Preparing for life after cash out

Ever wondered what you would do with $100m?

When that private equity firm or strategic buyer comes knocking, it pays to have a plan: cashing out raises complex issues ranging from family wealth preservation and philanthropy to how best to invest the windfall, be it tens of millions or hundreds of millions of dollars.

The knock could come sooner than expected. Flush with cash and access to cheap debt, private equity firms are on the hunt for buy-out targets, be they closely held or public companies. Last year, for instance, private equity firms bought 576 private US companies for a record $67bn, according to Thomson Financial. The market has also been receptive to initial public offerings – 198 were completed in the US in 2006.

Jim Raaf, managing director at Harris myCFO, part of BMO Financial Group, says one of the most important decisions faced by entrepreneurs is how to convert part or all of their investment in a business into a more liquid asset, whether the liquidity event is in the form of an initial public offering, a recapitalisation or the sale of the business to a financial or strategic buyer.

“Business owners should begin to plan for the implications of their shift from operators to investors,” he says. “The different events [that] occur before a transaction takes place can have a significant impact on the after-tax proceeds available to the selling owners.”

One of the main reasons for planning as early as possible – ideally at least 18 months before a transaction – is because a liquidity event is likely to trigger a big tax bill. The advantage of propitious planning is that it can enable the seller to take advantage of opportunities for discounting assets, which may not be available after the transaction.

Jeff Kauffman, president and chief executive of Northern Trust’s personal financial services group for the north east region, says a liquidity event may be the “definition of a good problem”.

”With the sale of a business or a large concentrated asset holding, there is the creation of liquid wealth. I’ve seen it work out exceptionally well and not so well,” he says. “The difference is the level of planning and how the proceeds are invested at the point of liquidity and beyond. It’s a good problem, but it’s still a problem and you need to optimise the solutions.”

There are several pre-liquidity strategies that can help lower federal transfer taxes, which include the gift tax, the estate tax and the generation-skipping transfer (or “GST”) tax. They range from basic steps such as taking advantage of the annual gift tax exclusion – you can make annual gifts of up to $12,000 tax-free to any number of people, with a lifetime exclusion of $1m per donor – to setting up a Grantor Retained Annuity Trust (GRAT) and making an instalment sale to a Grantor Trust.

Jenny Jordan McCall, a partner at the law firm Pillsbury Winthrop Shaw Pittman LLP and head of its Estates, Trusts and Tax Planning Group, says GRATs are a “very good idea” for assets that are likely to appreciate. The idea is that because the stock of a private company is illiquid, it is often not valued as highly as shares in similar public companies and can be discounted. Moreover, the value of the shares of the formerly private company often appreciates substantially after the liquidity event.

This is how a GRAT works: the business owner makes a gift of stock to an irrevocable trust and in exchange receives an annuity for the term of the trust, usually two or three years. The value of the gift for tax purposes is the difference between the amount contributed to the trust and the present value of the annuity payments the grantor will receive.

With a bit of financial engineering, an adviser can select a combination of annuity payments and trust term that will result in the present value of all future payments being equal to the amount contributed to the trust. By IRS calculations, the GRAT will have zero assets by the time the trust expires, so no gift tax is owed.

The tax efficiency of the strategy can be improved by first recapitalising the company, or retitling assets in a limited partnership and then transferring non-voting stock or the limited partnership units to the GRAT. Using non-voting stock or limited partner units may enable the grantor to receive a discount for lack of control and marketability on the value of the contributed assets of 25-45 per cent.

Another popular tax­efficient strategy is a sale to an Intentionally Defective Grantor Trust.

With an IDGT, a grantor sells assets – say, stock in a closely held or family business, marketable securities, limited partnership interests or property – to an irrevocable trust in exchange for an instalment note with interest. This trust works best if the assets are subject to discounts in determining their fair market value and are expected to appreciate in value at a rate greater than the interest payable on the note.

When the grantor dies, only the fair market value of the note is included in the estate. This technique “freezes” the value of the assets in the estate.

Another benefit of the IDGT is that the grantor pays the income tax on any income generated by the trust. “That effectively allows the trust assets to compound tax free and the payment of the trust’s tax by the grantor is not treated as a taxable gift,” says Mr Raaf, of Harris myCFO. Also, an IDGT can be used for very effective “GST” planning as the grantor can allocate his/her “GST” exemption to the trust.

Mr Raaf says an instalment sale to a grantor trust “works exceptionally well” for closely held businesses that are taxed as partnerships and S corporations where both have high cash flows.

When it comes to mitigating potential income taxes from the sale of a business, Daniel Lindley, president of The Northern Trust Company of Delaware, says one of the most popular strategies he sees is the Delaware Incomplete Non-Grantor Trust (DING).

“The idea is that if you have clients who have an interest in a closely held business and foresee a liquidity event somewhere down the road, not just around the bend, they can establish a DING trust to receive some or all of their interest in their closely held business in anticipation of a sale,” says Mr Lindley. “This is a strategy for residents of high income tax states; it is not a transfer tax strategy, but one for avoiding a state income tax on a capital gain that might be realised through the sale of a business.”

Devising a sound tax strategy is only one element of pre-transaction planning. It is equally important to formulate an investment strategy for putting the millions, or billions, to work.

“When a liquidity event involves payment in cash, a highly illiquid asset – such as shares in a closely held business – is transformed overnight into the most liquid of assets,” says Amy Braden, head of the Family Wealth Center at JPMorgan Private Bank. “In investment terms, this is a massive portfolio rebalancing from a high risk/high return asset to a very low risk/low return asset.”

John Hoffman, a managing director at Northern Trust and head of its wealth advisory practice, says business owners contemplating a sale need to be educated on diversifying into a broader portfolio.

It is important to set up a “receptacle to catch the wealth”, such as a cash managed account, he says. The purpose is twofold: it allows the money immediately to begin earning interest and then acts as the funding entity for the business owner’s – or family’s – investment and philanthropic strategies.

Another consideration before a liquidity event is the human dimension. Ms Braden says the sale of a family business “opens a Pandora’s box of emotions”.

“The transition from being a powerful CEO to being a private investor is a change in identity and self-image that can take considerable adjustment,” she says. “As business owners struggle with redeploying their assets, they are also struggling with the deeper question of what’s next in their lives.”

One often overlooked issue is personal safety. The publicity that often accompanies a big liquidity transaction can expose the family or entrepreneur to new risks.

When straddling complex financial and personal matters, it is important to enlist the help of skilled professionals. “Make sure you have a strong adviser team surrounding you,” says Teri Lyders, executive director of private planning at UBS Wealth Management. “You don’t want someone to be practising on you.”

Ms Lyders encourages clients who face a potential sale to think about a host of issues, including what he/she needs for financial independence, and how the sale, with its sudden influx of cash and change of lifestyle, will affect any children or other relatives.

The success of a liquidity event – and thus the business owner’s next phase – rests on tackling these questions and devising solutions well in advance of a trans­action. As Mark Twain once said, “Plan for the future, because that is where you are going to spend the rest of your life.”