Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-12 Problem 6-A: Alton Inc. Triggers: - Death : Insurance funded. - Employment Termination : Installment, perhaps wrapped with owner deferred compensation. Amount reduced if no non-compete – goodwill presumed lost. - Expulsion : Tough with only three. Require other two vote. Payout same as employment termination with non-compete. - Disability : Same as employment termination with non-compete. - Bankruptcy, Divorce : Purely optional. Payout same as employment termination without non-compete. - Voluntary Stock Exit: Employment remains. Staged exit program. Pricing presumes no non-compete, unless all agree otherwise.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-13 Problem 6- B: Knock-Down Inc. Wade advice: - Dump standard agreement - Explain facts of life to others – Wade has privilege - Structure one-legged buyouts for others with best triggers and provisions to protect business - Preserve maximum flexibility for Wade and family - Start process of identifying and prioritizing Wade’s transition objectives and priorities and related estate planning challenges

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-14 Problem 6- C: Sports Limited Jake advice: Right of first refusal does nothing for Jake. Where find new buyer of 30%? Plus may give Sam, wealthy and passive owner, big leverage if Sam wants out. Jake could end up with unwanted partner. Showdown clause a disaster. Gives Sam huge leverage. He has bucks and no career on the line. Jake could end up a forced buyer at crazy price or lose job and career. Dump this provision. Alternatives: Provisions that promote stability – not encourage exits. Long-term stages and generous payment terms.

Split Dollar Insurance Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-15 Company Insurance Company Premiums Portion of Death Benefit Employee/ Insured Policy Ownership Summary of impacts: Premiums paid by company treated as below-market loans to employee/insured Compensation imputed to employee for interest element Interest payment imputed from employee to company Collateral Assigned Policy Excess Death Benefit Policy Collateral Assignment

Split Dollar Insurance Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-16 Company Insurance Company Premiums Portion of Death Benefit Employee/ Insured Policy Ownership Summary of impacts: Company owns policy, not employee Company endorses policy to reflect employee’s interest in death benefit Employee each year deemed to have received compensation income for death benefit value over share (if any) paid by employee Company gets corresponding compensation deduction Endorsement Method Excess Death Benefit Policy Endorsed

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-17 Problem 6- D: Doctor Linda Building Option: Tiered Equity Structure - First Tier: 1 mill for original three owners (3 way split) - Second Tier: Equity over 1 mill; Linda and others (4 way split) Example: Owner A retires in 5 years when equity in building worth 1.8 million. A’s share: First tier share: 333,000. (1/3 of 1 mill) Second Tier Share: 200,000. (1/4 of 800k) Total payout 533,000.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-18 Problem 6- D: Doctor Linda If LLC borrows to cash out Partner A: Equity in building drops by $533,000 to 1,267,000, allocated as follows: - First Tier: 667k for remaining two originals - Second Tier: 600k; Linda plus 2 remaining If partners use own cash to fund A’s interest in equal shares (177,667 each), equity remain at 1.8 mill allocated as follows: - First Tier: 667k for remaining original owners - Second Tier: 1,133,000 ; Linda and two others

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-19 Problem 6- D: Doctor Linda Options for Linda’s receivables buy-in: Option 1: (Dreamland): Ignore receivables for entry and exit. Necessary ingredient for going concern. Option 2: Use receivable balance on date of hire, not date of admission to ownership. Concept: Linda shouldn’t have to pay what she helped create. Option 3: Structure as pre-tax buy-in: - Receivables allocated among owners and reflected in employment agreement as deferred compensation. Each owner collects share over time at exit. - Linda funds her share by taking pay cut over designated time frame (five years). At any point, her deferred comp is her share of receivables less unfunded pay cut. All pre-tax to Linda.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-20 Problem 6- D: Doctor Linda Linda receivables options for buy-in: Option 4: Tiered Equity in Receivables - Existing receivables of 800k allocated to existing three owners (first tier). All reflected in employment agreements as deferred compensation. - All receivables in excess of present balance allocated four ways through employment agreements. - Advantage to Linda: No pay cut now to fund equity in receivables first tier.

Problem 6-E: Smith Industries Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-21 S Corp 75% Stock David $3 million policy on Walter Cross Purchase Agreement 25% Stock Walter $9 million policy on David

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-22 Problem 6- E: Smith Industries Assume: David dies, Walter sells business for $12 million Return to David’s Family: Payment from Walter 9 million Estate Taxes (4 million) Net return 5 million Return to Walter Sales Proceeds 12 million Income Tax (.6 million) Net return 11.4 million What’s wrong here?

Problem 6-E: Smith Industries Restructured Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-23 S Corp 75% Stock David $3 million policy on Walter Cross Purchase Agreement 25% Stock Walter No policy on David Family ILIT $9 million policy on David

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-24 Problem 6- E: Smith Industries Restructured Assume: David dies, business sold for $12 million Return to David’s Family: Proceeds from sale 9 million Estate Taxes (4 million) Life insurance (tax free) 9 million Net return 14 million Return to Walter Sales Proceeds 3 million Income Tax (.6 million) Net return 2.4 million

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-25 Problem 6- F: Mad Golf Inc. Transfer-for-value can kill tax-free death benefit on conversion from redemption to cross purchase: - Policy transferred by corp to insured no problem - But insured’s transfer of ownership to other shareholders will trigger problem Two possibilities: - Cancel existing polices and re-underwrite with new applicants and owners - Rely on partner exception, if in fact there is bona fide partnership among the owners Note: Going from cross-purchase to redemption does not cause problem – officer/shareholder exception saves

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 6-26 Problem 6- G: Mad Golf Inc. Give each shareholder option to take policy and transfer to ILIT for family. May avoid insurability issues. If policy transferred through insured, no transfer-for-value issues but does trigger three-year clock for ILIT. Restructure buy-sell to include “look-back” valuation for any sale of company within designated timeframe (i.e. 2 years) of buy-out of any shareholder for any purpose. Consider S Corp conversion. Minimize BIG (Built-in- Gain) tax with appraisals and start 10-year clock ticking. Very little to lose (some employee benefit deductions); much to gain potentially.