Founders and entrepreneurs face many pressure points while building their company into their vision. Important decisions must be made relating to the choice of a business entity, how to fund the business, what sort of regulations impact the business, how to protect intellectual property, how to manage employees, and what to do if sued. Most of these points focus on the business.
As Founders are busy building their business and working towards success, they often overlook their personal estate planning. Founders are not alone in avoiding this topic – as few people enjoy considering what happens to their assets upon incapacity or death. Founders have unique needs that necessitate proactive estate planning as early in a company’s existence as possible in order to minimize tax consequences and maximize liquidity options. In order to simplify estate planning and encourage Founders to focus, estate planning for Founders should be broken down into the following segments:
Segment I: Core Planning.
Segment II: Business Continuity and Liquidity.
Segment III: Advanced Wealth and Transfer Strategies.
This article will detail each of the segments that all Founders should consider. Although presented in numerical order, we find that Founders are often driven into a particular segment that meets their personal situation. We note that once a Founder starts a segment, it almost always makes sense to consider the other segments as well.
Segment I: Core Planning
Core estate planning answers the question of what happens to the business and your other assets at death – including who controls those assets (the fiduciaries), who receives the assets (the beneficiaries), and how much tax is paid. Core estate planning involves putting together a well-constructed set of wills and revocable trust agreements that capture the available exemptions from state and federal estate taxes, protect your children’s inheritances from “creditors and predators” and name appropriate individuals or institutions to manage your estate after your death. This phase also includes setting up simple documents that appoint individuals to manage your financial and personal affairs in the event of your incapacity, including a living will and power of attorney.
Under current law, everything you own is subject to federal estate tax, and potentially state estate tax as well. Every person is entitled to an exemption from federal estate tax – that exemption is currently $11,180,000 (note that the exemption increases every year). The federal estate tax rate is currently 40 percent on the assets in excess of the federal exemption (reduced by any taxable gifts made during your life).
Even though the tax exemptions seem large, it is important for Founders to engage in estate planning that minimizes the taxes’ impact, especially since a startup’s value can grow rapidly over a short period of time. A married Founder’s estate plan can be carefully crafted to delay tax until the death of the survivor of the Founder and the Founder’s spouse.
Segment I planning also includes incapacity planning. If you become incapacitated and no planning has been done, your family may be forced to go to court to obtain the appointment of a guardian or conservator to manage your financial and personal affairs. This result can be avoided in almost all cases through power of attorney and health care proxy naming your spouse or other individual to make financial and health care decisions in the event of your incapacity.
Upon completion of Core Planning, a Founder will have created tax efficient wills and revocable trusts, considered asset protection planning for a spouse and children, and appointed fiduciaries to administer your estate and continuing trusts.
To us, Core Planning is the minimum amount of estate planning a Founder should complete. The Core Plan helps educate Founders on the planning, taxes and asset protection. The Core Plan ensures that the Founder is able to select the correct fiduciaries to manage his/her estate upon death and that the intended beneficiaries benefit from the Founder’s success. The Core Plan can, and should, change with time.
Segment II: Business Continuity and Liquidity
While Segment I planning is essential for everyone, Segment II planning addresses the unique needs that Founders have regarding business continuity and liquidity. With regard to continuity, it is often appropriate for Founders to consider a buy-sell agreement, which is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest upon the occurrence of certain events described in the agreement (the so-called “triggering events”). The buy-sell agreement’s primary objective is to provide for the stability and continuity of the startup in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer of ownership to unwanted third parties by setting forth how, and to whom, shares may be transferred. The agreements also usually provide a mechanism for determining the sale price for the shares and how the purchase will be funded.
Because a startup is built from nothing, it is often important to a Founder to maintain control while providing for a smooth transition to his chosen successors upon his death or disability. Structuring a buy-sell agreement provides a nonthreatening forum for the Founder to begin thinking about who should manage the startup in the future. By specifically carrying out the Founder’s intent, a properly structured buy-sell agreement avoids the inevitable disputes between people with competing interests. If the Founder becomes disabled or retires, a buy-sell can provide him with the security that his case flow won’t disappear, as the agreement can provide for the corporation and/or the other shareholders to purchase the shares, at a predetermined price, either in a lump sum or installments, typically at preferable capital gains rates.
Funding a buy-sell agreement is essential to its success, but that requires liquidity. Life insurance is an extremely common and effective funding choice. Whether owned by the business in a redemption agreement or by the other shareholders in a cross-purchase agreement, it provides the purchasers with the ability to guarantee a certain amount of money will be there when the Founder dies—as long as premiums are paid. The type of life insurance typically purchased in the startup context is some form of permanent insurance (such as whole life, universal life, or variable life) rather than term insurance, which gets more expensive as the insured ages and may not be able to be renewed beyond a certain age (usually between 60 and 70 years of age).
There are downsides in certain circumstances to using life insurance in this manner. As mentioned, if a cross-purchase agreement is chosen and there are more than two shareholders, each shareholder will need to purchase a life insurance policy on every other shareholder (unless a partnership is established to own the insurance). Additionally, life insurance doesn’t solve the funding problem for transfers while the Founder is still alive.
In addition to providing liquidity to the business, liquidity may also be important for the Founder’s beneficiaries. If significant wealth is tied to the business, the Founder’s beneficiaries may have little to no access to liquid funds upon the death of a Founder. The most common strategy to deal with this lack of liquidity is to purchase life insurance. As noted above, there are several types of life insurance available. In addition to the type of insurance, a Founder should consider whether it is recommend to own the life insurance policy inside an irrevocable life insurance trust in order to remove the proceeds of such policy from the Founder’s estate for tax purposes.
Aspects of Business Continuity and Liquidity are often addressed in the business’ governing documents. However, as the business grows, partners enter the business and investors come and go – these documents should be reviewed on a regular basis. The liquidity concerns of the Founder should also be regularly reviewed.
Segment III: Advanced Wealth and Transfer Strategies
Generally, Segment III planning involves the transfer of assets out of your estate to shelter them from estate tax. Although we often encourage clients to at least consider Segment I planning first, often a business is about to “pop” in value – this “pop” offers a great opportunity for tax planning. In those circumstances, Advanced Wealth and Transfer Strategies is often the initial introduction to estate planning.
If an individual attempts to transfer assets during life in order to avoid an estate tax, the transfer will generally instead be subject to a federal gift tax. Since the gift tax and the estate tax apply at the same rates and generally have the same exemptions, there should be no incentive for an individual to transfer wealth during life as opposed to waiting to transfer it at death. In effect, by enacting the gift tax as companion to the estate tax, Congress created an “airtight” transfer tax system. There are, however, leaks in that system. The three primary examples of the leaks in the system are: removing value from the system; freezing value within the system; and discounting values within the system.
Removing value from the transfer tax system is hard to do and takes time. In most cases, if an individual makes a gift during lifetime, that gift is brought back into the taxable estate at death. However, there are two exceptions to this general rule, which are the annual gift tax exclusion and the “med/ed” exclusion. If an individual makes a gift using his or her $15,000 annual gift tax exclusion, the gifted property is entirely removed from the taxable estate. Individuals are also permitted to make gifts of unlimited amounts for tuition and certain medical expenses, as long as the payment is made directly to the provider of services. Such med/ed gifts are entirely excluded from the taxable estate.
Removing value is done over-time and is a consistent theme for Founders in their estate planning. However, the real benefit of a business “popping” in value is in the freeze and discount strategies. Freezing value within the system usually connotes the individual making a gift using some or all of his or her lifetime exemption from federal gift tax. For example, you might make a gift of $5 million worth of stock to a child. Upon your death, the $5 million gift is actually brought back into your estate for purposes of calculating your estate tax. However, it is only brought back into the estate at its value at the time the gift was made and is sheltered from tax at that time via the use of your $5 million estate tax exemption. Accordingly, if the value of the gifted property increases between the date of the gift and the date of your death, the appreciation avoids transfer tax. In other words, you succeed in “freezing” the value of the gifted property at its date-of-gift value.
A holy grail of estate planners has been to find a way of freezing the value of an asset at some number lower than what it is actually “worth” to the gift-giver’s family, also known as “discounting” values. Suppose an individual owns all of the stock in a business with a total value of $10 million. If the individual gives all of the stock to her child, she will have made a taxable gift of $10 million. On the other hand, suppose that the individual gives 10% of the business to five people. An appraiser is likely to opine that the interests received by the individuals are subject to lack of control and lack of marketability discounts, since none of the recipients can easily control or transfer the entity. If the appraiser applies, say, a 30 percent discount for the lack of marketability and control, the value of the gift would be reduced to $3,500,000.
Accordingly, the Founder succeeds in freezing values at something less than the entity value of the business in the eyes of the family as a whole.
Founders generally use one of two strategies when planning for a “pop” in value – both strategies utilize both the freeze and discounting tactics discussed above – Grantor Retained Annuity Trusts (GRATs) and Sales to Intentionally Defective Grantor Trusts (IDIT Sale).
Grantor Retained Annuity Trust
A GRAT allows an individual to give assets to a trust and retain a set annual payment (an “annuity”) from that property for a set period of years. At the end of that period of years, ownership of the property passes to the individual’s children or trusts for their benefit. The value of the individual’s taxable gift is the value of the property contributed to the trust minus the value of his right to receive the annuity for the set period of years, which is valued using interest rate assumptions provided by the IRS each month. If the GRAT is structured properly, the value of the individual’s retained annuity interest will be equal or nearly equal to the value of the property contributed to the trust, with the result that his taxable gift to the trust is zero or near zero.
How does this benefit the children? If the assets contributed to the GRAT appreciate and/or produce income at exactly the same rate as that assumed by the IRS in valuing the individual’s retained annuity payment, the children do not benefit, because the property contributed to the trust will be just sufficient to pay the individual his annuity for the set period of years. However, if the assets contributed to the trust appreciate and/or produce income at a rate greater than that assumed by the IRS, there will be property “left over” in the trust at the end of the set period of years, and the children will receive that property–yet the creator of the trust would have paid no gift tax on it. The GRAT is particularly popular for gifts of hard to value assets such as business interests, private equity and hedge fund interests because the risk of an additional taxable gift upon an audit of the gift can be minimized. If the value of the transferred assets is increased on audit, the GRAT can be drafted to provide that the size of the individual’s retained annuity payment is correspondingly increased, with the result that the taxable gift always stays near zero IDIT Sale
A GRAT is often compared with a somewhat similar technique, known as the IDIT Sale. The general IDIT Sale concept is best understood by means of a simple example. An individual makes a gift to an irrevocable trust of, say, $100,000. Sometime later, the individual sells assets to the trust in return for the trust’s promissory note. The note provides for interest only to be paid for a period of, say, 9 years. At the end of the 9th year a balloon payment of principal is due. There is no gift because the transaction is a sale of assets. The interest rate on the note is set at the lowest rate permitted by IRS regulations.
How does this benefit the individual’s children? If the property sold to the trust appreciates and/or produces income at exactly the same rate as the interest rate on the note, the children do not benefit, because the property contributed to the trust will be just sufficient to service the interest and principal payments on the note. However, if the property contributed to the trust appreciates and/or produces income at a rate greater than the interest rate on the note, there will be property left over in the trust at the end of the note, and the children will receive that property, gift tax free.
Economically, the GRAT and IDIT Sale are very similar techniques. In both instances, an individual transfers assets to a trust in return for a stream of payments, hoping that the income and/or appreciation on the transferred property will outpace the rate of return needed to service the payments returned to the individual. Why, then, do some clients choose GRATs and others choose IDIT Sales?
The GRAT is generally regarded as a more conservative technique than the IDIT Sale. It does not present a risk of a taxable gift in the event the property is revalued on audit. In addition, it is a technique that is specifically sanctioned by the Internal Revenue Code. The IDIT Sale, on the other hand, has no specific statute warranting the safety of the technique. Unlike the GRAT, the IDIT Sale presents a risk of a taxable gift if the property is revalued on audit and there is even a small chance the IRS could successfully assert that the taxable gift is the entire value of the property sold rather than merely the difference between the reported value and the audited value of the transferred property. Moreover, if the trust to which assets are sold in the IDIT Sale does not have sufficient assets of its own, the IRS could argue that all of the trust assets should be brought back into the grantor’s estate at death.
Although the IDIT Sale is generally regarded as posing more valuation and tax risk than the GRAT, the GRAT presents more risk in at least one area in that the grantor must survive the term of the GRAT in order for the GRAT to be successful; this is not true of the IDIT Sale. In addition, the IDIT Sale is a far better technique for clients interested in generation skipping planning. The IDIT trust can be established as a Dynasty Trust that escapes estate and gift tax forever. Although somewhat of an oversimplification, the GRAT generally is not a good vehicle through which to do generation skipping planning.
Spousal Lifetime Access Trust
When using either a GRAT or an IDIT Sale, we encourage our clients to also consider a Spousal Lifetime Access Trust (SLAT). In addition, the SLAT is often the remainder beneficiary of the GRAT or IDIT transaction. A SLAT can remove, freeze, and discount values all in one fell swoop. In a typical SLAT, an individual creates an irrevocable trust, naming her spouse or some other trusted individual or institution as trustee. During the life of the individual and her spouse, the trustee is authorized to sprinkle income and principal among a class consisting of her spouse and descendants. Upon the death of the survivor of the individual and her spouse, the remaining trust assets are divided into shares for descendants and held in further trust. The SLAT provides several benefits. The individual’s gifts can qualify for the gift tax annual exclusion if the trust is designed properly. This removes value from the owner’s estate. If desired, the owner could use the trust as a repository for a larger gift utilizing her lifetime gift tax exemption, thereby freezing values for transfer tax purposes. Moreover, depending on the type of asset gifted to the trust, it may be possible to apply valuation discounts as well.
Beyond being a good vehicle through which to remove, freeze, and/or discount values for tax purposes, the SLAT provides a number of other benefits. The trust includes the grantor’s spouse as a beneficiary. Although the grantor can never have any legal right to the assets held in the SLAT, and neither can there be any prearrangement or understanding between the grantor and her spouse that the grantor can use assets in the trust, if the grantor is in a happy marriage, it nonetheless can be comforting to know that her spouse will have access to the property in the trust even after the gift. As an additional benefit, the SLAT would be established as a “grantor trust” for income tax purposes. This means that the creator of the trust would pay income tax on the income and gains earned by the trust. This depletes the creator’s estate, and enhances the value of the trust, but is not treated as a taxable gift, in effect providing a very powerful additional means of removing value from the transfer tax system. Finally, the SLAT can be structured as a “generation skipping transfer tax exempt trust” (also known as a “Dynasty Trust”), thereby removing the gifted assets from the transfer tax system for multiple generations.
Although a Founders’ personal and business life can be complicated and stressful, we find that breaking a Founders’ personal estate planning into three key segments allows the Founder to focus on what is important to them and take strong steps towards successful estate planning. We welcome the opportunity to discuss which segment is most relevant to your current personal and business situation while determining your estate planning needs.
This article is part of a series called, “Legal Issues for High-Growth Technology Companies.”