1. The Three Levels of Business Succession Planning
Sponsored by:
September 17, 2011
San Diego, California
Presented by:
Julius H. Giarmarco, J.D., LL.M.
Giarmarco, Mullins & Horton, P.C.
101 W. Big Beaver Road, 10th Floor
Troy, Michigan 48084
(248)

2. IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this presentation is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

3. The Three Levels of Business Succession Planning
Selecting Management and Retaining Key Employees.
Transitioning Ownership and Securing Retirement for the Founders.
Selecting a Transfer Strategy to Minimize Gift and Estate Taxes.

4. Estate, Gift, and GST Taxes
Year
Estate Tax Exemption
Basis Method
GST Tax Exemption
Top Estate/GST Tax Rate
Gift Tax Exemption
Top Gift Tax Rate
2009
$3,500,000
Step-up in basis
45%
$1,000,000
20101
- 0 -
Modified carryover basis 0%
35%
$5,000,000
20112
20123
2013
$1,000,0004
55%
1 The Tax Relief Act of 2010:
2 Beginning in 2011, introduction of the portability of the estate tax exemption between married couples (Note: not applicable to GST tax exemption).
3 Estate, GST, and gift tax exemptions are indexed for inflation in 2012.
4 Indexed for inflation ($1.4M estimate).

5. Case Study
John James is the founder, president and sole owner of JJ Enterprises (JJ), a successful manufacturer of machine tools.
John is 65 years old. His wife Mary is also 65.
JJ has two key executives. 5

6. Case Study
Their son, Bradley (age 35) is vice president of marketing at JJ.
Aspires to succeed John as president and controlling owner.
John generally concurs, but has concerns about Bradley’s wife.
John and Mary have another son, Blaze (age 30), who is not and does not want to be involved in the business.
Bradley has two minor children; and Blaze has three minor children. 6

7. Case Study JJ is worth $10M to the right buyer.
John’s annual salary and bonus is $300K.
JJ is an S corporation with taxable income averaging $1M over the last four years.
JJ has a profit-sharing plan.
No equity or nonqualified retirement plans for key executives.
No other retention plans for key executives. 7

8. Case Study
John and Mary own the business real estate, which has an estimated value of $5M. They own it jointly to avoid probate.
Their residence and vacation homes are valued at $2M and $1.5M and are owned jointly. The mortgages have been paid off.
John and Mary have personal investments of $1.5M, most owned jointly.
John has a $5M life insurance policy owned by an irrevocable life insurance trust (ILIT). 8

9. Case Study
John’s profit-sharing account is $1M; Mary is the beneficiary, and Bradley and Blaze are the contingent beneficiaries.
John and Mary have pour-over wills, living trusts with the usual “A/B” structure, powers of attorney, healthcare directives, and John has an ILIT. 9

10. John & Mary’s Balance Sheet
Value
Residence (Joint) $2,000,000
Vacation Home (Joint) $1,500,000
Business (S corp) (John) $10,000,000
Building (Joint) $5,000,000
Non-Qualified Investments (Joint) $1,500,000
Profit-Sharing Plan (John) $1,000,000
Life Insurance (ILIT) ($5,000,000)
Gross Estate $21,000,000 1 2 1
Cost basis of $500,000; assume 10% distributions and 4% principal appreciation.
Annual renewal term policy. 2

11. John & Mary’s Objectives
Retain control of the S corporation until death, disability or retirement.
Pass the entire business to Bradley at John’s death.
Retain the two key employees to assist in the transition period.
Treat both sons fairly, if not equally.
Guarantee retirement income (which may have to come from the business).
Reduce or eliminate estate taxes.

12. Projected Estate Tax Liability in 2031
No federal estate taxes at first death
Current Net Estate $44,000,000
Life Insurance $ 5,000,000
Total Estate $49,000,000
By-Pass Trust $5,000,000
Marital Trust /
Surviving Spouse
$39,000,000
ILIT $5,000,000
After-Tax Estate
$28,850,000
Federal Taxes
$10,150,000
Distribution to Heirs
After-Tax Estate $28,850,000
By-Pass Trust 5,000,000 ILIT 5,000,000
Total $38,850,000
Distribution to Family: 79.3%
Assumes 4% after-tax growth through 2031.
Assumes the estate tax exemption is $5M and the estate tax rate is 35%.

13. Options to Pay the Estate Tax if John & Mary Do Nothing
1. Good - IRC Section 6166 (5-year deferral; 10-year installment payment of estate tax).
2. Better - IRC Section 303 (redemption of stock to pay death taxes).
3. Best - Irrevocable Life Insurance Trust.
Discounted dollars.
Can purchase assets from estate.
Can loan monies to estate.

14. Installment Payments Under Section 6166
Extension of time to pay estate tax, but only for amount of estate tax attributable to the closely held business.
Value of business interest must exceed 35% of the adjusted gross estate.
Payments commence in fifth year after estate tax return due date. Interest-only need be paid during first four years, then principal and interest.

15. Installment Payments Under Section 6166
Interest rate:
Rate on first $1,360,000 for 2011 of business value is 2%.
Rate on excess is 45% of normal rate on underpayments.
No deduction allowed for any interest on Section 6166 deferral.

16. Installment Payments Under Section 6166
Tax will be accelerated upon:
Distribution, sale, exchange of 50% of the value of the business – valued as of the date of decedent’s death.
Withdrawal of 50% of the value of the business.
But, transfer to beneficiary doesn’t cause acceleration.
However, subsequent transfer by beneficiary will cause acceleration.

17. Section 303 Redemption
To qualify for sale or exchange treatment (as opposed to dividend treatment) under Section 303, the stock must exceed 35% of the adjusted gross estate.
Generally, little capital gain since stock receives “step up” at death.
Must be used to pay funeral costs, medical expenses of last illness, estate administration expenses and death taxes.

18. Section 303 Redemption During John’s Lifetime
Insurance
Company
Pays Premiums
S Corp
Obtains Life Insurance
John
If stock interest is more than 35% of adjusted gross estate, the estate will qualify for a partial redemption.
Insured

19. Section 303 Redemption At John’s Death
Insurance
Company
Pays Death Benefits
S Corp
Cash
John
Partial redemption is not treated as a dividend.
Family continues to retain an ownership interest.
Stock Transferred
Some Stock
John’s
Living Trust

20. Life Insurance – The Threshold Inquiries
How much is John willing to spend on life insurance?
Term insurance will be less expensive than permanent insurance in the short run.
But should consider permanent insurance for a permanent need.
Who will be the insured – John, Mary, or both?
To protect Mary, John should be the insured.
For estate liquidity or equalization for Blaze, Mary could be the insured (assuming she has the longer life expectancy), or a survivorship policy could be used.

21. Life Insurance – The Threshold Inquiries
Who will be the policy owner and beneficiary?
Given the size of the estate, an irrevocable life insurance trust should be the owner and beneficiary.
Who will pay the premiums and under what type of arrangement?
Gifts from John and Mary using their $26,000 annual gift tax exclusions per child / grandchild.
Loan regime split-dollar with the Corporation.

22. Level 1: Selecting Management and Retaining Key Employees
Will Bradley be ready to manage the business upon John’s death, disability or retirement?
If not, what options are available to retain the two key employees during the transition period:
Employment agreements with profit-sharing provisions.
Stock option plans (but this dilutes the family’s equity).
Change of control agreements.
Non-qualified deferred compensation (NQDC) plans.

23. Level 1: Nonqualified Deferred Compensation Plans
Plans are “nonqualified” because they do not have to comply with the rules for qualified plans. (Nor do they afford the same level of protection for the participant.)
Participant must be part of a select group of management or highly-compensated employees (“Top Hat Plan”).

24. Level 1: Nonqualified Deferred Compensation Plans
Defined benefit arrangements:
Employer funded retirement benefit based on a formula typically involving years of service and compensation over time.
Defined contribution arrangements:
Employee and/or employer funded account balance plan similar to a 401(k) plan.
In either type of plan, the employee is an unsecured general creditor of the Corporation.

25. Level 1: Nonqualified Deferred Compensation Plans
If executive remains a general unsecured creditor of the company, the amounts deferred are not subject to taxation.
The amounts distributed will be ordinary income to the executive and deductible by the employer at the time of payment (not the time of deferral like qualified plans).
This is particularly important to discuss with S corporations, like JJ.

26. Level 1: NQDC Plan Design Options
Type of plan (DB or DC).
Type of payout (lump sum or annuity).
Benefit for surviving spouse?
100% vesting for change in control or termination without cause?
Reasonable compensation.
Impact on the value of the business and lenders.
Funding.
Section 409A requirements.

27. Level 1: Sec. 409A Requirements
Distributions can only be made upon one of six circumstances:
Separation of service.
Disability.
Death.
Fixed time specified in plan.
Change in control.
Unforeseen emergency.

28. Level 1: Funding a NQDC Plan
Pay-as-you-go:
Benefits are paid from the general assets of the company, so it maintains use of funds.
But executive is at risk for payment.
Sinking fund:
Plan assets are placed in a designated account or fund (with after-tax dollars).
Company controls but at least there us an identifiable asset for satisfaction of future liabilities, subject of course to risks.
Requires time to accumulate funds.

29. Level 1: Funding a NQDC Plan
Corporate Owned Life Insurance (COLI);
Company is owner, beneficiary and premium payer of policies on the key executives.
Premium is not deductible, but generally:
Cash value builds on tax-deferred basis.
Cash value can be accessed on tax-free basis (if done properly).
Death benefit is not taxable when received by the company (but C corporations are subject to a 15% AMT).

30. Level 1: Non-Qualified Deferred Compensation Plan2 JJ
Insurance
Company 3 1 4
Key
Employees
JJ promises to provide a death, disability or retirement benefit. 1 2
JJ purchases life insurance to “informally” fund benefits. 3
Asset values help pay benefits and/or recover costs. 4
Benefits are paid based on contractual specifications.

31. Level 2: Transitioning Ownership and Securing Retirement for John and Mary
Decision tree:
The personal and business variables that will determine the extent and pacing of John’s transfer of the business. Can John give up the action?
How to transfer ownership (for wealth transfer purposes) but retain control for personal and business purposes (use voting / non-voting shares).
Should Bradley be given the stock or pay for it?
The impact on employees, creditors and customers.
The costs and potential risks of delay. Federal estate tax is only vulnerable to lifetime gifting. 31

32. Level 2: Transitioning Ownership and Securing Retirement for John and Mary
Equalization between Bradley and Blaze:
What does “equal” mean?
Does John really mean “equal” or just “fair”?
When should equalization occur?
True equalization for Blaze will be difficult to accomplish.
Can it be handled with other existing assets?
If not, an irrevocable life insurance trust is recommended. 32

33. Level 2: Transitioning Ownership and Securing Retirement for John and Mary
Options for securing John and Mary’s Retirement:
Retain control of JJ, thereby maintaining access to a salary and bonus.
Sell (as opposed to gift) Company to John (i.e., installment sale or private annuity).
Life insurance on John’s life owned by an ILIT for the benefit of Mary.
A non-qualified deferred compensation plan to provide John with a pre-retirement death, disability or retirement benefit (with survivor benefits for Mary). 33

34. Level 3: Selecting a Wealth Transfer Strategy
How?
Gifts of stock.
Stock bonuses.
Private Annuity.
Grantor Retained Annuity Trust (GRAT).
Installment Sale to Intentionally Defective Grantor Trust (IDGT).
Ownership first, control later by gifting or selling non-voting shares. Non-voting shares may also qualify for valuation discounts. 34

35. Level 3: Selecting a Wealth Transfer Strategy
When?
As soon as possible, to remove future appreciation from John and Mary’s estate.
When is the best time to plant an oak tree?
Impact of transfer to Bradley:
Bradley’s compensation expectations.
Note requirement for pro-rata distributions in S corporations. 35

36. Level 3: Private Annuity
Structure:
John (annuitant) sells JJ stock to Bradley in exchange for a life annuity.
Present value of annuity stream equals fair market value of assets sold, resulting in no gift.
When John dies, payments terminate.
Annuity may not be secured.
Bradley cannot deduct any part of payments.

37. Level 3: Private Annuity
Bradley
Sale of $6.5M of non-voting stock in JJ (with basis of $500K)
John
(Age 65)
Annual Payout of $473,488.30
Fair market value of stock is $10M, less 35% valuation discount.
Capital gain realized in year one is $6M; each payment is divided into interest income ($140,154.96), and a nontaxable recovery of basis ($333,333.34).
Calculation assumes a 19.5 year life expectancy.
Standard valuation tables may be used if annuitant has at least a 50% probability of living one year. If the annuitant survives for at least 18 months, the 50% test is presumed to have been met. Regs § § (b)(3) and (b)(3).
IRC Section 7520 Rate = 2.4%.

38. Level 3: GRAT John transfers JJ stock to an irrevocable trust.
Annual annuity paid to John for a term of years (in cash or in kind).
Assets remaining at end of term pass – tax free – to Bradley.
Statutory technique.

39. Level 3: GRAT
Tax-free gift of appreciation in excess of IRC Section 7520 rate.
John’s payment of GRAT’s income taxes is also a tax-free gift to Bradley.
No risk of unintended gift tax (because annuity self adjusts when initially set as a percentage of the fair market value of the transferred property).

40. Level 3: GRAT Diagram Bradley
John (age 65): Gift of $6.5M of JJ stock (after discount)
Gift = $4.17
Contribution of JJ Non-Voting Stock
GRAT Value: $10 million
Annual Annuity Payment of $813, (12.52%)
Remainder transferred to Bradley (or trust for Bradley’s benefit): Assumptions: 10% income/4% growth: $21.8M 10% income/8% growth: $34.6M Section 7520 Rate = 2.4%
Remainder after 10 years
Bradley

41. Level 3: GRAT Drawbacks Grantor must survive the GRAT term.
Assets must out perform the IRC Section 7520 rate.
Cannot allocate GST exemption until end of GRAT term.
Practical downside is transaction costs only.

42. Level 3: Bullet-Proofing a GRAT
John can purchase insurance on his life (to be owned by an ILIT for the benefit of Bradley) to provide the funds needed to pay estate taxes (on the stock bequeathed to Bradley) should John die before the end of the GRAT term.
Alternatively, Bradley can purchase life insurance on John’s life to provide the funds necessary to purchase the stock (pursuant to a buy-sell agreement) if John dies before the end of the GRAT term.

43. Level 3: Intentionally Defective Grantor Trust
An IDGT is a type of trust where all income earned by the trust is taxed to the grantor because the trust is drafted to be “defective” for income tax purposes, but “effective” for estate and gift tax purposes.
Defective nature of trust also allows for a “tax-free” gift to the trust’s beneficiaries when grantor pays income taxes otherwise attributable to the trust or its beneficiaries.

44. Level 3: Installment Sale to an IDGT – Summary of Technique
John sells JJ stock to an IDGT in exchange for an installment note.
For estate tax purposes John should make an initial “seed” gift (at least 10% of the total transfer value) to the IDGT.
To the extent that the growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note, the “excess” is passed on to the trust beneficiaries free of any gift, estate and/or GST tax.

45. Level 3: Installment Sale to an IDGT – Summary of Technique
No capital gains tax is due on the installment sale to the trust because the trust is “defective” for income tax purposes.
IDGT’s basis in the assets is John’s carry-over basis.
Interest income on installment note is not taxable to John because the trust is “defective” for income tax purposes. Instead, John pays the taxes on all of the IDGT’s income.

46. Level 3: Sale to an IDGT Grantor/ John IDGT f/b/o Bradley Life
1. Gifts $650K of JJ Non-Voting Stock
Grantor/ John
IDGT f/b/o Bradley
5. Excess Cash Flow / Premiums
Life
Insurance
Company
2. Sells $5.85M of JJ Non-Voting Stock (No Capital Gain Tax)
6. Death Proceeds (Income and Estate Tax Free / Leverages GST Exemption)
3. $5.85M Note to Grantor Balloon Payment in 9 Years
4. $142,740 annual interest (Interest Rate 2.44%)
Advantages:
Value of assets sold frozen at 2.44% for nine years (assumed mid-term AFR).
John’s estate further reduced by the income taxes paid on behalf of the trust.
The trust property escapes estate taxation for as long as permitted under state law.
IDGT can purchase a life insurance policy on John’s life. Upon John’s death, the death proceeds can be used to purchase John’s voting shares in JJ and the building used by JJ.

47. Level 3: Installment Sales to an IDGT - Example
Assumptions
FMV of Assets Sold to IDGT
$ 5,850,000
Gift to Trust
$650,000
Interest Rate (Mid-Term AFR)
2.44%
Terms (Years) 9
Payment Structure
Interest-Only w/Balloon Payment
Payment Period
Annually
Timing of Payments
End of Period
Year
Beginning Balance
Income
10.00%
Installment
Payment
Ending Balance 1
$5,200,000
$520,000
$(126,880)
$5,593,120 2
$559,312
$6,025,552 3
$602,555
$6,501,227 4
$650,123
$7,024,470 5
$702,447
$7,600,037 6
$760,004
$8,233,161 7
$823,316
$8,929,597 8
$892,960
$9,695,676
$969,568
$(5,326,880)
$5,338,364
Amount passing to beneficiaries free of estate and gift tax
And income tax on trust income is paid by grantor as additional “gift” without gift tax

48. Level 3: Grantor Trust vs. Non-Grantor Trust
Year
Beginning Balance
Taxable Income 7%
Less: Taxes at 40%
Ending Balance 1
$10,000,000
$700,000
$(280,000)
$10,420,000 $
$10,700,000 2
10,420,000
729,400
(291,760)
10,857,640
10,700,000
749,000 -
11,449,000 3
760,035
(304,014)
11,313,661
801,430
12,250,430 4
791,956
(316,783)
11,788,835
857,530
13,107,960 5
825,218
(330,087)
12,283,966
917,557
14,025,517 6
859,878
(343,951)
12,799,892
981,786
15,007,304 7
895,992
(358,397)
13,337,488
1,050,511
16,057,815 8
933,624
(373,450)
13,897,662
1,124,047
17,181,862 9
972,836
(389,135)
14,481,364
1,202,730
18,384,592 10
1,013,695
(405,478)
15,089,581
1,286,921
19,671,514

49. Level 3: IDGT vs. GRAT With IDGT: No mortality risk.
Can allocate GST exemption to seed gift.
Mid-term AFR is less than Section 7520 rate.
Back-loading (i.e., interest only with balloon payment vs. level annuity payment).
Not a statutory technique.
Possibility of unintended gift tax, which may be mitigated by using a “defined value” clause.

50. Level 3: Buy-Sell Agreement During John’s Lifetime
Insurance
Company JJ
Agreement
Pays Premiums
Pays Premiums
John
IDGT f/b/o Bradley
John Obtains Life Insurance on Bradley’s Life IDGT Obtains Life Insurance on John’s Life

51. Level 3: Buy-Sell Agreement Upon John’s Death
Insurance
Company
Pays Death Benefits JJ
Option to
Purchase
Must
Purchase
John
IDGT f/b/o Bradley
1st
3rd
Stock Passes
Option to Purchase
2nd
John’s
Living Trust

52. Level 3: Why Use Life Insurance to Fund Buy-Sell Agreement?
Creates a lump sum of cash when needed.
Results in a quick settlement of the buy-sell transaction.
Generally, an income tax free death benefit.
Income tax free access to cash values for a lifetime buy-out.

53. Level 3: Estate Equalization
John and Mary can leave Blaze their non-business assets.
John and Mary can “make up” the difference by funding a survivorship ILIT for the benefit of Blaze.
Alternatively, the IDGT f/b/o Bradley can loan premiums to Blaze’s ILIT under a loan regime split-dollar arrangement.

54. Level 3: Estate Equalization
John & Mary 1
John & Mary create an irrevocable trust, and make gifts of life insurance premiums to the trust. 2
Pays Insurance Premium.
Insurance
Company
ILIT fbo
Blaze 3
Pays death benefit upon death of John & Mary – income and estate tax free! 4
Transfers Cash.
John & Mary’s
Estate
Transfers Assets. 5 6
Pays Debts and Taxes.
IRS

55. Level 3: Family Bank Structure:
A family LLC or family limited partnership.
Members/Partners:
Bradley and Blaze.
Capital Contributions:
Either gifts from John and Mary and/or contributions directly from Bradley and Blaze.
FLLC’s/FLP’s Investments:
A survivorship policy on John and Mary’s lives.

56. Level 3: Family Bank Indicated Use:
If shares in JJ are transferred (either during John’s lifetime or death) to both sons.
Purpose:
To provide funds for Bradley to “call” Blaze’s shares, or for Blaze to “put” his shares to Bradley.

57. Level 3: Top 10 Uses of Life Insurance in Family Business Succession Plan
Estate Liquidity.
Funding Buy-Sell Agreements.
Estate Equalization.
Funding Nonqualified Deferred Compensation Plans.
Key-Man Insurance.

58. Level 3: Top 10 Uses of Life Insurance in Family Business Succession Plan
Funding a Section 303 Redemption Plan.
As a hedge against premature death with a GRAT.
To leverage the excess cash flow in connection with an installment sale to an IDGT.
Asset Protection Planning.
To fund a Family Bank.

60. THE END
THANK YOU