Case Study: Business Owner

John and Kate are the owners of Silicon Valley HVAC supply. John is 62 and Kate is 58. They inherited the business from John’s father and would like to eventually give the business to their children. Their oldest son, Christopher, is actively working in the business and has shown great promise. Their youngest son, Robert, is working at the company but shows less ambition than Chris and seems content calling on customers instead of running the day to day operations. John and Kate also have a daughter, Susan, who is married and staying at home with her own children.

John and Kate didn’t really know what the company was worth, although they had some idea based on what other HVAC shops had sold for. SVHVAC produced strong cash flow to John and Kate and, while they were starting to get tired of the day to day grind, they enjoyed reaping the fruit of their labors for all these years. SVHVAC had a very good general manager, Jim, who had been with the business for 22 years. Jim was a great employee who always had an ownership mentality and John and Kate always thought they’d eventually reward him for that, but they didn’t know how that would look.

In addition to the company, John and Kate also owned the land and building that SVHVAC was housed in. They owned their primary residence and had brokerage accounts worth approximately $2 million.

John and Kate came to Fluent because they didn’t know how they could retire, get value from the company and give the company to their children. They also realized that taxes were to play a big part in being able to fully transfer the business to the children.  

Fluent’s first task was to organize the issues and come up with a methodology for tackling them. Since many of these issues are interdependent, it is important to know in what order to handle them.

The first issue of consideration was that John and Kate had no formal succession plan and no structure for a buy/sell should something happen to them.

The second issue was to determine how John and Kate were going to be able to retire. Since they did much of the day to day running of the business, it would be difficult for them to leave.

The next area of consideration was how they were going to fairly divide their assets amongst their children. They wanted to pass the business on to children but only one of the children was active. How could they be fair and give each child an inheritance without creating conflict amongst the children?

The fourth area of consideration was how they were going to pass the business on to the children whole. The business would be worth more than the estate tax exemption, thereby triggering estate taxes that could not be paid unless the business was sold.

And of course they wanted the business to thrive and grow after they were gone.

After much consultation with Fluent, John and Kate determined that it would be best for Jim to manage the business in their absence until his retirement in ten years. That would give Christopher the time and mentorship to grow into running the business himself. In exchange, they would give Jim 5% ownership of the company, which would both reward him for years of faithful service and ensure he remains until retirement.

With respect to the children, John and Kate wanted to give each a fair amount, remembering that fair is not the same as equal. Christopher, it was decided, would get the majority of the business, since he was actively involved in the day to day operations as well as growing the business.   Robert and Susan would get cash flow but not have a say in the running of the business. Fluent decided it was wise to break the company into a land holding company and the business. The land and building would belong to Robert and Susan in trust. SVHVAC would lease the land and building thereby providing a steady income stream and tangible assets to Robert and Susan. They would also get their parents primary residence and the brokerage accounts. Finally Robert and Susan would have 10% each of non-voting shares in the company. This would provide additional income and finish splitting the assets fairly. Christopher would end up with 75% ownership of the business.

Rather than giving the children these benefits outright, it was determined that the business and property should be sold to the children and Jim. John and Kate would sell the business and property and then provide the financing for it. The owners would thus be paying John and Kate a substantial amount of money from the free cash flow of the business. This would enable John and Kate to retire with a similar amount of income as they were currently receiving. And with Jim and Christopher stepping up, they would be able to slowly disengage from the business.

Because they were selling the business to the children, it also would incrementally reduce their estate. This is important because John and Kate’s assets were over the estate tax limit. To further reduce estate tax, Fluent suggested a Qualified Personal Residence Trust (QPRT). This would essentially get the home to Robert and Susan, allow John and Kate to have full control over the house, and remove it from their estate.

Since Robert and Susan each had a minority interest in the company, they were able to discount their shares, thereby avoiding estate taxes on a larger amount. Additionally, John and Kate set up irrevocable trusts to capture the full $10 million ($5 million each) current estate tax exemption.  

In sum, between gifting, trust structures, and discounting, John and Kate were able to get most of the assets to Christopher, Robert and Susan estate tax free. However, John and Kate were still going to owe estate taxes on about $2 million. Fluent suggested an irrevocable life insurance trust (ILIT), to hold life insurance to pay for the estate taxes, roughly $1 million.

As an added benefit, since all assets were in trust, this would allow the children to receive the assets as their separate property, protected from divorce and creditors.

Over the course of a couple of months, John and Kate were able to ensure that their children would receive their assets with the best possible tax benefits. They were able to ensure that their children would get a fair distribution of their assets, strengthening family accord. They were able to structure the company to thrive in their absence. And they were able to retire while receiving a strong income stream throughout their lives. John and Kate could now move onto the next phase of their lives worry free.

Fluent Wealth Partners, LLC
1530 The Alameda #115
San Jose, CA 95126

Phone: 408-217-2000
Toll free: 866-630-7583
Fax: 408-217-2011