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Tuesday, May 7, 2024
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Case Studies |
Spicy Options for Restauranteur, Part 6
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Case:
Roger Garcia is CEO of The Enchilada Factory, a chain of upscale restaurants that serves Mexican food geared toward health conscious patrons. Roger opened his first restaurant 30 years ago. With initial table space for a mere 12 people, Roger never could have imagined that this company would grow to over 150 locations with revenue of $800 million per year. Not surprisingly, magazines and trade journals frequently request interviews with Roger and write about his amazing journey to the top.
However, it has not always been a smooth ride. The restaurant business is very competitive and there have been many difficult times over the years. For instance, about seven years ago, the company was on the verge of bankruptcy. Costs were soaring and customer service was abysmal. In need of new direction and new blood, Roger hired David Guerrero as President of the company. Not only did David have an amazing reputation for turning companies around, he had a restaurant business background. As expected, David pumped new life into The Enchilada Factory. He got costs under control, improved customer service and revamped the menu. In just two years, the company turned around and has never looked back.
This wonderful turnaround didn't come cheap, however. In order to acquire David, Roger gave him a substantial six figure salary and a plethora of incentive stock options (ISOs) - 10,000 ISOs to be exact. Given the current profitability and growth of the company, the stock price has skyrocketed in the past seven years. Accordingly, David's ISOs are worth a fortune.
Although very astute in turning companies around, David has less expertise in the field of tax law. Accordingly, he has some questions regarding his ISOs. In this case study series, we will address David's ISO questions and offer some planning options as well.
Question:
As an active philanthropist, David wants to know if he can transfer his ISOs to a testamentary charitable remainder trust (CRT) in the event of his untimely death. If possible, how can he implement the transfer? What are the advantages of funding a testamentary CRT with ISOs?
Solution:
Thankfully, the tax code is more flexible when dealing with transfers of ISOs at death than transfers of ISOs during life. As a result, ISOs and testamentary CRTs provide a good planning opportunity for philanthropically minded taxpayers.
For this strategy to work, it is vital that David designates a testamentary CRT as the beneficiary of his ISOs. Once David passes away, the transfer of the options is completed in accordance with the beneficiary designation. The beneficiary designation possibilities and limitations are generally governed by the plan of the company that issued the options. The company plan usually sets forth any transfer restrictions and the procedure for naming a beneficiary. The best course of action is for David to contact The Enchilada Factory administrator for a copy of the plan and to follow its procedures meticulously.
When ISOs are transferred to a testamentary CRT, the estate will receive a charitable estate tax deduction equal to the present value of the remainder interest. See Section 2055. This will produce significant estate tax savings in large estates. For example, assuming a 45% estate tax rate at time of death, a $1 million deduction can save David's estate $450,000 in estate tax.
In addition, when the CRT exercises or disposes of the ISOs, it will not be liable for income tax. The IRD asset is a passive asset and, thus, generates no unrelated business taxable income to the CRT. The CRT will merely account for any IRD pursuant to the four-tier accounting structure, i.e. tier one or tier two.
The ultimate benefits of the testamentary CRT are a minimization of estate and income taxes, a term of years or lifetime income stream for family, and an eventual gift to charity. And for David that is a recipe for successful planning!
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