Using Phantom Stock in a Family-Owned Business

Using Phantom Stock in a Family-Owned BusinessLike any business, a family-owned business needs to attract, retain, motivate and reward key employees. A competitive salary and benefits package may not be enough to do this in today’s market. Many businesses issue stock or stock options to employees as a form of long-term incentive compensation. For most family-owned businesses, though, issuing stock to non-family member employees is not a viable solution. Family members may not want to dilute family ownership or manage the corporate governance and fiduciary issues associated with having non-family member minority shareholders. Issuing stock would give non-family members voting rights, rights to attend shareholder meetings, rights to inspect books and records, and other fiduciary rights as shareholders.

A phantom stock plan is one way for family-owned businesses to provide long-term incentive compensation to key employees without actually issuing stock. Phantom stock is a way to give key employees the economic benefit of owning stock without requiring family members to give up any equity in the business.

With phantom stock, the company awards hypothetical or “phantom” shares to key employees under the terms of a phantom stock plan. The company has a contractual obligation to pay the phantom shareholders at a future date based on the terms of the plan and the value of the phantom shares, which typically track the value of the company’s actual shares. A plan participant may be entitled to receive a payment annually or at retirement based on the appreciation in the value of the phantom shares. Some plans also make payments to phantom shareholders equal to dividends paid on actual shares. Under other plans, payments are due only when the company is sold. In this case, the phantom shareholder typically receives an amount of cash for each phantom share equal to what the participant would have received in the sale if the participant owned the same number of actual shares in the company. An award of phantom shares may also be subject to vesting over time. Payments are generally contingent on continued employment with the company. The financial metrics, vesting schedules and payment triggers can be tailored for each plan.

There is no tax impact when phantom shares are awarded to a key employee. When payments are made under the plan, they are taxable wages for the employee and subject to applicable withholding taxes. There is no opportunity for capital gains treatment. The company generally receives a tax deduction for each payment. It is important for family business owners to consult with employee benefits counsel to confirm that the plan is structured to avoid being subject to certain complex rules under the Employee Retirement Income Security Act (ERISA) and Section 409A of the Internal Revenue Code, which imposes restrictions on the timing of certain deferred compensation payments.

If granting equity to non-family member employees is not feasible in your family-owned business, adopting a phantom stock plan may be a good solution for rewarding key employees and better aligning their interests with those of the family member owners.

Proposed Tax Regulations Limit Availability of Valuation Discounts to Family Business Owners

Proposed Tax Regulations Limit Availability of Valuation Discounts to Family Business OwnersFor family business owners who desire to transfer ownership of part of their business to the next generation, the valuation of the business interest is often an important factor to consider. This is especially true for family business owners with sufficient assets who are concerned about minimizing estate taxes at their deaths. Under current tax law, each individual has a gift and estate tax exemption amount of $5.45 million, which allows the individual to transfer (either during life or at death) that amount of assets to younger family members before being subject to estate taxes. For spouses, this combined amount is $10.9 million under current tax law.

Historically, family business owners who transfer ownership of part of their business interests to younger family members have been able to make transfers at values that take into account appropriate valuation discounts. For example, a transfer of a 10 percent interest in a family business from parents to children does not represent a controlling interest in the business. The 10 percent interest is also not readily marketable and cannot be sold quickly like publicly traded stocks and other marketable securities. Discounts for “lack of control” and “lack of marketability” have therefore historically been applied to arrive at the value (for gift or estate tax purposes) of a minority, closely held business interest whenever the interest has been transferred. If a family business is valued at $100 million and a business owner gifts a 10 percent interest to children, then the 10 percent interest would historically be valued at something less than $10 million. In this example, it might be valued at $6.5 million for gift and estate tax purposes (after applying combined lack of control and lack of marketability discounts of 35 percent).

In August 2016, the Treasury Department issued proposed regulations under Section 2704 of the Internal Revenue Code that, if finalized in their present form, would significantly impact the valuation of transfers of family-owned businesses for gift and estate tax purposes. Specifically, the proposed regulations would severely reduce, or even eliminate, a family business owner’s ability to take advantage of valuation discounts (such as the lack of control and lack of marketability discounts described above) when transferring interests in family businesses to other family members. It is especially worth noting that the proposed regulations would apply to operating businesses as well as passive holding companies, and would apply to all types of business entities (whether corporations, LLCs or other entities).

A hearing on the proposed regulations is scheduled for December 1, 2016, and the regulations will likely be finalized and become effective sometime in early 2017. Thus, there is a short window of time for owners of family businesses to make transfers of interests in their businesses and be able take advantage of the valuation discounts applicable under current law. Whenever the proposed regulations are finalized, the availability of traditional valuation discounts will likely be impaired.

If you are interested in making transfers of ownership interests in your family business, we are available to discuss whether these proposed regulations will impact your family business and the various strategies available to you before year-end.

Intra-Family Loans: An Estate Planning Strategy in a Low-Interest Rate Environment

Intra-Family Loans: An Estate Planning Strategy in a Low-Interest Rate EnvironmentIn the current economic environment, IRS-prescribed monthly interest rates for certain intra-family transactions are at historic lows. As a result, an excellent opportunity exists to transfer wealth to lower generation family members while minimizing taxes through the use of “Intra-Family Loans.”

One simple technique that is particularly effective in the current low-interest-rate environment is to loan money to a child, grandchild, or other family member – or perhaps to a trust for the benefit of one or more family members – with the borrower paying interest on the loan at the appropriate interest rate (referred to as “Applicable Federal Rates” or “AFRs”). The transaction must be properly documented with a promissory note, and interest should be paid on the loan.

The following table shows “safe harbor” AFRs for loans between family members made during July 2016, depending on the term or duration of the loan:

Loan Type

Loan Terms

AFR

Short-term AFR

Up to 3 years

0.71%

Mid-term AFR

More than 3 years and 9 years or less

1.43%

Long-term AFR

More than 9 years

2.18%

The borrower can use the borrowed funds to make investments with the goal of realizing a rate of return in excess of the interest rate payable on the loan. The borrower will eventually repay the loan principal and will keep any investment returns in excess of the interest paid without the excess being subject to estate or gift taxes. This transaction is obviously most effective when AFRs are lower, since the investment return does not have to be as high to exceed the AFR, meaning there is a greater potential for a tax-free transfer to the borrower. AFRs can also be used for loans related to the purchase of a personal residence by a family member or investment in a business.

As an illustration, assume a $1 million loan is made during July 2016, with a term of eight years and interest payable at the “mid-term” AFR of 1.43 percent, and further, that the investment return over the period is 7 percent on an annual basis. Under these facts, the amount the borrower will have remaining after repaying the loan principal, plus interest, at the end of the eight-year term will be in excess of $500,000.

As an alternative, the borrowed funds could be used by the borrower to pay off existing higher-rate debt, the result of which would afford the borrower the opportunity to satisfy the debt sooner than may have otherwise been permitted. In addition, if the existing debt is owed to a bank or other third-party lender, the act of refinancing with an intra-family loan ensures that the interest payable over the life of the loan will remain within the family.

Do You Need Directors and Officers (D&O) Insurance for a Family-Owned Business?

Do You Need Directors and Officers (D&O) Insurance for a Family-Owned Business?Family business owners may assume that D&O insurance coverage is necessary only for publicly traded corporations and large, non-family owned private businesses. That is not the case. Individual directors and officers of a family owned business may be subject to many of the same types of claims as their counterparts at other businesses—claims by employees, disgruntled shareholders, customers, competitors and government regulators.

The first line of defense for directors and officers is indemnification by the corporation itself.  Most corporate bylaws (and operating agreements for limited liability companies) contain indemnification provisions under which the corporation may be obligated to pay defense, settlement and judgment costs for individual directors and officers. The corporation’s indemnification, however, is only as good as the corporation’s ability to pay. And in a family-owned business, where a substantial portion of the owners’ personal wealth may be tied up in the business, indemnification by the corporation essentially means family owners making payments out of their own pockets.

Properly structured D&O coverage can help to shift the financial risk of claims to the insurance carrier. In addition, it will be difficult to attract and retain qualified directors and executives from outside of the family unless the corporation has D&O coverage. D&O policies generally contain three types of coverage:

  • Side C coverage is coverage for the corporation itself.
  • Side B coverage reimburses the corporation for money that it has paid to indemnify individual directors and officers.
  • Side A coverage provides coverage for individual directors and officers that are not indemnified by the corporation.

The coverage should be structured to protect both the corporation and individual directors and officers.

Before purchasing coverage, you should carefully review the key policy provisions with your broker or an independent insurance expert. Key provisions include the definition of “claim,” the policy limits, the deductible or self-insured retention amount, and the policy exclusions. As with most insurance policies, D&O policies contain a number of exclusions. Of particular importance to family businesses is the “family exclusion.” D&O policies routinely exclude coverage for claims brought by family members against the corporation or other family member directors and officers. Carriers want to avoid being pulled into family disputes and also avoid collusion between family members to fabricate claims. The family exclusion typically extends to multiple generations and will include shares held in a family trust. If you are concerned about obtaining coverage for potential claims by disgruntled minority family shareholders, you should carefully review the terms of the family exclusion with your broker before purchasing coverage.

For Love or Money: Considering Prenuptial Agreements

For Love or Money: Considering Prenuptial AgreementsThe question of prenuptial agreements comes up often in multi-generational family-owned businesses. The question is typically raised by mom or dad, or maybe grandmother or grandfather, and goes something like: “We’re all very excited about [daughter’s/son’s] upcoming wedding. Do you (i.e., family lawyer) think you should talk to [daughter/son] about signing a prenup? We think it would be a good idea.” Note that the question is rarely raised by the glowing bride or groom to be.

What should you do? Here are some basics to consider:

A prenuptial (or antenuptial) agreement is an agreement made before a marriage, typically to resolve issues of support and property division if the marriage ends in divorce or by the death of a spouse.

How can a prenuptial agreement be useful?

  • It allows the marital parties (as opposed to a court) to define the division of assets and debts between the parties if the marriage ends either by divorce or death.
  • It allows issues of business ownership and control to be handled prior to any potential problems that may arise.
  • It can be used to provide a method of valuation for the Company’s stock in the event of a death or divorce of a shareholder.
  • It ensures that both spouses will have adequate support if the marriage ends and will help uphold each spouse’s estate plan.

Prenuptial agreements have been recognized and upheld in all 50 states.

If challenged under Alabama law, a prenuptial agreement will be carefully scrutinized by a court. The agreement will be deemed valid in Alabama if one of the following conditions are met:

  • Consideration must be adequate and the entire transaction must be fair, just and equitable; or
  • The agreement is freely and voluntarily entered into with competent independent advice, full knowledge of interest in estate and approximate value.

What do these requirements mean?

  • There can be no fraud or duress at the time of entry.
  • Both parties must voluntarily enter into the agreement.
  • The agreement must be in writing.
  • Each party must know what rights he or she is relinquishing and have a general knowledge of the estate of the other.

Thus, the circumstances surrounding the preparation for and execution of the agreement are the key to its enforceability. We also recommend that each party be advised by independent counsel.

So, how should the topic be raised with a bride or groom to be? Answer: Very carefully. Each option discussed should be addressed with care, as these are very sensitive issues.

Some good reasons for a prenuptial agreement include:

  • Family history of ownership of the Company and desire to maintain family ownership
  • Importance of the family’s control of the Company to pursue long-term plans and preserve value and the threat of disruption caused by a minority shareholder who is not aligned with the family’s objectives
  • Best interests of the soon-to-be spouses (i.e., both agree in advance that they will receive sufficient support in the event of divorce or upon death)
  • Creates an environment of trust and financial openness
  • Valuable estate planning tool
  • “Marital Insurance”

However, there are also potential downsides:

  • Others may view the suggestion of a prenuptial agreement as a manifestation of one’s distaste for the potential spouse, or as meddlesome, greedy or unromantic.
  • Finding an appropriate time to approach the topic can be difficult.
  • It can be a challenging conversation for the parties involved.
  • Lawyers are involved.

We recommend that older generations begin educating the younger generation on the subject of protecting the family business, including techniques such as prenuptial agreements, early–preferably before the engagement.

Creating an Effective Family Employment Policy

Creating an Effective Family Employment PolicyIn order for a family business to survive and prosper beyond the first or second generation of family ownership, it must have a pipeline for developing talented leaders. Finding the best talent may require looking inside and outside of the family. However, it is often difficult for family business owners to be objective about hiring—and firing—family members.

One way for a family business to establish a fair process and procedure for hiring (and, in the event it becomes necessary, disciplining or terminating) family members is to adopt and consistently apply a family employment policy. Successful involvement of multiple family members is most likely to occur when clear employment criteria are in place.

While the terms of each family employment policy will differ from business to business, we have found that effective family employment policies address the following topics in one form or another:

  • Employment with the company must be earned—it is not a birthright.
  • As a condition to employment, the family member must have employment experience outside of the company (typically two to five years of outside experience) and must have received at least one promotion with another employer. If the family member has not been a valued employee elsewhere, the family member may not be happy or productive in the family business.
  • For a family member to be employed, the company must have a legitimate job opening. The company should not create a position for the family member unless the growth or needs of the business justifies a new position.
  • The family member should have the skills and qualifications that would be required of any non-family member candidate for the position.
  • The family member should be required to complete the company’s standard interview and screening process for new employees.
  • Once hired, the family member should receive a market salary and be treated the same as any other comparable non-family employee with regard to benefits, training, continuing education, performance reviews, disciplinary action and termination.
  • If possible, the family member should report to a non-family member.

A family employment policy certainly will not eliminate all of issues that arise when multiple family members are employed in a family business. In our experience, though, a family employment policy helps to establish the credibility of family member employees and makes it more likely that family member employees will be productive and successful in the family business.

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