One of the most effective ways of “freezing” a contractor’s estate while passing the construction company to children involved in the business and/or key employees is the establishment and growth of a new entity (“New”) and the eventual phase-out of an existing company (“Old”). A carefully planned structure can enable successors to take over the business and can also provide significant payments to the retiring parent for the value of the business.
To achieve this, a “New “entity gets formed and is owned by the children and/or key employees. All new work is performed, either as a prime contractor or as a subcontractor to “Old”. “Old” completes its existing contracts on it’s own or they, if allowable, are assigned to “New”. “Old” continues to guarantee lines of credit with personal guarantees and the bonding line of credit with personal indemnities. “Old” sells it’s equipment to “New” at fair market value utilizing a term loan for financing. Rental space is provided to “New” under a new lease. For these arrangements, rent, loan payments and guarantee fees are paid to “Old”.
Employees of “Old” gradually become employees of “New”. The owner of “Old” enters into a consulting agreement with “New” for a set annual fee, usually payable monthly, for a number of years. The owners and key personnel of “New” enter into employment agreements. Distributions, in addition to compensation, to owners of “New” is limited for the payment of any current taxes due based on “New’s” taxable income.
By utilizing this planning technique, the owners of “New” focus their energies on the future of the business The goal is to build up “New” to become a stand alone and viable business.. Once this happens, “Old” can be phased out and “New” can establish it’s own banking and bonding lines of credit.
Although the business has been transferred to “New” without an outright sale and resulting tax, “New” must make payments to “Old” and/or it’s owner, for any value transferred to “New”. Intangible assets such as goodwill, client base and supplier relationships must also be considered when calculating value. The transfer of these intangible assets without adequate consideration could, upon IRS investigation, cause an income tax for “Old” and a potential gift tax to the owner of “Old” for transferring these intangible assets to “New”.
If this transaction is carefully structured amongst the respective parties, the benefits derived would be as follows:
The owner of “Old” achieves an estate “Freeze” for the ownership interest in “Old”, since he/she will only receive the book value upon liquidation. All future growth of the business will be achieved through “New” and it’s owners.
The owners of “New” do not need to find sources of financing to capitalize and finance the company since only minimal capital will be required.
There are not taxable sales of stock or membership interests by the owner of “Old”. He/She can defer the taxation of his ownership interest and can share in the earnings of “New” through a consulting agreement.
As long as there is reasonable arm’s length consideration for the assets of “Old”, both tangible and intangible, there should be no gift tax considerations.
Since business activity in the construction marketplace has recently increased and is forecasted to be very active for the foreseeable future, a great deal of wealth will be achieved. Despite the increased estate tax exemptions and portability, many contractors will become subject to estate taxation. The technique described in this article, if done properly, will minimize the impact of the estate tax.
ARTICLES INCLUDED HEREIN DO NOT CONSTITUTE AN OPINION AND ARE NOT INTENDED OR WRITTEN TO BE USED, AND THEY CAN NOT BE USED, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER. This publication is designed to present matters of general interest relating to accounting, taxation and business management. Articles were written by the tax department of Castellano, Korenberg & Co., CPA’s, P.C. Please consult your CK & CO adviser before taking any specific actions.
© 2015 Castellano, Korenberg & Co., CPA’s, P.C.