Jeff Foster, 32, is the sole owner of a chain of motorcycle stores and was recently approached by a publicly traded conglomerate. He has invested almost $8 million in the company, a C corporation, and anticipates that the business is worth $35 million. After years of constant work, he would like to spend more time at home with his wife and 4-year-old twins. His initial plan is to take some time off, but he knows that he will become restless and will build another business in the next 10 years. One priority is to set aside funds to ensure his children’s financial futures. In addition, his mother is in failing health, and within a year or so will need constant care.
Heidi L. Steiger: This is another situation where you could use family-limited partnerships with the idea of putting future appreciation and income into vehicles for the benefit of the children to avoid or reduce gift and estate taxes.
Robert C. Lawrence III: If he took some of the ownership of his motorcycle stores and stock and put them in a family-limited partnership, he could give interests to his children. Those interests could go into a longer-term trust for them so that they wouldn’t get the money and the benefit until they are, say, 25 or 30. He and his wife could use their $1 million exemptions and get $2 million on a discounted basis into long-term trust for his children. There would be capital gain on the sale of the C stock, but other than that, you would have transferred a fair amount of wealth.
Jane Tse: He needs to do this as soon as possible.
Diane Lederman: Before he sells the business, though, there are opportunities for discounts, depending on how you value the company. There are techniques to transfer assets where you take advantage of the valuation and discounts that will put money aside.
RL: Assuming that he hasn’t already negotiated the sale, the value [of the company] would be pretty low, presumably. Then add the discount on top of it. So when the chain of stores is sold, the proceeds would go into trusts for the kids. If he establishes [the family-limited partnership] this year and can point to cyclical and other business events that created the increase [in value] between now and the time he sells, then the appraisal would hold up much more.
DL: I don’t think that somebody of this age would want to put everything in [the family-limited partnership]. He needs to maintain his lifestyle and goals of starting another business. There should be some lifestyle benefits he and his wife need to consider.
RR: Assume that the sale is not imminent.
HS: With respect to the sale agreement itself, he could have earn-outs, so that if he stays on with the company and contributes to its financial success, there would be some future compensation. Usually, we would also talk about noncompetes—is he going to be able to compete [by working for or creating another company]? If not, for how long? Another option would be some type of consulting or employment agreement and stock options. These would all have to be part of the negotiations and how the sale proceeds are actually paid out.
The third thing to think about is asset protection. There are offshore trusts that he can establish. We don’t know enough about his situation to know if we should be protecting him, but creditors are a possibility. Maybe he needs liability insurance.
RL: He’s got the company in a C corporation, and I’m not sure—if we were advising him—we would have done that. He would want to sell the stock; were he to sell the underlying assets of the business, there may be a capital gain to the corporation, which would be taxable at 35 percent federal. There may well be state tax, too, and then when they liquidate the company, there would be another tax. He could end up with a double tax; the structure of the sale is very important.
JT: If he wants to further gain, he could do a tax-free exchange: He gifts his shares of his company in exchange for the publicly traded conglomerate. He won’t have to pay tax until he sells his shares.
HS: The benefit is that there could be some future appreciation in the stock, but on the other hand, he would be putting all of his eggs in one basket. He’s going to be very concentrated in a single stock.
RL: There wouldn’t be a market for the stock—and it would be hard to do—but the idea would be to go to an investment bank and pledge that stock, maybe get a loan. But I’m not sure that makes sense.
JT: Then he can take the publicly traded stock and go to Goldman Sachs and ask them to do collars or other diversification techniques.
RL: There’s a cost, 2 to 3 percent or whatever the bank charges, but to get the diversity, it would be worth it.
RR: Let’s assume that the sale is imminent.
RL: Ideally, he should give away the closely held stock before the exchange, as the value of the closely held interests could be discounted for gift tax purposes. If the sale is too imminent for such gifts, he could take the conglomerate stock, put that in a family-limited partnership, and give away minority interests to the trusts for his kids. Since he is giving away a minority nonmarketable interest, he would be able to discount the value of the gift. The IRS has been recently settling family-limited partnership cases with a 25 percent discount where marketable securities are involved.
RR: Is there something he should do in anticipation of his mother’s health care costs?
HS: An obvious thing would be to consider long-term care insurance. I don’t know whether she’d be eligible, given her failing health. And would it be practical?
RL: He could pay his mother’s medical expenses directly, and it wouldn’t go against the $11,000 exclusion. But he’s paying with after-tax dollars, and he wouldn’t get any deductions for it.
HS: Presuming that he’s going to take care of this cost out of his own pocket, what if something happens to him? Jeff could create a provision in his will that creates a trust for her when he dies. Another possibility would be a life insurance trust. He could avoid estate taxes with his mother being the income beneficiary and his children the remaindermen.
RL: If the mother has enough money, I suspect that those medical expenses would be deductible. Anything above 7 percent of her adjusted gross income for medical expenses is deductible.
HS: Another thing to consider is an irrevocable trust. It can be established with the mother as an income beneficiary. He would place assets in the trust that will generate income to pay her medical expenses. There are gift tax issues there, but it’s something to consider. With the children, he could do a 529 plan for each. He could also establish an irrevocable trust for each child that distributes income at a specific age for health, education, and welfare.
RR: How should he plan for a future business?
HS: Jeff should think about how much seed money he might need and other liabilities he might have with the sale of the business. He should take that amount—money he doesn’t want to risk—and put it in high-quality bonds with a short duration. It would be very liquid.
DL: Since he might consider going into a new business, he has some protection strategies he might consider now. This is a litigious society, so asset protection now might serve him well down the road. You want to create [these strategies] when there are no creditors.
HS: Afterward, Jeff and his wife should estimate how much their annual living expenses will be and put a sufficient amount in high-quality municipal bonds. Then, they should think about nonrecurring expenses. For example, does he want to buy a second home or a boat? If there is anything left, he should invest in a very diversified portfolio. He could put those assets in trust, but he’d have to consider transfer tax—I’m not sure that’s the way to go.