Succession and Estate Planning: An Introduction

Penelope C. Roeder President, Strategic Support Services, Inc.

This material was written to be included as a chapter in How To Value Your Business and Increase Its Potential, Jay B. Abrams, editor (New York: McGraw-Hill), 2004.

Succession and Estate Planning

Introduction: why plan at all?...................................................................................................2 Gift and estate taxes .................................................................................................................3 Family issues ............................................................................................................................5 Creating effective plans............................................................................................................5 Structures and strategies...........................................................................................................6 Trusts........................................................................................................................................6 Revocable living trusts .......................................................................................................6 Irrevocable trusts ................................................................................................................7 Grantor retained income trusts ...........................................................................................8 Intentionally defective irrevocable trusts ...........................................................................9 Other intrafamily transfer mechanisms ....................................................................................9 Buy-sell agreements ...............................................................................................................11 Charitable strategies ...............................................................................................................11 Charitable trust strategies .................................................................................................12 Other charitable strategies ................................................................................................13 Conclusion..............................................................................................................................13

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SUCCESSION AND ESTATE PLANNING Introduction: why plan at all? Most of us dislike change. As much as we know that change is unavoidable, we make heroic efforts to evade it. As a result, we are often left to cope with emergencies occasionally very expensive ones. When a family owned (or other closely held) business faces a crisis for which they havent planned, the results can be devastating. If the sole shareholder of a business dies, for example, her family may be left with a large estate tax bill and no liquid assets with which to pay it. If that shareholder is also the senior executive and operating manager of the business, the family may be left with a large tax bill, little or no liquidity, and no expertise with which to run the business, or even to sell it. Even when there are other shareholders or partners in the business who have operating expertise, the outcome can be chaos: the decedents family can have a tax bill and a large ownership stake, while the other shareholders have de facto control of the business, its cash flow, and all of the other factors that contribute to its value. Family businesses make up a large segment of the American economy. By some estimates, they account for 75 per cent of all businesses, more than 50 percent of gross domestic product, and 60 percent of total employment.1 However, some also estimate that as few as 13 percent of family owned businesses stay within the family for more than three generations.2 Whether a business continues to be owned by the same people, or is sold so that the owners can invest the funds elsewhere, there are both direct and indirect costs of not making succession and estate plans for the family or closely held business. The best way to derive the greatest value from the business is to plan ahead, and do what is necessary to maximize the use of the asset and minimize the costs of transferring it. This discussion will begin with some information about the specific costs and causes of not planning. I will then briefly discuss the succession and estate planning process itself, as well as some of the many structures and strategies that can be used by the business owner to accomplish important wealth transfer goals. In the available space, it will be impossible to do complete justice to this important topic.3 If you leave this chapter with nothing else, I hope you will have learned one thing: for owners of family and other closely held businesses the single most critical step in shaping a lasting legacy is to ensure that you have a succession plan that will allow your familys business to be successful in the future and a wealth transfer plan that supports it.

See, for example, Tom L. Potts et al., Effective Retirement for Family Business Owner-Managers: Perspectives of Financial Planners, Journal of Financial Planning, June, 2001.

See, for example, John Bodesky, Planning a Successful Family Business Succession, Trusts & Estates, April, 2002.

This chapter is an abridgement of a much longer paper, and many important issues are touched on only briefly. Readers who desire a more extensive discussion of the topics addressed here may request a copy of the original paper from the author.

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Gift and estate taxes4 As any business owner knows, taxes are an important element of its cost structure. As such, no plan that claims to address the economics of the business can ignore them. Virtually all transfers of business ownership whether they involve a sale or a gift involve taxes. Since sales generally take place in real time, while we are watching, we tend to be more aware of taxes on them than we may be of the taxes on gifts and bequests, for which the bill often does not come due until we are no longer here to pay it.5 Taxes are generally imposed when one person (e.g., a parent) transfers assets to another (e.g. a child) without receiving payment or other consideration in return. If the transfer takes place during the life of the giver of the asset (the donor), the applicable tax is a gift tax. The amount of tax due is determined by the value of the individual gift. It may be paid by either the donor or the recipient of the gift. If the donor pays the tax, that amount is not subject to additional gift tax. If, however, the donor gives the recipient money to pay the tax, the amount to be used to pay the tax will be included in the valuation of the gift. Gifts between spouses are exempt from gift taxes, as are certain payments made on behalf of, or for the benefit of, others (such as payments made directly to providers for medical care or education). Gifts made to qualified charities are not taxed but generally provide deductions for income tax purposes (subject to certain limitations).6 Estate taxes are imposed on the assets owned by a person at the time of his or her death. Under current law, the estate tax rate is generally determined by the value of the whole taxable estate, i.e., the assets owned at the time of death or an alternative valuation date six months later, less certain deductible items like the assets left to the decedents spouse and those left to qualified charities. The actual tax calculation is complicated, but broadly speaking, it is determined by applying this tax rate to the taxable estate less the exemption equivalent amount. not already claimed for lifetime gifts.7 Many people currently believe that Estate taxes are going away. However, as of this writing, that perception is not entirely correct. The Economic Growth and Tax Relief Reconciliation Act of 2001 phases out estate taxes over the next decade. In the eleventh year, however, the whole system goes back to the way it was prior to the 2001 law, unless
I would like to thank William Kruse of Lagerlof, Senecal , Bradley, Gosney & Kruse, LLP in Pasadena, CA, and Edwin G. Schuck, Jr. of McDermott, Will & Emery in Los Angeles, CA, for their reviews of, and comments on, the technical material in this chapter. Their generous efforts should not, however, encourage any reader to construe any of this material as legal advice. All readers should seek advice from their own advisors, including their own attorneys, to ensure that the specific facts of their own situations are thoroughly considered and appropriately addressed using law that is then current. The decision to sell a business can be a legitimate succession strategy when it is made after a serious analysis that involves many factors, including tax implications. Space does not allow us to address it here. However, in terms of transferring wealth from one generation to the next, in most cases, only planning that is done before the sale is contemplated and certainly before it is consummated can significantly increase the proceeds available to the family.
6 5 4

A review of IRS form 709 and its accompanying instructions will provide a idea of the complexity of the gift tax and its application.

A review of IRS Form 706 and the accompanying instructions will provide a sense of the true complexity of the estate tax.

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new or renewing legislation is passed before then. (See below for a year-by-year summary of the phase out and re-imposition of estate taxes.)8
Estate Taxes Estate Tax Exemption Equivalent* $675,000 $1,000,000 $1,000,000 $1,500,000 $1,500,000 $2,000,000 $2,000,000 $2,000,000 $3,500,000 Repealed $1,000,000 *Includes gift tax exemption **GSTT rate, as well

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Top Estate Tax Rate** 55% 50% 49% 48% 47% 46% 45% 45% 45% 0% 55%

GSTT Exemption $1,060,000 $1,100,000 $1,100,000 $1,500,000 $1,500,000 $2,000,000 $2,000,000 $2,000,000 $3,500,000 Repealed $1,060,000

In addition to the long phase-out of the estate tax and the possibility that it will be reinstated, the 2001 legislation fundamentally changed the unified gift and estate tax system by permanently limiting the amount of lifetime gifts that can be made without being subject to gift taxes. Because lifetime gifts are generally valued independently of one another and at the time of the gift, they are generally less expensive from a tax perspective than are bequests from an estate. From 2002 on, the maximum amount that can be removed from a donors estate through tax-free lifetime gifts is $1,000,000.9 As a result of this change, planning for the maximum utilization of the gift tax exemption equivalent amount has become extremely important for anyone who hopes to transfer a significant asset or estate to the next generation. Another element of the gift and estate tax system that can diminish the value of assets transferred to a younger generation is the Generation Skipping Transfer tax (GST tax). This tax imposes an additional (and high) tax on transfers made either by lifetime gift or post-mortem bequest to anyone more than a generation younger than the donor. The rate used for this tax is equal to the highest marginal tax rate imposed on estates and gifts. There is currently a GST tax exemption of $1,100,000, which applies to each donor, not each

8 9

IRC 2001(c).

IRC 2502(a). The lifetime gift tax exemption equivalent amount does not include the annual exclusion amounts of $10,000 (as indexed for inflation, currently $11,000) that may be given by each donor to each recipient. Nor does it include certain payments made to health care or educational institutions by the donor for the benefit of someone else. However, use of the lifetime gift tax exemption equivalent amount by any donor will result in a dollar-for-dollar reduction in the amount available for the estate tax exemption equivalent.

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recipient.10 Beginning in 2004, as the estate tax exemption equivalent amount increases under the 2001 law, the GST tax exemption will also increase to be equal to the estate tax exemption equivalent amount. Despite all these potential tax costs, there are estate planning and wealth transfer techniques that can significantly reduce the burden of transfer taxes. A brief overview of some of them makes up much of the remainder of this chapter. Family issues Family issues can have a significant impact on the success or failure of succession and wealth transfer planning. Many characteristics of the successful entrepreneur, as well as the possibility of unresolved family matters, can reduce the chances for effective planning. In some cases, these issues can cause the avoidance of planning; in others, they can result in the formulation of plans that do not support the best use of the business asset. These issues include: general avoidance of planning; failure to designate a clear successor; failure to prepare the designated successor(s) with the training required to do the job well; planning as though the business will remain in the future as it is currently; mismatch between the ownership structure created by the estate plan and the other plans for the organization; and failure to execute tasks required to implement plans. Any one of these can be a recipe for trouble; and too often the reality is that more than one actually happens. Creating effective plans Effective succession and wealth transfer planning is complex and often requires the support of a number of kinds of professionals. These may include: business consultants, attorneys, accountants, valuation experts, investment bankers, insurance agents, and others. Generally, there are three critical rules that you should keep in mind throughout the process. First, make sure that your plans are your plans, and meet your goals. It is very easy for professionals who do something all the time to make suggestions based in their own perspectives and habits. However, these may or may not bring success to your family or business. Make sure that you create a planning process that focuses on helping you to define your goals and doing what is necessary to meet them; insist that your advisors maintain that same focus. Second, you should choose advisors who have the specific kinds of expertise you need. For example, you may have a long-time business attorney. He or she probably has expertise in business law, as well as knowledge about you and your business. However, there may be others who have stronger estate planning skills. You do not need to exclude your trusted advisor, but you should augment your team with an estate planning expert. Third, like any other complex process, your planning activities will have to be managed. This is ultimately your responsibility. However, if there is no one in the family that has the experience or fluency to function as an effective CEO of this process, it may be both wise and efficient to designate an advisor to fill or assist in this role. The chosen advisor may be a business consultant, an attorney, or anyone else you trust to help the business and the family with the important jobs of asking and answering its most difficult
10

The GST tax is not applied to amounts that qualify for the annual gift exclusion.

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questions and integrating the work of all the other advisors to help the family achieve its objectives. Structures and strategies Within the context of the goals that are particular to your family, your business, and your overall situation, there are several objectives that you will probably want to consider as you build your estate and wealth transfer plan. They include: enabling a smooth transition of the management of the business; ensuring that ownership will be structured to support your other goals; timing transfers so that they are congruent with your other plans; minimizing the value of each lifetime gift; and maximizing the amount you remove from your estate before your death. Since some of these things are likely to be in conflict with one another, you will probably have to find a balance on several issues. To do that, it will help you to learn some of the language of estate planning. You should always feel that you can ask a question or demand clarification of anything the advisory team is suggesting, and that is easier to do that if you know the basic vocabulary. This section is intended to provide some basic definitions and information that will help you in this task. Many of the strategies used to accomplish complex planning goals involve multiple structures (e.g., trusts, partnerships, annuities). Since I cannot cover all of the alternatives in the available space, I will focus on some of the basic building blocks. I will briefly review the basic features and uses of trusts, some uses of a special group of trusts known as grantor trusts, other mechanisms for making intrafamily transfers, and strategies for achieving charitable and related objectives. Although most of these structures also have uses for postmortem planning, I will focus here on the ways they can be used in lifetime planning to meet some of the objectives listed above. Trusts Perhaps the most common planning arrangement is the trust. A trust is an entity that allows for the separation of the legal ownership of an asset from its beneficial ownership. That is, a trust provide for one person (the trustee, which may be a trust company as well as a natural person) to have legal control of (and responsibility for) an asset or group of assets, while others (the beneficiaries) receive the benefit of (e.g., income from) that asset. In addition, a trust may allow the asset to be split between recipients who receive income benefits now (income beneficiaries) and the asset itself later (remainder beneficiaries). A trust may also be used to manage the timing of a gift so that a donor can make the gift now, although the beneficiary will not receive it until some time in the future. Under certain circumstances, two or more of the roles related to trusts (e.g., donor and trustee or donor and income beneficiary) may be played by one person. In those instances, there are generally specific reasons for the multiple roles, as well as specific rules that cover them. Revocable living trusts A revocable living trust is designed to allow the grantor(s) to fill the roles of trustee and income beneficiary, as well as to retain the right to change the terms of the trust. It can be an important planning tool for several reasons. First, it is an entity that can hold all or most of a persons (or couples) assets. Second, its governing instrument can contain instructions for the management of those assets should the grantor(s) become unable to take

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responsibility of their management (e.g. through illness or other incapacity). Third, the trust instrument can detail a plan for disposing of the assets at the grantor or grantors death(s). And, fourth, because the trust is revocable, changes can be made in the instructions provided in the trust documents as changes occur in the donors needs and situation. This living trust is a crucial element in estate planning for any business owner and should be put in place as early as possible, even before the business owner has made specific plans for the disposition of his or her assets. Without such a living trust even where the owner has a very specific will the owners stake in the business is likely to be subject to probate. In addition to being a lengthy and expensive process, probate is a public process during which many confidential business papers (including its valuation) may be available to the general public. The donation of the owners stake in the business to a living trust that provides for the appointment of a qualified decision maker to oversee the transition of the business at the owners death will avert the probate process and its pitfalls and ensure that someone is designated to make decisions to maximize the value of the business for the owners heirs. A revocable living trust is not by itself a tax management tool. Because the grantor retains virtually all rights to control the assets in the trust, the trust is not considered to be a tax entity separate from the grantors.11 Irrevocable trusts Trusts, however, often are separate tax entities, when the grantor relinquishes his or her rights (or most of them) irrevocably. It is these trusts that can be used to receive property a donor desires to transfer as a gift when the donor also wants to delay receipt of the gift by its ultimate recipient. This delay may be sought for a variety of reasons. For example, the intended beneficiary may be a minor and not legally able to accept responsibility for the gifted asset(s), or simply is not mature or responsible enough to handle them responsibly. Or, the donor may want to create specific goals (e.g. completion of various stages of education; savings of a certain amount of money; getting and keeping a job) that must be met by the beneficiaries if they are to receive any income from or distributions of the assets in the trust. Whatever the reason for using a trust, if the grantor makes the trust irrevocable, the gift to the trust is generally considered to be a completed gift and is valued for gift tax purposes at the time of the gift. The assets given to a trust in this way are also generally considered to be permanently removed from the grantors estate.12 This characteristic of irrevocable trusts makes them very important elements in the wealth transition plans of business owners. Particularly when the value of assets is expected to grow, there may be gift and estate tax advantages to making a gift of those assets sooner than later, even if the donor does not want the recipient to have control of, or access to, the assets for a period of time. Irrevocable trusts allow a donor to meet both objectives. The efficacy of making gifts can also be enhanced in a number of ways. First, if the gift is one of present interest, which provides control of the asset to the recipient at the
11 12

IRC 2038(a)(1). Reg. 25.2511-2.

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time of the completed gift, it will qualify for the annual exclusion. 13 Where a trust is designed to prevent the beneficiary from exercising control over the asset until some time in the future, the donor may use a Crummey power, which provides the beneficiary a brief period during which he or she can remove the assets from the trust. By providing that option, which probably will not be exercised, the donor provides a present interest in the gift, and may exclude $11,000 from the taxable amount. If the donor is married, the taxable amount of a gift can be further reduced if the spouse agrees to gift-splitting.14 If the couple splits the gift and it is structured to qualify as a present interest gift, twice the exclusion amount (currently $22,000) will not be taxable. If the total amount of the split gift exceeds the exclusion amount, only half of the remaining total will be applied against the $1,000,000 of the gift tax exemption equivalent amount that can be claimed by each spouse. A married couple can split the gift as long as they jointly sign the gift tax return, even if the gift is made from property owned by only one of them. There are a variety of irrevocable trusts that can be used to achieve a variety of purposes in the process of transferring wealth. Among them are by-pass trusts (credit shelter trusts, QTIP trusts), minors trusts, and dynasty trusts. Each has specific uses (and, in some cases, conditions for use); but when used appropriately they can allow a donor to accomplish very specific objectives. Irrevocable trusts that specifically call for the grantor to retain certain rights are known as grantor trusts. In these trusts, the grantor (or spouse) may retain rights to income, certain types of control over the assets in the trust, or even a reversionary interest in those assets. Trust income is generally taxable to the grantor of such trusts.15 Despite the rules governing them, properly structured grantor trusts form the basis of some interesting gifting strategies. Grantor retained income trusts The basic structure of the Grantor Retained Income Trust (GRIT) calls for the transfer of assets to a trust from which they will eventually be distributed to designated remainder beneficiaries. For a fixed period of time, however, the grantor receives a stream of income from the trust.16 The taxable value of the gift (which may be any assets, including a business) made using a GRIT is frozen at an amount equal to the appraised fair market value of the gifted asset at the time of the gift, minus the present value of the annuity retained by the donor. 17 In addition, the grantor pays taxes on the annuity stream from the
13

The first $10,000 (subject to indexing after 1998 and currently at $11,000) of gift of a present interest made by a donor to each donee in each calendar year is excluded from the amount of the donors taxable gifts. IRC 2503(b). IRC 2513. Specific retained rights that qualify a trust as a grantor trust are identified at IRC 671, 672, and 676.

14 15 16

If it is a fixed amount each year, annuity, the trust is an annuity trust (GRAT). If it is a fixed percentage of the value of the assets in the trust, as appraised annually, it is a unitrust (GRUT).

IRC 2036(a)(1). In theory, if the grantors retained interest is high enough, the value of the transfer will be zeroed out for purposes of determining gift tax. However, there has long been controversy about this issue. See, for example, Deborah V. Dunn, Coming to a Wal-Mart Near You: Tax-Free GRATs, Trusts & Estates, April, 2001, pp. 12-14, 63. In addition, there are special rules that must be observed when assets are transferred to members of the grantors family. Where a GRIT involves family members, the grantors retained

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trust, as well as on any capital transactions within the trust, thus depleting the value of his or her estate even further. While this strategy can reduce the taxable amount of a gift dramatically, its risk is that the gifted asset will return to the grantors estate, be re-valued at fair market value and taxed at the donors death if he or she does not survive the income period. However, if the donor does survive the term, the beneficiaries receive an asset that may have grown considerably in value without any incurring any additional gift or estate taxes. Intentionally defective irrevocable trusts An intentionally defective irrevocable trust (IDIT) provides to the grantor an explicit right to change or appoint assets in the trust. Because the retained rights in this trust do not meet the requirements for valuation at an amount greater than zero, this trust is not a vehicle for achieving discounted gift tax valuations. However, once an asset is transferred to an IDIT, its value is fixed for gift tax purposes. The asset, as well as any appreciation in its value, is permanently removed from the grantors estate. In addition, since the grantor is required to pay any taxes on income or gains in the trust, the trust will not have to expend funds for that purpose, and those funds will also be removed from the donors estate. In practice, the IDIT is often funded with minimal cash. The transfer of the business is then done as an installment sale (see below). In addition to minimizing the value of the gift made to the trust, this mechanism also increases the basis of the asset in the trust, thus reducing the capital gain to be taxed when the asset is later re-sold. The installment payments also provide a stream of income to the grantor. Other intrafamily transfer mechanisms There is also a group of intrafamily transfer strategies that can be accomplished using other kinds of structures. This section discusses some of those alternatives. Family limited partnerships One structure used to transfer business interests to children, without transferring control of the business to them, is the Family Limited Partnership (FLP).18 This structure can be a very effective vehicle for a family whose primary goal is to make effective use of the gift tax exemption equivalent amount. When the FLP is formed, one or both of the parents generally becomes the controlling decision maker. The children are gifted holdings in the business that do not entail formal decision making roles.19 The interests being transferred to the children are
interest will be valued at zero unless it conforms to the qualifying rules IRC 2072(b). Family for these purposes is defined at IRC 2071(c), 2072(e), and 2074(c)(2).
18

FLPs may actually be structured as limited partnerships or limited liability companies (LLCs), depending on the particular family business circumstances and the controlling state law. For an extensive discussion of FLPs see Jonathan C. Lurie & Edwin G. Schuck, Jr., Applying Valuation Discounts To Wealth Transfer Techniques, FLPs and LLCs: Their Uses in Family Wealth Transfers, Program Handbook, CEB, California, October, 2000, pp.5-80. In any FLP structure, the parents assume the controlling decision-maker role, the managing partner in a partnership or the managing member in the LLC structure. In a partnership structure, the general manager may be a corporate entity owned by the parents to enhance asset protection and liability limitations. The children are generally made limited partners, non-managing members, or given non-voting stock.

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generally appraised at significant discounts deriving from the limited (or non-existent) control of the business vested in the transferred shares (referred to as a minority discount), and then from their illiquidity or lack of marketability.20 Subsequent gifts of interests in the business can also be made to the children, and each will be valued as a standalone gift. Although each will require a new appraisal, each will generally also be subject to significant discounts. Intrafamily sales Another strategy that may be used to transfer assets from one generation to the next is a sale. While the use of sales for intergenerational transfers may seem inefficient, there are a number of strategies that can be designed around sales. For example, a parent may sell an asset that plays a significant part in the business (e.g., the real estate related to the business) to the next generation for fair market value, as determined by an appraisal. The parent would recognize a taxable gain for income tax purposes on the difference between the sale price and the basis of the asset,21 but the child(ren) would then have an asset with a newly established basis. The parents would still own the operating business, which could lease the asset from the new owner at the appraised fair market rate. The costs of the lease would be a deductible expense to the business and the lease payments would provide the children with income possibly enough, with depreciation, to defray the carrying costs of any loan taken to make the purchase. Variants on a sales strategy include a bargain sale,22 in which the parents sell the asset to the next generation for a price less than its fair market value, often by allowing the child(ren) buyer(s) to assume outstanding debt on the property. The parents would be treated as having made a taxable gift for the difference between the amount paid (e.g. the loan assumed) and the fair market value of the asset sold. Since the children gain immediate title to the property, this would be a present interest gift and its taxable amount could also be reduced by the annual exclusion amount available to each seller (and spouse) for each buyer-donee. Another variant on the intrafamily sale is an installment sale. In this case, the purchasing child(ren) would not give the parents cash for the fair market value of the asset, but would sign a note. The buyer(s) would assume ownership of the property, which would have a new basis. The seller(s) would recognize the capital gain over the term of the note as a percentage of each payment. Each payment on the note would also include an element of interest, which the seller would have to recognize as ordinary income when it is received. If the note were based on fair market values for both the asset sale price and the interest on the loan, there would be no gift tax related to this transaction unless, from time to time and without prior agreement, the note holder were to forgive scheduled loan payments. Such forgiven loan payments would qualify for the annual exclusion amount.23
20 21 22 23

Because these gifts are present interest gifts, the exclusion amount of $11,000 may be applied to them. They could not recognize a loss if one existed because the sale would be between related parties. Reg 1.1001-1(e).

If the seller were to die while an installment sale note is still outstanding, the tax implications can be complex. Other complications can ensue if the buyers default on a note. All of these should be thoroughly explored, understood, and planned for before such an arrangement is made.

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Private annuities A private annuity must generally be undertaken between two individuals (i.e. without intervention by a structure like a trust or FLP). It involves the sale of an asset by one family member (e.g. the parent) to another (e.g. a child) for an unsecured promise to pay a set amount, at regular intervals, for the remainder of the sellers life. The amount of the payment is based on the fair market value of the asset, the IRS-approved rate for valuing annuities at the time the arrangement is structured, and the IRS-approved life expectancy for the seller. The buyers basis in the transferred asset will be the fair market value at the time of the transfer. The seller will pay income taxes on the portion of the payments that represent gain over her basis in the asset. Since payments are made as long as the seller lives, the private annuity is a good deal for the buyer if the seller dies sooner than the required life expectancy and a bad deal for the buyer if the seller lives longer. If the arrangement is structured correctly and uses the correct IRS-approved factors, there is no gift tax associated with this transfer. Since the asset is already owned by the buyer, it is not subject to estate tax upon the death of the seller. Buy-sell agreements Buy-sell agreements can be an important tool where a business is a significant asset in the estate of its owner(s). These agreements are legally binding plans that set the terms under which ownership in a business will be sold at the departure (due to retirement, death or disability) of an owner. These agreements may be reciprocal agreements made between individual shareholders or between each of the shareholders and the business itself. One party to each agreement commits to sell the shares under the terms of the agreement, and the other commits to buy the shares under those terms. The agreements generally specify a formula by which the sale price will be determined at the time of the sale. The buy-sell agreements are generally accompanied by insurance policies that are designed to provide funding for the agreed upon purchases. These agreements accomplish several objectives. First, when the agreements are structured correctly, the purchase price establishes the estate tax value of the shares. Second, they ensure liquidity for each shareholders family, which can be used to pay estate taxes, or for any other purpose. Third, they allow the shareholders to agree to a specific price formulation, often averting difficult decisions at traumatic moments. And, fourth, by predetermining the buyers of the shares, these agreements can limit the ownership to a specified group of shareholders. Buy-sell agreements funded by insurance can also be used to make equitable gifts to family members for whom identical gifts would be inappropriate, such as when one child is interested in staying with the business, while other members of the family would like to have their assets available to do something else.24 Charitable strategies Charitable strategies can serve a variety of important functions in a familys overall succession and wealth transfer plan. The opportunity to plan often causes people to think

24

Some of these objectives can also be achieved by other mechanisms, such as ESOPs, which are addressed in detail in the following chapter.

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about their philanthropic goals and the organizations they would like to support. Parents may look to charitable strategies to help them structure a plan for teaching their children and grandchildren certain values. They may also find that they have tax problems that charitable strategies can alleviate. All of these roles for charitable strategies merit serious attention. However, I will focus only on the asset transfer and tax issues that can be addressed by charitable strategies.25 Charitable trust strategies Among the charitable strategies that are most widely used in succession and estate planning are the strategies that use charitable trusts to split the interests of a donation between a charitable entity (or entities) and other parties, often family members. The charitable remainder trust (CRT) provides for a stream of income for individuals in its early years, and distribution of the assets to a qualified charity at the end of its life. These trusts can be structured as annuity trusts (CRATs) or unitrusts (CRUTs). In either case, the CRT is a tax-exempt entity.26 The donor receives a deduction for the fair market value of the donation, less the present value of the required payout. However, this kind of contribution is rarely done simply to benefit the charity or to receive the tax deduction. Instead, it is often done to allow for the liquidation of a highly appreciated asset within a tax-exempt structure, and then to provide liquidity for the donor or the donors family members. The annuity stream is taxable to its recipients, but the strategy is generally used when the present value of the tax expense on the anticipated income stream is less than the tax that would be imposed on the sale of the highly appreciated asset.27 The CRUT has several potential advantages over the CRAT. First, additional assets can be added to the CRUT in later years, which is not true of a CRAT. Second, both the charity remainder(s) and the income recipient(s) share an incentive for the trust to grow in value: as it does, the annual payout amount increases, along with the remainder amount available to the charitable beneficiary.28 A CRUT can also be structured to allow for the delayed sale of the asset(s) used to fund the trust. This version of the CRUT, known as the net income with make-up unitrust (NIMCRUT), is designed to allow for the annual payment amount to be the lesser of any
25

Detailed rules regarding charitable deductions can be found at IRC 170(b)(1) and Reg 1.170. As noted above, contributions to charitable organizations are generally deductible for income tax purposes. The rules governing those deductions are complex, and may impact the choices made by any particular family. They should also be incorporated into any analysis of each option under consideration. The income stream must be at least 5% of the amount originally given to the trust if it is an annuity trust, or 5% of the assets in the trust, as determined annually, if it is a unitrust; the trust must be structured so that the remainder charity can expect, actuarially, to receive a minimum of 10% of the original assets in the trust. IRC 664(d).

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A wealth replacement trust is often used to replace the assets that will eventually go to charity. Using some of the income derived from the CRT, the donors make contributions to an irrevocable life insurance trust (ILIT) which uses those funds to buy life insurance on the donors lives for the benefit of the donors children or other heirs. The trust, which must be managed by an independent trustee, owns the life insurance policy, thereby excluding it from the donors estates. The beneficiaries will receive the insurance proceeds tax-free.
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Growth in the annual payout amount may not, however, be a desirable outcome if the donor is its recipient and one of the planning goals is to keep the donors estate small.

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unitrust amount or the amount actually earned on the trust property, with the deficiencies payable in later years when trusts income is higher. The NIMCRUT design is particularly useful when the assets to be used to fund the trust are not liquid at the time of funding. Another charitable strategy is the charitable lead trust (CLT), which may also be structured as an annuity trust or a unitrust. As the name implies, the CLT is designed to provide an income stream to the charity in the early years of the trust. After the payout period ends, the assets remaining in the trust may be distributed to third party beneficiaries or may revert to the donor. Generally, a CLT is used to make a low-cost gift of assets that are expected to grow significantly over the term of the trust. When the assets are donated to the CLT, their valuation for gift tax purposes is fixed at their fair market value less the present value of the stream of payments to the charity. Thus, if the assets grow at a rate higher than the rate required by the IRS for the valuation of the payments to charity, the corpus of the CLT can be significantly larger when it transfers to the remainder beneficiaries than was its taxable value, but it will not be subject to any additional gift or estate taxes. Other charitable strategies Other charitable entities, such as private foundations, or support organizations, and donor advised funds of public charities, can also be used to accomplish a variety of longterm charitable goals. In fact, each of them may also qualify as the recipient of charitable contributions made by a charitable trust. These entities differ from one another, subject to different rules and imposing different obligations on the donor family. These differences should be well understood before choices are made as to which should be used by any given family, for any given purpose. Conclusion Succession and estate planning will be different for every situation and every family. It will often be difficult and demand time, attention, and struggle that an accomplished and busy executive will not want to give. There is also no magical formula for determining which alternative is best used by a particular family, in a particular situation, which will create its own discomforts. However, the development of an effective succession plan that meets a familys real needs, and a wealth transfer plan that supports it, is the only way to ensure that the value that has been built into the business will survive. It can make the difference between a legacy of success and a legacy of failure for its current owner(s).

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PENELOPE C. ROEDER, PH.D. Penelope C. Roeder is President of Strategic Support Services, Inc., a management consulting firm in Los Angeles, CA. She has assisted organizations and their executives in making complex decisions for more than two decades. During this period, Ms. Roeder has guided and participated in all aspects of organizational planning and execution. Ms. Roeder also works with executives and managers at all levels to develop their leadership capabilities and managerial skills, as well as to develop personal financial plans. She has provided both one-on-one coaching to individual executives and managers and facilitated team-based planning and decision making. Ms. Roeder holds an MBA in Finance from the Stern School of Business at New York University. She has also earned a PhD in Human and Organization Systems, with an emphasis on decision making processes, group dynamics, and leadership. Ms. Roeder is also a Certified Financial PlannerTM . Email: Penelope@StrategicSupportS.com

2003 Strategic Support Services, Inc.