I’ll bet the farm that this article will save many business owners (who want to transfer the family business to their kids) a ton of taxes.
Let’s set the stage by quoting an email a loyal column reader sent to me: "Mom is 82 with an estate worth about $20 million. Included is an S corporation, recently valued at $1 million for IRS purposes. My dad started the company and ran it until he died two years ago."
"Sam [my brother] and I [Larry] are the only heirs and want to continue to run the company. You state in your articles that the estate tax can be avoided completely [true]. Mom has excellent tax attorneys and CPAs who say it can’t be done with an S corporation -- they have done what they can, but my brother and I will end up with a $7 million tax bill payable over 15 years."
Over the years, the above quote describes two important facts: (1) Succession is the most common problem that perplexes business owners who want to sell /transfer their business to their kids or employees and (2) their professional advisors are stumped when it comes to most tax effective way to implement the sale/transfer.
First, let me come to the defense of my fellow CPAs and lawyers (I am both). None of us knows it all. Certainly not your author, who is by education, reputation and experience supposed to be a tax expert. Well, the fact is I don’t know how to prepare my own tax return (it’s done by one of the partners -- a smart woman CPA -- of the CPA firm I founded over 50 years ago). Yes, experience is a key factor, but significantly more important is to know whom to call -- either in your own firm or another firm when necessary -- when you don’t know the answer to your client’s problem.
Next, let’s (1) set up the problem the way it comes up most often in real-life (the
business owner is married); (2) what most professionals get wrong; and finally (3) the solution.
Okay, here’s the typical problem: Joe (married to Mary) owns Success Co., which is worth say $10 million. Steve, Joe’s son, runs Success Co. The plan proposed by Joe’s professionals is for Steve to buy Joe’s stock for $10 million (to be paid over 10 years).
Steve must earn about $16 million, pay $6 million in income tax to have the $10 million to pay Joe. Joe must pay about $1.5 million in capital gains tax... only $8.5 million left. So, Steve must earn a stratospheric $16 million for Joe’s family to keep $8.5 million. That’s nuts.
Lesson 1: A sale of all (or even a portion of your stock) to your kids is a bad idea for tax purposes.
Sometimes professionals use various strategies (most likely a stock redemption or stock purchase agreement) requiring insurance on Joe’s life as a means to get the company stock to Steve. Better than Lesson #1, but the IRS will collect estate taxes on every dime of that life insurance (roughly $4.5 million to the IRS on $10 million of insurance using 2009 tax rates). In most real-life cases the insurance is either too much (stock was gifted to Steve while Joe was alive) or too little (Success Co. just kept growing in value).
Lesson 2: Life insurance can play an important part in your estate planning, but never (and I mean never) use it in a business succession plan to get your Success Co. stock to your business kids. You’ll always guarantee the IRS a big payday when you go to the big business in the sky.
Now, let’s give credit to the professionals Sam and Larry’s Mom are using. They avoided the pitfalls in Lessons #1 and #2. True, there would be an unnecessary $7 million estate tax bill, but they jumped on Section 6166 of the Internal Revenue Code, which allows certain business owners to pay their estate tax liability over a 15-year period, plus a low rate of interest (not deductible) on the amount of estate tax due. Never in my 50-plus years of practice have I used Section 6166 as part of an estate plan. Why? It cannot save a penny of taxes, just stretches out the time of payment.
In every case my network of professionals has been able to pass all of each client’s wealth (whether worth $5 million or $50 million -- or more) to their heirs 100% intact (no tax or all taxes paid in full). For example, if the client is wroth $5 million, the entire $5 million to the client’s heirs, if $50 million, the entire $50 million to their heirs.
Lesson 3: Never use Section 6166 as part of your overall estate tax plan. Instead, create a comprehensive plan (as described below) to eliminate the estate tax.
Now let’s turn to the solution for the typical family business owner (the Joe’s of the world) who wants to transfer his business to his kid(s). Most business owners have four kinds of assets: (1) the business (Success Co.); (2) a residence (often 2 or more); (3) funds in a qualified plan (for example, an IRA, 401(k), profit-sharing plan or similar plan); and (4) investments (like real estate, stocks, bonds cash, CDs and other investments)
The solution (really a System to create a comprehensive plan) requires two plans: first a traditional will and trust (one for Joe and one for Mary). This is really a death plan. It cannot save you a dime in taxes. It just defers the estate tax blow until both Joe and Mary have gone to heaven.
The second, a lifetime plan, beats up the IRS... legally.
Let’s look at the lifetime-plan strategies most often used in practice. The System uses strategies that are implemented during your life and are based on the assets you own.
1. Your business. We use an intentionally defective trust (IDT), which means the trust is intentionally defective for income tax purposes. What does this accomplish? The transfer of the Success Co. stock (typically nonvoting stock, while Joe keeps the voting stock and control) is tax-free. The tax savings -- compared to selling the stock to the kids - usually are $456,000 per $1 million of the value of Success Co. ($5,016,000 for Sam and Larry’s mom; $4,560,000 for Joe).
2. Residence(s). The most common strategy is called "50/50." We transfer the title of each residence by having 50% owned by Joe’s traditional trust and the other 50% owned by Mary’s trust. Tax result?... We get about a 30% discount for estate tax purposes (for example a $600,000 house is only valued at $420,000 in the estate). Of course, Larry’s mom cannot take advantage of this strategy (her husband is gone).
3. Funds in qualified plans. These funds are double taxed. Sorry, but the IRS winds up with about 70%, the family only 30%. For example, $1 million in a rollover IRA will only yield $300,000 to the family. Ouch! We use strategies like a subtrust or retirement plan rescue to boost that $300,000 to the $2 million to $7 million range (all tax-free) depending on age and health of the business owner (and spouse if married).
4. Investments. A family limited partnership (FLIP) is almost always the strategy of choice. Joe transfers his investments to a FLIP (could be more than one FLIP). Immediately the value of the assets transferred to the FLIP are discounted about 35% for tax purposes. Hey, $1 million of intrinsic value is a worth only $650,000 for tax purposes... yields estate tax savings of $158,000. Works for Joe... and Larry’s mom, too.
5. Still an estate tax liability: Often 1 through 4 above kills the estate tax liability. But what if it doesn’t? We fall back on one of about 20 life insurance strategies to create tax-free wealth (Easier if you are married, like Joe and Mary because you can buy second-to-die insurance, which cost much less in premiums than single life) to pay the estate tax.
What if the business owner is uninsurable (and so is his wife if married)? We then use a strategy called a "charitable lead trust" (works very similar to life insurance) to create tax-free wealth for the heirs. That’s exactly what Jacqueline Kennedy -- who was uninsurable -- did to get her heirs about $250 million, tax-free.
Lesson 4: The System as described above always works (kills the estate tax), whether you are young or old, married or single, insurable or uninsurable.
If your professional does not eliminate all of your estate tax burden, get a second opinion.
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.