Client acquired and remodeled a building to rent
out to their business. Unless the taxpayer has
other rental properties that generate taxable
income, new rental properties often generate tax
losses that are disallowed. However in this
case, since the building was being rented to
their business, the IRS allows the taxpayer to
aggregate the business activities. This means
that all losses from the building are fully
deductible. Since the rental losses are fully
deductible, Lloyd Malta Ltd recommended a cost
segregation study to maximize the losses
generated from the rental property. A cost
segregation study allocates the purchase price
and remodel of the building to the various
components that have shorter depreciable lives.
The additional depreciation generated from the
cost segregation study was in excess of
€200,000, saving the client over €80,000 in tax.
Exit Strategy using an ESOP
Business transitions sometimes take a somewhat
non-traditional path. One of those paths less
taken would be an Employee Stock Ownership Plan
(ESOP). Lloyd Malta Ltd works with several
clients that have adopted an ESOP but we wanted
to focus on a particular long term client to
help guide them through the more difficult
portions of adopting and administering their
ESOP. It is somewhat unusual for business owners
to decide to turn over their company to the
employees but that is what these particular
owners have done. Once that decision was made,
there were some hurdles to clear regarding
planning, valuations, annual administration,
census reports, cash flow, income tax effects,
etc. that required some fairly complicated
planning. This is made a little more complicated
if the business is operating as an S corporation
as this one was. However, as complicated as this
may be, there are many tax benefits that should
be considered and the savings can more than
offset the additional complexity.
Succession and Tax Planning
Our client, a profitable and valuable second
generation, family-owned S corporation, was
having difficulty determining how to effectively
and efficiently transfer ownership to selected
members of the third generation. The third
generation members had been working at the
company for at least 15 years each.
The problem was more difficult than usual because:
- Not every second generation owner had children
working in the business.
- Non-working children were not to receive any
stock.
- Each owner had several children who were not
working in the business.
- The second generation owners did not want to
create a significant amount of capital gain to
selling shareholders.
- Third generation owners did not have sufficient
personal assets or cash flow to buy the stock,
even if it was structured as an installment
sale.
- Projected excess cash flow was insufficient to
provide funding for a share repurchase in order
to bring all owners into parity with one
another.
- For a variety of management and personal reasons,
the second generation owners wanted to maintain
parity of ownership between themselves so that
no one owned a different percentage of stock in
the company than any other. This meant that
transfers by gift from parent to child would not
solve the problem.
As a result of prior planning with Lloyd Malta
Ltd, including, the making of a timely S
election more than 5 years earlier, a major
restructuring of the company “key person” life
insurance in order to exchange (tax free) the
insurance for new policies issued by a reliable
and much higher rated company and the initiation
of a stock bonus plan, the company achieved
limited transfer of ownership to the working
members of the third generation. The question
posed to us was how to increase ownership by the
two children from 10% each to 20% each while
fairly treating the one owner who did not have
any children working in the family business.
We first focused our energy and creative
thinking on how to obtain stock and/or funds for
the transfer. Limitations described above (and
reasonable compensation rules) precluded our
client from simply issuing more stock as
compensation. By focusing on reducing the
holdings of the second generation relative to
the holdings of the third generation, we were
able to propose a solution that solved
everyone’s concerns.
A redemption was proposed that satisfied the
primary goal of the engagement. A redemption had
certain potential tax issues because some of the
parties were related but this issue was
favorably resolved. Our approach to paying for
the redemption included looking beyond cash flow
and analyzing the future need for each corporate
asset. A non-qualified pension plan was
initiated so that the selling shareholders would
not be concerned about leaving too much value on
the table as they approached retirement. It was
determined, after obtaining a current valuation
of the company, that the amount of key man
insurance exceeded the amount that was
reasonably needed to fund future buyouts. Stock
was redeemed using a combination of the excess
whole life policies and notes to the selling
shareholders for any deficiency. The selling
shareholders were pleased to be able to continue
to own the insurance for their personal estate
and retirement planning. In connection with
transactions, Lloyd Malta Ltd worked with the
client’s lender (a large money center bank) by
preparing a detailed memo describing the
proposed reorganization, preparing pro-forma
statements and projections as well as holding a
meeting with all parties in order to answer
questions and address the lender’s concerns. In
the end, the lender became a willing partner to
the plan since the plan addressed unspoken but
very real concerns of the lender: would the
company be able to survive and thrive during
another change of ownership and what would
happen to the bank’s valued customer as the
current management continued to age.
