A Passive Foreign Investment Company, or PFIC, is a foreign corporation where passive income constitutes 75% or more of gross income during a year. A corporation is also considered to be a PFIC if 50% or more of corporate assets are held for production of passive income.

The PFIC rules deter taxpayers from seeking unlimited income tax deferral inside foreign corporations. They also seek to limit the ability of investors to convert ordinary income into capital gains through the same foreign entities. The PFIC rules impose a hefty interest charge on any deferred payments within a PFIC, and they treat all PFIC distributions as ordinary income regardless of its capital gains status.

In trying to determine if a foreign corporation might be classified as a PFIC, it is important for this discussion to know that income that is derived from “active banking” is excluded from the definition of “passive income.” In other words, banks are allowed to engage in banking activities without the threat of income from those activities being classified as passive, and without the banks being deemed PFICs. For investors, that means you can invest in foreign banks without the risk of hefty charges and the loss of capital gains status under the PFIC tax laws. This exception exists as a policy matter, so that investors in the US won’t fear investing in foreign bank shares.

The Problem

In recent years, economies have been shaky and foreign banks have invested quite heavily in US government securities (bond investments produce passive, non-banking income), rather than putting those funds to work in “active banking” (lending, etc.). The question this forces is, whether the increased degree of passive income in the foreign banks push them over the limit and trigger the harsh application of the PFIC rules? Will foreign banks be deemed PFICs, and will US taxpayers be punished with harsh charges on those investments?

The Solution

To address this question, the IRS issued a notice in late June of 2012. The notice stated that for tax years 2011 thru 2013, income from certain government bonds held by “active banks” will be treated as if it was earned from active banking. Thus, foreign banks can invest in US government securities, US taxpayers can invest in foreign banks, and otherwise passive income from the banks’ US securities investments will be ignored for PFIC determination.

It is important to understand that this does not avoid investor income tax obligations, but rather the imposition of the burdensome PFIC tax penalties. Essentially the IRS is recognizing that in the current global economic environment (low interest rates, soft economies, etc.) banks are going to need to invest more in government securities. Foreign banks investing in US government bonds are not having that income interest counted as passive income, and US investors are being allowed to avoid PFIC penalties on investments in these foreign banks.

You don’t — if you fall into one of two groups:

• Owners who are sure that their business exits are more than 10 years away.
• Owners who are certain that the value of their companies is miniscule compared to what they will need upon sale or transfer.

Most owners, however, look to the value of their businesses as the chief source of liquidity for their post-exit lives. We intend to leave as soon as it is feasible rather than when we are completely burned out. Therefore, most of us need to know the value of our companies now so we can be smart about creating greater business value in as short a time as possible.

Knowing the value of your business today is critical whether you plan to leave your business tomorrow, or in five years because:

1. An estimate of value establishes your starting line and distance to the finish.
   An estimate of value tells you where your unique race to your exit begins. Your job, whether your company is worth $500,000 or $50M, is to fill the gap between today’s value (the starting line) and the value you need when you exit (the finish line). Based on today’s value, your race to the finish may be shorter, longer, or perhaps much longer, than you expect. Once you know how far you and your business need to travel, you can begin to create timelines and implement actions to foster growth in business value.
2. An estimate of value tests your exit objectives.
   An estimate of value helps you to determine if your exit objectives are achievable. Let’s assume that you decide that your finish line (financial objective) is to receive $7,000,000 (after taxes) from the transfer of your business interest. You also want to complete your race in three years (timing objective). An estimate of value will tell you if the distance between today’s value and the finish line is too great to reach in three years. If a growth rate is unrealistic for your business, you must either extend your time line or lower your financial expectations.
3. An estimate of value provides important tax information.
   First, an estimate of value gives you a basis for analyzing the tax consequences of Exit Path alternatives. Once you choose your path, the value estimate provides a basis for your tax-minimization efforts. Taxes can take a significant chunk out of a business sale price so the value of your company (what a buyer pays for it) must usually exceed the amount of money you need to fund your post-exit life. The size of that excess depends on how you and your advisors design your exit, and exit design in turn begins with knowing starting value and the distance to your finish line.
4. An estimate of value gives owners a litmus test.
   When owners know how much value they need to create to meet their objectives, it helps them determine where they need to concentrate their time and effort. Instead of growing value for the heck of it, dedication to a goal enables many owners to exit sooner with the same amount of after-tax cash than owners who do little or no planning. Exit plan success all begins with a starting value.
5. An estimate of value provides an objective basis for incentive plans.
   As you design incentive plans for key employees (such as Stock Purchase, Stock Bonus and Non-Qualified Deferred Compensation Plans) to motivate them to increase the value of your company (so you can successfully exit) you must base these plans on an objective estimate of value. You and your employees need a current value (or starting line) that you all can confidently rely on.

This is Not a Full-Blown Valuation!

I know you are thinking, “How much is this going to cost me?” But I’m only suggesting that you need an estimate of value to establish a benchmark, not the opinion of value which precedes your transfer of ownership, years from now.

Estimate of Value

An estimate of value:

• Costs about half as much as a standard valuation opinion,
• Is the basis for the (later and) complete valuation, but
• Lacks the supporting information contained in a written opinion of value, and
• Is used for planning only. It cannot be relied upon for tax or other purposes.

Failure to Value

On some level, we all recognize that we will leave our businesses some day. While you may not yet have a vision for the second half of your life, you do understand that the exit from your company is likely to be the largest financial transaction of your life. Does it make sense to go into that transaction and into the second part of your life without an objective understanding of your company’s value?

An estimate of value can save precious time as you build value and achieve the exit of your dreams.

If you would like a copy of our White Paper that explains the hows and whys of valuation in more detail, please contact me.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

What information is the IRS seeking?

The IRS wants better information on foreign account-holders who are subject to US tax authority.

Participating FFIs will have to report the following to the IRS:

• Information about financial accounts held by U.S. taxpayers:
  • Account numbers
  • Account balances
  • Income paid or credited to the foreign account
  • Identification of each U.S. taxpaying account holder
  • Foreign entities in which U.S. taxpayers hold a substantial ownership

Why is the IRS seeking this information?

With increased globalization of investments, securities, and financial institutions, there is a strong tax incentive to “jurisdiction shop” for lower taxes or, in the case the IRS is most concerned about, to hide income and assets from the view of the IRS in an effort to unlawfully avoid taxes altogether. These information-sharing requirements seek to capture information that the IRS would not otherwise have access to.

How is the IRS going to incentivize and enforce the agreements?

Questions arise regarding the ability of the IRS to engage FFIs in these agreements and in the ability of the IRS to then enforce them. After all, tracking and reporting all this information will come at a huge cost and that cost will be imposed upon the shoulders of the FFIs. Also, the IRS has no jurisdictional legal backing to exercise authority over non-U.S. foreign institutions, so why should they take on this duty to report?

The IRS may not have the ability to directly incentivized or enforce the FFIs, but they can influence US Persons (those subject to US federal tax laws) who are depositors and investors abroad. So, what will the IRS do? If an FFI chooses not to participate, the IRS will impose a FATCA withholding on payments received by US taxpayers. This withholding, a tax on failure to report, will be implemented in 2014. This increased tax on no reporting FFIs will be sure to drive away US tax-paying depositors and investors. So, FFIs will be highly incentivized to agree, comply, and report, in order to keep their foreign account holders happy. The same withholding will also be imposed where FFIs are signed up to report, but where account-holders fail to provide required reporting documentation directly to the FFIs.

What are the Filing Requirements for US Taxpayers?

Any taxpayer holding foreign financial assets totaling more than $50,000 ($100,000 for jointly filed returns) must report information about those assets on Form 8938. This informational return is attached to annual tax returns. There is a $10,000 penalty for failure to report foreign financial assets. That penalty can go up to $50,000 for continued failure to report. Additionally, filing Form TD-F 90-22.1, Report of Foreign Bank and Financial Accounts, may also be required.

The clearest example of a failure to set objectives may be Bill Wilson (not his real name), a business owner who recently told us that he wanted:

• To leave his business within three years, but he was ready to leave today;
• Financial security, defined as a seamless continuation of his current lifestyle; and
• To transfer the business to his key employees.

A quick review of Bill’s personal financial statement, however, revealed that most of the income required to maintain his lifestyle would have to come from the business. Unfortunately, his business wasn’t large enough to attract a cash buyer. And, since Bill had done no Exit Planning, his employees had no funds with which to purchase his ownership interest. A long term installment note seemed to be the only answer — a risk Bill was unwilling to take.

Contrast this unpalatable solution with Bill’s objectives — objectives which could have been achieved had he taken the time (well before he wanted to leave the business) to establish and to prioritize his Exit Objectives.

If, for example, an owner’s need for financial security prevails, selling a business to a third party for cash may be the best and quickest exit path.

If, however, attracting a qualified third party is unlikely, an owner may need more time to devise and to implement a transfer to an insider (child or employee) that provides the owner adequate cash.

On the other hand, if an owner’s desire to transfer the business to a specific person or group trumps his or her need for financial security, and his/her deadline for departure draws near, financial security in the form of “up-front” cash must take a backseat.

As you can see, owners must consider—simultaneously—the three primary exit goals (listed below). Ask yourself which is your most important exit objective and rank your answers from 1 (most important) to 3 (least important).

• Financial security:
  1    2    3
• Transferring the business to the person of my choice (may include key employees, co-owner or child):
  1    2    3
• Leaving the business when I want (could be immediately or never):
  1    2    3

Prioritizing your objectives will help you choose your overall path. For example, if you want out—soon and with cash—but your business cannot be sold today, do you wait until market conditions improve or sell now to your employees? While prioritizing your objectives is not easy, doing so gives you a framework to decision making.

We suggest that you print this issue of The Exit Planning Review™ so you can complete the rankings above and share this information with members of your Advisor Team. We encourage you to contact us as you work through these decisions. With fresh eyes and experience with other owners we can help you to balance these competing objectives.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

The features of the Roth 401(k) mirror those of the Roth IRA, but have a higher contribution limit ($17,000 for 2013) like a traditional 401(k). Specifically, contributions are not deductible and withdrawals are tax-free. By paying taxes now, one doesn’t have to worry about paying taxes when he withdraws money from his Roth 401(k) later. Money withdrawn from a traditional 401(k), of course, will be taxed as ordinary income.

The big question investors have to grapple with is why they would rather pay taxes now instead of later — especially when there is no way to know where tax rates will be in the future. It’s a decision that should be carefully weighed, but a mix of tax-free and taxable income in retirement clearly has its benefits.

A Roth 401(k) also provides more flexibility when it comes to managing income and some less obvious payoffs as well. A traditional 401(k) requires you to begin taking distributions in the year your turn age 70½ (or, if later, the year you retire) — and then you pay taxes on that income. With the Roth 401(k), there is no required minimum distribution (if you roll the Roth 401(k) into a Roth IRA). That means you can choose to leave your funds invested and reduce your gross income.

Regardless of what happens to tax rates, if you have to take a distribution from a traditional 401(k) that could bump you into a higher marginal tax bracket as well as reduce the net value of your Social Security benefit and increase your Medicare costs.

It should also be noted that any employer-match contributions made to the plan must be deposited into a traditional 401(k), so participants in the Roth 401(k) will essentially have two plans. The traditional portion can be rolled into a traditional IRA upon retirement and the Roth portion to a Roth IRA.

If the Roth 401(k) sounds like an appealing option for your personal situation, we recommend inquiring with your employer to see if it is offered at your company.

Know that in your indecision, you are making a decision. As Winston Churchill observed, “I never worry about action, but only about inaction.” When you take a passive attitude toward the irrefutable fact that you will–one way or another–leave your business, you are deciding to settle for a least profitable exit for yourself and for your family.

If you are an owner who isn’t sure about what you want, or when you want to leave, why is it so important to decide to act today? Why can’t you wait?

• Preparing and transferring a company for top dollar takes time—on average about 5 years. Most of those years will be spent preparing the business for the transfer. If you decide to sell to employees or children (two groups who rarely have any money), they’ll need that time to earn the money to pay you for your interest.
• More time often equals greater reductions in risk. Time can be used to design and implement income tax-saving strategies, build value, strengthen your management team, begin a gradual transfer of ownership (not control) to key employees or children. If you wait too long, you probably won’t have time to implement these strategies and you’ll likely end up transferring your business on less-than-ideal terms.
• The market does not operate on your schedule and may not be paying peak prices when you are ready to sell to an outside party. Witness the state of the M&A market in 2008 and 2009: activity is almost non-existent in many business sectors and down in almost all.

If leaving a company you’ve worked so hard to build and having little or nothing to show for it, is unacceptable to you, let’s look at a few of your options.

Wait for a buyer. According to Deloitte’s Entrepreneurship UK: 2008 survey, 35 percent of business owners said they will wait for a third-party offer for their businesses. Owners in this group believe that one day a buyer will contact them, negotiate a sale, and that will be that. Well, this is a decision of sorts—but one that flies in the face of reality. While few businesses are being sold today, there will likely be a significant number of Baby Boomer business owners vying with you to sell their businesses when the M&A market recovers.

In a competitive buyer’s market, only the best-prepared businesses sell for top dollar. And the owners of those well-prepared businesses will be those who made the decision to act to prepare their company years ahead of the actual sale.

Liquidate. Liquidation is a common exit path for owners of companies whose cash flow is flat and has little probability of improving—absent the design and execution of a business/exit plan. If you find yourself in this group, we recommend that you meet with your tax and other advisors to do the planning necessary to create the most tax-efficient liquidation possible.

Decide to exit and plan accordingly. Start today and take the following steps:

1. Fix a departure date.
2. Determine your financial needs.
3. Decide whom you want to succeed you.
4. Have your business valued to see if: a) should you sell today; and/or b) it has the value necessary to meet your financial and other exit objectives.

Based on your objectives and the realities of your business, use a skilled Exit Planning Professional to forge a plan with accountability/decision deadlines.

Deciding to do something now to create the best possible exit path is not difficult. The failure to act, however, can potentially be fatal to a successful exit. The success of your business exit is simply too important to you (your family and your employees) to leave to chance. Why wait? Why decide not to decide?

Subsequent issues of The Exit Planning Review™ provide unbiased and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

For example, many foreign countries income tax an employee’s incentives stock options at the time of grant. The US income taxes the worldwide income of US expatriates, and, more specifically, recognizes incentive stock options that are given to an employee not at the time of grant, but at the time they are exercised. If the year of exercise is in a later tax year than the year of grant, the foreign jurisdiction would impose a tax in the year of grant, and the US would impose a tax in the year of exercise. There would be no foreign income tax credit for the options in the year of exercise since that tax was imposed in a prior year. This would result in very unfortunate double taxation!

Fortunately, there is a way to avoid this terrible outcome. The US expatriate should make an Internal Revenue Code section 83(b) election upon grant of the options. This code section permits taxpayers to make an election to recognize options as income, recognized at the time of the grant, rather than at the later time of option exercise. Doing this should sidestep the double taxation issue by bringing foreign and US income taxation of the options into the same year and allowing the foreign tax credit to offset US income tax on the options.

An additional benefit of making the election is that any gain realized between option grant and exercise would be taxed at the preferential capital gains rate instead of at the ordinary income tax rate.

Example—Double Taxation!

Assume a $1 million option grant is made to a US expatriate, residing in a foreign country. Assume, as well, that the applicable US income tax rate is 35% and that the foreign rate is 20%. At the time the options are granted, foreign income tax would be due in the amount of 20% of $1 million, or $200,000. In the next year, the US expatriate exercised the options, and the US tax is triggered in the amount of 35% of $1 million, or $350,000. Total taxes paid are about $550,000!

Example—83(b) Election, No Double Taxation!

Same facts as above with the exception that the US expatriate elects for the options to be taxed by the US at the time of grant (instead of at the time of exercise). US taxes would be 35% of $1 million and foreign taxes would be 20% of $1 million. On the surface this looks like $550,000 in taxes, just like the previous example. However, since both taxes applied in the same year, the foreign tax credit is triggered to offset US taxes in an amount up to the amount of foreign taxes already paid. Thus, $200,000 in foreign taxes paid is credited against the US tax burden of $350,000, leaving a US taxes owed at only $150,000. The final tax rate is only $350,000 ($150,000 to the US and $200,000 to the foreign jurisdiction).

Separately, it is noteworthy that if a foreign tax is imposed at option grant, rather than at exercise, there is a chance that the options might be taxed and yet expire worthless before they can be exercised in-the-money.

Options can be complex. International taxation can be complex. Combine the two and expert assistance is essential.

Many of you find yourself in the same predicament. You are able to envision your life beyond business ownership, but you don’t have a clear picture of how best to “leave your business in style.” So what do you and the Nora Chapmans of the world do? Here is what we told Nora.

First, understand that leaving your company is a process. Realizing that life after your business exit can be as fulfilling as your life as a successful owner is simply the first step. The next step is to figure out a way to approach your exit in a methodical, logical, rational manner. Most owners do not put enough thought and planning into their exits because they don’t know how to begin, that there’s a proven process available to them, or exactly what issues to consider and analyze.

If that describes your situation, you are not alone. Most owners, and their advisors for that matter, don’t know that there is a planning and an implementation process that is methodical, rational and can be tailored to your unique exit goals. It is The Seven-Step Exit Planning Process™.

This Process begins with setting your exit objectives and understanding the value of your business. Based upon what you want and what you have, you can then examine and choose a proper path for you: be it a sale to a third party, a transfer to children, a sale to an ESOP, a sale to a co-owner, or an orderly liquidation. As part of this Process, you also must consider what would happen to the business and to your family in the event your death or disability precedes your planned exit.

Simply knowing the process and proceeding down the Exit Planning path, however, is insufficient. According to the Small Business Administration (SBA) most business owners who begin the planning process fail because they fail to plan. To succeed, you need a written plan that:

• Identifies your exit, financial and other objectives that must be considered; and
• Documents how you are going to achieve those objectives.

Along with this written plan you must have a checklist that:

• Assigns responsibility for each task to be completed throughout the Exit Planning process;
• Sets dates for each task to be completed; and
• Designates the person responsible for completing each task.

How do you begin? 

“Let us, therefore, decide upon the goal and upon the way and not fail to find some experienced guide who has explored the region towards which we are advancing; for the conditions of this journey are different from those most travel.” — Seneca, “On the Happy Life” (AD 58)

As skilled and as successful as most business owners are, they cannot, working alone, create and execute their Exit Plans. Rarely have owners made a career of exiting businesses. Those owners who do attempt to craft their own Exit Plans usually fail and, at best, they leave a lot on the table: a lot of money, time and/or their own happiness.

And, as skilled as is your attorney, CPA or financial and insurance representative, acting alone, each is unable to craft a successful Exit Plan. Successful Exit Planning is a multi-disciplinary effort that requires you and your advisors working together. No one profession possesses the breadth of knowledge necessary to advise a business owner on the wide variety of Exit Planning issues.

For your Exit Plan to succeed, you need legal expertise, financial advice, tax planning, financial advisory input, and often, consulting ideas. If you decide to sell to a third party, you may require the services of a Business Broker or Investment Banker. No one advisor can be an expert in all aspects of exiting a business.

What does it take to create an Exit Plan?

• Understand that there is a proven Exit Planning process. Learn as much as you can before you make final decisions.
• Commit to see the process through—holding yourself and others accountable.
• Document your decisions and create a written plan.
• Hire an experienced team of professionals—attorney, CPA and financial or insurance representative (at a minimum) to help guide you through this process. These professionals should more than pay for themselves by putting money in your pocket. If they cannot, you have the wrong team.

If you are to exit successfully, there is much to do. We can help by providing more detailed information on Exit Planning in general, and by giving you a sense of the time and resources this planning and implementation process will take.

Stay tuned for future issues of this newsletter for more information about various aspects of the planning process. Expect hints to save taxes, money, and time.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

Examples of Items to Consider

• Retirement Living Expenses—Projections should be based on the pre-retirement budget but should remove items that will no longer be expenses at that point—such as monthly debt payments for loans that will already be paid off by retirement.
• Cars—A new car should reasonably last for about 10 years. If you own two cars, plan to buy one every 5 years. It is reasonable to assume that a new car will cost between $25k and $35k, but if it a more expensive car is anticipated, a higher price range should be used.
• Major Home Repairs—This is not the same as remodels (which should also be separately considered). Over a 30-year cycle certain things will need to be replaced: roof, water heater, furnace, etc. It is safe to assume about $25k in major repairs every 10 years. For those living in a condo or communal setting that number would be lower. For assisted living, that number would be $0.
• Travel—This is good to treat separate from living expenses because travel is very discretionary and flexible (be sure to reduce living expenses by this amount to avoid doubt-counting expenses). Note that the ability to travel usually declines as individuals reach the later chapters of their lives. Also to be accounted for are any unusually expensive “big” trips that don’t fit within annual travel plan budgets.
• Education—This would include funds set aside for self, spouse, children, grandchildren, etc.
• Weddings and Celebrations—This may include funds reserved for weddings, major birthday parties, extravagant anniversary plans, etc.
• Gifting—This may be to family (assistance to elderly family members, down-payment on children’s first home, etc.), friends, or charities (such as a church).
• Other Financial Goals—Such items may include, self-funded church or community service, philanthropy, charitable work, etc.

There really is no end to the list of possibilities that could be considered, but these ideas should help to get financial planning underway.

During the earliest phase, full-time employees are often covered by their employer’s health insurance plan. Normally the employer does not cover the spouse or children of the employee. The expense of providing health insurance and care for these family members falls on the family. In this phase, a financial shock, such as loss of employment would have two effects. First, it would increase family healthcare expenses by the cost of insurance and care for the terminated employee (since employer would no longer be providing coverage as a benefit). Second, lost income here would be likely to strain the ability of the family to continue to pay for family coverage.

In the next phase, kids grow older and begin to leave to home. If they go obtain their own full-time employment, they will likely be covered by their employer’s health insurance plan, and will no longer be a health expense for the family. If, alternatively, they go off to college, they may remain on the parental/family health insurance plans. In California, there is a special health insurance program for college students. Upon graduating or upon obtaining their own employment, their healthcare expense burden will be shifted onto the children themselves (or onto their employers).

In the final phase, working adults are usually covered by employer plans and kids are out of the house. As the empty nesters age, they will usually see increasing personal healthcare needs. When they are old enough to qualify for Medicare, some healthcare expenses will be offset. Since only two, and eventually, only one person in the household will need healthcare, this phase often actually requires even less expense than in previous phases. Naturally, near the time of death, healthcare expenses often are significantly higher for a given person than at any previous period of their individual life. Careful planning in earlier years can allow for the retirement income needed to provide coverage for healthcare and even long-term care needs.