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How To Sell Your Business To Your Key Employee, Make A Huge Profit, Yet Pay No Tax (Not One Penny)

by Irv Blackman
Posted On: 9/18/2012

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selling a business, sell business to employee, income tax, vending business planning, coin machine business, succession plan, Irv Blackman, small business, recapitalization, succession planning problems

So you (Joe, age 62) want to sell your business (Success Co.) to your key employee (Ken, age 38). Ken is terrific. Actually runs Success Co., but, as is usually the case, has no money to fund the purchase. What to do?

Joe decides to see his lawyer and longtime friend, Lenny. Joe tells Lenny, "Ken and I have agreed on a price for Success Co.... $4.2 million (to be paid over eight years with 4.5% interest on the unpaid balance.). The average before-tax profit for the last three years was $840,000. But the trend is up. My tax basis for Success Co.'s stock (an S corporation) is $800,000. What's the best way to structure the sale?"

Joe also explains to Lenny that he has three concerns that keep him up at night: (1) Make sure that he and his wife Mary (age 61) can maintain their lifestyle if they live to a ripe old age (both are healthy and come from long-life families); (2) runaway inflation (thinks it is inevitable because of the out-of-control national debt); and (3) his obligation to pay for the college education of four more grandkids (already paid for the three oldest).

NOTE: Joe always left the bulk of his profits in Success Co. to grow the business. Outside of the business Joe and Mary have two upscale, well-furnished homes (one in Indiana -- worth about $1.3 million and the other in Florida, worth about $1.4 million). A variety of other assets total about $850,000, including $475,000 of liquid investments.

After much discussion, Lenny advises Joe to structure the sale as an installment sale for tax purposes. Reason, Joe will not pay any tax on the $3.4 million capital gain until he actually gets paid by Ken.

The Tragic Tax Cost of an Installment Sale for the Seller.

Not satisfied, Joe goes to see his CPA, Cal (by coincidence a reader of this tax column for many years).

First, Cal explained the tax consequences of an installment sale to Joe. Subject to Congress changing the tax rates, under the current law the rates (including healthcare) will rise from a top rate of 35% for 2012 to 40.5% for 2013 and beyond for ordinary income (which includes the interest income Joe will receive).

Capital gains (long-term) are even worse: Rising over 50% from 15% in 2012 to 23.8% starting in 2013.

Simply put, Joe would be clobbered with Federal taxes, plus Indiana will get its State income tax.

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.

Next, the even worse tax cost for the buyer.

Cal explains that Ken gets killed with two problems: a tax problem and an economic problem. Let's lower the price of Success Co. to $1 million for ease of following the numbers. Assume the income tax burden (state and Federal combined is 44%). It's hard to believe, but Ken must earn $1.78 million, pay $780,000 in taxes to have the $1 million to pay Joe. And oh, yes, multiplied in this cases by 4.2 (remember the price for Success Co. is $4.2 million). On top of all that, the unpaid balance will always bear interest. That's the tax problem.

What's the economic problem? Sam's personal financial statement must now show a liability of $4.2 million, destroying his personal balance sheet, and making it almost impossible for Success Co. to borrow money for growth (banks want a personal guarantee from the owner).

Finally, Cal suggested Joe call me, which he did.

An Intentionally Defective Trust (IDT) solves the problems for both seller and buyer.

One strategy (an IDT) solves not only the tax and economic problems as outlined above but also solves a significant human problem: An IDT allows Joe to keep control of Success Co. until he is paid in full.

NOTE: The solution that follows assumes that Joe will sell all the stock he owns (100%) of Success Co. to Ken (because that is the typical situation we see the most in real-life practice). Later is an explanation of the variation we actually did for Joe.

The solution is a simple two-step process.

Step 1: Do a recapitalization (just a fancy name for creating voting and nonvoting stock)... say 100 shares of voting stock, which Joe keeps to maintain control and 10,000 shares of nonvoting stock, which ultimately will be transferred to Ken.

Step 2: An IDT is the weapon of choice to transfer the nonvoting stock to Ken. Actually, Joe creates the IDT and sells all 10,000 shares of his nonvoting stock to the trust for $4.2 million. The IDT now owns the nonvoting stock and Joe has a $4.2 million note receivable (payable from the IDT). The cash flow of Success Co. (must be an S corporation or become an S corporation) is used to pay off the note, plus interest.

Every $1 million of price for Success Co. will save about $200,000 in taxes. Here (with a $4.2 million price) the savings are $840,000.

Ken is the beneficiary of the IDT. When Joe's note is paid off, the trustee will distribute the nonvoting stock to Ken. Then, Ken buys the 100 voting shares from Joe for a nominal price (say $1,000). Ken now owns 100% of Success Co.

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 you (the seller) receive is tax free: no capital gains tax on the note payments, and no income tax on the interest income you receive.

Does an IDT work for a transfer to your kids?

Yes, it works exactly as explained above. Just substitute the name of your child for Ken in the above examples. And yes, the transfer can be to more than one employee or child. When one (or more) of your children is involved, an IDT offers three more important advantages: (1) The fair market value of the nonvoting stock can be discounted by about 40%. For example, if Success Co. is worth $10 million, the nonvoting stock (over 99% of the company's value) can be valued for tax purposes at about $6 million. (2) You can gift or sell all or a portion of the stock (voting and nonvoting) to the IDT. (3) The trustee of the IDT can be instructed to keep possession of the nonvoting (and the voting stock if in the trust) so if your child who is the beneficiary gets divorced, his/her spouse will have no interest in the stock.

NOTE: Can the same IDT strategy be used to buy out fellow stockholders?... YES.

How we adjusted the IDT strategy to accomplish Joe's special goals.

An IDT is extremely flexible. Go back to the beginning of this article and read again the three concerns that kept Joe up at night. To alleviate these concerns Joe sold only 65% of the nonvoting stock to the IDT. So Joe would continue to earn 35% of Success Co.'s income. A simple agreement tied up the 35% of stock so Joe could sell it to the IDT down the road at a formula price (intended to be fair market value at that time), and Ken was assured that some day he would own 100% of Success Co.

One more point: Joe was concerned that Success Co. could quickly lose its value if Ken got hit by a bus. To cover this problems we had the IDT buy insurance on Ken and in the event of his death, the insurance proceeds would pay any amount still due Joe.

And finally.

Every possible use of an IDT in succession planning is not covered in this article. Nor is every nuance, tax trap or exception covered.

One warning: If your professional advisor ignores the use of an IDT in your succession planning (no matter what his/her reason may be)... Run!

If you have a unique succession problem that is not covered in this article, contact me (Irv) at (847) 674-5295.

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.