Florida LLC is an effective and frequently used vehicle for holding real property, there are other options that may be more appropriate for property owners. The specific circumstances and goals of the property owner must be evaluated before making this decision.
The closing documents have been signed and recorded, the funds have been disbursed, and the parties are thrilled the transaction has closed. Unfortunately, closing the transaction does not always signify the end of the file. Post-closing issues sometimes arise, and when they do, it is important to resolve them as quickly and efficiently as possible.
An Error in the Legal Description of the Deed
One such post-closing issue that may arise is a mistake in the recorded deed. There are several examples of what constitutes a mistake in the recorded deed; one of the most common being an error in the legal description of the property being conveyed. An erroneous legal description attached to a deed operates to cause the recorded deed to be defective, and impacts the chain of title. Some examples of an incorrect legal description in a recorded deed include, but are not limited to, a wrong call in the metes and bounds legal description of the property conveyed, an incorrect lot number in a platted legal description, or an incorrect plat book reference. However, the good news is that it can be corrected by taking the required corrective steps.
Improper Way to Correct an Error in the Legal Description
A defective deed may not just be re-recorded with the new, correct legal description attached to it, or with information added to the legal description after execution. In Connelly v. Smith, 97 So.2d 865 (Fla. 3d DCA 1957), the section, township and range were omitted from the legal description of the property being conveyed. The grantee in that transaction inserted the section, township and range after execution and delivery of the deed, and then re-recorded the deed. The court ruled the legal description in the original deed was insufficient, and the grantee’s voluntary insertion of information to the legal description after execution and delivery was of no effect.
Proper Way to Correct an Error in the Legal Description
When a mistake in the legal description is discovered, the correct process by which the mistake is remedied is to: (1) have a corrective deed re-executed by the original grantor and properly witnessed and notarized in accordance with Florida law; and (2) have the new corrective deed recorded. Having the original grantor re-execute a corrective deed and recording the same is the only way to effectively correct an error in the legal description of a defective deed.
Drafting the Corrective Deed
When recording a corrective deed, it is helpful to include a cross reference within the corrective deed that references the recording information of the defective deed. For example, a notation within the corrective deed may be included that states, “This corrective deed is given to correct an error in the legal description of that certain deed dated ______ and recorded ______ in Official Records Book ___, Page ___, Public Records of _____ County, Florida.” The notation is not necessarily required, but may aid in the understanding the chain of title in transactions that follow.
In the frenzy to close a transaction, occasionally a mistake such as an error in the legal description attached to the deed may occur. In the event that it does, the mistake can be remedied but only by having a corrective deed properly re-executed by the grantor and recorded. Since parties move on and memories and feelings fade or change, it is important to act as soon as possible to properly correct an error in a deed as soon as the error is discovered.
Family businesses comprise approximately 90% of the businesses in the United States. Yet only about one in three survive to the next generation and one in ten to the third generation. Why? The closely-held family business often fails for the same reason that it originally succeeded. It relies on its uniqueness – the compassion and loyalty among the family members not present in other companies – to generate a dynamic viability to the company. Yet this uniqueness may also lead to distrust within the family and disruption of the family business as an ongoing entity.
To prevent the demise of the business, the family should create and implement a strategic business succession plan. This plan should integrate business, tax and liquidity considerations with the emotional and financial needs of the family and the needs of the business to achieve continuity and growth for the future.
The goals of a business succession plan for each family are unique to that family, but center around several core determinations. The family must decide:
- Who will be the future owners? Will they include key employees? Will they include only family members participating in the business? Who of the owners will retain control?
- How and when will the owner transfer control? Will the business be transferred to the next generation? Are there capable leaders, whether or not family members, to own and manage the business in the future? Or will it have to be sold? Will the business survive the imposition of estate taxes at the death of the owner?
- How will the family harmonize business and family needs? Does the family recognize that the needs of the business to grow, adapt to changes in the marketplace and aggressively face challenges are different from the needs of the family to remain compatible and unified? Will the family remain compatible if certain members receive greater rewards for their participation in the business and what can be implemented to equalize, to the extent possible, the rewards?
- How will the family successfully integrate its personal values and relations into the business without disrupting the ongoing needs and growth of the business? Do the family members communicate among themselves regarding these values and business goals?
- Who will manage the business in the future? Who will control the selection of management personnel and what rights will exist to change management? Will management have too much control? Will management be able to continue operating the business as a viable, successful entity without interruption or demands from family members not involved in the business?
With a general consensus on these core determinations, the family can begin to create its strategic business succession plan. It is often in this planning process that the family will flesh out the answers to some of these questions.
A “disregarded multi-member limited liability company” (“Disregarded MM LLC”) is a multi-member limited liability company for state law purposes but is disregarded as an entity separate from its owner for federal income tax purposes. All of the members of the Disregarded MM LLC are grantor trusts, with the same individual senior family member (“Senior”) serving as grantor of all such grantor trust members. One such trust member might be Senior’s revocable trust, and the other trust members might be intentionally defective grantor trusts established by Senior for the benefit of his children or grandchildren (“Lineal Trusts”).
From a cost savings perspective, this structure allows a client to avoid filing an annual federal income tax return for the Disregarded MM LLC. Further, the use of the “disregarded entity” adds significant value to the structure through enhanced asset protection and the opportunity to utilize valuation discount principles in making the gifts. In addition, the forgoing structure achieves income tax neutrality because the Disregarded MM LLC’s existence is ignored for federal income tax purposes. Similarly, because the Lineal Trusts are income tax defective, their existence is ignored for federal income tax purposes, and because the grantor bears the federal income tax burden with respect to the Lineal Trusts, the growth of the assets contained in such trusts is accelerated.
A wide variety of assets could be contributed by Senior to the Disregarded MM LLC to set the stage for tax planning involving the utilization of lifetime gift tax credit. The following example illustrates the potential of the Disregarded MM LLC for making gifts in a scenario where an entity classified as a partnership for federal income tax purposes could not be utilized.
Senior is the grantor and sole lifetime beneficiary of a revocable trust (the “Revocable Trust”), which Revocable Trust owns one or more installment sale notes receivable (the “Notes”). Senior forms a single member limited liability company under Florida law (the “LLC”), contributing the Notes to the LLC in exchange for 100% of the membership interests. The LLC is comprised of 100 Class A Voting Units and 9,900 Class B Non-voting Units (the “Non-Voting Units”). For federal income tax purposes, the LLC is disregarded as an entity separate from its owner unless the LLC elects to be treated otherwise. The LLC has not made such an election.
Senior establishes three (3) Lineal Trusts with Senior as the grantor. The beneficiary of each of the Lineal Trusts is one of Senior’s children. Senior transfers by gift one-third (1/3) of the Non-Voting Units to each of the Lineal Trusts in exchange for a membership interest in the LLC. The LLC is now a multi-member limited liability company for state law purposes but for federal income tax purposes is disregarded as an entity separate from its owner. The Lineal Trusts now own 99% of the LLC.
In general, a gift of an installment sale note receivable – including a gift of a partnership interest in a partnership holding installment notes receivable — is treated as a disposition made other than a sale, exchange, or satisfaction at face amount, in which case the donor immediately recognizes a gain in an amount equal to the spread between the fair market value of the note on the date of the gift and the adjusted basis of the donor in the installment note receivable. However, the transfer of an installment note receivable to and from a grantor trust is not a taxable disposition. Similarly, the transfer of an installment note receivable from a grantor trust to a disregarded entity wholly owned by the grantor should not be a taxable disposition. Thus, neither the contribution of the Notes by Senior to the LLC, nor the gifts of the Non-Voting Units by Senior to the Lineal Trusts, should result in an acceleration of the Notes under the installment sale rules.
Again, the use of the “disregarded entity” adds significant value to the structure through enhanced asset protection and the opportunity to utilize valuation discount principles in making the gifts. In addition, the forgoing structure achieves income tax neutrality because the LLC’s existence is ignored for federal income tax purposes. Similarly, because the Lineal Trusts are income tax defective, their existence is ignored for federal income tax purposes. Thus, Senior is deemed to be transacting with himself, and the whole series of transactions should be ignored for income tax purposes under the theory of Rev. Rul. 85-13. However, the advisor must be careful to ensure sure that (i) the LLC retains its status as a “disregarded entity”; and (ii) the Lineal Trusts retain their status as “intentionally defective grantor trusts” at all times prior to the complete satisfaction of the Notes.
Rev. Rul. 2004-77, 2004-31 I.R.B. 119 (8/2/2004); Regs. Section 301.7701-2(a)(providing that (i) a business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under Regs. Section 301.7701-3) that is not properly classified as a trust under Regs. Section 301.7701-4 or otherwise subject to special treatment under the Code; (ii) a business entity with two or more owners is classified for federal tax purposes as either a corporation or a partnership; (iii) a business entity with only one owner is classified as a corporation or is disregarded); Regs. Section 301.7701-2(c)(1) (providing g that, for federal tax purposes, the term “partnership” means a business entity that is not a corporation under Regs. Section 301.7701-2(b) and that has at least two owners); Regs. Section 301.7701-2(c)(2)(i) (providing that a business entity that has a single owner and is not a corporation under Regs. Section 301.7701-2(b) is disregarded as an entity separate from its owner); Regs. Section 301.7701-3(a) (providing that (i) a business entity that is not classified as a corporation under Regs. Section 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes; (ii) an eligible entity with at least two owners can elect to be classified as either an association (and thus a corporation under Regs. Section 301.7701-2(b)(2)) or a partnership; and (iii) an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner); Regs. Section 301.7701-3(b)(1)(providing that in the absence of an election otherwise, a domestic eligible entity is (a) a partnership if it has at least two members, or (b) disregarded as an entity separate from its owner if it has a single owner).
Regs. Section 301.7701-3(b)(1)(ii). All Section references contained in this Article are to the Internal Revenue Code of 1986, as amended (the “Code”), or to the Treasury Regulations promulgated thereunder (“Regs”).
Rev. Rul. 60-352, 1960-2 CB 208 (gift of partnership interest in a partnership that held installment notes receivable resulted in acceleration of all deferred gain); Regs. Section 1.453-9(b)(2)(Holder’s basis in installment note receivable is an amount equal to the excess of the face value of the obligation over the total amount receivable by the holder if the note were completely satisfied).
Rev. Rul. 74-613, 1974-2 CB 153.
If you are contemplating marriage, you should be aware that in Florida, spouses have certain legal rights to each other’s property in the event that one spouse dies, just by virtue of the fact that they have walked down the aisle.
A surviving spouse’s property rights are guaranteed by Florida law and cannot be altered unless the surviving spouse has waived them. One of these rights is the right to an interest in the deceased spouse’s homestead property. If a person is a permanent resident of Florida and owns and resides in a residence in Florida, then that residence will typically be considered “homestead” for legal purposes. A surviving spouse is entitled either to the right to live in the deceased spouse’s homestead for his or her life (which is referred to as a “life estate”) or to an undivided one half (1/2) interest in the deceased spouse’s homestead. This is the case even if the surviving spouse does not own an interest in the homestead property. In some situations, a surviving spouse may even be entitled to a fee simple interest in all of the homestead property. In practical terms, this means that the deceased spouse cannot disinherit the surviving spouse of his or her homestead rights without the surviving spouse’s consent.
Florida law also provides that a surviving spouse has the right to an elective share in the deceased spouse’s estate unless this right is waived by the surviving spouse. By law, the surviving spouse can elect to receive thirty percent (30%) of all of the deceased spouse’s assets, including real estate, cash, securities, revocable trust assets, some irrevocable trust assets, life insurance policies, pension and retirement plans. The elective share is in addition to the surviving spouse’s right to the deceased spouse’s homestead property. As with homestead, Florida law on elective share prohibits the deceased spouse from disinheriting the surviving spouse without the surviving spouse’s consent.
Consent of the surviving spouse can be given either through a prenuptial agreement prior to marriage or through in a postnuptial agreement after marriage. If the surviving spouse waives his or her right to homestead property and elective share in such an agreement, the deceased spouse may legally devise his or her assets to whomever he or she chooses without limitation.