Wednesday, July 31, 2013

Another Problem for the CH Brain

A guest post by bagoh20.

Let's say there is a man who has a profitable company.  Upon his death, he wishes the company to be transferred to at least some of the long term employees.  He would prefer that it continue to employ people and support its customers and vendors, but secondarily it could be sold and the proceeds divided among the employees based on seniority.

The problem:

1)     Depending on the law at the time, the tax burden of a transfer of ownership could be enormous and enough to make the new owners insolvent, and thereby prevent it from continuing.

2)     It will be impossible to sell it for what it’s worth, because the proceeds passed to the employees would be sufficient for most of them to quit their jobs, and the value of the company is closely tied to the employees.  The real value of the company is their ability to produce a profit.  If they are leaving, nobody will be buying.

It’s a catch 22.  Maybe I'm alone on this, but this post forced me to finally know the origin of that term after pretending to my whole life.

“The term catch-22 was coined by Joseph Heller in his novel Catch-22. Initially this is based on the explanation of the character Doc Daneeka as to why any pilot requesting a psych evaluation hoping to be found not sane enough to fly, and thereby escape dangerous missions, would thereby demonstrate his sanity:”  ~ Wikipedia

So: 

1)     Is there a way to avoid the pitfalls above?

2)     If you were a key employee, middle aged, and likely to inherit this, what would you want to happen?

53 comments:

chickelit said...

Stipulate: no wife or heirs?

ampersand said...
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ampersand said...
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john said...

Freeman,

This is a very common problem with service firms, consultants, etc. ESOPs and other asset transferring devices are used to transfer the ownership of the company and transfer the assets to the seller.

Because the only real company asset is the reputation, experience and expertise of the key employees, they will essentially purchase the company and sign agreements to stay on, and not cash out.

The continuing success of the firm is also often dependent on the original owner's continued involvement. So he can't die.

bagoh20 said...

"Stipulate: no wife or heirs?"

No. There will be no dispute. The business will be in a trust willed to the employees. Is there a better way? The problem is to get the value of the company to the employees with the least cost and risk.

bagoh20 said...

"So he can't die." I'm sure he'd like that plan.

The problem with ESOPs is that they are highly regulated, and therefore expensive and a hassle to implement and maintain. You need to marry a pack of lawyers. Nobody wants to marry a lawyer.

bagoh20 said...

I always thought the term "catch-22" was old, and that the book was named after it. I never read it, or any other book lacking animated characters or pop-ups.

chickelit said...

Another Problem for the CH Brain

Actually, Carol_Herman had quite the head for business or permutations thereof.

Lem the artificially intelligent said...

For the employees facing the problem Bags poses, what happened to me is not the same, but, in some respects, in what-if scenarios, I've had the time to look back in my mind, since I and about half that office staff was let go. Maybe I do have something to contribute, relating what happened to me.

I was laid off after the firm I worked for over 20 years was sold to a much bigger firm. Initially after the buyout, the new owners kept everybody on, for about 4 years, while the economy was booming.

However, sometime after the wall st / economic meltdown, they started lying off people, while at the same time, the new owners continued their aggressive expansion plans, which included buying up more smaller firms like the one I had worked for.

I thought, keeping employees would be their priority when times were bad. Maybe scale back their growth plans to be able to keep people on that way. That, however, was not the companies top priority.

I guess what I'm trying to say is that, once new owners take over, new economic realities and plans for growth come into focus, anything can happen.

"It's hard to make predictions - especially about the future." --Robert Storm Petersen

Lem the artificially intelligent said...

At TOP.

Last month we were talking about Supreme Court cases, and this month it's been the racial and sexual matters in the Zimmerman trial and the long shadow of the World Wide Weiner.

Lem the artificially intelligent said...

1) Is there a way to avoid the pitfalls above?

2) If you were a key employee, middle aged, and likely to inherit this, what would you want to happen?


The inheritor, it seems to me, has to have a desire to continue the work of the company. Otherwise I doubt much can happen from that quarter.

bagoh20 said...

"World Wide Weiner."

Nobody even says "www" anymore. And nobody really ever did say the words, even back in the 90s.

bagoh20 said...

I'm assuming a company worth at least $10 million where the tax burden really gets onerous enough to threaten survival, and where the proceeds of a sale leave the employees pretty well off, but not wealthy. If it's left to a few key managers, they'd be inheriting a nice income from profits of maybe $3 million a year if they keep it going.

bagoh20 said...

I always assumed Betamax was the spawn of Carol Herman, and slithered from her loins after she was run over by a drunken gang of Segway drivers?, riders?, pilots? leaners? or whatever the hell you call them. Anyway, they didn't even slow down, and only left a trail smoke from their clove flavored cigarettes.

Dante said...

I'm supposing you are trying to solve a very difficult problem.

First, find someone who can take over your job, and who you respect even if they do not agree always with you.

Second, perhaps you could look into cutting up the company, and putting shares into 401Ks.

Seek a lawyer to help out.

The Dude said...

Howard Hughes used to fire his valued employees, tell them to sue him for wrongful termination, put up only a minimal defense, then the court would order a huge settlement, which Hughes would pay, and the money paid was tax-free.

Howard Hughes hated paying taxes. He had his entire empire organized under his hospital, which was a tax exempt organization.

He may have watched Ice Station Zebra too many times, but he sure knew how to evade the long arm of the IRS.

Freeman Hunt said...

When they sell the company, they can sign agreements to stay on in order to get the full sale price.

Freeman Hunt said...

I know someone who did that. He also sold his company himself, then gave bonuses to all of the employees based on seniority. Can't wait for death to do that one though.

I Have Misplaced My Pants said...

Sixty, knowing that factoid puts a smile on my face and a spring in my step. Thanks for sharing!

The Dude said...

It's amazing what one can learn watching movies.

Joe Schmoe said...

Just a thought. Rather than wait for this one event, when you die or retire and then there's this instantaneous change in the company leadership, start ceding shares and control now and spread it out over several years. Also groom a successor; it's not clear in your problem if you will designate the next CEO or if these long-time employees will have to knife-fight to see who becomes the next CEO.

Estate planners encourage clients to give to their heirs while they are still alive, and the IRS allows gifts up to $14,000 per year. I suspect you could follow a similar model for a business.

Joe Schmoe said...

IRS allows gifts up to $14,000 per year tax-free, I should add.

Joe Schmoe said...

I should clarify a little more; the reason the estate planners encourage the gifting is that it will yield a lower inheritance later on when the client passes away; hence their heirs will have a lower estate tax burden.

Joe Schmoe said...

Last but not least, you could adopt me, Bagoh, and I'll come run that company right fucking proper.

That brings up a good idea. If Bagoh asked you to take over his company, which commenters would you install in what positions? Rhhardin is the head of engineering. Dust Bunny Queen could run the finance department. Chip Ahoy for marketing collateral. Paddy O as company chaplain. Meade for janitor.

Joe Biden, America's Putin said...

Doesn't matter. Government takes half.

I'm Full of Soup said...

Most people want to keep working even if they have a big pot of moolah.

In the ssituation you described, the employees would not get a big pot of money, they would receive a financial interest [stock or partnership interests] in the company and in its future profits and future losses. So they would not be able to retire unless they colectively agreed to sell the company which, as someone mentioned, could result in a less valuable enterprise [assuming many workers would take the money and run].

Joe Biden, America's Putin said...

It's best to sell before you die.
Perhaps arrangements can be made for an employee buy-out.

(Unlike the government) the employees have a vested interest in keeping things alive and profitable.

Joe Schmoe said...

Pastafarian could be the sexual harassment compliance officer. (I got the idea from his profile picture.)

Karen of Texas said...

I don't know what the 'right' solution is, Bagoh, but I do know that your employees work for a pretty amazing guy. Reminds me of this:

" When the Malden Mills factory burnt down on December 11, 1995, Aaron Feuerstein decided not only to use his insurance money to rebuild it, but to also pay the salaries of all the now-unemployed workers while it was being rebuilt. Feuerstein spent millions keeping all 3,000 employees on the payroll with full benefits for 6 months. By going against common CEO business practices, especially at a time when most companies were downsizing and moving overseas, he achieved a small degree of fame.

Feuerstein claimed that he couldn't have taken another course of action due to his study of the Talmud and the lessons he learnt there:

"I have a responsibility to the worker, both blue-collar and white-collar. I have an equal responsibility to the community. It would have been unconscionable to put 3,000 people on the streets and deliver a deathblow to the cities of Lawrence and Methuen. Maybe on paper our company is worthless to Wall Street, but I can tell you it's worth more."
—(Parade Magazine, 1996)

It would cost Aaron Feuerstein $25,000,000, his CEO position, and a November 2001 filing of chapter 11 bankruptcy to 'do the right thing'.

I read about him in Reader's Digest oh-so-many-many ymany ago, and I've never forgotten that someone, somewhere, running a company would do something like that. And I AM a firm believer in capitalism at its finest. But capitalism at its finest isn't sucking the employees dry nor bleeding out the employers. Balance - it's all about balance.

You seem like a stand up guy, Bagoh. It would be an honor and a privilege to work for someone like you.

Icepick said...

I always thought the term "catch-22" was old, and that the book was named after it. I never read it, or any other book lacking animated characters or pop-ups.

It's a funny book. There's a section in which people keep giving Col. Cathcart marital advice: "Why don't you beat your wife?" The wife desperately wants to be beaten, by the way, although that can be interpreted at least two different ways. A funny, sick and all-too-appropriate book....

Bender said...

If it is placed in trust, then, even though they own the beneficial interest, the terms of the trust will control as to when they can receive the actual money.

In other words, the trust can be structured to not require a distribution of principal until retirement age, or perhaps involuntary separation from the company, with the trustee having wide discretion as to pay-outs prior to retirement or involuntary separation.

That way, if they quit at 35, thinking they can take their share and never work again, they will find that they get nothing for the next 30 years. That is enough incentive not only for them to stay on, but to keep the business as profitable as possible.

Patrick said...

This requires more than I can type on my phone, but I would have the employees in question form a corporation and lut the company in trust that will be owned by the organization upon your death (or retirement). You show a lot of concern for those employees, but if you do too much to control how they handle it once they control it, it won't end well.

I understand your natural aversion to my profession, but you should consult a tax attorney, well versed in Federal and CA tax law.

Michael Haz said...

Bags - Taxes are the problem that screw up your plan. Giving the business to someone imposes two tax burdens: The first is the tax your estate must pay in very short order following your death. The second is the taxes a future owner would have to pay if that person chose to sell his interested in the (gifted) company.

To solve the problem you need to take the tax burden yourself by selling the company (while you are living) to your key employees. A sale can be structured over a period of years with a gradual shift in management so that you can back away when the new owners have accumulated enough operating experience, banking relationships, etc. to make the business keep running.

Businesses that are transferred at the owner's death usually wind up on the auction block to satisfy IRS demands.

ndspinelli said...

Haz, Very wise!

bagoh20 said...

This is not exactly my situation except for the desire to pass it on to the employees. I have consulted a number of attorneys and accountants, and I have a trust for my business that leaves it to a the employees with instructions on when they can sell and how to distribute the precedes.

It does not handle the problem of the death tax, especially if it ever goes back to $0 or very low threshold where it was just a few years ago. The issues of human nature and motivations are still beyond any solution I've found.

I would like to add that although I bag on lawyers all the time, I do like most of the ones I've worked with, and appreciate their work. It's the gardeners that will sneak in close, and then stick you.

One good solution suggested here and by the experts is to gradually gift away ownership, but that means giving away power, and Dr. Evil has a problem with that. Woohahaha Wooohahaha.

Joe Biden, America's Putin said...

The IRS is first in line after you die.
You know - The American dream.
After you run your truck off the road into the ditch and die, the government swoops in first to strip apart your belongings and take what they want. Family and friends get what's left.

You are obviously a man of integrity so I suggest you consider ditching that integrity and climb into bed with democrat officials or hire a lobbyist. Perhaps you can acquire a sweetheart Chobani deal?

Otherwise, prepare for major punishment. You run a profitable business-- you hire people and give them jobs. That's deemed "unfair" by your political betters. Your property is better off in the hands of the government.

Joe Biden, America's Putin said...

If I sound bitter, it's because I've witnessed it firsthand with the people I work for and with.

Family businesses that must be sold in order to pay the IRS bill.

It's disgusting. yet the media, our pathetic education system, the democrat party and the Hollywood propaganda machine keep perpetuating the myth that it's all for the best.

bagoh20 said...

Haz, I am thinking that strategy over as an alternative.

BTW, my desire to move us out of California is dead. Only 20% of employees would go, and it would require overcoming tremendous inertia logistically. Consequently, today I sign papers to buy 4 acres of Los Angeles industrial real estate. I'm now probably the poorest guy you know, and I'm stuck for life with a state full of nut job liberals and a city council that yesterday inside offices surrounded by a sea of potholes voted 13 - 0 to demand that Eric Holder in D.C. investigate civil rights abuses in Florida by George Zimmerman. The good thing is I feel exceptionally smart here.

Joe Biden, America's Putin said...

Well, at least the weather is nice.

Dust Bunny Queen said...

Joe Schmoo has a good strategy in systematically transferring ownership of a company during your lifetime. I dealt with many FLPs [Family Limited Partnerships] in my career and helped to set up separate trusts for the personal estates. Mostly for the large ranches in the area but also for some businesses. There is likely a similar mechanism that you could use in a non familial situation. The advantage of the gradual transfer is that the 'new' owners get to work with the existing owner to get training and hands on experience.

In addition, I would recommend, if the total transfer is to occur before death to avoid estate taxes, that the outgoing owner retain a contract to be a consultant (outside contractor type of position) to the company for an extended period of time. That way the owner, is not going to incur tax liability for the company upon demise, but still would have some influence in advising the new owners and be able to still have some income from the business.

My first recommendation would be to work with a very good estate planner and a tax attorney.

Questions "I" would ask.

1. How many employees do you envision as being the owners of the company. If you employ say 100 people, you probably in reality only want 3 to 5 people.

2. Is the company a C-Corp, S-Corp, Limited Liability Corp, Partnership? Other? The mechanism of transfer of ownership would be different for each entity. As well as the tax treatments.

3. Transfer of ownership in some of the above cases would incur a tax liability for the transferee, but it would be over time and not a big hit at the 'ultimate' transfer.

4. If the transfer is in shares of a non publicly traded company, most likely, the fair market cost can be determined on an annual basis by another accountancy firm, for IRS purposes. Similar to the FLP.

Other considerations in the value of the company are 'blue sky' types of issues. Is the value of the company predicated on who is the owner? or separate from the economic worth of the company and product?

If gradual transfer is not considered, then I would be looking at an irrevocable trust or a charitable trust if possible. A CRT or CLT. It might also solve the estate tax issue......HOWEVER....be aware of the Lifetime Gift Tax Exemption with if exceeded WILL incur taxes upon death.

Again. A good tax attorney and estate planning team is essential.

Dust Bunny Queen said...

@ Bags

Regarding giving up control, perhaps a LLP or LLC is the way to go. Similar to a FLP

The General or managing partner is in control. But again tax ramifications of the pass through nature of profits to the 'limited' partners. Your employees may not like that. But....they can't have their cake and eat it too.


Methadras said...

The solution is simple. Once the IRS get's it's money while the company is producing revenue, what happens to it should be none of their business as lone as the tax dollars flow. This is the problem of the tax structure and tax laws as they stand now. Convoluted and dangerous. I don't think you could hire enough lawyers to get out of a conundrum like this.

bagoh20 said...

I appreciate some of you thinking this is some stand up thing to do, but really what is the alternative? If the owner who made the investment and took the risks dies, who else deserves the value of a company more than the people who built it and work there? I don't have any heirs, but if I did, why should they get it?

I would most prefer it just keep employing, training, and paying people for as long as possible, but nobody listens to a dead guy unless they wore a tunic or a powdered wig, and even then the living twist things beyond recognition.

Once I'm gone I'm gonna start up a Zombie Insurrection Party (ZIP), and we will field some kick-ass candidates. So when some Democrat tells our guy "I knew so and so. He was a friend of mine. You sir are no so and so." Our guy will say, "Dude, yes I am."

What irks me is that all this value was already taxed and re-taxed at the corporate, and owner level as profit, income, fees and miscellaneous taxes, plus, all the incomes of all the employees over those years. Then after all that, they want half of what's left without ever stepping a foot in the place except to inspect, demand information without paying for it's production, and generally slowing us down. They are willing to kill that golden goose to get that last check too.

I really don't know how anyone can respect this system, but many do.

Bender said...

I really don't know how anyone can respect this system, but many do

The people who benefit (take) from the system respect it, you greedy One-Percenter. And, no, you don't get a "thank you," you only get a "Give us your damn money. We want it, so it's ours."

Joe Schmoe said...

Karen of Texas, excellent reference. Feuerstein was a god in the eyes of the lefty media when he did that. But he did a completely dumbass thing just to assuage his own guilt. It cost him and his employees everything.

Michael Haz said...

Bags - I had a similar situation. Hit my mid-50s, had a couple of health scares and noticed that some of my friends had croaked. What to do with the business?

My heirs were doing well in their professions and not interested in running my business.

I thought about giving it to my employees, then stood back from that idea and took another look. While each employee was very good at what they do, none had the overall ability to run the business. If they did, they'd be running their own business and not working for me.

What I did: First, created a temporary succession plan in the event I dropped over. A key employee would be appointed to run the day to day operation and my CPA would have all financial authority for expenditures, etc. until the business was sold or liquidated.

Second, I engaged a business broker to find a buyer. Any potential buyer would be given bare information until a confidentiality agreement was signed, and then be given the name of the company and some financial info.

A buy was found, someone in a similar, but not identical business who wanted to grow through acquisitions rather than organically. We structured the deal so that they purchased half of my stock on closing day and the remaining half one year later at a pre-determined price. If they didn't make the second payment, they gave me back the 50% I sold at $0 per share.

We explained this to employees, customers and lenders as a merger. I continued to work for one year, making sure the new owners knew how to run the business. We jointly visited all customers, suppliers and presented this as a merger. We had the same bank, so that part was easy.

At the end of the first year, my retirement was announced and I sold the balance of my shares. I was gone.

The "give it to the employees" idea has serious pitfalls. What if I did, and they made a mess of it? They could wind up, every one of them, having to go bankrupt. Then some lawyer would tell them "Hey, rubes, you're broke and the guy who gave you the business isn't. Let's go get his money!"

I had to get over the idea that I owed my employees something. I had given them gifts but they didn't know it. Every time I put debt on my home to keep the bills paid was a gift to them. Every time I gave up something of mine to give them a little better benefits, that was a gift. Every time I made payroll by taking money out of my pocket, that was a gift. Every time I didn't lay people off during slow periods, that was a gift.

Good luck!



Joe Schmoe said...

Bagoh, I just thought of a great idea. Life insurance policy on yourself: you have one, right? If not, get one. Then have all of your employees gather in the parking lot, and stage your death by flying over in your hang glider and appearing to 'crash' into something with a subsequent explosion.

Your selected employees (beneficiaries of your life insurance policy, natch) can use your life insurance payout to pay the inheritance tax on the business transfer.

And you get to live in Mexico for the rest of your life, because everyone who fakes their own death goes to live in Mexico. If you want to come back to the US, just say you are an undocumented Dreamer looking for a better life. They'll let you over the border, pay for your college education, and your health care. Then you can get a low-level job at your old company and work your way back to the top. Lather rinse repeat.

bagoh20 said...

Michael, Those are great points and your idea and others on this thread have opened my eyes to other options my experts did not present.

I really like going to my work, but my people are good, and can pretty much run the day to day without me, but I do have my special talents here at the higher level financial, legal, and direction stuff that requires someone with experience running a business at the top.

I'm gonna rethink it. I offered this post because I was unsatisfied with what I had put in place. I did my Trust primarily to keep things out of probate, but the plan doesn't feel smooth or predictable to me. I need something better, and thank you all for helping me see that something may exist.

See, the CH brain works. It's just a little schizophrenic.

bagoh20 said...

Joe, I can't get life insurance - liver transplant, some ribs removed, partially man made diaphragm under my lungs, cured of cancer twice, and other chronic stuff. You would think a zombie like me would be a great bet. It clearly takes a direct head shot to keep me down, and I smell better than most of us.

Joe Schmoe said...

Bag, you sound like the real Bionic Man.

I'll raise a Pastafarian cocktail tonight and drink to your continued good health. (As long as I don't get hyperglycemic shock from it; the man loves his sugary drinks.)

Joe Schmoe said...

Just remember Bagoh, if you follow through on the 'staged death' idea, make sure you create a different Blogger profile when you resume posting after your post mortem. If you dyed your hair blonds as a disguise, you could post as BagoH202.

bagoh20 said...

Thanks Freeman.

Methadras said...

In all honesty what I would do is wait until until the business was successful and then sell it to someone who will hopefully care and nurture it like I did and for a profit and live life comfortably. The government can go fuck itself. They aren't getting anymore of my money and the employees can deal with that caretaker owner that I found to keep it going. That's what my ideal would be.