Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-1 Exit Planning – Family and Big Fishes Option 1: Sale Out For Real Money Option 2: Transition to Next Generation Option 3: Divide and Do Some of Each The All-Important “Keep vs. Sale” Decision

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-2 Hard Facts 80% of businesses in U.S. family dominated Family businesses account for more than 50% of U.S. employment and nearly 50% of GNP. Over next 15 to 20 years, 43% of American’s family businesses will change leadership. Succession is dream: 79% of old say they want succession as do 70% of young. Only 30% survive through second generation. Only 15% survive through third generation

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-3 Primary Breakdown Factors Relationship Breakdowns – Players can’t get along. Some say as high as 65% Poor Management – Not up to job. Some say as high as 25%. Financial burdens and taxes – Some estimate no more than 10%

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-4 Problem 16-A: The Crane Company Sellout Math: Assume asset sale with basis of net assets valued at $4 million. Sale Proceeds $14 million Stock Basis 4 million Gain on Sale 10 million Tax on Sale 1.5 million After-Tax Proceeds $12.5 million

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-5 Problem 16-A: The Crane Company Future Math: Assume following post sale: Pre-tax investment long-term yield 7% Marginal tax rate 35% Live style annual expenditures (750k) growth rate 2% How much value after 20 years (Mark age 80)?

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-6 Problem 16-A: The Crane Company Bottom Line Numbers Remaining balance after 20 years if sell: $ 3,461,047 Keep Comparison – Company Value grows 5% per year: $ 30,070,707 (After Payment of income taxes)

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-7 So Why Even Consider Sell? Pressure is gone Nest Egg Assured Exit a winner The vulnerabilities (demons) are gone Time to play and stop worrying Down deep I know: “Kids can’t cut it” The world is scary and getting scarier

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-8 Advisors Role Brutal honesty: Not a time for client appeasement Encourage confrontation of the tough issues Emotional Ties Risk World Trapped Child Syndrome Qualified Heir Apparent? Bona Fide Sellout Option In-law Factor Key Business Indicators

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 16-9 Key Business Indicators Strategically v. Relationship Based Institutionalization Process; Brand development Margin Tolerance Uniqueness of asset base Low Tech v. High Tech; Permanence Industry Barriers to Entry; Competition Adaptability of Business and Market Capital Structure and Wealth Concentration

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Marble Planning Daughter Trust Son Trust Daughter Trust GC Trust – 1 GC Trust – 2 GC Trust – 3 GC Trust – 4 GC Trust – 5 GC Trust – 6 Duncan and Sandy Living Trust Personal Residence Trust Family L.L.C. (Growth) Family L.L.C. (New) Dynasty Insurance Trust Charitable Remainder Trust C Corporation Holding S Corp (Parent) Alma Mater Qualified Retirement Plan QSSS Corp (One) QSSS Corp (Two) Income Charitable Deduction Assets Remainder Contributions Distributions Compensation Distributions Home Term Use Assets Cash Remainder Income Units Income, support

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Family Business Mountain Challenge

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Timing Factors  Both Parents Living  First Parent Death  Surviving Parent Death - Moment of Truth

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 35% Hurdle Relief 303 Redemption Qualification: - Death taxes (Fed & State) plus funeral & admin expenses - Tax-Free vs. Taxable Dividend = Big Deal - Only hope with 318 attribution 6166 Estate Tax Payment Option: - Fed estate burden - Payment term up to 14 years - Favored interest rate break 20% Owned Biz: May be included in 35% factor. Spouses community interest may be included for 20% hurdle, but not 35% hurdle

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Targeted First Death Planning  Community Basis Step-Up. 1014(b)(6)  No Estate Taxes with Marital Deduction  Control Surrender Easier  Life Insurance at Its Best

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Valuing the Business  Use an Expert  Better - An Expert Expert  Don’t Get Too Cute or Aggressive

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Exciting Discount Math 100 / 11 = Something Less Than 6 Trap: Control Premium Math

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Discount Strategy  Transfer Minority Interests  Always Die Owning a Minority Interest  Control Value: A Disappearing Act

Constructive Premium Dividend Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Family Corp 75% Stock Parent $3 million policy on Child Cross Purchase Agreement 25% Stock Inside Child $9 million policy on Parent Insurance Company Premiums Constructive Dividends

Buy Sell 2056 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Parent Estate Family Corp Stock Other Family Estate Value > Buy/Sell Price = No QTIP Marital Deduction Family Stock QTIP Trust Family Stock Cash, Note Per Buy/Sell

Stock Compensation Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Family Corp Stock & Gross Up Cash Inside Child  Child Income per 83  Corp 162 Deduction  Zero Net Inc. Tax Cost  Child Basis = Full FMV  No Gift Tax Costs (Actual or Opportunity

Minority Discount 2056 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Parent Estate Family Corp Control Minority Stock Credit Trust, Others Estate Control Value - Minority QTIP Value = Estate Tax Liability Minority Stock QTIP Trust

Buy Sell 2056 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Parent Estate Family Corp Stock Other Family Estate Value > Buy/Sell Price = No QTIP Marital Deduction Family Stock QTIP Trust Family Stock Cash, Note Per Buy/Sell

Unrelated Party Common Stock Sale Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Family Corp $ 3 Mill Common $ 2 Mill Non-cum Preferred Parent Parent Income Tax = $ 3 mill less common stock basis Common Stock Unrelated Party $ 3 Mill Cash, Notes

Preferred Stock 2701 Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Family Corp $ 3 Mill Common $ 2 Mill Non-cum Preferred Parent Parent Income Tax = $ 3 mill less common stock basis Plus Taxable Gift of $2 million. Plus - Parent still owns preferred Common Stock Related Party $ 3 Mill Cash, Notes

2036(b) Voting Stock Trap Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 Controlled Corp Voting Stock Parent Stock Taxed in Parent’s Estate Per 2036(b) Note: Nonvoting Stock Works Voting Stock Trust, LLC Partnership, Corp Voting Rights - Direct or Indirect

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Family Corporation Children GC Trusts Stock Ownership dropping Stock Gifts Voting & Nonvoting Gift Transition Strategy

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Gifting Annual Exclusion Math 4 Kids, 4 Kid Spouses, 4 Grandkid Trusts Dad: 12k per year x 12 = 144k per year Mom: 12k per year x 12 = 144k per year Total Annual Before Discounts: 288k Discount 40%: $480,000 per year Total value moved in 10 8%: $ 7.5 million Total value moved in 20 8%: $ 23.7 million

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Gifting Pros & Cons Pros Value growth on gifted stock out of parents estate No transfer tax on gift tax if beat 3 year pullback Income tax shift Leverage annual exclusions & unified credits Cons Value growth still in parents’ estate Unclear when / how inside children get control Low basis transfer under 1015 C corp double tax on dividends to parents down road Parents’ financial security potentially compromised

Grantor Retained Annuity Trust Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Trust Annuity Term of Years Parent & Estate  Fixed Annuity Amount  Fixed Annuity Term  Annuity Paid Annually  No Debt, Etc.  No additions or others  Mortality Risk of Deal  Yield Risk of Deal  A “Darling” Children Property Remainder

GRAT Something For Nothing Example Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Trust Annuity $ 336,291 yr. Term - 5 Yr Parent & Estate  7529 Rate 5.4%  Zero Remainder Value  Annuity Funded Heavily From Principal  5 Yr Mortality Risk  Any Remainder Pass Transfer Tax Free Children Property $ 1.44 Mill Remainder

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com The GRAT & Family Stock Factors Will work with S or C stock - just make grantor trust Best to Use Nonvoting Stock Negative impacts of corp earnings distributions Yield risk at odds with other value strategies? Opportunity cost of gift tax exclusions & credits Gift tax payments with mortality risks - hard sell Zero Out Play Fund annuity with stock transfers back? Valuation boomerangs & costs Impacts on health of business Big costs and risks v. how much real benefit Screwy message to inside kids

Preferred Stock Freeze Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Family Corp Common Stock Cumulative Preferred Parent  No hope with S corp - One Class of Stock Requirement  Double tax hit on preferred dividend  Real Killer - preferred value under 2701 based sole on market value of cumulative yield. All other value in common under 2701  Hence, strategy only works with extreme annual growth rate Gift Common Stock Children

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Family Corporation Children Balance of Stock Gift stock now Redemption / Gift Combo Strategy Stock Ownership 100% Installment Note

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Redemption / Gift Combo Strategy Pluses: Children have 100% ownership now Note to parents reflect balance of stock value. Negatives: Exchange treatment to parents only if qualify under 302(b)(3) as complete redemption with no family attribution. Parents role limited to creditor. Note principal payments funded with after-tax dollars. All payments on note at parents’ death income in respect of decedent. Full income tax burden to heirs. Tremendous debt burden for company now. No basis step-up for note payments to parents. Parents needs may go beyond note term

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parents Family Corporation Children Cross Purchase Strategy 100% of stock Installment Note Stock ownership 100%

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Cross Purchase Strategy Pluses: Children get 100% ownership now Note to parents reflect balance of stock value No big gifting required now to spook other kids Parents can retain any role – no creditor limitation Children get stepped-up basis on all stock Negatives: Note payments funded with children after-tax dollars. All payments on note after parents’ death income in respect of decedent. Full income tax burden to heirs. Tremendous debt burden on children Children interest deduction? Investment interest tough. How do children get money out of corp to fund payments? S corp conversion issues

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Parent Family Corporation Grantor Trust Intentional Defective Grantor Trust Installment Sale “IDGT” Stock Installment Note Stock ownership Other asset Gift Children Beneficiaries Dream Scenario  No gain on sale  No gift tax impacts  Stock outside parent’s estate  Trust income taxed to parent  No mortality risk  Asset substitution pre-  death for basis step-up  Works with C and S stock

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com IDGT Issues What we think we know: Dual status possible No gain on sale to grantor trust No gift tax on income tax payments by parent No estate inclusion under 2036 if parent outlive note What we are not sure of: Gift tax impact going in if interest rate is applicable federal rate Estate inclusion under 2036 if death before note paid Debt v. retained equity on note – need for other assets equal to 10% What we don’t know Tax treatment on note payments post death – IRD? Gain recognition on note on grantor trust status termination Basis impacts on death with grantor trust termination

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com IDGT & Family Stock Key questions: Is cross purchase strategy best option? Parent’s capacity to gift other assets? Has stock basis been stepped-up at first death? Impact on business? Client’s stomach for tax uncertainty?

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Self – Canceling Installment Note (“SCIN”) Pluses: All note payments canceled on death of parent No residual note balance in parent’s estate Minuses Actuarial premium calculation required If parent lives, premium will result in gift tax cost (actual or opportunity) or child paying more May conflict with objectives for other children