Chapter 16
Structuring the transaction

At the outset, let’s be clear: There is no template or “cookie-cutter” approach for structuring a succession plan. Each plan is unique, and you should retain the services of a professional every step of the way. The purpose of this chapter is to help you understand the options that your attorney, CPA or other advisor may recommend.

Succession plans differ depending on which of the five succession planning methods you choose. Most of the following items relate to family and employee transfers. The issues involved in selling your business or going public are too involved for the scope of this book.

Buy-sell agreements
At a minimum, these four items must be in place: (1) key person insurance; (2) a buy-sell agreement; (3) a letter from the founder discussion key relationships and future direction; and (4) a will.

With one exception, each of these issues is either self-explanatory or has been discussed elsewhere in the book. One element that deserves more attention is the buy-sell agreement, which address a major complication to succession planning – multiple owners.

Businesses, including trucking companies, often have co-owners or partners, and usually each is involved in the company. Yet rarely can the owners answer these questions:

• What happens when one owner wants out?
• What happens when an owner desires to retire, becomes disabled, gets divorced, or worse?
• Would the company survive these events?

When one owner dies or otherwise is unwilling or unable to continue working in the business, the result usually is financial and operational turmoil. Owners are often too busy to deal with these contingencies in a buy-sell agreement and instead scramble to resolve these issues in the midst of a crisis.

Buy-sell agreements are legal documents, and you will need an attorney to draw one up. But your accountant also should be involved because the buy-sell anticipates buying one partner out and how the transaction will be financed.

There are at least five eventualities that involve an owner departing a business:

• Transfer of an ownership stake with one partner continuing the business;
• Disability of an owner;
• Retirement of an owner;
• Death of an owner, or
• Sale or dissolution of the company.

Your buy-sell should anticipate each possibility, and the financial obligations that would arise. Start by placing a value on your business as discussed earlier in the book.

The buy-sell first anticipates the death of one owner. Of course, cross-coverage of insurance makes the most sense, with each owner buying a policy on the other. Careful ownership planning is required to ensure that the beneficiary receives the policy tax free (see Chapter 17). Purchase more insurance than is needed solely for the buyout. Some companies add 25 to 50 percent, using the extra funds to help recruit and replace the lost partner’s talent. Insurance can also help cover disability, but you must buy it. A surprisingly large number of company owners overlook this critical insurance.

You obviously can’t buy insurance against a partner’s retirement, so this contingency requires planning at least 10 years before the anticipated retirement. A plan might set aside earnings into a fund or into permanent life insurance to help pay for the retiring partner’s interest. Or it may involve bringing in a new partner to buy out the retiring one.

The most challenging situation may be when an owner simply wants out. Plan for this contingency early through a buy-sell agreement.
One thing is certain: One of the events discussed above will happen eventually. Plan now while everyone is healthy and getting along. The longer you wait, the more likely the resolution will be costly and less than satisfying.

Tax planning
You can save the transfer taxes on your succession plan by paying attention to four areas – choosing the right legal entity for your business, paying taxes at a lower rate, delaying taxes and taking advantages of exclusions, deductions and credits.

Choose the entity
How you structure your business assets and operations has a significant impact on who ultimately pays taxes. In some structures, the corporation pays taxes, while the individual owners do not. In others, the reverse is true. There are five general categories of entities: Sole proprietorships; partnerships; limited liability companies or partnerships; S corporations; and C corporations. Here is a breakdown of the three types of entities that are most often used for trucking companies:

Limited liability company
• Formed by filing “Articles of Organization” and governed by an “Operating Agreement”
• Taxed as a partnership for income tax purposes Members, like corporate shareholders, not personally liable for the entity’s debts with the exception of personal guarantees
• Ability to make disproportionate profit/loss allocations and cash/property distributions
• Profit and loss may be subject to self-employment tax
• Allows for significant tax benefits on sale or transfer at death; assets may be stepped up to their FMV for the benefit of the
transferee and depreciated, to the extent possible
• Generally, assets may be distributed tax free

S corporation
• S shareholders elect to be taxed as a pass-through entity; election made on or before 2 1¼2 months at the beginning of the
corporation’s tax year
• Can have no more than 100 shareholders; can be expanded, however, as certain family members count as one shareholder
• Shareholders must be individuals, estates or certain trusts and tax exempt organizations
• Single class of stock; income and losses are allocated based upon pro rata stock ownership percentages; voting and nonvoting shares of the same class of stock are allowable
• Conversion from C corporation to S corporation is subject to a tax on built-in gains upon disposition of assets within the first 10 years from the date of election
• Shareholders are not personally liable for company debts with the exception of personal guarantees

C corporation
• Entity itself pays income tax from 15 percent to 35 percent ; earnings taxed twice – first at the corporate level then at the individual level for the dividends paid
• Shareholders are not personally liable for company debts with the exception of personal guarantees
• Unreasonable accumulation of earnings is subject to a tax
• Generally, the distribution of assets to a shareholder are subject to tax to the extent the FMV exceeds such assets’ adjusted tax basis

As you structure a succession plan, you may want to change entity types to better accommodate your plans and tax strategies. For example, if you choose to put an ESOP in place, you must either be an S corporation or a C corporation. Other examples include how you will transfer the assets to family members. You may want to start giving your real estate and office to your family and divide the trucking operations into a separate plan. You will want to know the best entities to hold real estate and your trucking business. Most likely they are different.

Lower the tax rate
There are various rates that apply to income taxes, including capital gains rates and ordinary income tax rates. There are various ways to structure transfers that push proceeds into capital gains rates that are lower than ordinary income rates. Capital gains rates became even more attractive several years ago when Congress enacted lower dividend tax rates that will be phased out in later years.

In this environment, you may want to consider how dividends play a role in your transfer. Your goal, of course, is to lower the tax rate of the proceeds. Note that C corporations have only one level of tax with multiple brackets with a maximum rate of 35 percent. There is no rate reduction for capital gains. Finally, every plan should take note of and incorporate the impact of the alternative minimum tax, which aims to ensure that taxpayers can’t avoid taxes altogether.

Delay the taxes
There are several ways to delay taxes for years or even permanently. Here are a few:

Installment method – The installment method is a special method of reporting gains from sales of property where at least one payment is received in a tax year after the year of sale. Capital gains are prorated and recognized over the years in which “principal” payments are made. Ordinary income from “depreciation recapture” is still recognized in the year of sale irrespective of the amount of cash received – if any.

Employee stock ownership plan (ESOP) sale – The owner of a closely held company can defer taxation from the sale of company stock to an ESOP, provided the ESOP owns a certain percentage of company shares after the sale. Sales proceeds must be reinvested in stock, bonds or other securities of U.S. operating companies.
Qualified stock rollover – An individual may elect to roll over the capital gain from the sale of qualified small business stock held for more than six months if the other qualified small business stock is purchased by the individual during the 60 day period after the sale.

Tax-free mergers – The IRS refers to tax-free mergers as reorganizations. When properly structured, they result in no immediate tax liability to the seller. The basis that the seller had in his stock in the former company becomes the substituted basis in the stock received through the merger. Partnerships (LLCs, LLPs) can generally merge tax free. However, individual members need to be aware of phantom income due to the relief of basis from debt if they have negative capital accounts.
Stepped-up basis at death – The basis of any property, real or personal, acquired from a decedent is its fair market value on the date of the decedent’s death, or at the alternate valuation date (six months later).

14-year election to pay estate taxes – An executor of an estate can elect to pay estate tax attributable to a closely-held business in installments over a maximum of 14 years. If the election is made, the estate pays only interest for the first four years, followed by up to 10 installments of principal and interest. To qualify, the family must continue to run the business.

Exclusions, deductions and credits
Here are a few ways that you can use the tax code to your advantage assuming that other items are in place such as type of entity, will, etc.:

50 percent small business gain exclusion – A noncorporate taxpayer can exclude 50 percent of any gain from the sale or exchange of “qualified small business” stock (C corporation with assets under $50 million) held for more than five years. The catch is that you have to find someone willing to buy the “stock.” Most purchasers want your assets and customer list. For liability reasons, they don’t want your stock.

Annual gift tax exclusion – As addressed in Chapter 15, an individual may give up to $11,000 per donee per year tax free.

Unlimited marital deduction – Also addressed in Chapter 15, upon death, the decedent can give an unlimited amount to his or her spouse.

Unified credit (now called the applicable exclusion amount) – Allows $1.5 million to be passed to a beneficiary estate tax free. Also, you can give a lifetime gift of $1 million and get the associated growth out of the estate. This is also discussed in Chapter 15.

Qualified Family Owned Business Exclusion – If more than 50 percent of the value of a decedent’s estate consists of a qualified family owned business, the executor can make special elections to exclude a certain portion of value from the estate.

Employee Ownership
As discussed in Chapter 7, an ESOP is a mechanism to sell your shares to the employees through a structured purchase. The employees are represented by a trust that purchases the shares of stock on their behalf and acts as their representative. Each ESOP has different rules, but in general the employees can cash in their share of stock when they retire, assuming they are vested.

You are paid immediately for your shares and the tax treatment on that payment is different depending on how it is structured. There is the opportunity to defer the taxes as discussed.

The administration of the ESOP is handled by the trustee and involves a fair amount of paperwork. The amount is not prohibitive, but it requires an annual business valuation and other administrative details pertaining to vesting and employee accounts.