Planning for Closely Held Business Owners

Question 1

Angel Investors

Answer 1

Angel investors typically form groups to provide equity financing to start-up companies.
Angels should be considered if the new business owner(s) cannot qualify for adequate bank financing, but still require outside financing.
Because angels can set their own terms, care should be taken when negotiating this financing.

Question 2

Venture Capital

Answer 2

provide financing for high growth companies in exchange for significant equity.
Generally funded by risk-tolerant private investors who seek high returns within a short period of time.
Typically strive for annual returns of at least 20% to 40% with investment periods ranging from three to seven years.

Question 3

Mezzanine Financing

Answer 3

a hybrid types of security, junior to venture capital and senior debt, often requires little to no collateral, equity conversion feature in case of default.

Question 4

What are 3 types of private equity?

Answer 4

Mezzanine capital.
Leveraged Buyouts (LBO).
Distressed or special situations.

Question 5

Leveraged Buyouts (LBO).

Answer 5

a method of acquiring a company with money that is nearly all borrowed. This allows investors to make a large acquisition without committing a lot of capital.
The acquirers of the target company often attempt to sell or take the target company public after five or ten years in the hopes of making sizable profits.

Question 6

Distressed or special situations.

Answer 6

investments in equity or debt securities of financially stressed companies.

focuses on investing in entities that are in default, under bankruptcy protection, or headed in that direction, investors must evaluate not only the ability for the entity to make a comeback but also which class of securities might be more beneficial to hold during a restructuring process.

Question 7

What is a restructuring?

Answer 7

mergers, acquisitions, divestitures, recapitalizations, leveraged buy-outs, reorganizations, downsizings, and other types of restructuring of a corporation.

Question 8

6 Succession and Exit Strategies

Answer 8

Private and public sales
Recapitalization
Employee stock ownership (ESOP)
Self-cancelling installment notes (SCIN)
Seller financing
Private annuities

Question 9

What structure is the ideal structure for a business desiring liability protection, corporate format, and flow-through taxation.

Answer 9

S corporation

Question 10

What are the S Corp requirements

Answer 10

100 or fewer shareholders
all shareholders must generally be either individuals who are U.S. citizens or residents, a decedent’s estate, certain types of trusts, or certain exempt organizations.

Question 11

IRC 1202 allows individuals to do what?

Answer 11

exclude 50% to 100% of the gain realized from the sale of qualified small business stock held for more than 5 years.

Question 12

What is the 1201 exclusion limited to?

Answer 12

limited to the greater of $10 million or ten times basis.

Taxable amount taxed at a maximum 28% rate.

Question 13

What are 6 typical Issues Covered by Buy-Sell Agreements

Answer 13

1. Control of ownership
2. Provide liquidity for ownership interests upon the occurrence of certain “triggering events”
3. Avoid “deadlock” among owners
4. Protect the business from competition from former owners
5. Establish value for estate tax purposes
6. Does not typically provide a mechanism for establishing or determining the best price

Question 14

What value is a big component of a business’s value and is estimated by capitalizing a future period’s expected cash flow, earnings or EBITDA ?

Answer 14

terminal value

Question 15

Capitalized Earnings formula

Answer 15

Valuation = earnings / (discount rate – growth rate)

Question 16

An investment property is expected to generate $5m in annual income. The discount rate is 15% and expected growth rate is 3.5%. What is the value of this property?

Answer 16

Valuation = $5m / (15% - 3.5%)
Valuation = $5m / (11.5%)
Valuation = $43,478,261

Question 17

Discounts & Premiums

Answer 17

1. Control Premium
2. Minority Interest Discount
3. Lack of Marketability Discount
4. Other Discounts

NOTE: Application of these discounts require detailed analyses of the facts and circumstances of the situation

Question 18

4 Structures & Strategies for sale to family

Answer 18

1. Installment Sales, Private
2. Annuities and SCINs
3. Trusts
4. FLP/LLC

Question 19

3 Strategies for sale to employees

Answer 19

1. Employee Stock Option Plan (ESOP)
2. Management Buyouts
3. Stock Appreciation Rights

Question 20

3 Strategies for sale to co-owners

Answer 20

• Buy-Sell Agreements
• Right of First Refusal
• Dutch Auction

Question 21

3 Strategies for sale to outsiders

Answer 21

• Recapitalization
• Private Auctions
• Public Offerings

Question 22

What tax benefits may be available if an ESOP purchases stock from an owner?

Answer 22

• The company can deduct purchase payments;

* The owner(s) can defer tax on the sale.

Question 23

taxable gain will not be recognized by a shareholder’s sale of stock to an ESOP if what requirements are met?

Answer 23

• The shares are “qualified securities”;

• Immediately after the sale, the ESOP owns at least 30% of the total value of all outstanding stock
and
• Qualified replacement securities are purchased by the seller within a 15-month period beginning three months before the sale date.

Question 24

What is a Self-Canceling Installment Notes

Answer 24

The sale of property in exchange for an installment note calling for a specified number of fixed payments at a specified interest rate over set period of time, but also provides that the note payments terminate upon the death of the seller

Since death terminates the seller’s right to receive
payments, there is nothing of value to include in the seller-decedent’s estate

Question 25

Is there gift tax on a self canceling note?

Answer 25

Nope, avoided because of the bargain-for consideration for the sale by placing a premium on the price or having an above the market interest rate.

Question 26

Is a SCIN included in the estate?

Answer 26

No

Question 27

What is a private annuity?

Answer 27

The business owner transfers ownership of the business to the family member in exchange for the transferee’s promise to make payments to the transferor for life

no gift tax cost, and the value of the annuity is not included in the annuitant’s estate

Proposed regulations taxing the transaction from its inception have obviously limited the appeal of the private annuity as a planning technique

Question 28

What is IRS Section 338 Election

Answer 28

Allows acquiring corporation to buy stock of the target company for “legal purposes” BUT allows this purchase to be considered a purchase of assets for “tax purposes”.

Question 29

What are the requirements for 338?

Answer 29

Only allowed by corporations (C-corps and S-corps)
Must be made jointly by seller and the buyer
Purchase must be considered at “qualified stock purchase”

Question 30

to qualify for 6166 requirements what percentage of the estate must be comprised of the business?

Answer 30

the interest in a closely held business exceeds 35% of the value of the decedent’s adjusted gross estate

Question 31

what does section 303 allow?

Answer 31

For qualified transactions, distributions in redemption of a deceased shareholder’s stock may be treated as a capital gain and not as dividends taxable at ordinary income tax rates

Question 32

when must a 303 redemption be made?

Answer 32

no later than 3 years and 90 days from due date of IRS Form 706, or 60 days after court decision if contested, or no later than allowed installment payments of estate tax due.