Wealth Harvesting: More Than Just Retirement or Succession Planning
EXECUTIVE SUMMARY
The first step in developing a wealth harvesting plan is to identify the client’s departure objectives, focusing on four categories: providing for the client and the people and causes they care about; ensuring a smooth and successful succession; protecting assets; and developing tax-smart strategies.
It takes a variety of expertise to help create a wealth harvesting plan. In addition to the CPA, the team should include someone with a good working knowledge of the company’s operations; a finance person; an estate planning and transactional attorney; experts in valuation, insurance and compensation; and, often, a trusted friend of the client.
Priorities should be established according to the client’s most important personal and business objectives. It is important to manage the client’s expectations at the outset by dividing the project into discrete tasks.
Presenting a worst-case scenario of what would happen in the event of the client’s sudden death can sometimes be the best way to motivate the client to act. Without planning, for example, the client’s company may have to be sold to pay estate taxes.
Solving the larger, more personal issues will help the technical aspects of tax and retirement planning fall into place.
Some solutions the client may wish to consider as part of a wealth harvesting plan include executing a buy-sell agreement, establishing a grantor trust, and creating a more sophisticated compensation structure.
Adam Snyder, is a freelance business writer and the author of a number of business books and articles on accounting issues. His e-mail address is snydera@optonline.net.
Harry Golucki is beside himself. After spending the better part of four decades building the Nevada Manufacturing Company (NMC) into a consistently profitable $6 million business, at the age of 67 he is ready to retire and enjoy himself with Happy, his wife of 40 years. But he is feeling overwhelmed with the choices he faces. For example:
How can he leave the company to his son and daughter, who have been working there full time since college, and still maintain enough personal cash flow to maintain his current lifestyle?
How can he be fair to his third child, who has never had any interest in being involved in the family business?
What can he do to be sure that the company is able to retain certain key employees after his retirement?
How can he do all this in a way that allows his children, upon his death, to avoid selling the company to pay estate taxes?
Jeff Saccacio, the head of wealth planning for Deutsche Bank Private Wealth Management’s Western Region, helps people like Harry and Happy answer these questions. “Imagine if, in your capacity as Harry’s CPA, he asks you to develop a plan for his retirement and continued compensation, succession at his company, and estate planning,” Saccacio says. “The job is much more than retirement or succession planning. That’s why it really should be called wealth harvesting.”
For the past three summers, Saccacio has been a part of a panel on closely held business succession planning at the AICPA’s Advanced Estate Planning Conference. At the conference, moderated by David Johnson, a principal at Ernst & Young LLP in Cleveland, Johnson and his team of experts use a case study like Harry and Happy’s as a way, in a single morning, to cover all the important personal and business issues that need to be considered for a small business owner to develop an exit strategy.
DEPARTURE OBJECTIVES
Johnson and Saccacio agree that the first step in developing a wealth harvesting plan is to identify the client’s departure objectives. To encourage his clients to think about the answers to the most difficult questions, Saccacio has created a detailed “Wealth Harvesting Questionnaire.” He also uses the acronym “PSST!” to help clients organize their thinking.
P = providing—For themselves and the people and causes the entrepreneur cares about.
S = stewardship—For years, the entrepreneur has controlled the family’s wealth. How, if, and when does he want that to change? Who does he want to control the company after he has exited?
S = safety—How can harvested wealth, including the company, be protected from potential creditors, everyone from the disgruntled spouse of a divorced family member, to someone suing a family member after slipping on the ice in front of their home?
T = taxes—Every financial strategy needs to be tax-smart.
ASSEMBLING THE TEAM
Wealth harvesting is a complicated business, a fact made evident by the variety of expertise that needs to be represented on the team that will ultimately help propose a solution. The group will typically include:
The CPA, who will act as quarterback.
The company’s CFO, or someone else with a good working command of the company’s operations and numbers.
A finance person, most frequently a banker who has worked with the company in the past.
An estate planning and transactional attorney. Often these are two people, although sometimes one attorney will have the dual expertise.
A valuation expert, who will be able to put a value not only on the company but on any real estate or other assets held by either the company or the entrepreneur personally. In the case study, for example, Harry and the company own valuable patents.
An insurance expert.
A compensation expert.
A trusted friend who has Harry’s ear. This person will likely be the group’s X-factor, either your biggest impediment or your most important ally.
ESTABLISHING FACTS AND PRIORITIES
In addition to assembling a team of experts, another important early step in developing any wealth harvesting strategy is to establish the facts. Since the entrepreneur’s most important concern is likely to be maintaining the cash flow necessary to retire in comfort, part of this task will involve quantifying his current cash flow and assets. In Harry Golucki’s case, for example, his annual salary and bonus together are about $1.5 million, but NMC has also been providing his health insurance, golf club dues, and a generous expense allowance. He also has a net worth of about $37 million, which includes his 90% share in NMC, his retirement savings, and equity in two homes, but does not include several patents he owns that are used in the company’s manufacturing process. Other “facts” also need to be quantified.
Exhibit 1 outlines most of the issues that need to be resolved in any wealth harvesting plan.
GETTING STARTED
At this year’s Advanced Estate Planning Conference, July 28–30 in Chicago, Johnson and Saccacio are to be joined by Steve R. Akers, who directs the Southwest Region of Bessemer Trust’s family estate and legacy planning practice. Akers, an attorney with 31 years of experience in estate planning and probate law, believes that sometimes the CPA’s toughest job is to motivate the client to act.
“Deciding what to do with a closely held family business is a difficult process and not particularly fun,” Akers says. “Sometimes these initial meetings can become quite intense. I’ve heard of situations where the couple wanting to retire sit in the back of the room and listen to their children quibble.”
Saccacio warns that entrepreneurs tend to be suspicious of large groups of professionals, and that “often the business owner’s biggest fear is that he will go through the whole process, and all he’ll have to show for it is a big bill.” He suggests that the solution lies in managing the entrepreneur’s expectations, and the best time to do that is at the outset. “The engagement letter can define that the CPA will be the team coordinator, and map out the components of the process that will be billed,” he explains. “Dividing this massive succession process into discrete project tasks can allay a lot of fears.”
BUY–SELL AGREEMENT
One way to motivate the entrepreneur is to spell out what would happen if the business owner suddenly dies. “Often this helps spur the owner to action, because he learns that the consequences of inaction are so horrific,” says Akers. “Without planning, the company may even have to be sold in order to pay estate taxes.”
In Harry’s case, for example, virtually all of his net worth is wrapped up in the family business, organized as a C corporation. With assets of about $37 million, in the event of their untimely death their estate’s tax bill would be almost $13 million, even with Harry and Happy each taking their $2 million exemptions.
One typical solution is a buy-sell agreement, which is simply a binding contract between business partners or shareholders about the future ownership of the business. It controls business decisions, such as who is allowed to purchase a departing shareholder’s share of the business and at what cost, and what events will trigger a buyout. A buy-sell agreement protects the company not only from the consequences of an entrepreneur’s and spouse’s deaths, but from other life events, such as a divorce of one of the children. Often such an agreement will be funded by a life insurance policy, which will provide the business owner’s heirs the funds to buy the company upon his death. Typically, the policy will be placed in an irrevocable life insurance trust (ILIT) as a way to keep the proceeds of the policy outside of the estate, and thus free of estate and income taxes.
Akers emphasizes the importance of placing a fair value on the company at the time the buy-sell agreement is executed. A number of court cases, as well as IRC § 2703, have held that a buy-sell agreement that sets a price lower than fair market value will be disregarded for tax purposes.
SELLING THE COMPANY
Ultimately, the family business owner will realize that his successful retirement inevitably comes down to selling the company, either to insiders or outsiders. “Most business owners start with wanting to keep the business in the family,” Saccacio explains. “But that makes leaving the company with a good management team all the more critical, because if you sell to insiders, they rarely have the money to give you up front. But what if Harry could get a better deal, not only for himself, but his family, by selling it to an outsider? Will the children have a productive life if the parents go for the money? These are very serious, personal questions, but ultimately the ones that will determine the wealth harvesting plan that the team recommends.”
One way or another, any wealth harvesting plan must fulfill Harry’s primary objectives—maintaining adequate cash flow and financial security for him and Happy. That can be accomplished in a variety of ways, including an outright sale of the company to a third party or to an employee stock ownership plan (ESOP). In many instances, however, cash flow is created through some kind of retirement or severance payment, or even through a consulting contract. Saccacio warns that facts and circumstances must justify any large payments to maintain their deductibility. “It is not unusual for entrepreneurs to forgo salary during their work life, which can make the case for a large payout for past performance reasonable from a compensation perspective,” he explains.
GRANTOR TRUSTS
Once Harry is satisfied he has met his support needs, a good strategy for shifting large amounts of appreciation from Harry and Happy to their kids with minimal or no gift tax is through the establishment of either a grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (IDGT). In exchange for a regular payout, Harry can transfer a substantial part of his ownership of NMC into one of these grantor trusts. This freezes the value of the assets “transferred,” while shifting posttransfer appreciation to family members. Ideally, the assets will “explode” in value. As long as the post-transfer appreciation significantly outpaces the payments back to the owner, this will maximize the wealth shifted to others in a tax-efficient manner. In Harry’s case, he could transfer a block of his shares of NMC into a grantor trust in exchange for a regular payout.
While either a GRAT or IDGT can be used to provide cash flow to the client and a tax-efficient transfer of ownership, the choice of strategy often depends on who will ultimately benefit from the assets transferred. A GRAT typically works best to shift wealth from one generation to the next, while an IDGT is specifically used for multiple generations.
Saccacio says it is important to include appropriate language in the trust document if the planning objectives are to be achieved. “The language used not only impacts achievement of the desired tax treatment, but also how and when trust assets are enjoyed, protection of the assets from creditors, and the ability to address changing circumstances throughout the lives of the beneficiaries. It’s the age-old case of the devil being in the details.”
SUCCESSION PLANNING
One of the most difficult decisions an entrepreneur seeking an exit strategy will have to make is to determine who will succeed him in running the company that has been his life’s work. “This is the part of the succession plan that can be most challenging because of the issues it forces to the surface,” says Johnson. “In many respects, it is often more difficult dealing with compensation issues for growing closely held businesses than it is for Fortune 500 companies.”
The issue a wealth harvesting plan most often forces to the surface is how the entrepreneur wants to treat his or her children. In Harry’s case, for example, he has expressed a desire to treat his three children equally. But the CPA will have to determine precisely what he means by that. “Fair and equal are not the same thing,” notes Saccacio. “Is it fair for Harry Jr., who is not involved in the company, to benefit equally from the company’s success? Perhaps a high-water mark needs to be established, over which Harry Jr. will share equally. These are all issues that have to be explored with the client.
“Being involved in sales or operations doesn’t necessarily equip either of his children to lead this company,” Johnson warns. “The other concern is that, in my experience, two family members running a family business doesn’t always work. Harry’s comfort level in retirement is to a great extent going to depend on the company remaining stable and successful. If he ends up getting his compensation from a company that is spiraling downward, none of this will have been worthwhile.”
In most companies, there are also non–family key employees vital to the continued success of the business. In NMC’s case, two employees who have helped Harry develop certain engineering innovations each own 2% of the common stock. Potential buyers would almost certainly view their retention as an integral part of any acquisition.
One of the most important decisions Harry will have to make is to identify those key employees who can be leaders and managers going forward, and to be honest about their capabilities and weaknesses. “The question Harry needs to answer is how to be certain they are properly motivated to stay once he retires,” Johnson points out. “There is often tension among these key employees concerning what have they been promised and what the business is worth without them.”
In many cases, there also might be a need for outside hiring, which creates an entirely new set of tensions among family members and key employees. “Anyone you bring into an organization in a key leadership position is going to want a piece of the action,” explains Johnson. “For all these reasons, it is time for this company to get more sophisticated about its approach to compensation. You don’t want to end up negotiating with outside people and then creating a reverberating effect with current employees asking, ‘Why didn’t I get that deal?”
Johnson says a competitive compensation structure needs to be developed instead so that at least a piece of the total package for any new top employee is self–funding. He suggests, for example, an incentive structure that mirrors the ownership of stock but which is a cash equivalent, and therefore does not disrupt legal ownership of shares.
Akers notes that these so-called “soft issues”—the entrepreneur’s continued financial interest in the business, how to treat the children and key longtime employees, and naming a successor—are actually more difficult than working out the technical aspects of tax and retirement planning. “Financial and tax strategies tend to fall in place once the big issues are settled,” he says. 
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