Designing an Internal Perpetuation Plan

January 12, 2004

Perpetuation planning should begin as soon as the business is acquired. While immediate action is not necessary, there should be initial consideration given to the process.

The four major techniques to transfer ownership of a business are:

• Internal sale to key employees, including family members.
• Sale of the business to an outside firm.
• Merging with another agency with plans to eventually sell to the new partners.
• Passing the ownership to family or friends through inheritance.

A quick review of these four techniques shows that a perpetuation plan can either be internal or external. One should be chosen as the primary plan and another as the secondary. This article describes internal perpetuation options.

The pros and cons
The successful internal transition of a business requires planning for the founding owners’ retirement, death or disability. Without a good plan, the fate of the business is up to the whim of outside influences, such as the courts. Also, the lack of any plan may create a situation that will drastically lower the equity or value of the firm, thereby not preserving the family wealth.

Internal perpetuation is usually the most risky form of perpetuation. Recent statistics indicate that only 35 percent of family businesses survive past the first generation of ownership and about 20 percent survive to the third generation.

There are many reasons why small businesses do not always successfully pass down through the generations. Sometimes no family member wants or is able to manage the business. Not
everyone is capable of running a business successfully. Not everyone is an entrepreneur capable of running a business successfully. This applies to non-family employees as well. Typically, however, internal perpetuation fails because the buyers cannot afford to handle the buy-out.

For an insurance agency, there are techniques that can be used to minimize taxes and ensure that the payout does not break the business. Like anything else that is worthwhile, these techniques require planning and usually reduce the retiring owner’s return on equity.

For many owners, however, the end results of successfully passing the business to the next generation are more desirable than the sales price or the payout terms.

Pass control efficiently
There are numerous options for passing the business to the next generation. The three most common are gifting, stock redemption and stock purchase. There are also many other tools, such as trusts, that add to the variations that can be used to transfer business ownership.

Which “tools” are used and how the transfer is structured is based on three things: minimizing taxes, making sure it is affordable and ensuring that the seller has an adequate income stream. It is important, however, that the sale must be treated as an arms-length sale in order to avoid the IRS perceiving it as a gift or a “bargain sale.”

Create a deferred liability
Establishing a deferred compensation plan is a tool one can use to lower the value of the firm in order to make the purchase affordable for the new owners. Deferred compensation is a way of saying that you are not currently receiving fair compensation for your current work and you plan to take it out at a later date.

The deferred compensation becomes a liability on the firm’s balance sheet, since it is a debt that must be paid. Because it is a liability, the value of the firm is lowered by that amount.

There are two uses for this plan:

(1) the owner’s deferred compensation, and
(2) a producer’s deferred compensation.

Owner deferred compensation
The firm needs to file with the state that it is establishing a deferred compensation plan. This should be done years in advance of
retirement. The plan can be funded or unfunded. However, for lowering the value of the firm it should not be funded. Since the deferred compensation is treated as regular compensation, it becomes deductible for the firm.

The retiring owner receives their equity in two components: the value of their business interest and the deferred compensation. The drawback is that the deferred compensation is taxed as ordinary income (currently up to 35 percent for federal taxes alone plus payroll taxes), whereas, the income from the sale of the
business is taxed as capital gains (which can be as low as a 14 percent rate for federal taxes).

Producer deferred compensation
In the insurance industry it is an acceptable practice for a producer to own their book of business. An axiom in business valuation is that you cannot sell what you don’t own. Therefore, producer owned books of business are usually excluded in the valuation of an agency. This technique can be used for relatives as well as non-related employees.

First, the producer/heir signs a regular producer contract as an employee of the agency. This contract includes a clause that allows the producer/heir to own the accounts they produce. This way the next generation is not paying for their own effort (the book produced) and the cost of buying the agency is effectively reduced.

The drawback to the retiring owner is that their equity in the business is reduced. On the other hand, taxes are minimized (due to the lower value), and the buy-out is less likely to cause a drain on the business. The heirs will also not resent having to pay for their efforts since their books are excluded from the value of the firm.

Gifting the stock
Individuals may give up to $11,000 (for 2003) 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 $22,000 annually to any number of recipients.
A child and their spouse can therefore receive up to $44,000 in stock per year, free of gift taxes.

Because the marginal federal estate tax brackets begin at 20 percent and go up to 49 percent for estates subject to tax, for every $11,000 given during lifetime, at least $2,200 and up to $5,390 of death taxes can be saved (as of 2003).

Perpetuating through a 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. Under such a plan, 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 thereafter by the seller of stock are taxable. The tax benefits derived by a corporate tax deduction are thus 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.

Perpetuation through a 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 clear 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. In addition, the sheer simplicity of this method is appealing though 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.

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 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:

(1) currently diversify a portion of the equity in the business without taxable event and without selling a controlling interest in the business,
(2) lock in valuable key employees with “golden-handcuffs,” and
(3) create a plan for the eventual sale of the rest of the stock, again without paying income tax on the gain realized from such sale.

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.

The owner of the business can then take the proceeds from the ESOP transactions and invest in a more liquid portfolio of assets outside of the business as a non-taxable event. In addition, if the sale and subsequent reinvestment of proceeds are properly structured, income taxes resulting from the sale stock can be deferred.

An ESOP can result in a mutually beneficial outcome: Employees receive an ownership interest in the company, which can boost morale and productivity, while you cash in part of your ownership interest on a tax-favored basis.

Setting up an ESOP can be fairly expensive. There is also a need for an annual valuation of the ESOP shares, which will add to the annual cost. Tax savings might outweigh expense for firms over a certain

The ESOP must be adequately funded so that vested employees who quit or retire can be bought out. This repurchase liability creates additional costs to the company above and beyond the annual loan

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 (this is permissible in an S corporation so long as the only difference is in voting rights). The donor can then give away substantially all of the equity without relinquishing the vote. Gifts of non-voting interests will generally be eligible for substantial valuation discounts.

In a typical (simplified) situation, parents trade 100 percent of their
company’s stock for a 1 percent class A interest and a 99 percent class B interest in the company. The ownership characteristics of class A and B stocks are identical, except that class A shareholders have the right to vote and class B shareholders do not.

Gradually, the parents transfer the nonvoting shares to their children, using their annual gift exemptions and unified credits and discounts to the stocks value. After a few years, the parents retain only
the 1 percent voting interest. In short, the parents retain control and the children receive value.

Any succession planning will take time and must include the advice of tax and estate planning professionals. Keep in mind that 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 well after they exit the firm. With the proper planning, owners can create a structure that will increase the chances that their business will be passed successfully to the next generation.

Bill Schoeffler and Catherine Oak are partners in the international consulting firm Oak & Associates based in Northern California. The firm specializes in financial and management consulting for national and international agencies, including valuations, mergers, acquisitions, clusters, sales and marketing planning, as well as perpetuation planning. For more information, call (707) 935-6565, or e-mail

Topics Property

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