Techniques to allow owners of S and C Corporations to take profits out of the business for owner’s benefit;  Merits of S and C Corporations and Change from C to S Corporation

By Robert A. Adelson, Esq.

1. Taking Money out of S Corporation

• S Corp Distributions in lieu of CEO Salary  

i.      Single level taxation

ii.      S Corp dividends not self-employmt earnings

iii.      Avoidance of 15.3% payroll taxes

iv.      IRS can re-characterize dividends

v.      9 Factors on reasonable compensation

vi.      Cases and Treasury Study

vii.      Documents to support determination and reasonableness

• Pass-through gains on asset sales
• Pass-through losses

2. Taking money out of C Corporation

• Maximize salary/bonus compensation

i.      Avoid double taxation of large profits (though not so severe)

ii.      Same issues on unreasonable compensation

• Pay dividends, if profit is small or retained

i.      Utilize skinny graduation of Corp . rates

ii.      Utilize retained earnings to payout dividends  at current low capital  gains rates

3. Taking money out of both S & C Corporations

•  Income splitting with family members

i.      Utilize their low tax brackets

ii.      Limited by Kiddie tax

• Lease of business assets to corporation
•  Coordinate andmaximize entertainment, travel and conference expenses
• Vehicle, home office and equipment reimbursement
• Age weighted profit sharing plans
• Other Employee Benefit or Fringe Benefits plans
• Thinning new corporation by use of debt and corporate loans to owner
• Stock redemptions of owners
• Employee stock ownership plans
• Tax free separations and divisions of the business
• Charitable trusts on sale of stock

 4. Avoidance Constructive Dividends Red Flags in Audits

• Payment of benefits to owners
• Payment of debts, personal expenses of owners
• Bargain sales of property to owner
• Bargain use of company property
• IRS determined unreasonable compensation

5. Which is better: S Corp or C Corp?

• Merits of S Corporation

 i.      Single level of taxation

ii.      Pass through of tax gains/losses

iii.      No accumulated earnings tax

iv.      Avoidance pay roll tax

v.      Single level tax on sale on liquidation of business

vi.      Ability to allow future acquirer a favorable Section 338(h)(10) election

•  Merits of C Corporation

 i.      Accumulation of income without immediate shareholder tax

ii.      Ability to have complex capital structure (i.e. preferred stock)

iii.      Ability to have foreign shareholders

iv.      Ability to be a public company (i.e. unlimited number of shareholders)

v.      Ability to use fiscal year

vi.      Ability to use Section 1202 stock

6. Change from C to S Corporation

•  BIG – Built In Gain Rule

i.      Asset sales – tax gains on corporate level for  10 years after change

ii.      Taxed at highest corporate rate

iii.      Need for valuation in connection with change

•  LIFO inventory recapture tax
•  Excess Net Passive income tax

i.      If accumulated E &P

ii.     Over 25% gross receipts passive income

iii.    Loss of S election if 3 consecutive years

About The Speaker

            These materials were prepared by Robert A. Adelson, Esq., Partner at Engel & Schultz, LLP, 265 Franklin Street, Suite 1801, Boston, MA 02110, (617) 951-9980, fax: (617) 951-0048, e-mail: radelson@engelschultz.com

            Mr. Adelson is a graduate of Boston University, Phi Beta Kappa, and Northwestern University Law School in Chicago where he was a member of Law Review. He has an LL.M. degree in Taxation from New York University, and is a member of the Massachusetts, New York and U.S. Tax Court Bars. He began his legal career in 1977 as an associate at major New York City law firms, first Dewey Ballantine and later Weil Gotshal & Manges, before returning home to Massachusetts in 1985, where he has been a partner at several Boston firms before joining his present firm as senior business law partner in 2004.

            Mr. Adelson is specialized in corporate, taxation, business and technology transactions.  In those areas, he frequently represents (1) small companies with their various business needs, including shareholder and employee issues, financing, commericial contracts, intellectual property, joint ventures, mergers and acquisitions, succession planning (2) senior executives, in negotiations over severance, employment, relocation, stock options, compensation and stockholder arrangements, and  (3) consultants – in liability protection, intellectual property protection, trade identification, vendor, client and subcontractor arrangements.

            Mr. Adelson’s firm, Engel & Schultz, LLP, is a small but broad service law firm of 6 attorneys in Boston’s Financial District.  The firm complements Mr. Adelson’s work in business and tax law with seasoned attorneys in family, probate, real estate and litigation matters. 

            Mr. Adelson is a frequent speaker at business forums and Chairman of IEEE Boston Entrepreneurs Network www.boston-enet.org .  Further information on Mr. Adelson’s background and his past published articles is available at his law firm website.  To view many of Mr. Adelson’s past articles, see http://www.engelschultz.com/index.php/category/publications/  or http://robadelson.wordpress.com/

            The speaker thanks Bonnie Gorbaty for the invitation to speak to the CEO Forum program of The Commonwealth Institute on the topic of  “How To Maximize Your Return, As Owner, From Your Business”, at the offices of corporate sponsor Citizen Bank, 53 State Street, Boston, MA, March 10, 2010.

© Robert A. Adelson, Esq. 2010.  All Rights Reserved.

A.      Business Succession Planning:  Overview

1. Why plan – Circumstances giving rise to Necessity

• Death or Disability of owners
• Retirement of owner or business owners
• “Hastened” Retirement – revolt in the ranks

2.  How to plan – Alternative choices for succession

• Internal Transfer one Generation to the next and Continuation of existing Business

• External Sale of Business to outside third party

3.  What we seek – Goals to try to accomplish

• Continuation / survival of the business
• Retirement and Liquidity for the owner(s)
• Fairness / Inheritance for non-owner family members
• Maximization of value & favorable sale terms
• Efficient tax planning

B.      Internal Transfer and Continuation of Business

1. Case Example – Bonanza Lumber, Inc. (Hypothetical)

2.   Planning for Continuation

• Identification of able employees
• Training of family members
• Recruitment and Utilization of employees outside family
• Provision of capital / means for success

3.  Transfer to next Generation

• Employment agreements
• Buy-sell agreement terms

1)   Functions

2)   Advantages

3)   Triggering Events

4)   Structure – Cross Purchase, Redemption, Hybrid

5)   Valuation

• Life-time Stock Transfers

1)      Intrafamily Installment Sales

2)      Private Annuities

3)      Self-Canceling Installment Notes

• Gift Transfers

1)      Gift Tax and Annual Exclusion

2)      Estate Freezes

3)      FLPs / LLCs for Discounts

4)      GRAT, CRTS, Grantor trusts

• Non Family key employees

1)   Phantom Stock &  Employee Incentives

3)   LBO – Zenz “bootstrap” sale

4)   Sale to ESOP

4.   Providing for non-operating family members

• Separation of real estate / non-operating assets
• Corporate separations
• Life insurance to equal out interests
• Buy-sell agreement / to provide buyout terms
• Voting and non-voting shares
• Springing interests

5.   Further Planning for Estate Taxes

• IRC §303 redemption to pay taxes
• IRC §6166 to defer taxes
• IRC §2057 Family Business deduction

C.      Desiring Internal Transfer vs. Facing External Sale

1. 80% of Family Businesses do not succeed to next generation

2.  Recognition that continuation not possible

• Inability or disinterest of next generation
• Sale at peak price rather than fire sale
• Owner liquidity & preservation of estate

3.  Preparing business for sale

• Maximize value of business
• Maintain good business records
• Engage key consultants
• Develop contracting process
• Confidential information memorandum
• Auction atmosphere

D.      External Sale of Business to Outsiders

1. Case Example – El Tiante Sports Shoe Co. (Hypothetical)

2.   Purchase and Sale of Corporation – Key Business Issues

• Liabilities
• Tax Issues  – Basis, Character of income, Deferral
• Purchase Price / Earn Out
• Warranties
• Covenants

3.   Structure of sale

• Sale of assets
• Sale of stock
• Nontaxable sale
• Bootstrap sale / Redemption
• Corporate separation

4.   Implementation and Documentation of Sale

• Letter of intent
• Due Diligence
• Sale Agreement
• Closing
• Post closing obligations

5.   Estate & Family issues

• Tax Planning for Year of Sale
• Calibrate income and loses
• Acceleration of deductions

E.      Conclusions – Implementing a plan

• Beginning and continuing succession plan
• Determining a direction / hedging bets
• Engaging the parties concerned
• Communication, involvement, ownership
• Committing the plan to writing
• Perils, pitfalls and dispute resolution
• Updating over time
• Working with consultants

**  This outline was for the presentation by Attorney Robert Adelson,  a 4-hour seminar course he offered for attorneys, accountants and other professionals, for continuing professional education credit, sponsored by Foundation for Continuing Education.

Questions on this presentation or the subjects covered, including any questions by

Owners or participants in family businesses or closely held businesses on buy-sell agreements, estate freezes, gifting plans, phantom stock, employment and bonus plans, and other issues concerning business succession planning or the sale of a business,

may be directed to the author and speaker at his current law firm, as follows:

Robert A. Adelson, Esq.

Engel & Schultz, LLP

265 Franklin Street, Suite 1801

Boston, MA 02110

Tel:  (617) 951-9980 ext 205

E-mail:  radelson@engelschultz.com

Are you an entrepreneur trying to build a startup company?  Do you feel your family business is stalled?

If you face hurdles in your early-stage company, or if you are in a family business and find the family expertise limits you, you may wish there was someone on your side to offer useful advice.

One way to get that help is to hire paid consultants.  Another is to recruit executives who have that experience.  However, both approaches can be expensive to an early stage company that must conserve its cash or to a family business not used to paying outsiders.  Also, if only one or two people can be hired or contracted with the breadth of experience needed, the hire may be insufficient.

There is another way: recruiting a board – a board of advisers or a board of directors, sometimes both.

Corporations must have a board of directors.  However, most entrepreneurs like to be their own boss and often regard a board of directors as a nuisance to be avoided.  So most early-stage companies have single-member boards.  That’s likewise true in even more mature family businesses, with either a single-member board or two or three members of the family, but no outsiders.

However, the board can be an asset to your business—to offer a key supportive resource.  A board can offer advice on an “as needed” basis, at a fraction of the cost of employees or consultants, with no long-term commitment, and if you choose your board carefully, a board can offer greater depth of experience.

To tap this resource, you don’t have to create a formal board of directors.  Many entrepreneurs start with an informal board of advisers that meets on an occasional basis.

When picking this board the entrepreneur should avoid friends and relatives and instead focus on filling in experience, gaining practical advice and opening doors, including:

• Tips to build your organization and structure
• Marketing and production advice to expand
• Personnel references and contacts
• Contacts and credibility to raise capital
• Advice when unforeseen hazards arise
• Independent advice on succession planning

Boards of advisers generally meet several times a year, often over a meal.  Initially, the board may meet and help for the cost of the entrepreneur picking up the cost of a good meal.  In time, stock options may be offered.  For the board member, advantages include the ability to help a colleague, and to do so with no liability or responsibility and with limited time commitment.

To get best use from this initial, informal board of advisers, the entrepreneur should value the time and advice offered: Prepare for adviser meetings, keep advisers informed on company developments and set limited terms for service to keep the board fresh.

The Voice of the Family

The board of advisers in family businesses also deals with interpersonal family issues that affect the business.  Thus, a family advisory board should have at least one member with professional expertise or knowledge and credibility within the family to lead resolution of interpersonal disputes.  This role can also be filled by a separate family council.

The adviser’s mission is to reconcile the family’s vision and direction with business needs.  Sound management, growth and profitability can clash with needs and ambitions of family members.   Non-family business also has issues with “office politics” and corporate greed versus meritocracy and system growth.  However, family businesses require special vigilance to check erosion of competitive position and personnel attrition over perceived family restrictions or nepotism.  They also require timely development of succession planning.

As the early-stage company takes on full-time employees, generates revenue and considers investment and expansion, selecting a board of directors can expand the reach and enable the entrepreneur to reach the next level.

With growth, knowledge gaps become more pronounced, the demands are greater and the need for real experience more acute.  In the family business, this can come when the knowledge and skills needed can only come from outside the extended family.  With growth, the entrepreneur may be more willing to share the burden of running the company.

Unlike advisers, directors take real responsibility and potential liability for management of the corporation.  The board of directors directs officers and governance.  Directors generally meet monthly, and instill financial accountability and appropriate record keeping in the business.  That discipline and the time board members invest can help the company avoid or overcome pitfalls, and it can put the company in its best posture to gain financing, forge alliances or make important hires.

© 2006 Robert A. Adelson

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To follow-up this “Building Boards” article, if you have questions or needs –

• For a start-up, early stage or maturing business? Or a family business?
• Concerning a board of advisors or Board of Directors? Or both?
• Over formation, recruitment or management of the board?
• Over liabilities, responsibilities and corporate governance?
• Over how to compensate board members? Other issues?

Below is contact information for the author –

Robert A. Adelson, Esq.

Engel & Schultz, LLP

265 Franklin Street, Suite 1801

Boston, MA 02110

Telephone: 617-951-9980 ext 205

E-mail: radelson@engelschultz.com

With the stock market apparently recovering from the “dot-bomb” crash of 2000-02, companies are again using their rising stock to lure top executive talent. If it’s time for your family business to recruit key technical employees or senior executives from outside the family, how can you compete with these non-family firms? What can you offer prospective employees instead of stock or options?

As employee appetites for stock and options rise anew, it’s important for family businesses to meet the competition by offering their own form of equity — without actually transferring ownership. The good news is that today’s tax climate has made it easier for family firms to compete in the recruitment wars.

There are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock, ways and means that are discussed in this article.

Recruiting talent from outside the family

Your business may not be able to grow or face tougher competition if there are gaps in your family members’ knowledge, skills or experience. The best way to fill in the missing pieces is by hiring non-family employees.

Even if there is no gap, it may be wise to recruit a senior manager to help train and mentor the next generation in preparation for a leadership transition — someone who would also be available to step in if illness, death or disability strikes a core family member.

Unfortunately, a family business’s stability and long-term perspective, while attractive, don’t go far enough to lure potential recruits. A non-family executive may fear that nepotism and family loyalty may supercede sound business judgment. Hopefully, if you are seeking non-family talent, your company can allay these concerns by citing its record of putting growth of the business before the personal concerns of the family owners.

Offering a stake in the upside

But even if you can show a track record of growth and sound judgment, there is something else that might make non-family candidates skittish about joining your company: the perception that as non-family members, they won’t get to share in the benefits of their hard work.

Because most family business owners want to ensure that their company stays in the family, they don’t offer their non-family employees the opportunity to own stock. But there are ways to give non-family executives a share in the rewards of ownership without actually transferring even one share of family business stock. The three strategies below — particularly the phantom stock approach — are powerful weapons in your arsenal. Recent changes in federal tax and securities laws have made these options even more attractive.

Non-voting stock and ‘rabbi trusts’

One option is to institute a non-voting stock plan for key non-family employees. Non-voting shares are allowable in LLCs, C corporations and even S corporations. This structure provides for all the capital appreciation of normal shares and permits shareholders to take advantage of the record low 15% tax rate on capital gains and dividends. Under this arrangement, non-family executives have no voice in the company’s operations and strategic choices.

The second approach is a non-qualified deferred compensation plan, which can provide a secure future payout to a key executive. Taxation to the executive is deferred via a “rabbi trust,” a trust that is set aside for the employee but remains subject to company creditors. (It was first used for a New York rabbi and the nickname stuck.) The plan can include “golden handcuffs,” or vesting arrangements in which benefits are lost if the executive leaves the company. It can also include “bad boy” provisions, in which benefits are forfeited if the executive violates confidentiality or non-compete agreements or other company rules and restrictions during employment or post-termination.

Phantom stock: The most far-reaching solution

The third approach — a phantom stock plan, taxed in the same manner as deferred compensation — combines the first two. As the most far-reaching and innovative solution, it offers the family firm a real advantage.

Under a phantom stock plan, the company sets a share value benchmark at the time phantom shares are issued (phantom strike price). The phantom stock contract issued to the executive provides a vesting and redemption schedule as well as a method of future stock valuation. If the executive does a good job and the family business prospers, when redemption occurs the executive will be paid an amount equal to the value appreciation. That is, the executive is paid the difference between the share value on the date of “sale” (phantom stock redemption or payout date) and the original phantom strike price. This spread is the same kind of payout the executive would achieve if he or she had conventional stock options in a non-family business.

A family company’s phantom plan not only offers key employees a share in the company’s growth but also can do so on far better terms than plans offered by non-family competitors. Here’s how.

Sarbanes-Oxley and phantom stock liquidity

Many small public companies are going private or delisting their securities rather than face the heavy costs of compliance with provisions of the Sarbanes-Oxley Act, passed by Congress in response to several high-profile corporate scandals.

Executives at those companies will now have equity that is illiquid. This gives closely held family businesses a distinct advantage in recruitment. A well-designed phantom plan provides liquidity (i.e., an exit strategy) for executives that small-capital companies no longer offer.

Phantom capital gains vs. incentive stock options

A phantom stock plan can generate both phantom dividends and phantom capital gains by taking advantage of the deductions available in the tax law and sharing the benefit with key hires.

Under the 2003 tax law, capital gains are taxed at 15%, the lowest rate since 1933. Dividends also are taxed at 15%, the lowest rate since the introduction of the graduated income tax in 1916.

Plans that provide incentive stock options rarely allow executives to take advantage of capital gains or dividend tax treatment. Under today’s tax law, this is a huge lost opportunity.

2004 Election:  Opportunities in new tax proposals

At this writing it is unclear whether the next administration will be Republican or Democrat, but the beneficial use of phantom stock appears likely continued and even enhanced regardless of the outcome of November 2004 election.

If the President and Congress are re-elected, the thrust of GOP tax policy in 2005-09 will be to make permanent the recent Bush tax cuts, including those for capital gains, dividends and marginal rates scheduled to sunset during that ‘05-09 period, with an added drive to eliminate all tax on dividends.  If there is a change to Democratic rule, the Kerry program would roll back those same tax cuts for families earning over $200,000 and create new tax credit incentives for high-earning employers to hire new workers.

As said a phantom stock plan that generates phantom dividends and capital gains is well positioned for these currently planned 2005-09 GOP tax initiatives. However, the well-designed plan can cope and even utilize the Democrat policy shift.  The income deferral embedded in phantom plans allows beneficiaries to spread income.  So, the Kerry $200,000 family income safe harbor is obtainable.  Also, to the extent phantom stock aids hiring it gains the family business owner a tax credit, to benefit from tax changes.

A case example

An established family business (FamCo) has outgrown its current management and wants to recruit a chief operating officer from outside the family. The top candidate knows the industry, has managed a larger workforce with multiple offices and has proved his ability to take a company to a new level.

The current family CEO, at age 70, is looking toward retirement. The prospective COO, Bill Wilson, is 55 years old. Hiring this key player would bring new vigor to the company. The parties hope to see FamCo grow from its current valuation of $5 million to $10 million over the next decade.

FamCo offers Bill Wilson phantom stock that matches his annual salary of $200,000. During each year of a five-year contract, Wilson receives phantom stock units at a strike price of $5 per unit with the units vesting annually at 20% (half the vesting based on his remaining with FamCo and half based on achievement of his performance goals). In ten years, when Wilson retires, the company would again be valued and Wilson paid on the growth of his vested units, with a buyout over ten years.

Thus, if Wilson stays with FamCo 4 1/2 years, he accumulates 160,000 units. In that time, for example, if he achieves half his business targets, he’ll vest 60% of these units (vesting 80% based on four years’ tenure and 40% based on meeting half his targets). When he leaves after 4 1/2 years, 96,000 phantom stock units are vested (equivalent to almost 1% of the company) at the original $5 per unit. Wilson has no voting rights or rights to stock, but — assuming he doesn’t violate company covenants — he will receive a future payout for the units.

Now suppose that because of Wilson’s achievements over those 4 1/2 years, FamCo grows from a $5 million company to a $15 million company by 2014. The stock price (and, thus, the phantom unit value) grows to $15 per share. Under the plan, Wilson would be paid off at the spread between the $5 original strike price and the $15 current market price in 2014. With a $10 spread per unit, the payout on Wilson’s vested units would be $960,000, which would be paid over ten years with interest on the $960,000 note at the Wall Street Journal prime rate. With phantom income spread over 10-years at $96,000 per year, this plan is well designed to be taxed at lower rates even if Kerry plans for a roll-back in tax rates occurs for families earning over $200,000 per year. Under a phantom capital gains plan, the tax deductions generated by this payout would be shared between FamCo and Wilson to reduce his tax from 35% to 15%, thus achieving effective capital gains treatment on the payout, in line with low capital gains rate achieved by the Bush administration tax cuts.

This example works for any family business in any American industry, whether the business valuation is $5 million or $5 billion. Although the company must incur the cost of paying out phantom stock, it derives a much greater benefit from growth. These plans give family-owned companies the ability to recruit and retain key talent, which more than offsets the cost involved.

Robert A. Adelson, J.D., LL.M, a partner in the law firm of Engel & Schultz LLP in Boston, is a corporate and tax who represents closely held and family businesses and executive employees.

© 2004 Robert A. Adelson

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Robert A. Adelson, Esq. can be reached at Engel & Schultz LLP,

265 Franklin Street, Boston MA 02110  radelson@engelschultz.com

(617) 951-9980 ext. 205