Leading Companies Online Magazine Archives
Getting Some Estate Planning Help From Your Employees
By
Anthony I. Mathews, Beyster Institute Staff
It is sometimes difficult for consultants to remember, but the truth is, no one ever woke up in the morning in a cold sweat with a panicky need for an ESOP, or a Charitable Remainder Trust, or a life insurance trust, or for any other among the basket of tactics that are currently available under the tax laws. What keeps people up at night is not the need for complex financial strategies for their own sake, but rather the need for security for themselves and their families, the desire to leave a legacy they can look to with pride, and the chronic worry that all they have built is constantly at risk.
Often, though, those who are commissioned with the responsibility to help people find answers to these worries are trained in specific tactics that fall within their specialty and, in fact, earn their living selling those specific tactics as well. To paraphrase Mark Twain, "When one sells hammers, every problem they see looks like a nail." If you happen to be building a shed out back, you may be fine to start your preparation with a hammer salesman, but even then it might make more sense to start with an architect.
So, the moral so far is - if you want an overall strategy that will help with your real worries, you need to start with an understanding of what those worries are for yourself (which is not as easy as it sounds) and then seek the help of someone who's willing to take the broadest possible look at how those worries might be addressed.
In general, what is needed is not any specific tactic for financial planning, but rather an overall strategy that addresses all your worries. And let’s not forget the worries of all the other people around you who are also important to you – spouses, children, communities, associates, employees and others all have objectives that may be very important to you as well. So, most often, what is needed is a varied and seemingly unrelated group of tactics that, in combination, address the real substance of your worries and theirs.
Let’s take a quick example that will illustrate this process. Jim and Mary Jones are owners of a small business worth around $10 million. They have three children: Joe, who works in the business as the general manager; John, who is in graduate school studying archeology and not interested in the business at all; and Melissa, who is married to a dentist and busy raising grandchildren. Jim and Mary are in their late 50s and are very active in their community. They serve on the advisory board of their local children’s hospital and participate in numerous civic activities, and they also like to travel and see the world. Like so many people in their position, they have done very little planning.
What are their real worries, then? Well, most often their list of worries will include: creating a secure income for them for their lifetimes; finding an equitable way to leave as much as possible for their children and grandchildren after they are gone; making a difference in their family’s life today; continuing their legacy of support for the children’s hospital; taking care of the employees who have worked beside them for all the years they have been building their business; seeing their business carry on after them; and so on.
A plan that is right for Jim and Mary will have to address all these concerns and it is entirely possible to do so if they take a broader view. In part, this broader view is called estate planning, but really this process is just organizing the parts of life that can be controlled to address what you really want to accomplish. Their overall strategy needs to create a stream of income for them for their lives and to create liquidity in their estate sufficient to fund all those other objectives while keeping in mind the values that are so important to them: family and community and service.
And that’s where the government can actually help. As we all know, our Federal government has a long-standing and very interesting way of inspiring particular behaviors. Anything they want us to do becomes a tax benefit (like a deduction or a credit). And, conversely, anything they want us to stop doing becomes more heavily taxed (like with an excise tax or tax penalty).
Relevant to this discussion, it is clear from reading the tax shorthand that the government wants to encourage long-term financial planning for its citizens. It is also clear that the government is very interested in helping employees secure ownership interests in the companies they work for (mostly through ESOPs as we have discussed many times in the past). It is even clearer that the government is interested in incentivizing the better off among us to subsidize the less fortunate through charitable giving.
Though those interests may not seem to directly relate to Jim and Mary’s estate planning needs, they do come together in some very interesting ways. Working together, tax and other benefits attached to insurance products, charitable trusts, ESOPs and others can provide Jim and Mary with a strategy that meets most of their goals, but none of these tactics can do it alone.
To begin with, an estate plan for Jim and Mary that might put several of their worries to rest could include a Charitable Remainder Trust (or some similar instrument like a family foundation). These charitable trust instruments would allow Jim and Mary to promise a large part of their estate to help fund the future operation of the children’s hospital and in return for that promise, the charity (the hospital in this case) agrees to allow them to take a specified amount of income out of the trust each year in order to support them as long as they are alive. When both of them have died, the balance of the trust goes to the charity.
What most complicates implementation of this sort of estate plan is illiquidity. There is no doubt that they have accumulated considerable wealth in their lifetimes, but a large part (in their case virtually all) of that wealth is nested in a closely held company and is, therefore, not easy to use. A charitable trust is not going to be able to provide them with a life income based on an ownership interest in a closely held company. Unless the charity can get access to underlying value of the business, it just won’t work economically.
That’s where an ESOP might come in. If they were to combine the charitable remainder trust with an ESOP and its ability to allow either Jim and Mary or the trust to liquidate all or part of the business without paying any federal or state capital gains taxes as well as to pay off any debt associated with the liquidation in pre-tax dollars, another set of their worries is addressed. The charity will have liquid assets to fund the trust so they can invest that and guarantee the life income Jim and Mary need. The company can continue to operate and provide jobs for the employees that have helped to build it. The future growth of the company can make for a much more secure future for all the employees as well. And there is one other significant benefit of using this liquidity method: the use of ESOP debt has the effect of reducing the value of the overall company.
Now, there aren’t many times when reducing the value of an asset is a good thing, but one is when you are trying to figure out a way to transfer that asset between parties with the least cost possible. In this case, they may well want to transfer a substantial interest in the company directly or indirectly to their son Joe so he can take over the business with as little direct investment as possible, and an ESOP can make that happen. Joe can continue to run the company and Jim and Mary can transfer some of the ownership to him directly under very attractive terms.
Well, that’s fine for Joe, but what about John and Melissa? How will their future interests be addressed? In some ways, that is the easiest of the issues to address: insurance. By setting up an insurance trust that is owned by John and Melissa, Jim and Mary can direct some of the annual income from their charitable trust into funding insurance policies that will pay John and Melissa their share of the estate in tax-free dollars when the time comes.
All of the pieces of this strategy can be adjusted in scope to cause virtually any configuration or outcomes.
If you think about it, we have addressed all their estate planning objectives. They have removed a large taxable asset from their estate while gaining access to its equity to fund an estate plan. They have arranged that the business can continue under Joe’s leadership while, at the same time, Jim and Mary will be in line for an income for life that does not burden the business or the children. Jim and Mary will have the freedom and the liquidity to help the children in their lives today to whatever extent they would wish, and they have assured that their legacy of charitable giving will continue after them. On top of all that, they have created a much more secure future for all the loyal employees who have worked so hard to help them get to this very fortunate position. I think that qualifies as a job well done, and what is most important here is the fact that none of the techniques discussed can deliver the total outcome by themselves. It takes a coordinated application of several techniques to make it all work.
Oh, by the way, there are a few other benefits to this process: tax deductions. The establishment of the charitable trust creates a current tax deduction for Jim and Mary, and because the law allows for the contribution of appreciated property to generate tax deductions without taxable income, the capital gains that are built into their stock in their company can be realized tax-free to them and their children. They are guaranteed an income for life and their estate has been reduced so that upon their death, estate taxes that might otherwise apply have been reduced or eliminated. The ESOP has set up the company to provide the liquidity they need on a fully tax-deductible basis. The charity is taking the risk of future volatility in the value of the underlying assets, and in exchange for taking on that risk, the hospital will be in line for the balance of the trust upon their death. Joe is able to use tax-deductible dollars to secure his position in the company and the other two children have converted their taxable interest in their parents’ estate to the tax-free proceeds of an insurance policy.
The only real point I am trying to make with this is that there are no silver bullets in this life. No single tactic will answer all objectives. And no one should ever implement any tactic until they understand completely how it fits into meeting their real objectives.
©2007 The Beyster Institute and its authors and their entities. All rights reserved.
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