Wealth Transfer Planning

Many business owners find it difficult to free up capital that has been tied up in business assets, making liquidity a challenge, and often complicating wealth transfer efforts. Many strategies exist to help alleviate this issue:

• Initial public offering (IPO).
• Sale to a third-party investor.
• Sale to an insider.
• Divestiture of non-core assets.
• Personal line of credit against company shares.
• Recapitalization.
• Employee stock ownership plan.

The following strategies are meant to free up capital without the need for an outright sale of the company.

Personal Line of Credit Secured by Company Shares

Oftentimes, financial intermediaries will be willing to lend money to business owners, under the promise that if the business owner (borrower) is unable to pay, some or all of the business assets may be sold to satisfy the loan payments. A put option will also typically be available in which the borrower can close out the loan, and thereby repay all of the borrowed funds. In most jurisdictions, this action would constitute a taxable event, much like the shares having been sold themselves. This taxable event is what a personal line or credit secured by company shares seeks to avoid in the first place. Additionally, one major advantage of this strategy is that business owners can maintain control of their firms while enjoying high liquidity from that same firm.

Leveraged Recapitalization

This method refers to the business owner accepting funds from PE firms who come on board as partial owners. The PE firm purchases some newly created shares (recapitalized), using funds that they have borrowed (leveraged). This will reduce the original owner’s equity stake, but not require their giving up complete control. This method works well for mid-market firm owners who want to reduce their risk in the concentrated position but still stay involved in day-to-day operations.

Employee Stock Ownership Plan

In certain countries, business owners can sell some or all of their company shares to certain types of pension plans. An employee stock ownership plan (ESOP), is a pension plan created by the company that can buy some or all of the owner's shares of company stock. A leveraged ESOP is a version in which the ESOP borrows funds (typically from a bank) to buy shares, provided the company has the borrowing capacity to do so.

It may be possible to defer the capital gains tax on shares sold to an ESOP, depending on the legal structure of the company. ESOPs allow owners to diversify their holdings and overall portfolios while maintaining control of the company and retaining upside potential for their retained shares.

Strategies for Managing Concentrated Positions in Real Estate

Single real estate properties can often be subject to massive single-property risks. Natural disasters, political events, or the loss of key tenants can all threaten the economic condition of owners of these types of properties.

As opposed to an outright sale, owners of concentrated real estate positions frequently utilize various forms of debt and equity financing to monetize their properties. Similar to private companies, real estate owners can use a range of strategies to monetize their properties. These include mortgage financing (recourse and non-recourse, fixed, or floating rate) and charitable trusts or donor-advised funds.

Mortgage Financing

Mortgage financing involves taking out a loan from the bank using the property itself as collateral. This is common when properties are first purchased, but can also be a useful strategy for properties that are paid off. Oftentimes a high loan-to-value ratio will be possible, depending on the quality of the property and its history of net rental income. Often the interest payments on the mortgage can be set close to or equal to the net rental income. This results in the owner accessing liquidity from the property without the need for an outright sale, and with no net cash outlays. The owner can continue to enjoy price appreciation from the property without losing the property or having to pay capital gains taxes.

Real Estate Monetization for the Charitably Inclined

A donor-advised fund (DAF) is a way for organizations, families, or individuals to make contributions to charities, managed by a public charity on their behalf. Contributing individuals or organizations open an account in a donor-advised fund and deposit cash, securities, or other financial assets. Even though they surrender their ownership of the fund, they retain advisory rights over how their account is invested and how it distributes money to charities.

Much like the previous strategies, DAFs offer numerous tax advantages, and also offer some degree of control over the investments to continue on behalf of the donor, while simultaneously avoiding capital gains taxes.

Question

Which of the following strategies most commonly uses financing from a private equity firm?

1. Donor-advised Funds.
2. Employee Stock Ownership Plan.
3. Leverage recapitalization.

Solution

The correct answer is C.

A leveraged recapitalization involves selling shares to a private equity firm.

A is incorrect. A donor-advised fund is administered by a charity, and no financing is received by the donor. Rather a gift is made, and the giver is allowed to maintain some control over the funds thereafter.

B is incorrect. The influx of funds from an ESOP may be provided from the firm's own pool of cash, or possibly from a bank.

Reading 8: Topics in Private Wealth Management

Los 8 (i) Discuss objectives – tax and non-tax in planning the transfer of wealth