Do you own all or part of a family business? And run it? But the clock is ticking. The time has come to step down (or slow down) and transfer your ownership to the next generation. You want the business (Success Co.) out of your estate (to save estate taxes). So, what's the problem? CONTROL! You don't want to give up control. The purpose of this article is (1) to show you how to keep control, (2) get Success Co. out of your estate (tax-free) and (3) deal with some collateral problems that plague the typical transfer of a family business.
Let's start with a fact pattern that comes up often in real-life family businesses: Joe (married to Mary) owns 100% of Success Co. His son Sam actually runs Success Co., which Joe wants to transfer to him. Success Co., worth $9.5 million (professionally valued), grows in sales and profits almost every year. Joe was advised (by his lawyer and CPA) to sell Success Co. to Sam, stopping the growth of potential estate taxes. Joe agrees, but can't stand the thought of giving up control.
The transfer plan that we created for Joe, which follows, is a road map that first clearly identifies each problem -- starting with control -- and then shows you how to solve it. Although each real-life business succession situation is unique, after creating and reviewing hundreds of plans over the years, the problems (and the solutions that follow) tend to be common for almost all family business transfer/succession plans.
It's a two-step process. For ease of following the numbers, let's say Success Co. is worth $1 million.
Step #1 Recapitalize Success Co.: Joe now has 100 shares of voting stock and 10,000 shares of nonvoting stock. Under the tax law, the nonvoting stock is entitled to a series of discounts (total of 40%), which makes the value of Success Co. (for tax purposes) only $600,000. As you can see, although Success Co. is really worth $9.5 million, the discount would be $3.8 million, so for tax purposes, Success Co.'s value is only $5.7 million.
Step #2 The nonvoting stock is transferred (exactly how is revealed later) and Joe keeps the voting stock (and absolute control).
The Punishing Tax Cost of a Sale
Here's how I explained the tax consequences of selling to Joe: "If you sell Success Co. to Sam, each $1 million of the price will be socked with three taxes":
1. "Sam must earn $1.666 million. The 40% income tax (Federal and state) nails Samfor $666,000. Only $1 million is left."
2. "Sam pays you $1 million for your stock (assume zero tax basis). Your capital gains tax enriches the IRS by $200,000 -- now only $800,000 is left."
3. "At your death, the IRS siphons off another 35%, or $280,000 for estate taxes -- only $520,000 left. It's nuts! Sam must earn $1.666 million for your family to receive $520,000."
NOTE: Congress may change the tax rates, which will alter the tax dollars due, but the concept (the lousy tax results) will remain the same.
How to Legally Beat the Tax Cost of Selling
Now the secret: Instead of an outright sale to Sam, sell the nonvoting stock of Success Co. for the same $5.7 million to an intentionally defective trust (ID). Joe gets paid in full with an interest-bearing note from the IDT.
What is an IDT? It is the same as any other irrevocable trust, with one big difference: The trust is not recognized for income tax purposes. The result under the Internal Revenue Code is that every penny Joe receives is tax free -- no capital gains tax on the note payments, and no income tax on the interest income received.
Sam is the beneficiary of the trust and has no obligation to pay the note. Instead, the cash flow of Success Co. (must be an S corporation or elect S corporation statues) is used to pay the note and interest. When the note is paid off, the trustee can distribute the nonvoting shares to Sam (because Joe is now legally paid off and completely out of the nonvoting share picture). Joe still owns all of the voting stock and has absolute control of Success Co. Typically, Joe will gift the voting shares to Sam if and when Joe retires. Should Joe's death come first, these shares will be bequeathed to Sam.
Joe and Sam will save about $200,000 in taxes for each $1 million of Success Co.'s price (here about $1,040,000 in tax savings). Bless the IDT.
More Tax and Economic Magic Using an IDT
1. Sam is married. One of Joe's concerns: If Sam gets divorced, will his ex-daughter-in-law wind up with a piece of Success Co.?... No! The IDT trustee is instructed to hold the stock in the trust for Sam's benefit, taking the stock out of the divorce court's jurisdiction.
2. If Sam were to buy Success Co. from his dad, the obligation to pay the $5.7 million sales price would destroy Sam's personal balance sheet. Using an IDT eliminates any personal liability to Sam, allowing his guarantee of a bank loan -- when Success Co. wants to borrow -- to be accepted by the lending bank.
(Sam applauded this strategy.)
3. Joe has two nonbusiness kids, who he wants to treat equally to Sam (receiving a $9.5 million business). But Joe doesn't have enough other assets. Yes, a second-to-die life insurance policy (with Mary) is the answer, but the annual premium payments would be a drain. The IDT to the rescue. The trust would buy the policy, pay the premiums (so it would take longer to pay off the note) and the two nonbusiness kids would be the beneficiaries (via the IDT) of the policy's death benefit.
Joe called the concept, "Tax Magic."
It is important to note that this article does not attempt to cover every possible transfer situation we see in practice. So, if you have a question or a unique succession problem that is not covered in this article contact me.
IRVING L. BLACKMAN has been practicing accounting and law more than 50 years, specializing in wealth transfer, business succession and valuation. He was a founding partner of Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs, American Institute of CPAs and the American Speakers Association, among other organizations. Blackman has authored 21 books on taxation and penned hundreds of articles for trade publications. His company, Tax Secrets of the Wealthy, is headquartered in Naples, FL. He may be contacted at (847) 674-5295 or Irv@IrvBlackman.com.