Successful franchisees often have a problem in effectively transitioning and protecting the value of their business interests from events such as estate taxes, creditor collections and forced sales. As franchisee organizations mature, they become what we call “cash cows”, generating significant amounts of cash for the benefit of a broad base of constituents, particularly the primary owner and the owner’s family (as well as providing for subsequent generations).
The franchise legal system does not offer many options relating to passive ownership and mechanisms to use the company’s cash flow as an annuity. In particular, most franchise agreements constrain the franchisee with franchisor approval and other appropriate consents. We’ve recently seen an increase in valuations; and therefore, the issue of how one can protect these assets within a legacy arrangement for an owner’s family has become even more important for an owner’s financial planning process.
The following are two options we have used to protect franchisee assets:
1. Real Estate as a Legacy Asset. Most of you are aware of the vital sale/leaseback market for franchise real estate. Why not have your own real estate holding company that is controlled by professional managers who will manage the assets for the benefit of your family for years to come? Even if the operating assets are sold, the real estate certainly could act as a legacy and valuable cash flow investment, provided the real estate is of good quality. Also, if properly examined, there may be some opportunity (as cash accumulates) to diversify away from your initial real estate holdings and look at other options. If the real estate is heavily mortgaged, a transfer to some type of family trust may not result in gift tax issues. Yet, as the debt is paid down, these assets become very valuable; and the value of that equity-creation can go to someone other than the initial owner, thus, shifting wealth to the next generation.
2. Grantor Trust. One of the most beneficial and effective franchise transitional techniques is to consider the use of a grantor trust. In this case, a grantor trust is a trust created by the franchisee. For income tax purposes, the franchisee is still treated as the owner (so there is no taxable sale at the time of the trust’s creation). Further, the ongoing income, attributable to the assets contributed to the trust, is taxed in full to the franchisee/grantor. The franchisee simply obtains an outside third-party valuation and sells the operating assets to the grantor trust. Even though the grantor trust has certain characteristics that do not alter the income tax effect, it does have certain provisions that allow for the non-inclusion of these assets in the franchisee’s estate.
Once the franchisee has obtained an outside third party valuation, the franchisee sells the assets to the trust either under a private annuity (where the value is paid over the franchisee or the franchisee’s spouse’s life) or paid under an installment obligation (where the full amount is paid in full over a defined period of years). There needs to be an applied interest factor under these sales to the trust, which is determined by the applicable federal rate which changes every six months. In effect, this approach shifts all of the business’ future value to the beneficiaries of the grantor trust (who will most likely be the franchisee’s family). The franchisee retains all of the rights to income from the trust as a result of the sale of assets. Additionally, the trust may even, under flexible situations, be able to satisfy tax obligations of the grantor. In summary, under a grantor trust:
- • The franchisee retains the current value of the assets through a fair market sale;
- • The franchisee is able to shift the future appreciation of these assets as the company grows; and
- • Debt is paid down by the cash flow from the business.
There are numerous iterations of this approach, but a grantor trust is one of the most effective vehicles for a franchisee to move appreciation of the franchise business to the next generation while retaining the cash flow benefits of the business. Unfortunately, the franchisee will still remain liable under the franchise agreement, and it may be necessary to get franchisor approval to implement a grantor trust. However, this should not be a problem so long as the franchisee is still active in the business (and where the trustees, other than the grantor, manage the trust assets).
We have suggested two excellent options to protect the value of a franchise business while still utilizing the attributes of the business’ cash flow: (i) the segregation of the real estate by creating a good cash flow entity and (ii) the use of a grantor trust for shifting business appreciation to future generations. Consult with your business and financial advisors to determine if these options would apply to your situation.
From September 2005 Franchise Times