Transcript Slide 1

THE ESTATE PLANNING COUNCIL
OF HAMPDEN COUNTY, INC.
PRESENTED BY
Dana R. Barrows
Estate and Business Planning Specialist for the
Northwestern Mutual Financial Network
Email Address: [email protected] Office Telephone: (413) 748-6015
&
Steven J. Schwartz, Esquire,
Shatz, Schwartz and Fentin, P.C.
On FEBRUARY 8, 2011
Held at the Colony Club located at Tower Square
DEFINITION OF EXIT PLANNING
Exit Planning is the comprehensive approach to designing an
exit strategy for a business owner.
Why is an Exit Plan Important?

50% of high net worth individuals are business owners

$3.2 Billion in business assets will be transferred in the next 10 years.

88.6% of households that have over $50 million own a private business

67% of those business owners do not have complete transition plans

72% will seek advice of the sale of their business
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90% of U.S. businesses are family owned
 Only 30% of such companies succeed in the second generation; and
 Just 15% make it to the third generation.
ROAD
MAP
To encompass setting exit objectives, such as:
When does the business owner want to retire?
What are the business owner's financial requirements
upon retirement?
To whom will the business owner sell the business?
What is the estimated fair market value of business?
To assemble a “team” of trusted, professional advisors;
To develop a written plan of ideas for each aspect of the
transition sequence in the form of a "road map" that
explains exactly the transitional steps to be taken, when
each transitional step will be taken and why each
transitional step is taken.
FACT FINDING
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Assemble with the client a "team" of advisors.
 Lawyer
 Certified Public Accountant
 Financial/Insurance Advisor
 Business Appraiser
 Investment Banker
 Business Adviser
Establish responsibility of each team member.
Produce an introductory exit plan.
The Case Study is a result of the Fact Find
Case Study
Family Circumstances
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John and Ruth Successful are 65 years old and in good health. They
have four children who are all married and have eight grandchildren.
John and Ruth’s son, Rich, and their daughter, Sue, are working in the
family business, namely High Tech, Inc. (the “Company”). Rich and Sue
are successful in managing the business and have been primarily
responsible for the growth of the business in the last five years. Jane
and Robert are children who have independent careers.
Rich is the Chief Executive Officer of the Company and Sue is Vice
President and is in charge of sales and marketing of the Company’s
products. Rich and Sue have a good working relationship and enjoy
managing the business. They anticipate that their employment at the
Company will be their sole careers and they are hopeful that the next
generation of the family will also join them in operating the business.
Case Study
(continued)
Family Circumstances (continued)
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John and Ruth’s other children have careers of their own and are
financially independent. John and Ruth give all their children the
maximum annual exclusion gifts of $26,000 each year. Their children
invest their annual gifts.
John and Ruth have established 529 Plans for each of their
grandchildren, which are all fully funded at this time.
Balance Sheet
a)
John is the sole owner of the shares of common stock of the Company
which is an "S corporation".
The Company has a book value of $3,670,000.
John owns 120 Class A voting shares and 1080 Class B non-voting
shares.
His accumulated adjustment account is $2,000,000.
Case Study
Balance Sheet
(continued)
(continued)
The earnings of the Company before interest, taxes, depreciation
and amortization are consistently in excess of $2,000,000.
b)
c)
d)
e)
f)
John wishes to retire from the Company at age 70.
John feels the market value of the Company is $12,000,000.
John’s salary each year is $250,000.00.
John is the sole owner of High Tech, LLC (“Realty”) which owns
the real estate leased to the Company.
The real estate’s fair market value is $2,000,000 and there is no
mortgage outstanding.
John's net distribution each year from Realty is $240,000.
John has a 401(k) plan of $1,000,000 expected to be $1,500,000
when he retires.
Case Study
Balance Sheet
g)
h)
i)
(continued)
(continued)
Ruth has stocks and bonds of $3,000,000 invested in municipal bonds
with a yield of 3% per annum which is expected to be $3,500,000 when
John retires.
Ruth owns their residence with a fair market value of $1,000,000 (no
mortgage).
Ruth owns their vacation home with a fair market value of $600,000 (no
mortgage).
Pertinent questions to ask John and Ruth:
a)
b)
c)
d)
e)
f)
g)
John and Ruth’s income and lifestyle objectives;
John’s exit from the business;
Estate equalization;
John and Ruth’s post mortem objectives;
Lifetime gifts;
Lifetime charitable objectives; and
Post mortem charitable objectives.
Case Study
(continued)
Goals:
a)
b)
c)
d)
e)
f)
Disposable income need upon John's retirement is $350,000.
Transfer of 40 Class A voting shares and 540 Class B non-voting shares,
to each of Rich and Sue as soon as possible using the most favorable tax
structure.
Jane and Robert are each to receive an inheritance of $3,000,000 after
estate taxes.
John has asked for advice on the disposition of the real estate occupied
by the Company.
John and Ruth wish to use every tax strategy available to reduce estate
taxes, provided, that they have financial security until the death of the
surviving spouse.
They would like to make charitable gifts of $500,000 on the death of the
survivor.
Case Study
(continued)
What plan due you recommend to John and Ruth to
fulfill their objectives:
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Disposable Income Goals
Transfer of business alternatives:
i. Gift
ii. Sale to a Grantor Defective Trust
iii. Transfer to a Grantor Retained Annuity Trust
iv. Conventional Sale
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Estate Equalization, Life, Health and Long Term Care Insurance

Real Estate
DISPOSABLE INCOME GOALS
for John and Ruth
Net Income for Lifestyle
Net Income for Insurance*
$350,000
$ 80,000
Total Net Income:
Age 65 – 70
John’s W2 Salary
John’s 3.33% “S” Profit
Rental Income
Pre Tax
$430,000
$250,000
$ 66,667
$275,000
$591,667
After Tax$355,000
Bond Income – Net
$ 90,000
Total Net Income
$445,000
DISPOSABLE INCOME GOALS
for John and Ruth
Age 71 & Up
John’s W2 Salary/SERP & Consulting
John’s Continuing 3.33% “S” Profit
Rental Income
401K RMD/Average
Pre Tax
$100,000
$ 66,667
$300,000
$100,000
$566,667
After Tax
Bond Income – Net
$340,000
$ 100,000
Total Net Income
$440,000
Assumed $6 million second to die coverage $60,000; $350 per day/lifetime
benefit for long term care $16,000; Supplemental Medical Insurance $4,00080,000 total annual premium.
Business Appraisal
Valuation
1.
Fair Market Value of the Business is
$12,000,000
2.
LESS Minority Interest Discount of 20% ($2,400,000)
$9,600,000
3.
LESS Non-Marketability Discount of 20% ($1,920,000)
$7,680,000
Assume Voting and Non-Voting shares have the same value
of $6,400 per share.
Revenue Ruling 93-12
1993-1 C.B. 202, 1993-7 I.R.B. 13.
Internal Revenue Service
Revenue Ruling
VALUATION; STOCK; INTRAFAMILY TRANSFERS;
MINORITY DISCOUNTS
Published: January 26, 1993
26 CFR 25.2512-1: Valuation of property; in general.
Valuation; stock; intrafamily transfers; minority discounts.
In determining the value of a gift of a minority block of
stock in a closely-held corporation, the block should be
valued for gift tax purposes without regard to the family
relationship of the donee to other shareholders.
Rev. Rul. 81-253 revoked.
Transfer Goals
John would like to retain one-third of the voting shares in
the Company.
John presently owns:
 120 shares of Class A Common Stock, and
 1080 shares of Class B Common Stock
To accomplish John’s transfer goals, the following should
occur.
1.
2.
John will transfer 40 shares of Class A Voting Common
Stock to each, Rich and Sue; and
John will transfer 540 shares of Class B Non-Voting
Common Stock to each, Rich and Sue.
Transfer Alternatives

Direct Gift
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Sale to a Intentional Defective Grantor Trust (IDGT)
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Transfer to a Grantor Retained Annuity Trust (GRAT)

Conventional Sale to a Third Party
Direct Gift
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Value of each gift without Discount:
Discounted Fair Market Value:
Reported Gifts (no annual exclusion):
Federal Unified Exemption:
Tax on Gift:
Remaining Exemption for Ruth:
$5,800,000
$3,712,000
$7,424,000
$7,424,000*
$0
$3,576,000
* Ruth joined in the gift and allocated $2,424,000 of her Federal Unified Credit
Exemption to eliminate any taxes due.
NO step up in basis at death of Donor.
NO Massachusetts Gift Tax.
Intentionally Defective
Grantor Trust

Establish an Intentional Defective Grantor Trust
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An IDGT is an estate planning tool used to freeze certain assets
of an individual for estate tax purposes, but not for income tax
purposes.
The intentionally defective trust is created as a “grantor trust”
with a purposeful flaw that ensures that the individual continues
to pay income taxes, as income tax laws will not recognize the
assets as having been transferred away from the individual.
For estate tax purposes, however, the value of the grantor's
estate is reduced by the amount of the assets transfer. The
individual will "sell" assets to the trust in exchange for a
promissory note of some length, such as 10 or 15 years. The
note will pay enough interest to classify the trust as above
market value, but the underlying assets are expected to
appreciate at a faster rate.
What constitutes a “IDGT”?
An IDGT can be created in one or more of the following
ways:
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The Trustor or his or her spouse retains the power to recover the
trust assets (e.g., the Trustor retains the right to reacquire
property out of the trust in exchange for property of equal
value);
The Trustor or his or her spouse can or does benefit from the
trust income (e.g., the Trustor and/or a nonadverse Trustee can
sprinkle income for the benefit of the Trustor's spouse)
The Trustor or his or her spouse possesses a reversionary
interest worth more than 5% of the value of the trust upon its
creation;
What constitutes a “IDGT”?
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(continued)
The Trustor or his or her spouse controls to whom and when trust
income and principal is to be distributed, or possesses certain
administrative powers that may benefit the Trustor or his or her
spouse (e.g., a non-adverse Trustee may add beneficiaries of the trust income
and/or principal);
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The Beneficiary has a power to withdraw income or principal to
himself or herself (e.g., a Crummey power); and/or
The Trustor and/or a nonadverse Trustee has the power to apply
trust income to the payment of premiums for insurance on the life
of the Trustor or the Trustor's spouse.
Structured Sale to an “IDGT”
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The IDGT need to be seeded by a cash gift or by the
transfer of shares of common stock of the Company.
a)
b)
Gift of Cash (Triple A Distribution)
Gift of Shares
$412,445
- 4 shares of Class A
- 61 shares of Class B

$371,200
Sale Price of shares sold to each IDGT
a)
b)
Gift of Cash
Gift of Shares
$3,712,000
$3,340,800
Appraised Value
Structured Sale to an “IDGT”
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(continued)
Issue a Promissory Note in the amount of $7,680,000
Note for a nine (9) year period with the applicable
Federal interest rate annually of 1.94%; or an annual
long term interest rate of 2.84%; or

Note for interest payments only

Right of Note Prepayment without penalty

Interest rate based on IRC Section 1294(a).
Important
IRC Sections
1.
2.
Retention of certain powers under IRC Section
675(4)(c) will result in Grantor status.
Must not violate IRC Sections 2036 through 2038
which would result in the inclusion of the shares in
John’s estate.
Grantor Retained Annuity Trust
(“GRAT”)
Definition of a “GRAT”:
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
A GRAT is one of the most powerful and tax efficient
wealth transfer tools available today. A GRAT allows a
person to share the future appreciation of an asset with
the next generation with virtually no gift tax.
A GRAT protects the client if the 2010 tax laws change
after two (2) years.
Definition of a “GRAT”
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
(continued)
A GRAT is a trust with a specific life or term, i.e., 5
years, 8 years, etc. The grantor transfers assets to the
GRAT and retains an interest in the trust. This income
interest will be stated as an annuity percentage of the
original assets transferred to the GRAT. Each year the
GRAT will pay the grantor the required payment.
At the end of the GRAT term, any remaining assets will
be distributed to the named beneficiary of beneficiaries.
The gift will be calculated using the subtraction method.
The present value of the annuity payments to the
grantor will be subtracted from the original value of the
assets placed into the GRAT.
Establish the “GRAT”
1.
Transfer 40 Class A shares and 540 Class B shares to
the two individual trusts established for Rich and Sue.
2. The beneficiary for a term certain will be John.
3.
Rich and Sue will be the owner of the assets of one
trust at the end of the term certain.
4.
Calculation
Establish the “GRAT”
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(continued)
Calculation:
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Term:
Transfer Date:
7520 Rate:
Grantor’s Age:
Income Earned by Trust:
Total Number of Payments:
5 Years
01/2011
2.40%
65 Years
0.00%
5
Annual Annuity Payout:
Initial Amount of Payment Per Period:
Value of Term Certain Annuity Interest:
Value of Grantor’s Retained Interest:
Taxable Gift:
742,400
742,400
3,458,990.08
3,458,990.08
$253,009.92
Other Benefits to a “GRAT”

Income Tax Benefits:

NO Capital Gains tax on proceeds from the sale

Grantor pays Income Tax on the IDGT earnings.
This ingredient may be the best benefit of the IDGT
in many cases.
 Other than the 40 Class A shares of Common
Stock, the shares are no longer included in John’s
estate. If he survives a five (5) year term.

NO appreciation on shares transferred to the IDGT


Generation Skipping
Grantor’s payment of income taxes can be altered by
provisions in the trust.
Negatives of using a GRAT


Under Internal Revenue Code Section 2642(f)(1), the
grantor of a trust cannot effectively allocate generationskipping transfer (“GST”) tax exemption to property
transferred until the close of the estate tax inclusion
period.
Thus, it appears that in order for GRAT property passing
to the GRAT remainderman to be exempt from GST tax,
the grantor must allocate GST exemption to the
remainder property at the end of the GRAT term rather
than at the time the property is initially transferred to
the GRAT.
Conventional Sale
to Third Party




A conventional sale for the shares could be done on the
same basis as the transaction.
However, the business owner/seller would have to pay a
capital gain on all the payments received.
Business owner/seller would have to pay ordinary
income tax on the income generated by interest; and
Business owner/seller would not be able to pay the taxes
on the earned income of the corporation.
Conventional Sale
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(continued)
Sale Price
7,424,000
Installment Payments
3,712,000
Mid-Term Interest Rate
1.95%
Long-Term Interest Rate
3.88%
John’s Tax Basis
2,000,000
John’s Capital Gains
5,530,667
John’s Capital Gains Tax Rate/20%
1,860,133
Rich & Sue’s Earnings
12,373,333
Rich & Sue’s Tax Rate/40% (individually)
Payment on Notes (individually)
3,093,333.50
ESTATE EQUALIZATION AND
INSURANCE SUMMARY
$60,000
$6,000,000 Survivorship Second to Die life insurance;
$60,000 annual premium funded via annual gift to an
ILIT.
Open to traditional portfolio design or universal life
policy design. Considerations: premium flexibility;
short pay, importance of cash value
Rationale – Guaranteed benefit for Jan and Robert.
Income and estate tax free liquidity if needed for
taxes.
ESTATE EQUALIZATION AND INSURANCE
SUMMARY (continued)
$16,000
Long Term Care $350 per day, lifetime
benefit, 3% inflation
Rationale – prudent transfer of risk;
preservation of assets for John and Ruth then
heirs
$4,000
the
$80,000
Medical Insurance Supplement to Medical
A & B – assumes John and Ruth stay in
company plan
Total annual premium
SUMMARY

In Depth Fact Finding

Advisor Team Work

Clear Focus on client Lifestyle Income Needs

Integration of Insurance and Tax Strategies

Questions and Answers