Quimbee logo
DMCA.com Protection Status

It’s So Hard to Say Goodbye! Business Valuation, Business Succession, and Estate Planning

4.8 out of 5 Excellent(10 reviews)
RB
Presenter(s)
Start your FREE 7-day trial
Preview this course and the rest of Quimbee's CLE library for free with a 7-day free trial membership.
Buy this course - $49
Get access to just this course for $49
Play video

It’s So Hard to Say Goodbye! Business Valuation, Business Succession, and Estate Planning

Selling or transferring a company can be a once in a lifetime event and understanding the value of the company when transferring it can be a difficult challenge. This course will focus on how to value a company and how to successfully transfer the company and capture its value while minimizing the tax liability and the estate planning that follows. Roman Basi will teach participants the methods used in valuations, succession planning, estate planning, and much more.

Presenters

Roman Basi
President at The Center for Financial, Legal & Tax Planning, Inc.
The Center for Financial, Legal & Tax Planning, Inc.

Transcript

- Hello. My name is Roman Basey. I'm the president of the Center for Financial, Legal and Tax Planning. Today's session is titled, it's so hard to say goodbye, business valuation, business succession and estate planning. Just to give you a little bit of background about myself as we get started today, and that'll help you understand some of the examples that we will use, some of the topics that we will cover and things like that. I am an attorney, I'm licensed in Illinois, Florida, Missouri, and Arizona. I'm also a certified public accountant, a managing real estate broker in the state of Illinois, a real estate salesperson in the state of Florida and a title insurance agent in both Illinois and Florida. There's gonna be three parts to today's session. Number one is understanding what is needed to value a company and the four methods that we professional valuations that we use in a professional valuation. And part two is going to be about the alternatives for succession planning for the future of a company or for selling a company. Once we have the value of a company and we know what our client's company is worth, then the next step is, what are our alternatives for succession planning for that company? Are we going to be selling the company? Are we going to be transferring the company? Or is there some other mechanism of transfer that we're going to use? And we're going to look at all of those today. And then finally, part three, why is it important to create a succession plan and an estate plan? I get this often from my clients, in fact, just yesterday, I received a call from a client that we are helping purchase a couple of car dealerships. And he said to me, "Roman I know we're in the process of purchasing these car dealerships, but I want you to look at everything that I have and I have car washes and I have a tow truck operation, and I have other real estate that I am involved with." And that's exactly why today's topic is so important. Because number one, we want him to understand what his valuation of all of those entities are. Maybe it's going to be what we call a consolidated valuation of the businesses. And then number two, what is his alternatives for succession and how right is he set up for succession? And then three is we've gotta create a plan for him, a succession plan. Sometimes we also call it a strategic plan. And then we finally wrap that up at the bottom of that with an estate plan. And when I talk about this section three and I talk about planning, I really truly mean a written step by step set of recommendations to a client, telling them what we recommend for their company, how best to set it up, how best it should be operating, what they should be doing financially and tax wise on their financial statements and tax returns. And then finally, what should they have in a best practices, estate plan? Should there be a will, a trust, powers of attorneys, irrevocable trusts, life insurance, other things that we may incorporate in a proper estate plan. And that's what I really mean when you see the words succession plan, or you see the words strategic plan, that's what it means. It's a written step by step set of recommendations, all combined into one document. And then in our plans, the way we craft them, each step, each recommendation has its own set of requirements. In other words, maybe I wanna create a limited liability company and put his real estate into a limited liability company. So then I tell him in the plan, okay, we're gonna file articles of organization. We're going to have a record book. We're going to have an operating agreement. We're going to have minutes and resolutions and unit certificates. And then we're gonna deed your property in with a quick claim deed into the limited liability company. These are all part of a written plan, whether it be succession, strategic or estate plan. So let's start with where I typically start, valuing a company. So many of our clients say, "Well, Roman I want you to do this, or I want you to do that, but I really don't know what I'm worth." And the answer there is we've gotta start with the valuation of the business or of the company. And we have to understand the four methods that a professional evaluator uses when we are valuing a company. Now, some people are gonna hear, "Oh, I just took my EBITDA times a multiple and that's how I came up with my value, Roman." Or, "I make this much a year and I wanna make this for the next five to 10 years, that's how I came up with my value." And while those are okay, those aren't really the professional preferred method of valuing a company. And when we say EBITDA, let's step back for a second. We mean earnings before interest, taxes, depreciation and amortization. So that's something someone can do fairly easily. You look at a financial statement, or you look at a tax return and you say, okay, here's the earnings of my business. Now I'm gonna check my earnings or my net profit before I've paid any interest, before I've paid any taxes and before I've taken any depreciation on my assets. Now, what are my earnings before all of that? And then you take that times a multiple three, four, five, six, seven, eight, whatever that may be, again, just trying to help you understand some of the terminology you might hear when people talk about valuing a company. But in reality, we look at valuation under four methods. Number one, we look at the earnings. We do wanna know what are the true earnings of the business? What is the business really making on an annual basis? And let's dive into the earnings method just a little bit more. So if a company says that if I look at a company's tax return or financial statements, and it shows that they paid taxes on $100 of profit, is that their real true earnings? No, there's things called seller discretionary expenses called SDS, expenses that an owner of a business may take that are not necessary to run the company. I'll give you an example. Been working with a janitorial supply company for many, many years. One of the first companies that I've ever been a part of representation with, and I've had my law license now for almost 20, almost, excuse me, almost 19 years. And one of the, the owner is a mom and pop operation. And the mother comes and says in the meeting, she goes, well, "I do have some expenses that I run through the company that probably are not necessary." And I'm looking at their financial statements. And I say, well, "This cell phone expense looks rather large for a janitorial supply company. You've got about a $22,000 annual expense of cell phones. So what are you running through the business that you have this cell phone expense?" And she proceeds to tell me it's for her 20 plus grandchildren, that she pays their cell phone bills for everybody in the family. And that's what's called a seller discretionary expense, an expense that while it may seem reasonable on its face, maybe some of the grandkids work in the business, maybe some of them help out in the business, it's not a, it's a discretionary expense. It's not a necessary expense. So when we are looking at the earnings method, we wanna know from our sellers, our business owners, what expenses are you running through the business that are not necessary, that are discretionary. And honestly, things like charitable contributions are seller discretionary expenses. We add those back to the earnings. So all of a sudden, if I've got, let's just round it up, $24,000 of cell phone expenses, and my profit was $100 or add zeros to it, $100,000, and now I can add those expenses back. So if the profit was $100,000 and the cell phone expenses are $24,000 that have already been removed from that profit, now we're gonna add that back. And now all of a sudden we have $124,000 of profit showing, not $100,000 of profit showing. We're starting to craft the true annual earnings of the business. And there's other things that go into that number. A couple other things that go into that number are, what if it's a one time expense? What if your client put a roof on the building and they expensed it in one year? Or what if they bought a vehicle? You can buy a 6,000 pound plus vehicle and expense it in one year. And some of you may have heard of bonus depreciation or accelerated depreciation. They're expensing these items very quickly and that's not normal, or it's a one time expense, again, or maybe we buy new software for our company, new computers, and we write all that off in one year, but that's only a one time expense. It only affects one year out of maybe the next five or 10. So we add that expense back. Again, we are creating the true earnings of the business for one period of time to say, this is what we make on average in one year. Now, an evaluation for succession planning, which is what today's topic is all about. We probably will look back five years. Sometimes we look back three years, four years or five years. And in a succession planning situation, we typically look back five years. So we want five years of adjustments to these earnings, is exactly what we want. We don't want three years. We don't want four years. We want five years so that we can make sure that we have a good representation of the business for five years and keep this in mind. For a typical business succession plan, we wanna lower the value usually of the company. And if we go back five years, we're going to produce a lower valuation. Now, when we're going to market, when we think we might sell the company, we will only want to go back three years on all of these methods we're gonna talk about because that's going to raise the value of the business, potentially giving us more value because typically our numbers are higher. Okay, so now we've got the earnings, we've got the true earnings of the business. And again, maybe we took the bottom line from $100 to $150 or $200 or whatever it may be. Now, we wanna divide that by what we call our capitalization rate. And that's a built up rate, a built up rate of return on an investment for lack of a better term. So if I wanna make 10% on my investment, and my investment is $100 I'm expecting $10 at the end of the year. And 10% is my capitalization rate now. I won't go into the specifics of how we build the capitalization rate, but we build it through a series of factors. So we take the annual average earnings of the business over the last three to five years. We average them and say, what on average is this company really making? And we divide it by the capitalization rate that we are seeking. And that gives us the value of the company under the earnings method. Under the earnings method, as you'll see under the income method and under one of our goodwill methods, we don't just look at a snapshot and say, okay, that was the average earnings for one period of time averaged over five years, but one period of time. We also need to look at what we call the discounted future benefits method saying, what is the time value of money if this company continues to produce these earnings indefinite for the future? And I won't get into that calculation with you right now, but just keep in mind that under the earnings method, there are actually two methods. We're gonna look at the single period method, looking at one method and the discounted future benefit method. And we're gonna be looking at a future going forward, and we're gonna average those two numbers to come up with our true value of our earnings. Our second method is assets. We wanna look at what's on the balance sheet. What is the company made up of? And what's on a balance sheet? Cash and cash equivalence, accounts receivables, inventory, equipment, and goodwill. And there may be other things on the balance sheet as well. There may be investments. There may be loans that the company made to employees, to shareholders, things of that nature. And we wanna look at those assets and see what the real value of them is, why? If you look at a balance sheet, is that telling you what the fair market value of those assets is? No, the balance sheet is only telling you what the book value of the asset is, what the company bought it for, less what it's depreciated or used and what it's left on the books with. And that is our asset method. We look at the book value. We look at the balance sheet and what do we do? We wanna do what we did in the earnings. We wanna make that be more reflective of what they're worth right now. So we recast the balance sheet and we come up with fair market values. What is the fair market value of your equipment? Is the inventory stated correctly? Is all the equipment on the books and records of the business? How many of our clients are using other assets in their business and they are not on the books and records of their business? So we wanna make sure that the balance sheet accurately reflects the assets that are on the books. Once we have all the fair market value of the assets, we know what the assets are worth, but we're not done with that method. We wanna calculate the blue sky or the goodwill of the business. We wanna say, what is this name worth? What is the reputation worth? What is the customer list worth? And we look at it in relationship to the first method. We say, okay, we have earnings that, we know what our annual earnings are, and now we know what our assets are. And we say to ourselves, well, the company's making $20 a year on its earnings method. It doesn't have a lot of assets. Based on the rate of return that I want, and the assets that it has, it should only be making, let's say $10 a year. And the difference between the assets and what they're worth on the books and what that rate of return would look like if I bought the assets at their fair market value and the real number of what they're earning under the earnings method, that differential is how we calculate goodwill. So when I get involved in a business valuation with a client, I actually calculate the goodwill or the blue sky in their business. So they may say to me, well, Roman, my assets on my books are only worth a couple hundred thousand dollars, how can I prove that I'm worth a million or $2 million? And we go in and calculate the goodwill of the business under the asset method. And then we look at the income method or what we otherwise call the cash flow method. And we're just looking at their cash flow statements. We're looking at only items that are affected by cash itself. We remove everything else that's not cash related. Things like depreciation that are not cash related. Those are removed from that method. And we look at it again, very similar to the earnings. We look at one single period, and then we look at a discounted future period. And then finally, which is the most popular one, sometimes, is the market approach method or what we formally call the comparables approach. Where we're looking at comparables, just like a realtor looks at real estate comparable sales sold in the community within the last six months, we do the same thing. We subscribe to databases that give us comparables of businesses sold. Let's go back to my first example. I've got a client selling or wanting to buy, excuse me, some car dealerships. And the client says to me, "Ron, what do you think they're worth? What do you think the market method looks like? What are they selling as a multiple of EBITDA?" Like we talked about at the very beginning, there's two multiples that I really look at. Number one is a multiple of EBITDA. And number two is a multiple of their net sales by the year. And sure enough, what we found was that car dealerships at the time of production of this presentation are selling for five times their EBIDA. And as a result of their net sales, they're selling for about 30% of their net sales. So if a company's net sales, if a car dealership's net sales are 20 million a year, we might expect to see that car dealership sold for around 6 million a year. And if it's a 20 million a year company that they're bringing in that revenue, maybe their EBITDA is a million. Maybe they're really earning a million or a little more than a million on EBITDA, and we multiply that by the average multiple of five, and maybe we get 5 million. And that's how we look at the market approach. We get this data, we subscribe to databases where business brokers, some CPAs, probably a very few lawyers are reporting their transactions to these databases. They get paid by these databases to report their transactions, and then it gives us a field of data. And so we subscribe to the database and then we can pull it. And you may say, well, Roman, how do you know what you're pulling? Every tax return has a special code in the left hand corner, every business tax return, and it tells me what industry they're in. So I am able to drill down by the industry to determine what I'm looking for. Am I looking for a new car dealer? Am I looking for a used car dealer? Am I looking for a garage that is repairing vehicles? Those are all different codes that where this data is reported. And those are called the NAICS codes. And so we search via those codes and we get our data in that way. So those are the four methods. Now, when we do evaluation, we will come up with, normally we will use three of the four methods, if not all four of the four methods, but we may strike a method or two, and then we average them and we weight them and we determine what the value is and we still get the question. Well, is this covering my goodwill? You calculated my goodwill method, Roman, in the asset method, but is this still covering my goodwill? And what really is goodwill? And just kind of gotta think about it this way. Goodwill is an intangible asset that makes up the additional value of a business over its net assets. Exactly what we talked about in the asset method. What value do we have above and beyond our assets? What are we making in our business that is above and beyond the rate of return we would've expected if we bought the asset by itself? And that's the goodwill, and it's the product of a number of factors. How old is the company? What is the value of the service or the products that we are providing? What is the value of the brand name? The market area, the customer base, the growth, the efficiency, the location, and the lending relationships that we may have, that all adds to the goodwill of the business. And you may say, well, Roman, what do you do with these factors? When we're looking at that capitalization rate for earnings, we are also looking at that capitalization rate for what we think our assets should be making. And this is where we factor it in. And we factor it in with the goodwill. Now that capitalization rate has an inverse relationship to the company, think about it. If I wanna make 10% on my investment and I'm willing to pay $100 for the assets, I'm expecting $10 as a return. If my capitalization rate goes up, in other words, I wanna make 11% on my money, 12% on my money, and as interest rates go up, our capitalization rate goes up because cost of money is more expensive. Well, what does that mean? If I wanna make 11% on my money and I was willing to pay $100, am I willing to pay more now? No. I wanna pay less to make my $11. So as my capitalization rate goes up, the value of my company goes down. So as I produce this today, we are in an economic climate where interest rates are increasing and they may be increasing rapidly. Valuations of businesses are coming down. So we are warning our current clientele to say, "Hey, if you wanna sell the business and you wanna maximize the value of the company, the sooner, the better as interest rates go up. Now, if we see a little drop in interest rates, then we're gonna know that values are gonna go back up as interest rates go down, I'm willing to pay more for the company because it's easier for me to make my targeted capitalization rate." That can get a little confusing sometimes, I know, but I just want you to understand it, and remember, how we're calculating that goodwill. It's the underlying assets, we're figuring those out without goodwill. What is the fair market value of the assets in my business? What was my weighted annual earnings under the earnings method? And then I take the difference between the two. If the result is positive, I have goodwill. If the result is negative, I do not have goodwill. We talk a lot about goodwill in the valuation of a business. So from a seller's standpoint, why do we want it? Why does a seller want goodwill? Goodwill is a capital gain item. And typically a capital gain tax rate is less than an ordinary income tax rate or what we call a depreciation recapture tax rate. So traditionally sellers prefer goodwill. We wanna sell our goodwill and pay capital gains rates. We don't wanna pay high and ordinary income tax rates. So funny when my, I have two daughters, a 21 and a 19 year old and when they got their first paychecks, as we all did, right, we looked at our first paychecks and we're like, oh my goodness, why do we have all these taxes taken out of our paychecks? And that's our ordinary income tax rates. If we can sell our businesses or transfer our businesses and lessen that impact by the use of capital gains tax rates, we are saving, we can potentially save a tremendous amount of money. But a buyer and a seller are diametrically opposed to this because a buyer of a business takes goodwill and has to amortize it or depreciate it over 15 years. Whereas if the buyer could allocate that to the assets themselves and not goodwill, they might be able to write those off quicker. Maybe it's equipment that you could write off in one year or five years or seven years, maybe it's real estate. real estate might be depreciated over 27 and a half years or 39 years. That's why the buyer and seller are usually diametrically opposed in an allocation when we are working with goodwill. But the bottom line is this, the buyer can depreciate it over 15 years. Goodwill that, and don't get confused. You might see some documentation that says you can't amortize goodwill. That is goodwill that you believe you've created in your own company, that is not goodwill that you've purchased. When you purchase goodwill from a company, when you're buying a company, you can depreciate that goodwill over 15 years. When you put goodwill randomly on the books of your business, larger companies, large public companies may do that. They may say, "Hey, we just had something really good happen. We're gonna add 10 million of goodwill to our books." They cannot depreciate that. They can add it as an asset, and they can only write it off if it's impaired. A bad lawsuit happens, a bad liability, a bad claim, bankruptcy, then they can write it off if it's impaired. So there's really a couple different types of goodwill when you're looking at it from valuation and tax perspective. And I'll digress just a second. There's company goodwill, otherwise known as enterprise goodwill in some states. And there's something we call personal goodwill. And personal goodwill belongs to the owners of the business themselves. It does not belong to the business or the company. And there's a distinction there. Because when we sell goodwill and we attribute a certain percentage of goodwill in the deal to the individual owners, and we're saying it is their skill, it is their reputation in the community, it is their knowledge, it is their relationship with customers. They can sell their personal goodwill in the sale of a business and avoid the corporation. I sit here today, and as I produce this for you, we have approximately 4 million closing going on. And there was personal goodwill used because the $4 million was a C corporation. So if we take $4 million and put it into a C corporation, it faces potential double taxation. However, if we allocate to personal goodwill, then we're not putting 4 million into the company, are we? We may put 2 million into the company of company goodwill and 2 million into the personal coffers of the owners as personal goodwill, avoiding double taxation and being taxed at capital gains rates. That's the benefit of different structures of goodwill when you're looking at these valuations and the planning. That was a very high level overview of valuation of companies. Things to keep in mind there are the four methods that are typically done when you see evaluation. You should see four methods or the explanation why they didn't use the methods. And you should see an attempt at calculating goodwill. It would be a disservice to our clients if we did not attempt to calculate goodwill when valuing a business. Let's move on to part two of the presentation, which is alternatives of succession planning for the future of a company. And I introduced succession planning to you in my introduction, but what is it really? It's a process where the owner of the business creates a procedure where the ownership is either transferred or able to be smoothly transferred to the next generation. Succession and estate planning involve tax and non-tax considerations. What are some of the things that we look for in succession planning? Maintaining control, who's going to control the company once the succession plan is started? I gave you my credentials at the beginning of the session. I'm an attorney CPA, and I'm also a real estate broker. My father started investing in real estate in the late seventies, early eighties, I took over that company from him in 1997. In 2014 or thereabouts, my father suffered a heart attack and I had to take over our law firm and accounting firm. So we created a succession plan for us. And as I just said, there are tax and non-tax considerations. Maintaining control is one of them. If my father, after his heart attack maintained control of the business, and yet I took the business over, or if I tried to buy the company from him, there's some special tax laws out there that say, if he maintained control while I was paying him for the business, it would be taxed as ordinary income to him. So there are some massive tax considerations. If you have an owner of a business that wants to maintain control yet, create a succession plan, becomes very tricky. Number two is providing adequate income to the owner. And here's the way I describe it. When I walk into a business and I'm gonna create a succession plan, I tell the owners, look, what is your standard of living right now? What are you taking out of the company? What are you distributing to yourself from the company? What are you living on at home? And I wanna continue to provide that for you as long as I can in relationship to the value of the company, let's make it easy. Let's say the valuation came in at 10 million, excuse me, $1 million. We value the company and it's worth a million bucks. And the owner's been taking out 100,000 a year in income. So what do I wanna do? I wanna create a succession plan where that owner is still gonna receive $100,000 a year at least for the next 10 years. Maybe we say, look, I wanna receive money for 20 years, fine. Then we're gonna give you 50,000 a year for 20 years. We're also providing a benefit because of what we just talked about earlier. I'm gonna make the succession plan to where it's capital gain to the owner and not ordinary income as best I can possible. It's not always possible to do it 100%, but I will do it as best I can. We wanna minimize third bullet point really here with succession planning is I wanna minimize estate and gift tax liability. Again, at the time of production today, our federal estate tax exemption sits at 12.06 million per person doubled if they're married. So 24.12 million, they can pass away with and not pay taxes. So I wanna make sure of my succession plan that I am minimizing the estate taxes by doing what? By maximizing the use of the federal estate tax exemption and any gift tax liability that I may be incurring, whether I'm reporting that or not. I wanted a number fourth bullet point. I wanna preserve the ongoing concern of the company. I want to make sure the company is going to survive after the succession plan is initiated. I don't wanna transfer the business to a son or a daughter or a partner when they're not ready to take it on, and it's not going to continue to be an ongoing concern. Maybe I've got a fear that the son, the daughter, maybe it's a key employee, is not gonna be able to adequately run the business. I do use this as an example in all the years I've transacted. I've been in the merger and acquisitional field. I've practiced for about 25 years in the field. I didn't become a lawyer for the first six of those, only one transaction really ended up ever going south on the ongoing concern part where the business was going down the drain quickly. And the previous owner had to re-step in. So it becomes a very important bullet point when we're creating a succession plan is how can we do it to make sure that we have an ongoing concern. And then finally we want to provide sufficient liquidity. And this goes to the owner of the businesses, as well as the business itself. So what are options? How do we create these succession plans? Well, when you sell or transfer a business, you've essentially got two ways to do it. You can transfer the assets, you can take all the assets on the balance sheet, inventory, cash, receivables, equipment, goodwill, and you can sell them or transfer them to another company. And that's what's called an asset transaction. Your second form is stock. I can simply give the stock, sell the stock, or do a stock redemption of the stock of the owner traditionally in a succession plan, which is today's topic. We do a stock redemption, and you can look that up if you wanna look a little bit more into detail about these, but a stock redemption is when the company buys back the stock from the owner of the business. We are using profits of the business to buy back the stock of the company so that the other owner, whether it's an employee, family member, whatever it may be is using these profits of the business to pay off their other owner. And this works very, very well. There are a lot of other ways to transfer a business. There's also a hybrid method where you can do an asset and a stock transfer, and that's called a 338 H-10. You get into some very specific code sections when you want the benefit of both worlds. And you've gotta be very, very careful. And what are other ways that we transfer a business in stock? Whether it, sometimes it may be a stock sale. Right now we see a lot of stock gifting. Because if we have a 24 million federal estate tax exemption right now, and that is set to expire and go away, why not use it? Why not gift stock right now? Gift the stock over, do evaluation of the company, file a gift tax return and use up some of the $24 million now, before it goes down. And we've had a lot of clients do that, use up that $24 million exemption now, before that expires, and we're back to 5 million adjusted for inflation, not doubled. So we got a lot of things to think about as these tax provisions begin to expire digressing a little bit into some of the more complicated transactions. And just to give you a brief overview of them, a 338 H-10, this allows the buyer of the stock of an S Corp to treat the transaction as a purchase of the assets. And that means they get a stepped up basis. So if the assets are on the books at $10, but they're really worth 100, when we do a 338 H-10, the buyer can put 'em on the books at $100 and start to depreciate 'em again. In this case, in a 338 H-10, the buyer must buy at least 80% of the corporation stock, the buyer and all the shareholders of the seller have to agree on this transaction. And then the transaction is treated as if it was a 100% purchase of the assets, but it's actually a purchase of the stock. So why do we do these 338 H-10s? Your client may have licenses, this is typically the situation. Your client may have specific licenses that are, cannot be transferred. They cannot move 'em from the balance sheet. So it has to be a stock transaction, but the buyer wants to get stepped up basis in the assets. I did a company a couple years ago, and it's a prime example. It was a white water rafting company. And they had federal licenses for all their rafts on the federal rivers. The federal government limits those licenses. They're not easy to get. Therefore we did a 338 H-10. The buyer bought the company under the 338 H-10, was able to get a stepped up basis in the assets, but bought the stock of the company so the licenses stayed with the company and nobody had to transfer anything. We didn't have to ask the federal government for a transfer of those licenses. There's other options, things such as tax free reorganizations under internal row revenue code, section 368, or you may hear another term called an F reorganization. Sometimes there's conditions that must be met here. And the four conditions to be concerned are of continuity of ownership. Sometimes in these reorganizations, you've gotta be careful of continuity of ownership. Continuity of the business enterprise is number two. They must have a valid business purpose, number three, and it cannot be part of a larger plan that taken into its entirety would constitute a taxable acquisition, which is called the step transaction doctrine. So whenever you see the words reorganization, you just need to have a light bulb that goes off that says, man, Roman said there were four conditions that you gotta be leery of. And you can start looking in that direction. Whenever we're transferring businesses or creating a succession plan, we wouldn't be doing it justice if we didn't talk about 10 31 exchanges. 10 31 exchanges are still with us today. And I do a lot of them. I do a lot of reverse 10 31 exchanges. And a 10 31 exchange is when someone sells and now it's limited. Now we are limited to real estate only. We used to be able to do business property, other assets like equipment and things like that. And now the new law for now limits it to real estate. So I can sell a piece of real estate and take my gain from the sale and buy another piece of real estate with that gain of like kind property and not pay tax on my gain. So if my gain is $100 and I'm gonna be taxed on it, and instead I take my money and I go buy additional property with it, within 180 days, you have to buy the new property, you're gonna defer the tax on the gain. You're deferring it, you are not eliminating it. Keep that in mind. And that is a 10 31. So couple of questions to ask yourself before determining the sailor succession of your client's business. And we said, number one, are there tax considerations? Do you need to do, what's called a tax minimization analysis to determine what the potential tax liability is of the transaction? And have you taken into account all considerations? In a succession plan where the owner's gonna retire, is there someone that's currently employed that can take over the ownership and run the operations day to day? Is their equity in the company to secure a long term monthly payout suitable to fit the owner's desired style of living? And what's the market value of the company? And I said, the first thing is a tax minimization analysis. What is that? And that is the tax impact of the plan. Whether your client is selling, whether they are redeeming their stock, whether they are selling assets or selling stock, or even gifting stock, what's the tax impact? We call it a tax minimization analysis, and that provides the client with the ultimate bottom line. It's a waterfall. It's a running tax calculation that shows them down to the individual shareholder level, federal, state, and local tax rates. I put this in a nutshell. So we say, okay, here's the value of the business minus the expenses of the succession plan or selling the company, now you're to your net selling price, okay. Now, how are we structuring it? Is it a stock deal? Is it an asset deal? Is it a 338 H-10? Now we know the structure. Now we can apply the tax. We know what the state, federal, and local tax is. Now we have our net cash, right? Selling price minus expenses. What's the structure? What's the tax? Net cash in our pocket for now. Now we have to say, okay, what's our liabilities? Is there an earn out? Did we escrow some money? Is there a promissory note? Is there an employment agreement, a non-compete, a consulting agreement? How's that gonna impact my net cash? So finally, what is my bottom dollar number? This provides the seller with a benchmark allocation goal of what they wanna sell the company for, or transfer it for, and through the use of what we call our TMA, they understand how to best allocate the purchase price of the transaction. It provides our clients with a clear picture and outlook of the overall transaction. I can't tell you now, we use them on almost every single transaction. Whether we're doing a succession plan, whether we're buying a company, whether we're selling a company, we look at these in every fashion. In a succession plan, we have to think of, so we think about a lot of things. We say, "Hey, what else is on the table? What else can we create in this succession plan that's going to, to help our client?" And one thing is this. We say, "All right, we're gonna transfer your company." How do we want the transfer to occur? And do we wanna set it up in a different manner? One thing you'll run across in your practice is something called qualified small business stock. And again, is our client set up this way. This is a very, very interesting provision. It's section 1202 of the internal revenue code. If the company is a C corporation, and if the client was issued their stock after August 10th, 1993, and if it was acquired by your client from the company for money, for property or other services, most likely they started the company. So they start up the company. Hopefully it's possibly the C corporation under 1202 here, and what's the benefit, and what's the benefit? And it is considered a qualified small business stock so long as it has less than 50 million in total gross assets, which is most of the companies that I'm gonna ever represent and probably most of you, it becomes qualified small business stock. Why is this so important? Because in a succession plan, we can sell qualified small business stock, completely tax free, up to 10 million of gain, and then there's some other unadjusted basis language as well. But that's what I want you to know today is if your client has a business and can be, or was set up as a C corporation under section 1202, we might be able to create a succession plan that sells their stock or transfers it completely tax free. And that's the beauty of planning. We always, we always say, "Hey, we wanna create a succession plan or strategic plan to effectively transfer my business, minimize my tax liabilities," and that's what this is doing. Minimizing the tax liabilities. Why that's why we just talked about a 10 31, that's why we talk about a 1202, potentially the 338 helps them as well. Another thing I look at in a strategic plan or a succession plan is a buy-sell agreement. Is there two parties that own the business or are running the business, and they are not married. Even if they are married, you can have a buy-sell. But most specifically, if there's two or more parties running a business, and there needs to be a buy-sell agreement in place. These arise in succession planning and they have triggering events. So if one person passes away or they become incapacitated, or they just simply stop working for the company, the buy-sell agreement is triggered and they have to sell their stock back to the business. I'll give you not so good example. I have a company I represent out in Washington and there are four partners. I've represented them. I've worked with them for a long time. They're wonderful clients, but they got a problem. There's four partners. One runs the business. Another one thinks he runs the business, but he's really not there very often. He goes on global vacations, about two to three times a month. The other two people are completely silent partners, have nothing to do with the day to day operations. They just simply sit back and collect checks. And these are four different families that are involved. And they developed this company over two generations ago. They don't have a buy-sell agreement. The one owner that runs the business, they're all 25% equal owners. And the one owner that runs the business knows there's a lot of animosity with the global traveler. And there's another animosity with the two that just sit back and collect checks. And without a buy-sell agreement, without those triggering events, he's been stuck, and he's been stuck for about the past five to seven years, trying to find a way to get control of the company where the 75% other shareholders aren't just essentially squandering the profits, which is what has been happening for the last several years. The company could have been in a much stronger position with four actively involved owners. So buy-sell agreements become very, very important in situations like that. Just to kind of briefly touch back on 1202 as well as we talk to, I get a lot of questions about 1202 stock, it's in our succession planning discussions. But, and again, just to kind of wrap this section up a little bit. We look at 1202 and we say, all right, we're gonna exclude a hundred percent of the gain of this stock because, it's C Corp stock we've had, and you have to have it for more than five years. We already gave you the parameters of what qualifies. And it must be issued at original issuance, which you're gonna run into a lot is, a corporation is formed and they become an S corporation right away. They really never issued C stock. So then we go back, we convert them back to a C corporation. We issue them C stock and we wait five years. And then we have the potential now of selling the stock tax free in the succession plan coupled with all the other things we've talked about. Finally, in the succession plan, we talk about what they're gonna do after the company is transferred, or after the company is sold and how can they invest their proceeds? Or are there tax deferral or tax minimization opportunities for them, if they're, after the deal is over? And one that popped up recently and we included it today as part of the presentation and a lot of you may have heard of it by now is opportunity zone investments. And this was in the 2017 Tax Cuts and Jobs Act, or excuse me, I'm sorry, this was in that act, but buried in the creation of the zones, which does what? We are allowed in these zones to put our, invest our capital gain from our business, sales, investments, whatever it may be into these opportunity zone funds and we defer the payment of capital gain on them until December 31st of 2026. Now there used to be some other benefits if you had them the capital gain in these funds for five years or seven years, you got some additional stepped up basis in these funds. Those have gone away right now. But if I sold my company or transferred my company and I have $100 of gain and I put it into an opportunity zone fund, I don't pay any taxes on that gain in my plan. That's why we include these sometimes. When we ask our clients, what do you wanna do with the proceeds from the succession plan? If they say, well, I just kind of like to invest 'em and sit back, okay, here's an option, opportunity zone fund investment. You're gonna put your $100 of gain into the fund and not pay any taxes until December 31st, 2026. So your money is working for you for the next couple of years. You're gonna pay your tax on that gain in the 2026 tax year, 2027 tax filing season. If you leave that gain in there for 10 years, you will never pay tax on any additional gain that it makes. So if that $100 in 10 years has now turned into $200 and you decide to take out the $200, you already paid taxes on the original $100 on December 31st of 2026. And now you've just made $100 completely tax free. It's been a great tool for spurring economic development across the country. And we want you to know about that because I often, so in a succession plan and you're starting to see the full picture, hopefully, we're telling you, okay, here's what the companies are worth. All right. We valued them. Okay, here's what we're gonna do. Here's how we're gonna transfer the business. Now here's what we're gonna do with some of your investing. We're gonna show all of you this on a tax analysis on a waterfall of how this all shakes out. And then now finally, part three, how are we gonna fulfill the exit plan with an estate plan? And that's the bottom part of every written strategic plan I have. What's the focus? We develop an efficient strategy to meet both family and philanthropic goals. We wanna identify appropriate measures through a variety of trusts to ensure proper implementation. We want tax efficiency, compliance and minimization. We wanna ensure gift and estate tax related compliance services are met. We wanna remedy any unforeseen tax liabilities at the time of death. We wanna avoid probate. We want to try to be, I always tell people with an estate plan, we have federal tax implications and state tax implications. We wanna try to craft an state that avoids probate, avoids the expense, the time and the stress of probate. And we wanna see if they want it to be eligible for Medicaid benefits. If they're gonna go into a long term care facility, do they want to use their assets for that? Or do they wanna become eligible and not be part of the spend down process with Medicaid? So proper estate planning will hit those topics for us. And I counsel a lot of young attorneys that work for our firm over the years. And I always start with this, with estate planning. And I always start with this with my clients as well, because I don't think a lot of 'em understand what all goes into the estate plan portion of the succession plan. Number one, we want 'em to fill out an estate planning organizer. Now, all of you that are listening today, we have a couple products that we would be more than happy to share if you just send us an email. We'll share 'em with you, number one is our 32 item list. We keep it on our website as well. But when we are creating a succession plan or evaluation or a strategic plan, we have a 32 item list that we like to provide to our clients, and that's the information that we wanna see when we're gonna create that plan. Secondarily, we have an estate planning organizer. We want them to fill out the estate planning organizer so we see what their estate looks like. With that organizer, we're looking at it and saying, look, conversion and transfers do not have to end upon death. A well-constructed plan can be ongoing. So the estate planning organizer is filled out by them when they're desiring the business succession plan and they should really update their estate plans every year. Our estates change so dramatically over the cost of a year. Now, when I'm drafting the part of the estate plan, I typically explain to the clients and to the young attorneys, everyone needs a simple will. In most states a will if it does nothing else, it can avoid the purchase of a bond. It can wave bond. If the will does not wave bond, and if there is no will and the estate has to be probated, then a bond will have to be purchased. And the bonds are typically non-refundable bonds and they're very expensive. Even a small estate worth 50,000 to $100,000 may have a bond cost of somewhere between three to $5,000, just an estimate. But those are some of the bonds that I've seen where the creation of a simple will that waived the bond is enough for court in most states to say, you don't need to purchase a bond. The executor of the will waived bond for you as the representative of the estate. Therefore, no bond is required by this courtroom. It's so important in an estate plan. Secondarily, the importance of filing of federal income taxes and being eligible to pay them is huge. We want to try to form an estate plan that minimizes those effects and what opportunities do we have to give our beneficiaries stepped up basis in our assets. And that's where the dichotomy comes in with a succession plan and an estate plan. You heard me say earlier, we want to use up the gift of 24 million that we can do right now. But if we gift them the values, they're not getting the stepped up basis. In an estate plan, where they're given the assets upon death, they can achieve a stepped up basis and the states continue to change things. I just read an article, I'm licensed in the state of Florida, just read an article and just learned about the new Community Property Trust Act in the state of Florida that allows married spouses to put their assets into a community property trust and they can give the other spouse a full step up in basis to the assets when the first spouse passes away. So the moral to that story is, pay attention to your state laws, pay attention to the taxation of those, reach out to a tax professional, if you don't understand the tax implications. One of the things I've learned over my career is, just simply drafting a will and a trust, you may be doing your clients an injustice if you don't understand the tax implications to those trusts, yes. You have some liability protection implications that you probably well understand as a practicing attorney or whatnot, but do you understand the tax implications of what you're creating also? Is a revocable trust doing the trick to protect it from federal estate taxes? No, it needs to be an irrevocable trust to protect it from federal estate taxation. So there's all these little nuances in the laws that really affect our taxation and a step up in basis can mean a tremendous, tremendous difference. You just hear me use the word trust. And of course, a lot of you understand what trusts are. And I think they are one of the most effective methods for estate planning. They can conserve property, they can remove property from business commitments, for example, most of the time in a succession plan when I see an owner getting of age and I say of age and I usually kind of target age 60, I'm sorry, that's usually what I use. I'm sitting here and I'm 46. It's creeping up on me quickly. And I say, look around age 55, 60 up in there, we wanna remove property out of your name. And we wanna put it into trust for you, even your stock of your companies. And at some point I want it to go irrevocable trust to remove it from federal estate taxation. So there's all these, the trusts are a really important, effective planning device. Of course we know they can delegate financial affairs. They are a great way to safeguard inheritances. You can provide directions to trustees. So it's very important to really think about them when you're crafting an estate. As we know, I've talked about it with estate planning, we look at that estate tax exemption, really, you're gonna hear the terms it's 10 million right now. Because it's 5 million adjusted or it's doubled to 10 million and adjusted for inflation. And every year it changes. There may be a year or two where it didn't change. But I think for the most part every year it does change. So keep that in mind. And here we sit in 2022 at the production of today's session and it sits at 12.06 million per person. And that's like a, that's an estimated number. The actual inflationary number is a little bit more specific, but we use 12.06 million as our example. Estate tax portability is very important. What I don't use of my estate tax exemption can be passed on to my spouse. And I literally just read an article that the IRS just produced today that they're making portability easier because there was some portability elections on estate tax returns that was becoming very confusing to practitioners and it caused the IRS to get backlogged on estate tax returns. And they just passed some legislation to make that simpler going forward. Haven't read the full article yet, but that just came out this week or last week, but I just read the article today. So pay attention to estate portability and what the IRS is changing there to make it easier on us practitioners when we're completing those tax returns. Insurance trusts are the final kind of piece of the puzzle. When we we're looking at this 30,000 foot overview of succession and planning and of course insurance trusts are important. What do they do? An insurance trust takes the insurance proceeds out of the estate and they're not taxable. They're insurance proceeds, they're not taxable anyway, but they are accountable towards the exemption. If your client has a $1 million insurance policy and it's in their name, that needs to be removed and put into a trust. And that's what we would put in our plan. So in our succession plan, we are not just saying, okay, here's the value, here's what we wanna do. No, we're gonna say, look, we wanna create an insurance trust. We wanna put your insurance policies into your trust. We wanna put the stock of your companies into your trust. There's all these different things that we wanna do within the estate plan. I know we covered a lot today and I really appreciate your listening and your attendance with today's session. Hopefully I'll be able to produce more for you in the future. I could probably give a one hour session on every single one of these topics, but today's thing to really remember is this, number one, we wanna know the value of assets, and we wanna know the value of someone's business. And now you know the way I approach it. Number two, we wanna write a plan. When we say succession plan, I want a step by step plan on how we're gonna get this owner to their retirement and beyond with the estate plan. Thank you very much. You'll have my information from the presentation from Quimby. If there's any questions, feel free to email me and reach out to us with questions. We'll answer them as quickly as we can. Thank you for listening today.
Start your FREE 7-day trial
Preview this course and the rest of Quimbee's CLE library for free with a 7-day free trial membership.
Buy this course - $49
Get access to just this course for $49

Course materials

Supplemental MaterialsHandout

Practice areas


Course details

On demand
1h 2m 57s

Credit information