How alternative legal service providers can add efficiencies, create value

With companies consistently scoring law firms an average of just 2 to 3 (on a scale of 10) on the value they receive for legal services, businesses and firms alike are increasingly employing the value-added services of alternative legal service providers (ALSPs).

“Alternative legal service providers are a legitimate avenue to unlock enhanced value and services for clients, and the use of this model is increasing,” says Christian Farmakis, shareholder and chairman of the board at Babst Calland, and president of its affiliated ALSP, Solvaire. “The intersection of the rise in ALSPs, coupled with the use of technology, allows ALSPs to increase efficiencies and reduce legal costs.”

Smart Business spoke with Farmakis about how ALSPs can help businesses get more value from their legal providers.

Why is the use of ALSPs on the rise?

Businesses are continuing to face unprecedented financial and legal challenges. As a result, companies are placing constant demands and pressure on all vendors, including their legal firms, to deliver more value. Well-run ALSPs allow in-house counsel and law firms to work more efficiently and focus on higher-priority work.

The traditional law firm model is based on billable hours. And while businesses generally like the quality of service they receive, they don’t believe they are always getting value based on the type of legal work being performed. While it makes sense to assign complex and specialized legal work to seasoned associates or law firm partners, other services, such as discovery, diligence and technology-enabled tasks should be delegated to others with specific skills and defined pricing models. This is where ALSPs come in. Both clients and their law firms see the value proposition in ALSPs, which are increasingly gaining traction, moving beyond ‘just’ a cost-savings measure to becoming a true industry service partner.

How do ALSPs function?

ALSPs can be independent of a law firm, owned by it, or have an affiliation with a firm, such as Babst Calland and its ALSP, Solvaire. Services include those traditionally performed by law firm associates, such as due diligence, document management and discovery, but at a lower rate structure — not necessarily driven by the billable hour — and a service-oriented delivery service model. Usually there are licensed attorneys overseeing the work.

Clients don’t care how a project gets done. They are looking for fast, efficient, accurate service, with budget certainty. They are demanding this service, and law firms that associate with ALSPs will be the winners.

How is technology helping ALSPs increase the value they provide?

Legal technology used by ALSPs brings efficiencies, and artificial intelligence (natural language processing and machine learning) can help identify relevant information within documents more quickly than a full manual review. Compared to an attorney doing a full manual review of documents in a diligence context, using ‘legal tech’ can decrease the review time by as much as 40 to 60 percent. As such, ALSPs can often cover more information and provide a more complete diligence work product.

Anyone can license legal technology, but you need to know how to properly use it to maximize its benefits. Project management skills, critical to the success of any legal technology services project, are typically not germane to a lawyer’s core competence. Those that can harness the legal technology and provide sound project management skills will excel in this new marketplace.

How can business owners approach their legal provider about engaging with an ALSP?

Ask if the law firm offers alternative legal services, what kind of legal technology they use, and how. Get testimonials from others who have engaged with ALSPs who can speak to the value and quality.

If the firm uses an ALSP, ask if they met deadlines, and if they were happy with the quality, reporting and security. Finally, ask if the ALSP worked seamlessly with the lead law firm managing the overall legal project.

Clients are expecting a higher quality of service for the price they pay. ALSPs are not competitors of law firms; they are partners that can add value through the services they provide.

INSIGHTS Legal Affairs is brought to you by Babst Calland.

“Title theft” myth persists, but mongers of “protection” against it have slightly improved their mislabeled product

Two years ago, William Maffucci, a real-estate lawyer with Semanoff Ormsby Greenberg & Torchia, LLC, exposed on these pages the myth of “title theft” — i.e., the concept that a criminal could “steal” a house by simply forging the owner’s name on a deed, then “drain the equity” in the house by defrauding a mortgage lender into loaning money against the house, and thus force the actual owner to repay the loan or lose the home through foreclosure [Read the original article here].

Since then, other commentators have joined Maffucci in debunking the myth of “title theft.”

Smart Business spoke with Maffucci to find out how — if at all — the providers of “title lock” protection have reacted.

Do services providing “title lock” protection still claim that “title theft” is real?

Yes. The industry has grown over the past two years, and the false advertising seems to have intensified. This is baffling, because the legal principles are not in dispute. Surely companies with multi-million-dollar yearly advertising budgets can afford lawyers to screen out the misrepresentations with which advertisements about “title theft” are replete.

Although the advertisements are as bad as ever, the chorus of complaints about them has resulted in a subtle but important change. It’s not reflected in the video or radio ads, but you can sometimes spot it in the written advertisements: Under some circumstances, the ‘title lock’ services will pay for the legal fees necessary to clear title if, after purchasing a subscription, the subscriber’s title is forged.

Two years ago the leading provider of ‘title lock’ services did not cover the legal fees necessary to clear title of a forgery that occurred to a subscriber. The service would record a statement to warn third parties about relying upon the forged title, and it would take a few other actions to try to prevent the forger from compounding the owner’s problems. But the subscriber would still have to find and pay for a lawyer to clean up the title. Now, it seems, all of the ‘title lock’ providers will cover a subscriber’s legal fees — at least if the subscriber purchases a long-term plan.

If “title theft” is a myth, how difficult could it be for a lawyer to clear the title?

Sometimes very difficult. And often prohibitively expensive. The lawyer must first locate and confirm the identity of the forger, who may or may not be the named grantee. After drafting the complaint, the lawyer must find a way to serve the defendant(s). Forgers and their accomplices have many ways to frustrate those steps, so a lawyer must often seek court permission to accomplish them through alternative procedures. And proving that a signature has been forged isn’t easy. It usually requires retaining a forensic handwriting analyst.

Does the possibility of having legal fees covered warrant the expense of a “title lock” subscription?

Legal-fee coverage would certainly change the cost-benefit calculus. Without it, the service is little more than a glorified title-monitoring service. But note: Some homeowners already have insurance against title forgery, and most of them don’t even know it.

This highlights yet another misrepresentation in the ‘title lock’ advertisements: that traditional title insurance — i.e., the insurance that homeowners obtain by paying a one-time premium when they buy their homes — never protects them from subsequent forgeries. That statement was true historically, because for most of its history title insurance covered only title defects that were in place as of the time of the closing. And it’s still true for owners who acquire the traditional, basic form of title insurance. Now, however, in most states, homeowners have the option of buying an ‘enhanced’ policy of homeowners’ insurance that protects them from many specified post-closing events. Forgery is one of them. And the coverage would include the expense of the insured’s legal coverage.

Although the ‘enhanced’ homeowners’ policy is more expensive, it’s part of the one-time, up-front premium. And it largely precludes the need for the services that ‘title lock’ advertisers provide.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia LLC

EPA heightens aftermarket defeat device enforcement

As vehicle emissions continue to represent the largest contributor to air pollution, the Environmental Protection Agency is becoming more vigilant about prosecuting manufacturers of the parts designed to decrease the effectiveness of emissions controls, and those who use them. And if your business has these parts installed on your vehicles or other equipment, you could be at risk of fines, or jail time — even if you’re not aware that tampering has occurred.

“The EPA has been, and will continue to, look seriously at tampering with vehicle emissions controls and has issued guidance to clarify its approach and requirements,” says Julie Domike, shareholder at Babst Calland. “The transportation sector is a huge source of emissions, and the EPA is signaling it is working with the states to step up enforcement, taking a closer look at vehicles that have been tampered with for the purpose of increasing fuel economy and decreasing down time.”

Smart Business spoke with Domike and Gina Falaschi, an associate at Babst Calland, about the crackdown on the use of aftermarket defeat devices and how businesses can ensure they remain in compliance with the Clean Air Act.

Why is the EPA increasing its enforcement of tampering and the use of defeat devices?

The EPA reports that more than 550,000 diesel trucks have had emissions controls tampered within the last 10 years, increasing emissions equating to having 9 million additional diesel vehicles on the road. With a goal of reducing emissions, pursuing illegal tampering is much more palatable to states than limiting the use of vehicles. While the EPA has arguably the most robust enforcement authority for new vehicles and engines, it is looking to states and associations that deal with air quality issues to take on cases involving tampering with vehicles once they are in use.

The new EPA memo doesn’t come in a vacuum — the agency has been stepping up enforcement the past few years. The last guidance document was issued in 1974, when onboard diagnostics and sophisticated control equipment didn’t exist. Today, there are more ways of tampering with vehicles, including shutting down software in addition to physically changing the hardware.

The agency isn’t just pursuing businesses and individuals who drive vehicles that have been tampered with. It is also going after manufacturers of the devices people put on vehicles, looking at online forums and trade magazines to identify who is selling and who is purchasing. Many of these sellers are advertising things that are clearly illegal, but may be unaware of just how illegal they are.

How can businesses protect themselves?

Make it clear in a written policy that tampering is not acceptable and that compliance with the Clean Air Act is a stated goal in the maintenance and operation of vehicles. Ensure employees are trained on the Clean Air Act and that mechanics are aware that tampering is prohibited.

However, even establishing a consistent, reasonable basis that you are actively trying to prevent tampering, no matter how well executed, may not be enough if the EPA or the state comes calling. To ensure compliance, buy only aftermarket parts stamped with a California Executive Order number. The state has its own program to certify aftermarket parts sold and installed won’t affect emissions. EPA’s guidance recognizes that program and accepts an Executive Order as a reasonable basis to believe those parts will not impact emissions.

What other steps can businesses take to ensure their vehicles and other equipment are compliant?

Have an independent inspector audit your vehicles to ensure no tampering has occurred. And for businesses that buy used vehicles or other equipment, it’s critical to have them inspected before taking possession, because ignorance is not a defense. For example, an auction house was found liable for selling tampered vehicles, and the state also pursued the dealerships that bought those vehicles.

Failure to ensure your vehicles and equipment are in compliance to save a few thousand dollars a year is penny wise and pound foolish. The cost of defending a case and the resulting hefty fines will cost far more than you save and can put you out of business — and even land you in jail.

Insights Legal Affairs is brought to you by Babst Calland

Determining when venture debt is the right path for your business

For startup companies lacking the cash flow or liquid assets to obtain a traditional bank loan, venture debt could be the answer to help elevate them to the next level.

“Startups often lack many of the characteristics that would give traditional lenders comfort that a regular commercial loan would be a good deal for them,” says Michael Fink, attorney at Babst Calland. “Venture debt can be an alternative to help bridge the gap to a company’s next valuation.”

Smart Business spoke with Michael about how taking on venture debt can keep a business moving forward without decreasing its valuation.

What is venture debt, and how is it structured?

At its core, venture debt looks similar to other commercial debt a company may incur; it may be structured as a term loan or line of credit, or an option to draw on either. The startup generally may choose the facility it feels best fits its needs.

However, because it’s a riskier loan for lenders, venture debt terms are generally more favorable to the lender than those of traditional loans. Borrowers can expect an interest rate higher than the prime rate (5 to 15 percent being common), more lender control rights and expanded negative covenants, prohibiting, for example, making large purchases or divesting a line of business without the lender’s consent.

Venture debt’s availability is based primarily on a company’s ability to raise future equity rounds, so venture debt lenders often require a small equity component in exchange for the higher risk the lender is taking on. For example, the lender may receive a warrant to purchase either common equity or the preferred equity to be issued in the next fundraising round, typically at a discount.

When should a company consider pursuing venture debt?

Venture debt typically isn’t available until a company has had a priced equity fundraising round that includes a valuation for the lender to work from. Once available, companies find venture debt useful for many capital expenditures or operational needs, or possibly even acquisitions, all without further dilution to the current stockholders.

It’s common for startups to seek out venture debt after an equity round to bridge the gap to the next round. This could extend the cash runway to a new equity round and is generally cheaper to current stockholders than a whole new equity investment.

Finally, venture debt allows companies to avoid ‘down rounds,’ where a company sells shares at a lower price than in the previous round. A down round dilutes investors, can impact conversion and related capitalization calculations, may violate contracts, and signals to the public that the company may be troubled. Venture debt can help by providing a path to avoid this decreased valuation.

How can a business determine if venture debt is the right path?

Just because you can go out and get money doesn’t mean you should. There should be a solid reason for taking on venture debt or any other investment.

It’s really dependent on the circumstances of the business. As with any financing deal, venture debt can get complicated very quickly, and an experienced attorney can help evaluate where a company stands. Additionally, venture debt can be obtained from a number of sources, and an expert adviser can help navigate those options.

Although the process could be completed quickly in some circumstances (generally resulting in less favorable terms to the company), having a clear vision of your cash needs three to six months ahead can allow you to secure the most favorable terms and position your company for success. If you have six months of funding left and you’re not currently planning another equity round, it may make sense to start investigating your venture debt options now.

Venture debt can play a crucial role in helping companies grow. To determine whether taking it on makes sense for your business, speak with an expert adviser to help you work through the issues and come to the best decision.

Insights Legal Affairs is brought to you by Babst Calland

How employment laws differ in New Jersey and Pennsylvania

Although the states of Pennsylvania and New Jersey are separated only by a river, in some cases there is an ocean of difference between the employment laws in each state.

Smart Business spoke with Frank P. Spada Jr., an attorney at Semanoff Ormsby Greenberg & Torchia, LLC, about those differences.

How do family leave laws differ?

Under the New Jersey Family Leave Act (NJFLA), employers with 30 or more employees worldwide who have been employed for at least one year and have worked 1,000 hours in the past 12 months can generally take up to 12 weeks of job-protected leave during any 24-month period to bond with a child, and care for a family member or the equivalent of a family member with a serious health condition. That includes a diagnosis of or suspected exposure to COVID-19. This also includes required care or treatment of a child during that state of emergency if their school or place of care is closed. Further, the NJFLA does not provide leave for an employee’s own serious medical condition, as the federal Family and Medical Leave Act does.

Pennsylvania does not have a specific family leave law, so employees in Pennsylvania must rely on the FMLA.

What about earned sick leave?

In New Jersey, under the Earned Sick Leave Law, an employee can accrue one hour of earned sick leave for every 30 hours worked up to a maximum of 40 hours of leave per benefit year.

Although Pennsylvania does not have a similar law, certain municipalities may. For example, Philadelphia has an ordinance requiring employers with 10 or more employees that are within the city to provide one hour of sick time for every 40 hours worked in Philadelphia, for a total of no more than 40 hours of sick time in a calendar year. This time can be used for a variety of reasons, including to care for a family member. It also includes any absences necessary due to domestic abuse, sexual assault or stalking for an employee or family member, to allow for mental and physical recovery, and has been extended to include COVID-19 issues.

Do discrimination laws differ?

In Pennsylvania, the Pennsylvania Human Relations Act (PHRA) protects employees from discrimination, while in New Jersey it’s the New Jersey Law Against Discrimination (NJLAD).

The NJLAD is very broad and includes a number of protected classes and activities, like gender identity and expression, that are not covered by the Pennsylvania statute. For those employees working in Philadelphia, the Philadelphia Fair Practices Ordinance provides more protections then the PHRA.

The NJLAD permits the recovery of punitive damages as well as the right to a trial by jury, while the PHRA does not. The NJLAD also permits the option for an employee to file a complaint with the New Jersey Division on Civil Rights or go directly to the New Jersey Superior Court system for relief. In Pennsylvania, an employee must file with the Pennsylvania Human Relations Commission (PHRC) initially and, if the case has been dismissed or has failed to be resolved within a year, the employee could seek redress in the Court of Common Pleas.

How about hiring laws?

According to the New Jersey Opportunity to Compete Act, employers may only inquire into an applicant’s criminal history after the employer has selected the applicant as the employer’s first choice to fill the position. The same restrictions apply to recruiters or job placement agencies.

In Pennsylvania, the Criminal History Record Information Act permits employers to only consider felony and misdemeanor convictions that relate specifically to the job applied for. But employers can seek information about an applicant’s criminal history before an offer is made. Municipalities, such as Philadelphia, however, have ordinances that prohibit an employer from inquiring about criminal convictions during the application and interview process.

In New Jersey, employers must comply with a ‘Ban the Box’ law that prohibits asking about a criminal record on an employment application. In Pennsylvania, the law applies only to public sector employers, although a number of municipalities, including Philadelphia, have their own versions.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia LLC

Has your business continuity plan changed for 2021?

A business continuity plan helps protect your business both today and into the future in a way consistent with your goals and culture. But it’s not just about planning for contingencies this time. The pandemic has changed the way businesses need to approach their plans, says Attorney Donald C. Bluedorn II, managing shareholder at Babst Calland.

“Things are much different than a year ago, and along with business and operational contingencies, companies should review their legal and regulatory risks and opportunities as well,” he says.

Smart Business spoke with Bluedorn about how to ensure your business continuity plan moves your business seamlessly forward.

What changes during the pandemic are now either beneficial or detrimental to Business operations?

Businesses need to reimagine how they operate and create a proactive mindset around challenges the business or industry is facing. Are there any advantages or savings in how you operated last year that are sustainable or should be adopted?

Concerns with significant legal and contractual commitments are likely to emerge. And as people re-enter the physical workplace, or not, there may be employment issues. In addition, new leadership at the federal level could pose legal challenges and create evolving tax issues. In the Western Pennsylvania region, this could result in changes to energy regulations, a risk for some but an opportunity for others. Environmental compliance and regulatory obligations are also likely changing, and trusted advisers can help you navigate these challenges and incorporate them in your plan.

It’s an opportune time to review your plan from a business risk or legal and regulatory perspective. Are vendors fulfilling their commitments and are you fulfilling your own contractual obligations? Look at your real estate needs going forward. Will you need as much space? Will it be configured the same way? If you need to change your footprint, begin reviewing your leases now.

Audit your environmental and regulatory obligations to see if you can reduce spending while maintaining the same level of compliance. It goes without saying that your inside or outside legal counsel is integral to this entire process. In addition, litigation has changed dramatically. With court closures, re-evaluate litigation to determine whether there is an opportunity to change your strategy with a more cost-effective, faster way to achieve your goals.

What should you be thinking about with your business continuity plan?

Think about the impacts on the business, as well as your employees, that were prompted by the challenges of the pandemic. Revisit and reanalyze your plans in light of the pandemic and its impact on achieving your business goals. Consider your challenges and opportunities, keeping one eye on protecting people and the other on positioning and maintaining and growing the business.

How should a business continuity plan address technology issues?

It should address whether you have enough licenses and sufficient infrastructure to have everyone work at the same time and whether you have protocols to address issues, making sure you have the capability to seamlessly transfer work and recover data.

The second concern is data and cybersecurity. The pandemic has created new risks for companies — and new opportunities for cyberhackers. Rethink and aggressively address security. Keep an eye on potential risks and continue assessing the need to make changes relevant to legal, regulatory and insurance matters that may have greater costs and risk to the business if they aren’t promptly addressed.

How should a plan incorporate the importance of people?

Be aware of your employees’ concerns and be sensitive to ways to protect them. Then think creatively about how to safely re-enter the workplace while achieving your business goals, incorporate what you will do if people get sick and be flexible on schedules.

Remember that, as uncertain, fearful and anxious as you may be about the future of your business, your people are just as fearful. If you can help them through it, you will emerge with a much better culture.

Insights Legal Affairs is brought to you by Babst Calland

Virgin’s hyperloop project highlights region’s emerging technology capabilities

West Virginia scored a huge win when it landed the contract for the high-tech Virgin Hyperloop Certification Center in October. Now the state — and the region, including Pittsburgh — are looking to build on that success.

“We’re hoping this is going to be a jumping off point,” says Moore Capito, a shareholder at Babst Calland who also serves in the West Virginia House of Delegates. “Any time you can lend a huge name like Virgin, it certainly gives the region an increased amount of credibility.”

Smart Business spoke with Capito about what the project means for the region and how its success could attract other big projects — and jobs — to West Virginia and Pennsylvania.

What is the Virgin Hyperloop Project?

In general, a hyperloop is an experimental, next-generation mode of transportation that will transport passengers through a network of under- and above-ground tubes, capable of reaching speeds of 670 mph. The goal is to transform transportation, and the broader economy, so that travel that previously took hours will instead take minutes.

More specifically, the Virgin Hyperloop Project, with substantial investments from Sir Richard Branson and DP World Ports, is headquartered in Los Angeles and has been primarily testing the technology in Las Vegas. As part of its growth, Virgin sought a location for a certification center to serve not only as a venue for moving the technology forward but as a place where they could create a regulatory framework.

Regulations cover other modes of transportation — air, rail, sea, cars, trucks — but hyperloop is a grey area. This center will build out that regulatory framework around this new mode of transportation to certify that it is viable for commercial use.

What does the project entail?

The project is located on 800 acres where, in addition to the center, Virgin plans to build a six-mile hyperloop track. The undulation of the West Virginia landscape made it an attractive location to test how robust the pods must be to traverse such terrain.

At this point, the timeline is very broad, with 2021 focused on design, planning and feasibility of facilities. The goal in 2022 is to begin construction on the facilities. That construction will be rolled out in phases, with an end goal of certification by 2025.

How will this project benefit not only West Virginia, but the entire region?

Directly, the project is expected to create somewhere between 150 to 200 engineering and technician jobs, with thousands of additional indirect jobs in areas that could include maintenance, construction and manufacturing. It allows firms that have expertise in emerging technology — including businesses in the Pittsburgh area — to showcase that expertise and focus on mobility.

It’s been such an uplifting dialogue. There have been conversations, for instance, on how to increase regional entrepreneurship to modernize the economy to attract and retain new talent. We want people who want to jump in, but they need a pool to jump into.

This project gives people another reason to talk about the region’s capabilities. This is a fertile region for developing emerging technologies, and it’s exciting to see it move in this direction and to see more eyes on our region.

West Virginia is showing its commitment to modernizing and growing and engaging. Its technology movement is on the march.

This is a sign of more things to come as West Virginia continues to grow in this emerging technology, benefiting not just the state, but the greater region, as well.

Insights Legal Affairs is brought to you by Babst Calland

Corporate venture capital funds can give companies an edge

Corporate venture capital (CVC) funds are gaining in popularity as established companies seek a competitive advantage in the marketplace.

“More large public and private companies are investing in startups, frequently with an end goal of making an acquisition,” says Sara Antol, a shareholder at Babst Calland PC.

Smart Business spoke with Antol about the rewards — and challenges — of these investments.

What is the difference between a venture capital fund and a CVC fund?

With a venture capital fund, the fund is formed with the sole purpose of investment and is looking for a positive financial return within a relatively short period of time.

With a CVC fund, an operating company puts funding into a startup, generally in its market space or a space the company wants to enter. It still seeks a financial return, but the investment is more likely strategically driven. The end goal is frequently to eventually acquire the startup, but the CVC fund can hedge its bets by first making an investment.

CVC investors want to know the startup’s strategy and be involved, and they may want a bigger voice than a typical venture fund would expect. The CVC fund generally avoids legal control — it wants the ability to make a difference but not to affect the company’s overall growth curve.

Recent reports have shown that CVC funds have accounted for almost 25 percent of all venture investments in 2020. It could be because technology companies have rebounded during the pandemic, giving them more access to capital. It may be that private equity has pulled back, creating more capacity for CVC investment.

Whatever the reason, it’s becoming more common for forward-thinking companies to make these types of investments as part of their strategy.

What are the challenges of this type of investment?

There can be a struggle between operating a larger business and being a startup. The investing companies have to understand how startups operate and the risks that go with that, without the controls in place that a large corporation will have.

Because of that gap, the investing companies should work with seasoned professionals who understand the ecosystem of startup financing, who can help them navigate the playbook of what their equity investment entitles them to. Larger companies tend to be risk-averse, and they have to understand there is a greater risk of losing their investment in this context. The investment must be small enough that it’s not a game-changer and that they are willing to risk losing it.

In addition, larger companies may face strict regulations on the kinds of investments they can make, and there may be issues with board representation. If the investment is large enough that the investor wants a board seat, it runs the risk of learning something that could benefit its business. You need to be aware of your fiduciary responsibility, and it needs to be very clear what information can be used by the investing company, if any.

How important is due diligence?

It is critical. Even with a very small investment, the larger company can face risks that can seem like a minor issue to the startup but that can have big impacts on the overall compliance of the larger company. It is imperative to do adequate due diligence, and an outside professional can help before you move ahead.

What advice would you give to companies considering a CVC fund-type investment?

Really think through working with another company and what it’s going to mean for the longer term. It can get ugly when a startup fails, so understand what that would mean for the investing company.

The key is to get experienced advisers. If you decide to engage in these types of investments — and more companies are doing so as part of their day-to-day strategy — understand the process and consider what issues it could create for the overall business.

Insights Legal Affairs is brought to you by Babst Calland

Leveraging with GRATS as a pertinent, timely estate planning option

A Grantor Retained Annuity Trust (GRAT) freezes and discounts the value of larger gifts at their current discounted values rather than at their date of death values. GRATS work particularly well under two circumstances, both of which are currently present due in part to the COVID-19 crisis: (i) depressed values of businesses and other investments and (ii) very low IRS interest rates that are used to value gifts.

Smart Business spoke with Wilbur D. Dahlgren, an attorney at Semanoff Ormsby Greenberg & Torchia, LLC, about how a GRAT works and why employing one now as part of your estate and business succession planning may make sense.

How is a GRAT created and funded?

With a GRAT, the grantor — the person creating the trust — transfers certain assets to a trust while retaining an annuity interest in the trust for a term of years. After the term expires, the trust terminates and the trust fund is paid to the trust’s remainder beneficiaries.

A GRAT splits the ownership of the assets put in the trust. The grantor retains an annuity interest but irrevocably transfers the future ownership of the gifted property. This irrevocable transfer of the future ownership of the trust fund is considered a taxable gift for federal gift tax purposes.

The gift valuation process starts with determining the current value of the assets placed in the trust, usually publicly traded or closely held stock. If the stock is for a closely held business, the IRS usually allows a 20 percent reduction in the value because of the lack of marketability and lack of a controlling interest. The value of the gift is further reduced by the present value of the grantor’s annuity interest, calculated using IRS tables, currently at favorable lower interest rates.

The key is that the value of the remainder interest is ‘frozen’ as of the date the trust is created, as reduced by the discounts and the present value of the grantor’s annuity. The value of any growth in value after the gift will not be subject to federal estate or inheritance tax.

The catch with GRATS is that if the grantor dies before the term of years expires, the entire amount of the trust assets will be brought back into the grantor’s estate for estate tax purposes.

What might GRAT benefits look like?

Let us assume that a closely held business owner, age 60, desires to transfer a 40 percent interest in his corporation to his children using a GRAT. Because of market conditions, the value of the business is comparatively depressed (let’s assume it’s worth $2 million); however an increase in demand for the products and services it provides may significantly increase the value of the business over the next three years. A GRAT is created with a three year term to shift the anticipated appreciation out of his estate for gift and estate tax purposes. If the business is currently valued at $2 million, the starting point for the 40 percent interest is $800,000.

The next step in the discounting/freezing process is to reduce the $800,000 by the lack of marketability/minority interest discounts. Usually 20 percent is the safe discount accepted by the IRS. After these discounts, the gifted stock is considered to be worth $640,000.

Let’s assume that the gifted stock will generate annual dividends of $40,000 — we will make this the annuity amount payable back to the grantor over the three year term of the GRAT.

Using IRS tables, and the September 2020 interest rate of .4 percent, the present value of the grantor’s annuity interest is $103,895. The present value of the remainder interest given to the grantor’s children is therefore $536,105 ($640,000 minus $103,895).

Let’s assume that at the end of the three-year term the stock in the GRAT actually appreciated in value to $1,500,000. So the grantor transferred an asset valued at $1.5 million, but for gift tax purposes the gifted value was only $536,105. That is what is referred to as ‘leveraging.’

To determine if a GRAT makes sense, business owners should consult with a knowledgeable estate planning attorney to review circumstances and, if a GRAT makes sense, assist in the creation, funding and proper reporting of the GRAT to the IRS.

Insights Legal Affairs is brought to you by Semanoff Ormsby Greenberg & Torchia, LLC

Considerations when making generational ownership transitions

Some firms owned or dominated by family have achieved monumental success. Others have found the transition process difficult. Relentless competition, caused in part by the internet, and struggle for customer loyalty, combined with the thorny issues of family dynamics, are challenging.

Smart Business spoke with Howard N. Greenberg, managing member of Semanoff Ormsby Greenberg & Torchia, LLC, about making generational ownership changes in a family business.

How should owners prepare to transfer control of a family business?

The first step is making certain each potential successor is fully committed. Talk to them well in advance and explain the benefits and pitfalls of ownership and control. Evaluate their interest, qualifications and commitment. All three are required. Performance in college, grades and choice of major are important signs.

Prior to joining the family business, outside employment in a related field is extremely beneficial. Working for an accounting, finance or legal firm can provide the younger generation with confidence, stature and valuable knowledge. Performance on the outside likely will evidence future performance with the family business.

You shouldn’t, however, staff your business based on family. Staff it based on talent. Perhaps your family has talented managers, or people knowledgeable in finance. If not, you need to fill the gaps with non-family members. Similarly, if the third generation isn’t ready to take the reins, bring in interim managers as caretakers until the younger generation is ready.

How do generational mindsets affect success?

Typically, entrepreneurial founders do not have significant resources, but they do have lots of resourcefulness, drive and passion for the business, as well as talent and willingness to work very long hours with little pay. These characteristics and an intense drive to succeed help an entrepreneur create something that hopefully can be passed on to the next generation.

The second generation watched parents exert their efforts into their business venture, witnessed their passion and hopefully it rubbed off on them. They feel the responsibility to further the business and want to impress their parents. Though they might not have quite the same drive, they may have the privilege of greater resources and education. They are often successful at maintaining, growing and managing the business.

The next generation is where problems may arise and where outside help may often be required. The third generation usually has more resources, more education and more alternatives than the founding patriarch/matriarch had. But they may have other interests, lack the same drive and abilities, and there are usually more of them.

What should be done for non-participating family?

It may be better to provide the people not actively running the business with other assets from the founder’s or second-generation member’s estate. To reward long-term performance for successor generations running the business, it’s advised that the company recapitalize to lock in the current value with preferred interests. This provides the members of the next generation ceding control and those who choose a different career path with the value of their interests and provides the next generation who will run the business with the value of their future contributions. Include these provisions in wills, shareholder and operating agreements, as well as employment agreements and continuation plans.

It’s extremely difficult for the first or second generation to objectively evaluate the talents and value of their children and grandchildren. And if the second generation comprises more than one sibling, there will be arguments concerning rewarding the third generation and picking leaders. Trying to make things equal for everyone is a mistake. People are not equal. Their talents differ. Outside advisers and consultants can help make these decisions objectively. They can assist in preparing the comprehensive agreements that are carefully tailored to the particular family business. Doing this in advance of the generational transition is imperative.

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