Family Business: Providing Tax-Free Succession
FAMILY BUSINESS: CASE NUMBER TWELVE: THE GILBERT FAMILY
A Practical Method to Provide Tax-Free Succession to the Younger Generation
Jacques and Blanche Gilbert had spent their entire lives raising their five sons in Sherbrooke, Quebec. The Gilbert Family were logging contractors, sometimes working for Canadian firms harvesting on government land in Quebec, and sometimes crossing the border to work in the United States if they could meet whatever the visa requirements of the time were. They preferred to work in the United States as the base pay (predicated on how many cords cut and delivered to roadside) was higher in the United States and the currency benefit of having U. S. dollars to spend in Canada made the economics all the better. Jacques and Blanche often talked about moving to Berlin, New Hampshire, where there were many French Canadian families. Until the boys finished high school, those plans were just tentative. Blanche made sure that all the boys studied English in school and she also had a designated English day each week at home when everyone spoke English. She was a careful planner and wanted her boys to have every opportunity if they did move. Jacques was almost always away during the workweek, which was just as well as he would not speak English in his ‘French home..
Logging contractors had been an essential part of timberland management ever since king pine was discovered in New England by the early explorers. Those pine trees were reserved to be used as masts for the British sailing ships. In the early years, harvesting crews followed the king pine’s scouts into the areas where the huge pine trees grew. These magnificent trees were cut(some would say slaughtered) with crosscut saws and axes. At the turn of the century, most of this special pine was gone and those that remained were protected. Other species, mostly softwood, then drew the attention of the harvesting contractors as the markets were great. Europe had diminished its timber stands long before so the plentiful timber in New England was a desired commodity. These early 20th century harvesters would leave their homes in mid-November and go to the woods living in cabins until the spring thaw when they would leave the forest until the next fall. It was not an easy life. “Tall Trees and Tough Men” by Robert E. Pike, is a book that offers a fascinating view on the life of these hardworking men.
Jacques’ great grandfather lived that life, and whenever the Gilbert family assembled for holidays, the men would tell the stories of the adventures of those early loggers and add their own. Crosscut saws, double bit axes, and horses were replaced over time by chain saws and skidders, which in turn, were replaced by feller bunchers, huge harvesters, and log carriers known as forwarders. The river drives, the principal way that logs got to market, have also been replaced with truck transportation. The demand for wood however has never stopped. The only change is the way that wood is harvested and transported.
Jacques and Blanche continued to be worried about their economic future. Governmental restrictions and cross-border problems worsened as time passed. In 1990, as the last of the boys graduated from high school, they moved to Berlin. Jacques had carefully timed his equipment purchases so that he was able to sell all his harvesting equipment in Canada before leaving. It was easier to immigrate to the United States with cash than with equipment. They also sold their home but kept their fishing cottage located between Baie Comeau, Quebec and Labrador City, Labrador. It was a special place.
It was not an easy transition however. Blanche and the boys had to leave all their friends. Jacques initially had difficulty finding work, as he wanted to go to work as an employee for a harvesting contractor and not have to take the risk again of buying equipment. A new harvester cost over $400,000. Many of the crews working the New Hampshire and Maine woods were English-speaking and Jacques realized that he should have listened to Blanche. It was not just the matter of speaking with fellow workers, but as all the equipment instructions were in English, Jacques realized he was lagging behind and was not the desired worker he had hoped to be. It was Blanche who actually got him a job with a French firm in Berlin as she met the wife of the owner at church.
Jacques was a skilled equipment operator and knew how to maneuver the equipment to maximize the number of cords that he could cut in one day. He was actually faster than the man operating the log carrier, who supported his production by taking the tree length logs out of the woods, so there was some tension. Jacques constantly tried to get the carrier operator to speed up and also tried telling the other harvester operators to change their techniques. Not all of his advice was welcome so Jacques started to plan for a transition into a business that he could own. In 1993, he purchased a small trucking company that owned three log carrying trucks and had a hauling contract with a large harvesting contractor in western Maine. Jacque drove one, Jacques Jr. drove one, and a friend of the family drove the third truck. It all worked quite well so they added more trucks and drivers; expanding into hauling contracts with several more harvesting contractors and with two pulp and paper companies to carry softwood chips to their plants. Two of Jacques Jr.’s brothers- in- law were also hired. Jacque Jr.’s wife came from a large family. One family member was an accountant – a role that the growing company greatly needed to fill and the other was a human resources and safety person, who also fulfilled another important role at the company.
It was a sad day in 1994 when the youngest son who had gone to work as an employee for a harvesting contractor, was killed in a gruesome woods accident. Jacques and Blanche were devastated. As a result, Jacques decided that he wanted to somehow protect the boys from equipment risks and get them all out of the woods. In early 1995, he bought a chipping plant, which purchased softwood pulp; chipped it; and then had the chips trucked to the mills in Berlin, New Hampshire and Gorham, Maine. His second oldest son, Henri, was made the plant manager and did a great job. He knew that keeping the existing employees, especially the maintenance guys as chipping plants have a lot of mechanical problems due mostly to the percussion of the machinery as the huge mechanical knives cut the wood into chips was crucial. The debarker, the conveyor system, the augers, and the knives all were susceptible to issues, so preventive maintenance and the on-site ability to fix problems made all the difference in the chipping business. Jacques Jr. was already managing the New Hampshire trucking operation and the corporate entity that owned it. The other sons, Robert and Paul, were interested in starting a trucking operation in central Maine so they came to dad for help.
A Growing Business
Jacques and Blanche were now approaching age 65 and had started to think about their retirement. They had long been advised in business matters by their bilingual accountant, Ray Runyon, who had an office in southern Maine. Ray was a good accountant who always provided his clients the best service he could.
When Jacques called Ray asking to meet and talk about his growing business enterprise and plans for the future, Ray had just finished preparing the Gilbert family business tax returns and financial statement. Ray was amazed how the businesses had grown and even more amazed to see that the businesses had produced more than $500,000 in net income. Jacques had also mentioned that it was time for him and Blanche to do some estate planning, as they had done nothing since moving to the United States. Jacques and Ray made an appointment for the next week.
Ray knew estate planning was not his area of expertise so he called his friend and former accounting firm colleague David Reed, to see if he would be willing to go to Berlin and help with a client in the timber industry. David agreed and said Ray could tell his client there would be no charge for the first meeting. Jacques was called and a meeting was set up.
Ray and David spent the whole day in New Hampshire. Jacques had decided to provide his guests Gilbert Family hospitality. During the morning David and Ray met with Jacques, Blanche, Jacques Jr., Henri, and Paul. Robert could not be there. At noon they all went to Jacque and Blanche’s home where Blanche had prepared a great meal. The social time was also business time, as David learned about the family background, saw pictures of the six grandchildren, and was briefed on how each of the separate businesses were doing. Ray had already shared the financial statements and tax returns with David. That morning Jacques gave David a copy of a recent personal financial statement he had just presented to his bank, in the process of borrowing funds to purchase equipment for the new trucking operation.
Jacques agreed to have David prepare ideas for business and estate planning as long as Ray looked them over. David was pleased as he enjoyed his day with the family and already knew he could be a great help to them. He also knew the family was going to need a good attorney who had expertise in trusts and estates with families who own family businesses. It would also help if the attorney had experience in dealing with businesses with operations In New Hampshire and Maine. Before he left, he told Jacques not to complete the formation of the new trucking corporation, nor purchase the trucks or complete the bank financing until an agreed upon plan was implemented. Jacque said it was easy to put that on hold and he did.
The Business and Succession Plan
It is always crucial to know all the facts related to an assignment so David first prepared a statement of facts and forwarded it to Jacques to make sure it was completely accurate.
The key items were:
- The New Hampshire trucking business was operated by an S corporation owned entirely by Jacque.
- Ray had participated in the formation and had filed the S Corp election form so David knew that would have been done correctly.
- Jacques was also sole owner of the S Corp which operated the chipping plant managed by Henri.
- Jacques and Blanche had investment and real estate assets worth $1.3 million, not including the businesses. At that time the Federal estate tax exemption was $1 million per person, so David knew that if he could help transfer the businesses to the sons without using any of Jacque’s or Blanche’s lifetime exemptions, everything would work out.
- No one in the family had any life insurance and no one had any long-term care insurance. Jacques did not believe in life insurance and expected his sons to take care of their parents in their old age.
- Form a Maine LLC to operate the new trucking business.
- Paul and Robert should be the principal owners, at least by value. Jacque could be the sole managing director with a small amount of ownership, if he wished.
- The new trucking contracts should be held in that company’s name.
- All the new trucks and other equipment should be purchase in that company’s name.
- Paul and Robert would need an operating agreement for the LLC which would provide for succession if one of the brothers was to die, become permanently disabled, or just decided to do something else. The lawyer who drafted the agreement knew to put in provisions to protect ownership against divorces to the extent possible.
- The new LLC would execute an agreement with the New Hampshire S corp. owned by Jacques for management and administrative services, thus offering a part of Jacque and Blanche’s retirement income. The agreement would terminate on the deaths of Jacques and Blanche.
- Ray and David would prepare a valuation of the S Corp. which owned the chipping plant so that a gift program could be initiated using the annual exclusions available to Jacques and Blanche to transfer the ownership of the corporation over the next several years. The chipping plant had not done very well financially in the past three years as they lost a key contract. David thus knew the value would not be high, and a modest value coupled with appropriate discounting for non-voting stock having no marketability would permit the desired ownership transfer to Henri in a couple of years.
- This S Corp. would also execute a management agreement with the original S Corp for the services it would receive and to provide a second source of retirement income to dad and mom.
- The New Hampshire S Corp, which owned the original and most profitable part of the family enterprise needed careful planning. Jacques wanted Jacques Jr. to eventually own this business but that would mean he would be getting a larger share of the business assets than his brothers. Jacques Jr. insisted that his two brothers- in -law be equal owners as their hard work had been instrumental in the growth and profitability of the company.
- David suggested that a new LLC be formed, and be owned equally by Jacques Jr. and his brothers in law; but not dad, and used to slowly take over the N H trucking business. The ‘takeover’ was the crucial part. First, as new trucks were needed, the new LLC would purchase them and rent them to the existing S Corp. as needed. Second, as hauling contracts came to the end of their term, the new LLC would negotiate to take over the work previously done by the S Corp. In this manner it would take about five years for the old trucking business to become just a management company owned by Jacques Sr., and the new LLC to have a thriving business. David knew to be careful here as he did not want the Internal Revenue Service doctrine of liquidation reincorporation to come into play as a large income tax would be possible. The facts of the new ownership helped him be careful and all was fine.
- This new LLC would also execute a management agreement with the original S Corp for administrative services, again as part of providing his father and mother a source of retirement income.
- The management agreements would work just fine as the original S Corp. which owned several large, recently acquired buildings, which produced paper losses (commercial buildings in Berlin, New Hampshire had not been a good investment) that could be used to offset the management fee income. The S Corp. owed Jacques over $500,000 that he personally loaned it when they bought the trucking business and outfitted it with new trucks, so the net management fee income could be used to make nontaxable loan payments to Jacques.
- David called this technique of transferring a business to a younger generation “DOUBLING DOWN.” It works if done carefully but the facts have to match the technique or you simply use different techniques.
- David told Jacques and Blanche that their investment assets were at the border line level for using a family limited partnership but they decided they would like to place $500,000 of assets in such a partnership – the assets most likely to appreciate, and be able to make equalizing gifts of limited partnership interests. Jacques Jr.’s one third interest in the N H trucking business was worth more than the business assets transferred to his brothers, so some equalizing gifts could be made in a manner free of gift tax.
The Gilbert Family retained the skilled attorney recommended by David and Ray and all the above steps were completed and the sons agreed to have their own estate planning documents prepared as well. The Family businesses continue to be successful for this hardworking family.