Perpetuation Planning – Part Two
Last month’s “Minding Your Business” column explored a few reasons an agency might perpetuate the firm, the four common techniques to transfer ownership, pros and cons, and some options for internal perpetuation. This month’s column will discuss the remaining most popular perpetuation options used by insurance agencies.
Planning for perpetuation long before the agency needs it is again desirable and recommended.
Gifting the Stock
Individuals may give up to $14,000 to any number of recipients each year without being subject to federal gift taxes. A spouse may also join in gifting. This allows a husband and wife to give together up to $28,000 annually to any number of recipients. A child and their spouse can receive up to $44,000 in stock per year, free of gift taxes.
For 2014, the maximum one-time gift amount is $5.34 million, and this can be used in increments, not all at once.
Personal Buy-Out
One option that can be used alone or in combination with others is that of the personal buy-out. In a personal buy-out, an employee of the agency purchases stock from the retiring shareholder. The buying employee could fund the purchase through his existing salary or personal funds. Alternatively and realistically, the corporation can fund the buy-out by creating a device called an enabling bonus.
The enabling bonus provides employees who otherwise could not afford a large block of stock with the means to do so. However, the enabling bonus offers a far greater advantage if also used as an incentive, such as for writing new business.
Likewise, there are disadvantages. In a personal buy-out, the enabling bonus paid by the corporation is tax-deductible. However, the bonus received by the buyer of stock and proceeds received by the seller of stock are taxable. The tax benefits derived by a corporate tax deduction are wiped out in large part by the taxes imposed on both the buyers and sellers of stock.
So that the buyer of stock is not overwhelmed with a tax burden he cannot handle, the enabling bonus must be adjusted upward, thus making the transaction more expensive. As a generalization, for every dollar spent to fund a personal buy-out, about $0.44 is lost to federal taxes alone.
Stock Redemption
A method commonly used in the perpetuation process involves the corporation buying outstanding shares of common stock and retiring these shares into treasury stock. A disadvantage with this method is that the payment for the stock must come from after-tax dollars. However, interest associated with a stock redemption can be tax-deductible. The sheer simplicity of this method is appealing, although costly from a tax point of view.
As a generalization, for every dollar spent to fund a stock redemption about $0.43 is lost to federal taxes alone. If a company has the unfortunate choice between only a personal buy-out, or a stock redemption, neither method produces a clear advantage.
GRATification
A grantor retained annuity trust (GRAT) is an irrevocable trust to which a donor transfers property, retaining the right to receive annual payments from the trust for a term chosen by the donor. A taxable gift is made as to the present value of the remainder interest (at the end of the fixed term) in the property. If the grantor survives the fixed term, the entire value of the property escapes estate tax. The value of the stock remains frozen until it passes to the designated beneficiaries.
The value of the grantor’s annuity interest is subtracted from the value of the trust property in determining the amount of the taxable gift resulting from the creation of the trust. The transaction is leveraged in the sense that the gift removes a larger amount from the grantor’s gross estate for estate tax purposes than is subject to the gift tax. Basically, a GRAT allows property to be transferred to a member of the grantor’s family at a reduced transfer tax cost. Payments are normally deductible for the firm. There are sizeable gift tax savings when the stock is transferred to the trust.
Leveraged ESOP
An employee stock option plan (ESOP) is a defined-contribution benefit plan designed to invest primarily in the employer’s stock, providing employees with ownership of the company.
An ESOP allows a business owner to:
A business with an ESOP typically uses internal cash flow or outside financing to make regular tax-deductible contributions of cash to the plan, which then purchases from the company shares of company stock.
Oak & Associates does not recommend most independent agencies set up an ESOP, as they can be fairly expensive. There is also a need for an annual valuation of the ESOP shares, which will add to the annual cost. Expenses incurred might be outweighed by tax savings for firms over a certain size. The ESOP must be adequately funded so that vested employees that quit or retire can be bought out. This repurchase liability creates costs to the company above and beyond the annual loan repayment.
Recapitalization
Consider corporate recapitalization prior to transfers. Restructuring the capital of the business can permit senior business owners to achieve many of the objectives of business succession planning. Creating the second class of common stock is a nontaxable event.
The corporation is recapitalized so that the bulk of its equity lies in non-voting stock (permissible in an S corporation so long as the only difference is in voting rights). The donor can then give away the equity without relinquishing the vote. For information on recapitalization, contact the business attorney and/or CPA.
Any succession planning will take time and must include the advice of tax and estate planning professionals. These techniques must be done within the context of acceptable legal limits and must not be used in a manner to avoid taxes.
Most owners would like their business to continue and thrive after they exit the firm. With the proper planning, owners can create a structure that will increase the chances that the business will be passed successfully to the next generation.