This article shares a few ideas on how a company might be restructured to adapt to this challenge. It has only one purpose - to help educate all of those who want and need more information.
We’ll use a simple case study to help illustrate the ideas. The case study involves a family business, but the ideas may work for the owner of a non-family enterprise who wants to phase out and have a new person (a non-relative) run the show.
The BackgroundEarl and Betty Wilson own 90% of the outstanding stock of a C corporation that has been in a specialized distribution business for 26 years. Earl Wilson (age 65) is the founder and president of the company and historically has been the principal force behind the company. Betty, his wife, who is 60 years old, serves on the board but spends no serious time in the business.
Jeff Wilson, Earl and Betty’s oldest son, owns the remaining 10% of the stock. He is married, and he has been actively involved in the business for years. Jeff is considered to be second-in-command behind Earl. In addition to having a strong financial background, Jeff has a proven knack for sales and marketing, and he is really skilled in dealing with people. Jeff is anxious to take over the reins, and he wants to aggressively grow and expand the business.
Earl and Betty have two other children, Kathy and Paul. Both are grown and married, but neither of them works in the business. Paul is a doctor. Kathy works in commercial real estate. Earl and Betty have four grandchildren, and they hope to have one or two more.
The ObjectivesEarl estimates that the business is worth approximately $10 million. That’s the price that he believes that it could be sold for today. Earl and Betty’s total estate, inclusive of their share of the business, is valued at about $18 million. Earl and Betty are anxious to form a succession plan and begin to move on. They’re looking forward to their retirement. They would like to develop a plan that will accomplish a variety of objectives:
- Earl would like to phase out of the business over the next year, but continue to receive payments from the business that will enable him and Betty to ride off into the sunset and enjoy the rest of their lives in retirement.
- Jeff will take over the control and the management of the business. Earl wants some ongoing involvement, as a hedge against the boredom of retirement and to ensure that the financial integrity of the business is protected for the sake of his retirement and Betty’s welfare.
- Jeff will have the freedom to diversify and expand the business. Ideally, the value of all future appreciation will be reflected in Jeff’s estate and will not continue to build Earl and Betty’s estates or the estates of other family members, specifically Kathy and Paul.
- Earl and Betty want to make sure that, at their passing, each child receives an equal share of their estate. They appreciate that the business represents the bulk of their estate right now and want to ensure that they wisely manage the family dynamics as they transition out. They want Jeff to control and run the business, but they want to make certain that Kathy and Paul are treated fairly.
- Earl and Betty want to minimize taxes, consistent with their other objectives and their overriding desire to be financially secure and independent.
- Lastly and most importantly, Earl and Betty want to make certain that they will always be financially secure. They never want to be placed in the position of having to depend on their children, and they always want to know that their estate is sufficient to finance their lifestyle for the years that they have left. They are willing to pay some estate taxes for this peace of mind.
The DilemmaEarl and Betty have explored various business transition options, none of which have appealed to them. They do not want to start gifting stock or other assets to Jeff or either of the other children at this point. They realize that the future is uncertain, that they each have a long time to live, and that no one knows what they will need or want for themselves in the future. The idea of selling their stock to either the corporation or to Jeff, in return for a long-term note, really doesn’t work for them. Given their low tax basis and their stock, any such sale would just trigger a big, long-term double tax since all principal payments on the note would have to be funded with after-tax dollars.
Plus, any sale to the corporation, to make any tax sense, would require that all of the stock be sold in one transaction and that Earl have no further dealings with the company. He couldn’t be an employee, a director, a consultant, or involved in any way. None of this works for Earl, and any sale to Jeff would create a difficult burden, a real tax killer. The challenge would be to get enough corporate funds into Jeff’s hands that he could make the payments required by the note, much of which would be with after-tax dollars. On top of that, they would have to cover all of the associated tax burdens.
There’s another problem. Wilson Inc. is a C corporation. Earl has regularly drawn a salary of between $350,000 and $450,000 a year, and he would like to continue drawing at that pace as he transitions out of the business. However, if he’s out playing and no longer working full-time for the enterprise, all (or at least a major portion) of any such payments may end up being taxed as dividends, which would produce no deduction to the company. This would be an expensive double income tax burden.
So next, we’ll take a look at another idea for Earl and Betty to consider.
The SolutionOften, some simple business restructuring can help immensely in the design of a family transition plan. It’s phasing out without selling out.
Suppose, for example, that Wilson Inc. is restructured to take advantage of two basic realities. First, the distribution of S corporation earnings presents no double tax issues. Second, Jeff’s desire to expand into new markets—and to garner all of the benefits of the expansion for himself—can be accomplished by having him form and operate a new business that finances the expansion, takes the risks of the expansion, and realizes all the benefits. This restructuring might be implemented as follows:
Wilson Inc. would make an S selection. The shareholders of the company would remain the same, at least for the time being. Earl and Betty would keep their stock for now. Earl would retire now and ride off with Betty. The company, as an S corporation, would make regular distributions of its earnings to Earl and Betty, none of which would be subject to double taxation or payroll taxes. Jeff would form a new company. This new company would be structured to finance and manage the growth and expansion of the business. It would take the risks; it would reap the benefits. The old company would either employ Jeff as its CEO or it would contract with Jeff’s new company to provide top-level management. Appropriate provisions would be drawn to ensure that the new company does not adversely affect Wilson Inc.’s present operation and ensure that it has the latitude to both enhance the existing markets and expand into new ones. Preferably, the new company would be a pass-through entity, an S corporation, or a limited liability company. Jeff would select the entity form that works best for him. Earl and Betty would structure a gifting program to transfer their stock in the company and possibly other assets to their children, if and when they determine that they have sufficient assets and income to meet their future needs. These gifts, when made, would be planned to maximize the use of their annual gift tax exclusions and the unused gift tax unified credits of both spouses.
Earl and Betty’s wills or living trusts would be structured to leave each child an equal share of their estate. Jeff would have a preferred claim to the Wilson stock, which would allow for an eventual change of control, while Kathy and Paul would have a priority claim to the other assets in the estate. If it becomes necessary to pass some of the Wilsons’ stock to Kathy and Paul in order to equalize the values, the will or living trust would include a buy-sell provision that would give Jeff the right to buy the stock that is passed to Kathy and Paul, under stated terms and conditions. Jeff’s management rights would remain protected by the existing employment management contracts.
The ProsThis simple restructuring would offer a number of potential benefits.
First, since Earl and Betty retain their stock, they will have an income from the business for life; if that income grows beyond their needs, they will have the flexibility to begin transferring stock and the related income to their children and grandchildren, as they choose. Since the cash distributions would be stock-related distributions, there would be no unreasonable compensation risk nor would there be any payroll tax burden.
By virtue of the company having made the S selection, the income distributed to Earl and Betty each year would be pre-tax earnings, free of any threat of double taxation. As long as the corporation has sufficient current earnings to cover these distributions, this income will be taxed only once. No longer will a party be forced to make payments with after-tax dollars to another family member.
Next, Jeff’s management and control rights will be protected by the employment and management agreements. Earl can play as much or as little a role in the business as he chooses. The parties can scope their control and management agreement in any manner they may choose, free of any tax restrictions or limitations.
Jeff would be the primary beneficiary of the future growth in the business through the new business entity. The operating lines between the old company and the new company would need to be clearly defined. The goal would be to preserve the existing operation for the old company and its owners, primarily Earl and Betty, and to allow any new operations and growth opportunities in the company that is to be owned, financed, and operated by Jeff.
Any stock owned by Earl and Betty, at their deaths, receives a full step up in income tax basis.
Future increases in the value of Earl and Betty’s estate could be limited and controlled by three elements:
- The incentive employment management contracts with Jeff
- The new company owned, financed, and operated by Jeff
- A controlled gifting program, implemented by Earl and Betty
Finally, the income stream for Earl and Betty would be insulated for some or all of the financing risks taken by Jeff to expand into new markets. These financing risks would be in the new company, not the old one.
The ConsThere are limitations and potential disadvantages with such a restructuring approach, which would need to be carefully evaluated and might require some creative solutions.
First, Jeff may need the operating and asset base of the old company in order to finance the expansion efforts. Various factors could influence the issue, including the historical success pattern of the old company, the likelihood of future success, Jeff’s track record and expertise, and other assets owned by Jeff. If this situation exists, it may significantly complicate the situation. Workable alternatives are usually available, depending upon the flexibility of the lenders and Earl and Betty’s willingness to take some risks to help with the new financing. But clearly, this may be a complication depending on the circumstances.
The second potential disadvantage is the possibility that the value of Earl and Betty’s common stock in the old company may continue to grow with a corresponding increase in their estate tax exposure. There would be no automatic governor, no automatic limitation on the stock’s future growth and value. Hopefully, this growth fear could be mitigated or entirely eliminated with a carefully implemented gifting program, the operation of Jeff’s new company, and special incentives under the employment or management contracts.
Third, conversion to S corporation status likely would create additional tax challenges that often are regarded as serious nuisances, but not necessarily a reason for rejecting the strategy. Converting out of C corporation status is not a free lunch. There are various issues to deal with in the conversion process. Usually, the biggest issue is the potential impact of what’s called the "built-in gains tax," the big tax. This tax applies when an S corporation disposes of assets that it owned at the time of its conversion to S status, if the sale occurs within 10 years of the conversion. It’s an entity-level tax that is imposed at the maximum corporate rate of the built-in gain on the asset at the time of the conversion. This tax is an addition to the tax that is realized and passed through to the S corporation shareholders on the sale. Its purpose is to preserve, at least in part, for a period of 10 years, the double tax burdens of the corporation’s C existence.
To combat these challenges, it’s best to convert early and put as much distance as possible between the conversion date and any corporate asset sale. But note, in Earl’s situation, where the goal is to start pulling dividends out of the company on a regular basis that will not be subject to double taxation, the S corporation will work for this purpose from day one, so long as the current earnings of the S corporation are sufficient to cover the dividend distributions.
Oftentimes when this issue of S corporation conversion surfaces, the question is raised as to whether it’s possible to convert the C corporation to a limited liability company, which would be taxed as a partnership. It just can’t be done. The tax costs of such a conversion are prohibitive for almost everyone. The only option, in almost all cases, is an S corporation conversion.