Almost all readers of this column with tax problems who contact me are owners or part owners of a family business. Each has a unique story... Most would make an exciting, interesting and fascinating real-life TV drama.
The typical owner/caller has one or more problems... which the family can't solve... nor can their professionals. The problems typically fall into one of three specific categories: (1) taxes; (2) economics or (3) human. It is not uncommon for the same person or family to have a problem or problems that fall into two or all three categories.
If you have any connection to a family owned business, you should enjoy spotting one or more of the problems -- in the following mini-case studies -- you too may be trying to solve... Even better, discovering the solutions.
When I originally made the problem/solution list to write for this article, there were 18 must-write-about items. Too many. So, I whittled the list down to the seven items in practice that (a) come up the most often; (b) involve the most amount of money; or (c) most professional advisors don't know what to do.
Here's the simple format of each case study that follows: (a) start with the Facts:, (b) state the problem and (c) the solution. My purpose is to clearly show you there is a solution (easy and legal) for each tough problem listed.
In every case study that follows, the owner of the family business (Success Co.) has a name beginning with the letter J, is married and has one or more kids (name begins with an S) who work in the business and will eventually own it.
Case Study #1. Facts: Joe has two kids (Sue and Sam) who work at Success Co. Joe wants to give them a stock bonus. Sue is single, Sam is married. Problem: Stock could be marital property.
Solution: The stock bonus is okay for Sue, but not for Sam. Here's why: Sam is married and the stock would be marital property, which a judge, in case of a divorce, might say belongs one-half to Sam's wife. Ouch!
Burn these three rules into your mind: (a) Any property received prior to marriage is nonmarital property (good); (b) any property acquired after marriage that is received as compensation or paid for with funds that were earned after marriage is marital property (bad if the divorce devil dances); and (c) if you receive the property after marriage by gift or inheritance it is nonmarital property (good).
COMMENT: Divorce is the most common "human" problem that plagues family businesses.
Case Study #2. Facts: Jack wants to sell Success Co. to his son Sid. Problem: The insane tax burden Jack and Sid will suffer. For example... Say the price is $1 million. Sid must earn about $1.6 million, suffer about $600,000 in income tax (State and Federal) to have the $1 million to pay his dad. Jack will be hit with about a $150,000 capital gains tax. Only $850,000 left... Must earn $1.6 million to have only $850,000 left. Truly a tax travesty!
Solution: Transfer the stock from Jack to Sid using an "intentionally defective trust" (IDT). Three big advantages: (a) The entire transaction is tax-free to Sid (saves $600,000) and Jack (saves $150,000); (b) when Sid receives the stock, it is considered a gift under the law (avoids the marital property trap in Case Study #1; and (c) Success Co. is out of Jack's estate. IMPORTANT NOTE: Jack keeps control of Success Co. by retaining a tiny amount of the shares: voting stock (while nonvoting stock is transferred to Sid).
Case Study #3. Facts: About 90% of Jim's wealth is tied up in Success Co., which Jim transferred to his son Sean (who runs the business) using an IDT. Problem: What if Jim and/or his wife live to the biblical age of 120 (or 85 or 95). Will they be able to maintain their lifestyle?
Solution: Have Success Co. create a death benefit agreement (DBA), which is really a wage continuation plan. The DBA kicks in after Jim is paid in full by the IDT and is no longer receiving a salary from Success Co. When Jim dies, his DBA wages stop and his wife then gets the wages (usually a reduced amount) for her life.
Case Study #4. Facts: Jake has four kids: two (the business kids) work for Success Co., two (the nonbusiness) kids do not. Problem: How do you treat the non-business kids "equally" (or "fairly" or "equitably")?
Solution: The easy solution (when there are enough assets) is to (a) give the non-business kids nonbusiness assets (can include the business real estate if not owned by Success Co.) or (b) simply acquire enough life insurance (if mom and dad are both insurable, acquire second-to-die life insurance because premiums are much less than single life) to accomplish equality. Sorry, but often -- for many reasons -- the easy insurance solution won't work. In real-life practice there is always a solution, but the possible Facts: are endless and each solution must be specially designed for your unique family situation. Call me if nonbusiness kids are your problem.
IMPORTANT NOTE: Once there is a more than one shareholder (including your kids) for your Success Co., you must have what we call a "unit buy/sell agreement." If you hate your son-in-law or daughter-in-law, this type of agreement assures you they will never own a piece of the family business.
Case Study #5. Facts: Jerry and his three business kids all receive their compensation from Success Co.
Problem: Their fringe benefits must be the same as for all other employees or the IRS "discrimination" monster will raise its ugly head.
Solution: Form a new Management Co... Frees Jerry and the business kids from the discrimination rules. Then awesome fringe benefits abound: Your own pension plan or 401(k); health care plan (pays all your medical expenses... including spouse and dependent kids); health insurance, long-term care and sales promotion.
A NICE LITTLE TWIST: If you are (or can become) a resident of a no-income tax state (like Florida or Nevada), you can deduct the management fee paid in the income-tax state where the business is located, but the entire fee is tax-free in say Florida.
Case Study #6. Facts: Success Co. makes over $1 million a year. Problem: Neither Jeff nor his professionals can think of any way to get more deductions to reduce taxable income.
Solution: Form a "captive insurance company" (Captive). You'll love this. You create the Captive (a real insurance company that insures risks your normal property and casually insurance company will not insure: like loss of a key vendor, customer or employee; strikes; warranty of your goods or services, war, change in law, rules or regulations).
Let's say Success Co. pays a $500,000 premium to Captive. Success Co. deducts the entire $500,000... but Captive receives same tax-free and invests the $500,000... and the earnings are usually tax-free. Also, the Captive structure allows you to enjoy significant savings on your property and casualty insurance expense.
The larger your company's before-tax profit, the more tax dollars you can keep instead of losing them to the IRS. Check it (Captives) out.
Case Study #7. Facts: You have a large amount -- say $500,000 or more -- in a qualified plan (like a 401(k), profit-sharing plan or an IRA). Problem: At current rates (income tax and estate tax) the IRS can wind up with 70% of your plan funds... your family only 30%. What might the numbers look like?... A $1 million IRA can enrich the IRS by $700,000. Outrageous!
Solution: In most cases you have a choice: a "Subtrust" or a Retirement Plan Rescue (RPR). Which one depends on your age, amount in your plan, your goals and other factors. A few examples should get your greed glands flowing: (1) We used a Subtrust to turn an after-tax 401(k) plan amount of $300,000 into $4.5 million of tax-free wealth. (2) A RPR was used to turn a rollover IRA with a $652,000 balance into $3.75 million of tax-free wealth for the kids and grandkids.
Each Subtrust and RPR is designed to meet the client's exact goals. Either strategy is an opportunity to turn a potential tax disaster into a tax victory. What's most interesting is that both strategies are easy to do. The IRS loses. You win, big.
Finally, a caution that applies to each of the above seven case studies. All of the opportunities, rules, exceptions and an occasional trap have not been covered in detail. So, only work with an experienced professional who has implemented the strategy many times.
Want more information? Browse my website: taxsecretsofthewealthy.com. In a hurry, call me (Irv) at (847) 674-5295.
IRVING L. BLACKMAN is a practicing certified public accountant specializing in wealth transfer and business succession and valuation. He is a founding partner in Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs and the American Institute of CPAs. The firm can be reached at (312) 207-1040. Blackman is the author of 31 books on taxation, as well as hundreds of articles for professional publications.