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PERSONAL FINANCE

Planning Ahead

There are a number of advantages to early estate planning.
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Estate planning isn't just for your heirs. It can save your company

Jack Bares has always been an unusual kind of guy. When his wife, Alice, decided to return to work after their kids were grown, Bares helped her start her own specialty hand-tool company down the street in Chagrin Falls, Ohio, rather than simply bring her into Milbar Corp., his hand-tool manufacturing company. Years later he set his daughter up as another potential rival in New York State.

Bares, now in his sixties, is unusual for another reason as well. This Cleveland-born entrepreneur has been practicing the fine art of estate planning for the past 29 years, nearly as long as his company has been in operation. "It's not so much that I'm worried about my business continuing long after I'm gone," he emphasizes, "but I never wanted to see Milbar just dumped on my wife's lap or left to my kids in a way that would lead to battles between them."

Estate planning is actually just another aspect of the kind of long-term, strategic thinking that helped Bares build his business. But not enough company founders and owners see it that way. After all, estate planning is distracting, taking valuable time away from the day-to-day responsibilities of growing one's business. It's also difficult, forcing owners to hunt down reliable executors and trustees, choose among possible heirs, and at least contemplate giving up some control of the business. Depressing food for thought.

Still, the advantages of savvy estate planning outweigh those disincentives. That's because estate taxes -- currently pegged at up to 55% of a business's appraised value at its owner's death -- are nothing short of murderous. After all, how many businesses valued at $10 million would have enough cash flow to cover a $5.5-million tax bill from Uncle Sam, even if the heirs could spread payments (plus all the accruing interest charges) out over 10 years? (That extension, known as a Section 6166, applies only to estates in which the closely held business is worth more than 35% of the gross estate.)

Most financial advisers recommend that company owners set up full-fledged estate plans -- including wills, executors, tax-avoidance schemes, management-succession strategies, insurance policies, trust funds, and more -- regardless of the other constraints on their time. The risks of going without are simply too great.

Jack Bares didn't have the time or interest to work out that kind of bulky estate plan. Instead, he worked out a more practical approach that geared his planning to three stages in the life cycle of his growing business and family. He may have missed some opportunities along the way. But overall, Bares's plan is a useful blueprint.

For Bares, estate planning began the day his first child was born, in 1960. He wrote a will, leaving the fledgling business and his other assets to his wife. Then he signed up for plenty of life insurance.

Meanwhile, he decided to try out an idea he had heard on a cassette tape loaned by a friend: the family partnership. Bares's scheme combined a standard family partnership with a sale-lease-back strategy, an arrangement still possible under today's tax laws. He placed the few assets Milbar owned within the partnership; then the corporation leased those assets back from the partnership. "We wound up with the corporation basically owning its working capital and the family partnership owning everything else," says Bares.

The family partnership was structured with estate planning in mind. Jack and Alice began as equal partners with the children; they have since reduced their stake to a scant 0.5% each, while their daughter and three sons split the remaining shares. Year in and year out, the Bareses made tax-free contributions in each child's name to the partnership -- starting out at the Internal Revenue Service's then-limit of $6,000 (per couple and child), eventually reaching the current $20,000 cap. Meanwhile, thanks to the regular addition of leasing fees, Bares was able to pass on more revenues to his children than would have been poss-ible had he stuck to the tax-free gift limits. And because the revenue was in the form of leasing fees, he didn't have to pay gift taxes.

Bares and his wife were the general partners. They controlled the use of the partnership's growing funds, spending the money on machinery, trucks, and finally, a combined factory-office building that Milbar leased for use at fair-market value. This was a safer strategy than simply giving money to the kids, who might have used it for fancy trips or cars. And thanks to tax reform, there's another advantage to Bares's family partnership/leasing strategy: income earned by the partnership, mainly in the form of leasing fees, is taxed at low personal rather than corporate tax rates, since it is treated by the IRS as income to each individual partner.

Bares's instincts were right on target: he had set up a preliminary estate plan that was flexible enough to adjust to the changing needs of a growing business, without a lot of unnecessary paperwork and administrative costs. (The family partnership/leasing scheme would work just as well for families that share ownership in their businesses, whether with venture capitalists, employees, or other partners. All that's required is agreement about which assets need to be owned by the corporation and which can be leased just as easily from the partnership or another third party.)

It took Bares longer than it should have, perhaps, to slip into stage two. It happened long after his company had passed from start-up to success, right around the time that his first child went off to college. By then, Bares had about 70 employees and a business that he knew had the potential, at least, to survive its founder.

Ideally, an estate plan at this stage of a business's development should focus on 1) reducing future estate taxes; 2) planning for future ownership of the company; and 3) contingency arrangements for management succession. Bares ignored the succession issue -- in hindsight a risky omission, since no one in his family was interested then in running the business.

Instead, he concentrated on what was then the best estate-planning scheme around, the estate freeze. It was a way for entrepreneurs to have their cake and eat it too: to continue building, running, and profiting from their businesses even while they passed along the pro forma ownership of their companies to the kids at large tax savings. The key was a stock-recapitalization plan that transferred nonvoting common stock to Bares's children, while he kept the preferred stock.

The Tax Reform Act of 1986 wiped out many of the tax benefits connected with doing estate freezes -- but luckily for Bares, not retroactively. Today's company owners, though, have to make do with some second-best alternatives, first and foremost the so-called GRIT (grantor retained income trust). It's another way of minimizing taxes while passing along stock to the second generation. In a nutshell, GRITs work like this: a business owner transfers shares in his or her company to an irrevocable trust, set up for a maximum of 10 years. The gift is then taxed at a maximum rate of 55%, which at first glance sounds just as terrible as the estate tax rate. But here's the advantage. The GRIT gift is first discounted to only 38.5% of its face value, so the tax on a $10-million gift would be only $2.12 million, compared with $5.5 million if it passed at the owner's death.

During the lifetime of the GRIT, the owner can receive income from its shares in the form of dividends. (Owners who have never declared dividends before must set up a formal structure -- a simple matter for accountants -- since funds transferred to a GRIT must produce income.) Afterward those shares pass on to children free of all estate and gift taxes -- no matter how big the business has grown. There are just a couple of problems. If the grantor dies during the 10-year term, the trust is voided and the assets revert to the estate. The heirs get a credit for the gift tax paid, but they have to make up the balance. Also, most people are only comfortable putting up to 49% of their company's stock into a GRIT, since they don't want to give up control of the business. For business owners too young -- or uncomfortable with the logistics -- to consider GRITs, the best alternative is insurance and lots of it. Buy enough to pay off whatever estate taxes are expected, above the $1.2-million exemption permitted to each married couple ($600,000 for singles).

During the second stage of Jack Bares's plan, his oldest child cashed in some of her holdings from the partnership to finance the start-up of her tool company. And he set himself the goal of reviewing his "interim" estate plan in five years.

All right, so he was a little late. But Bares had been a busy man, building a business that now employed 200 people and rang up twice the sales of nine years earlier, when the estate freeze had taken place. His attitudes about estate planning had finally changed as well. "I knew I had the dollars taken care of. But I realized that I had these four adult children and a wife to think about. I wanted to make sure that the business was ready for them to take over, regardless of what they wanted to do with it."

Inevitably, every business owner's priorities at this stage will be different, as different as their final estate plans. Bares figured that he had two loose ends to tie up: first, informing his children about the family business and finances; then, setting up a formal structure that would pave the way for management succession. And he has stopped adding to his life-insurance coverage. "I've been told that there's very little we'll have to worry about in estate taxes," he confides.

Bares's final estate plan? He promoted one of his vice-presidents to the president's spot and is in the midst of a search for three outside businesspeople to appoint to his board. Their role will be either to ensure a smooth succession to new family management or, if none of his children wants to stay involved, to sell the company. He also has formalized an arrangement whereby if only one of his children wants to stay in the company, he or she must buy out the other family members at market cost.

But all this doesn't mean Bares plans to stop working 60-hour weeks -- far from it. With a new president in place and plans to appoint an outside board before year end, he can concentrate, as he says, on the larger issues that interest him, such as Japanese production methods, Cleveland's economic revival, and various schemes to keep Milbar growing.


WHAT TO LOOK FOR

Estate-planning guidelines

There's more to savvy estate planning than writing a will, although that, admittedly, is a fine place to start. As you make plans to pass your business and estate on to heirs:

* Stay informed. Experts predict further crackdowns on estate-tax breaks for small-business owners and investors. If you know which developments are likely, you can take measures to protect family holdings and sometimes slip in under grandfather clauses.

* Look for special tax breaks. Occasionally windows of opportunity open, as with the Gallo Exemption, which permits business owners and others to gift up to $2 million to each grandchild, tax free, before January 1, 1990.

* Keep priorities straight. "Tax-minimizing schemes work only if they also fit in with the long-term interests of the business and the family," says Leon Danco, founder and chief executive officer of the Center for Family Business, in Cleveland.

* Involve family members. Bares accomplishes this by writing an occasional newsletter for his wife and children, reporting on everything from the specifics of his estate plan to his thoughts on the philosophy of management succession, and even the effect of Black Monday on the family's investment portfolio.

* Review the estate plan regularly. "Kids grow up, laws change, your health changes, the business grows -- there are a thousand reasons to take a fresh look at your plan every few years or so," advises Bares.

Last updated: Aug 1, 1989




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