Succession Planning and Tax-Advantaged Estate Planning for Contractors

Getting out of the construction business can be almost as complicated and challenging as getting in. In some cases, the very survival of the business may depend on succession plans made and implemented long before the owner actually leaves the company.Begin with Four Questions

Succession is a process through which the management and operation of your business is transferred from one person or group to another. To be successful, a succession plan must be implemented while you can still act in your own best interests and the interests of the business. Acting now can save a great deal of time, money and stress by putting a plan in place well in advance of the succession event.

Succession planning begins with four fundamental questions that help define your planning objectives.

1. Who do you want to own the business?

This often is a very personal and emotionally charged question, especially when family members are involved. If your transfer of control or ownership of the business is due to retirement, there may be a spouse, children, siblings or others with direct or indirect interest in taking over. The caveat when dealing with family members is to never assume that someone is ready, willing or capable of running the business. What you see as a reward to your son or daughter may end up being a burden to them and, ultimately, a detriment to the business.

Frank, open discussions with potential successors is the best way to judge the field. Find out what key employees and partners are thinking before making any moves. Some business owners never formalize their succession plans with the people involved, which can have the same result as not having a plan at all.

Remember that the same people who own the business do not have to run the business. Often, second or third generation family members are not interested in managing the day-to-day business operations. Make no mistake, though, most of the time these same folks want to fully benefit from their family business. Under these circumstances, it may be time for you to explore the possibility of adding a few pivotal employee-owners who are not family members.

2. How much longer do you want to work?

Consider factors such as personal health, the size of non-business retirement assets, family dynamics and the relative health of the company. Other key factors include your minimum age to receive Social Security benefits, and the minimum and mandatory ages to begin receiving disbursements from retirement accounts. Some will choose to work as long as possible, while others will run for the exit at the first opportunity.

3. What level of income will you need to achieve your desired lifestyle?

With the help of a financial planner, you need to determine how much money you will need to retire. Someone who retires at age sixty-two might expect to live another fifteen or twenty years, depending on family history. A net worth statement will be a key piece of the puzzle, since the business may be your largest asset. Determining your net worth will require an independent valuation of the business (not what you think it’s worth), and the determination of how much of that value will contribute to your retirement income.

Unfortunately, many small business owners overvalue their business and are unable to get the selling price they want. Many who say, “I’m depending on this business for my retirement,” are often disappointed that selling it will not provide adequate income. In this case, the only option may be to postpone retirement, retain ownership and work to increase the value of the business. This takes time, so the questions should be raised well in advance.

Ultimately, you may find that there is no market for your business, that the economy is not favorable or that your need to sell outweighs your ability to wait for a buyer. The last resort may be to liquidate the business, selling off assets individually in order to extract as much cash as possible.

4. How can you transfer ownership in a tax-efficient manner?

Evaluate your exit strategies with the goal of reducing future estate tax liability for yourself and your heirs. Depending on your specific objectives, there are a number of tax planning techniques to consider.

Tax planning with gifts – Business owners accumulate assets that may increase the estates of both the owner and the owner’s spouse. When the combined estates of you and your spouse total more than $7 million (the current exemption), lifetime annual exclusion gifts of appreciating property-at a minimum-should be considered.

Annual exclusion gifts are a systematic transfer of appreciating assets to heirs, either outright or in trust, during your lifetime. By making annual exclusion gifts, you can reduce future estate tax liability without using any of your lifetime estate tax exemption. You may also generate income tax savings by shifting income on the gifted assets to an individual who is in a lower income tax bracket.

Under current tax law, the first $13,000 of gifts ($26,000 per couple) during a calendar year to any individual is excluded from gift tax. While the amounts transferred in any one year may not be significant in terms of your overall estate, the amount transferred, as well as all future income and growth on that amount, are removed from your estate. The compounded effect of gifting can have a substantial impact in reducing your estate tax liability.

Family Limited Partnership – A Family Limited Partnership (FLP) can significantly reduce estate taxes while providing maximum management flexibility over your assets during your lifetime. In general, an FLP is created pursuant to a contractual agreement between family members who contribute specified assets to a limited partnership in exchange for general and/or limited partnership interests.

One of the primary objectives of an FLP is to transfer assets to younger family members in a tax efficient manner, while insulating the assets from the direct control of the younger family members. This can be accomplished by transferring limited interests in the FLP rather than the underlying assets of the partnership.

In recent years, the IRS has questioned the validity of FLPs as legitimate estate planning vehicles. The question is whether an FLP is truly a valid business entity or is personal in nature. In spite of this added scrutiny, the FLP can be a very effective estate planning technique when the partnership holds operating business interests.

Charitable Remainder Trust – A Charitable Remainder Trust (CRT) is designed to help significantly reduce your income tax burden and provide an endowment to a charity of your choice. The trust pays a fixed dollar amount or a percentage of the annual value of its assets to a non-charitable (income) beneficiary for life or for a specific number of years. The non-charitable income beneficiary is often the grantor’s children or the grantor themselves. Upon expiration of the income beneficiary’s interest in the CRT, the trust terminates in favor of the charitable beneficiary, and the charity receives its endowment.

The grantor of the CRT receives an income and gift tax deduction (or an estate tax deduction if the trust is funded by a transfer at death) for the actuarially determined present value of the charity’s remainder interest.

A CRT is generally exempt from income tax, so any gain realized on the sale of appreciated assets, and any income earned by the CRT generally, will not be subject to income tax until it is distributed to the non-charitable income beneficiary.

Plan Early and Review Regularly

An effective business succession plan can take years to develop and implement under the best of circumstances. In fact, allowing seven to nine years for a full ownership transfer is not uncommon. The first steps are often the most important and the most difficult. Finding the time is always a factor, but in the end, nothing will stop the march of time. The sooner you focus on your succession and estate plan, the sooner you can move on to doing what you do best – running a successful construction business.

Construction Business Owner, December 2009

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Clifton Gunderson LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Clifton Gunderson LLP or other tax professional prior to taking any action based upon this information. Clifton Gunderson LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.