Joe and Mary (both in their early 60s) consider themselves blessed. Joe started his one-man-show business in 1975. The first dozen years were a struggle. Then revenue and profits began to blossom.
More customers. More employees. Now, two key employees are his only kids, Sam and Sid. After college Joe insisted they work elsewhere for three years. They did. Got great experience. Now the boys run the business (Success Co.), with (when necessary) some coaching and help from Joe.
First, let's take a look at Joe's current wealth. This year's annual personal financial statement prepared for the bank by Joe's CPA (Cal) shows a net worth of $18.5 million. Included are two homes: the primary residence in Michigan and Mary and Joe's winter home in Florida; the land and building leased to Success Co.; Joe's 401(k) [$1.1 million]; and a stock and bond portfolio ($1.6 million). The prime asset, of course, is Success Co., which Cal values at $11.7 million.
How did Joe feel about taxes? Income taxes are okay. "The price of doing business in America," he would declare. But estate taxes, he fumes using a few expletives to describe his feelings toward what he calls, "A double tax on success."
Now let's talk about (Joe's) taxes -- estate taxes. The President signed the new tax law, avoiding the "fiscal cliff," on Jan.2, 2013. The part of the law concerning estate taxes made two significant changes: (1) lowered the top estate tax rate to 40% (55% by old law) starting in 2013; and (2) continuing forever $5 million (tied to inflation) that is free of the gift or estate tax, starting on Jan. 1, 2013. Because of inflation the free amount rose to $5.125 million in 2012 and is now $5.25 million for 2013.
Are you married? That's times two or $10.5 million for 2013; and will grow in future years, boosted by inflation.
As soon as (Jan. 3) Joe heard the new estate tax news he called a meeting with Cal and his attorney (Lenny, specializing in estate planning).
Joe had questions: First, "What would my estate tax be on my current net worth?" Everyone had a copy of Joe's latest personal financial statement. "In the $3.2 million range," answered Lenny.
"But my wealth grows almost every year, particularly the value of Success Co. What happens to the estate tax cost as my wealth rises?" Lenny responded: "Well for every $1 million in increased wealth, your estate tax bill will go up $400,000."
Joe kept asking questions. Lenny or Cal would answer. Then Cal said, "Let me try to summarize the problem and once we all agree on the problem, we will try to solve it." After a bit of give-and-take discussion, all agreed this is Joe's problem: Joe's wealth is already in the highest estate tax bracket (40%). The value of Success Co. continues to grow. It should be removed from his estate (by some kind of transfer to Sam and Sid) as soon as possible. Joe must retain control of Success Co. for as long as he lives. Also, Joe and Mary must have a flow of income to maintain their lifestyle when Joe retires in three years.
All agreed the above was the problem to be solved. A long discussion followed concerning the fate of Success Co.: sell the company to Sam and Sid; give it to them; have the company redeem Joe's stock; different variations and combinations.
No cigar. Try as they would, a viable solution could not be found. The next day Joe called me.
Joe sent me a file of documents that, together with his input, brought me up to speed on the problem. What Joe did not realize is that his problem is not unique. Many family business owners have been down the same frustrating path.
A sale kicks up current capital gains tax. A gift means no more income to Joe and Mary. Variations suffer one or both disadvantages. And inflation, for either a sale or gift, remains an unknown fear factor for Joe when he retires
What to do?
Enter a concept called "Spousal Access Trusts." As you will see SATs, which are irrevocable, solve every issue raised by Joe's problem.
The first step in creating SATs for Joe and Mary is to divide the Success Co. stock so Joe and Mary each own 50% of the nonvoting stock.
NOTE: If you do not have voting/nonvoting stock, it is a simple tax-free transaction to create them. Typically, Joe will keep (say 100 shares) the voting stock and control of Success Co. The nonvoting stock (say 10,000 shares) is gifted to the SATs: 5,000 shares to Mary's trust and 5,000 to Joe's trust.
Now Joe and Mary can each use all or a portion of their $5.25 million gift tax-free exemption when gifting the nonvoting stock to the trusts.
An important tax note: nonvoting stock is entitled to various discounts of about 40% making the 10,000 shares that were gifted to the SATs worth only about $7 million (rounded) for tax purposes.
Joe's trust, in simple terms, gives Mary a right to the trust income for life, and at her death the trust assets go to Sam and Sid. Mary's trust does the same for Joe.
It is critical that the trusts be drafted in such a way as to be different in order to avoid the so-called "reciprocal trust doctrine," which would pull the gifts made back into the grantor's estate. So, make sure you work only with an advisor who is experienced in drafting and working with SATs.
The second and final step is the operation of the SATs on a year-to-year basis. Joe and Mary are limited to working only with their spouse's trust to get the income they need from time to time. Any income that they do not take, stays in the trust and will eventually go to their heirs (kids and grandkids) estate tax-free.
A little summary: The results of the SATs for Joe and Mary are (1) Success Co. is out of Joe's estate, but he keeps control; (2) the income earned by Success Co. in the future will be available to Joe and Mary as needed; (3) when Joe and Mary have gone to the big business in the sky, (a) Success Co. and (b) all of the non-used income accumulated over the years in the SATs will go to Sam and Sid... free of the estate tax.
Joe's comment -- "WOW!" And even Lenny and Cal agreed.
If you have a business succession problem, logic tells you to consider SATs.
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.