1 Mike Halloran

2 Business Continuation – general  Sooner or later, the day will come when the current owner of the business no longer owns it.  What will happen to the business then? ► Cease/liquidate? ► Continue?

3 Business Continuation – who, when, how If want business to continue, some things to ask/determine are:  Who... who should take over business (or each owner’s portion of it)?  When... what event should trigger the transfer (death, disability, retirement... even sooner)?  How... ► By gift or bequest? ► Sale?

4 Some additional things to ask/determine:  What’s value of business (or each owner’s portion of it)?  If selling, what are terms of sale (lump sum v. pay over time)? Business Continuation – more Qs

5  Very few privately-held businesses have a written succession plan  If no preparation is done, what happens with the business? let’s see the results...

6 Corp A B 50 Shs spouse B now in business with A’s spouse

7 Buy-Sell Agreement – what is it? Agreement to buy a business interest, and sell a business interest, upon a certain triggering event, such as …  Death  Disability  Retirement or termination of employment

8 Types of Buy-Sell Agreements  Business buys  Entity Purchase  Other owner(s) buy  Cross Purchase  Option to buy  Wait & See

9 A B Corp 50 Shs spouse B now owns all 100 shares; A’s estate/spouse has $ $

10 Corp 50 Shs spouse A B B owns all 50 remaining outstanding shares; A’s estate/spouse has $ $

11  Where to come up with the money to buy ? ► Cash on hand / existing funds ? ► Save for it ? ► Payments over many years? ► Life insurance and disability insurance !

12 Buy-Sell Agreement … if funded with insurance Cardinal rule (or semi-cardinal)... Whoever is supposed to buy the business interest upon triggering event should be  applicant,  owner, and  beneficiary (loss payee if disability ins.) on insurance policy insuring the other

13 Effect of Cardinal rule...  Entity purchase – business owns policy and is beneficiary (or loss payee)  Cross purchase – other owner owns policy and is beneficiary (or loss payee) Buy-Sell Agreement … if funded with insurance (cont.)

14 A Life Ins A B C Corporation B Life Ins Entity Purchase

15 A Life Ins A B C Corporation B Life Ins Cross Purchase

16 So …which is “better” … Cross Purchase ? or Entity Purchase ?

17 1.Survivor’s Basis  With cross purchase, remaining owners (survivors) more easily get high basis in newly acquired stock 2.Relative tax brackets  If business is C Corp and in lower tax bracket than individual owner, might be cheaper to do entity purchase 3.Number of owners  The more owners there are to be insured, the more likely entity purchase is easier 4.Related parties  If parties are related, cross purchase avoids “attribution” problems Cross Purchase v. Entity Purchase … some factors

18  can be important for survivors, especially if plan on selling the business in the future.  with pass-through entities (e.g., S Corps and Partnerships), survivors receive some basis increase when death proceeds are paid to pass-through entity. Cross Purchase v. Entity Purchase … some factors 1.Survivor’s Basis  With cross purchase, remaining owners (survivors) more easily get high basis in newly acquired stock

19 A Life Ins A B C Corporation B’s payment of premiums not deductible for B Insurance Co. $

20 B receives death benefit income tax free $1 M C Corporation Insurance Co. A B A Life Ins

21 $1 M C Corporation Insurance Co. A B Purchase of stock not deductible for B

22 C Corporation A B FMV = $1 M Basis = $100k Original $1 M = $1 M Newly Bought FMV Basis B’s stock: FMV  $1 M,... and basis  $1 M

23 C Corporation A B FMV = $1 M Basis = $100k Original

24 C Corporation A B Basis = $100k Original $1 M FMV = $2 M B’s stock: FMV  $1 M,... but no basis increase

25  Cross Purchase: $2 M - $1.1 M = $ 900,000 gain  Entity Purchase: $2 M - $100 K = $ 1,900,000 gain Pro-cross purchase Survivor’s basis... effect on later sale

26  Entity purchase plans funded with life insurance pay death proceeds to entity  With pass-through entity (S Corp, P Ship, most LLCs), surviving owners receive basis increase pro rata to ownership  Basis increase for deceased owner is “wasted” because already has basis step-up  But owners may think this is small downside, if prefer entity purchase for other reasons

27 2.Relative tax brackets  If business is C Corp and in lower tax bracket than individual owner, might be cheaper to do entity purchase Cross Purchase v. Entity Purchase … some factors

28 15% $10 k prem. 40% $10 k prem. B C Corporation Relative Tax Brackets Pro-entity purchase (with C corporation) $12 k $18 k

29 3.Number of owners  The more owners there are to be insured, the more likely entity purchase is easier Cross Purchase v. Entity Purchase … some factors

30 C Business A B C AB n Pro-entity purchase BCAC AB Business A B C n (n - 1) Number of Owners

31 4.Related parties  If parties are related, doing cross purchase avoids “attribution” problems Cross Purchase v. Entity Purchase … some factors

32 Corporation Smith Jones Unrelated ? Then no attribution problem Related Parties ? Johnson Corporation Dad Mom Related ? Entity purchase might have attribution problem Son

33 Normal tax effect on A’s estate While A is still alive … Basis $100k FMV $1 M

34 Normal tax effect on A’s estate At A’s death … Basis $1 M Estate’s Stock Basis = FMV at death (“Step-Up”) FMV $1 M

35 Effect when A’s estate sells stock...? Basis $1 M FMV $1 M A’s estate

36 If A’s estate sells to B via cross-purchase Basis $1 M B A’s estate Amount received – Basis = Estate’s Gain $1 M – $1 M = $ 0

37 If A’s estate sells to Corp via entity purchase Basis $1 M A’s estate Corporation The $1 Million received could be treated as taxable dividend, unless A’s Estate sells all its stock... not easy to do because of “attribution”

38 Corporation Dad Mom Son Related Owners (Estate Attribution) Dad’s ESTATE is considered to own stock that is owned directly or indirectly by a beneficiary of Dad’s estate Mom and/or Son probably are beneficiaries of Dad’s estate, and they still own stock $

39 Corporation Dad Mom Son Related Owners (Family Attribution) Dad is considered to own stock that is owned by his FAMILY (parents, spouse, children and grandchildren) $ Dad sells while alive... Mom and Son are his family, and they still own stock

40  Transfer for Value Rule.  Unintended shifts in control. Not every remaining/surviving owner must buy from a departing owner. If want to sell to just one of several remaining owners (e.g., to Child only), then don’t do entity purchase.  Disability Policies. Disability Buy-Out underwriting rules and policy provisions can differ greatly from life insurance. Call home office before promising anything. Other factors...

41 Even more considerations...  Accounting.  AMT. Alternative Minimum Tax potentially could affect C Corporations.  IRC § 101(j). Notice and Consent.

42 Thank You

43 This presentation is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by The Northwestern Mutual Life Insurance Company. Representatives. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions.