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 percent 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 percent), 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”:
- “Sam must earn $1.666 million. The 40 percent income tax (Federal and state) nails Sam for $666,000. Only $1 million is left.”
- “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.”
- “At your death, the IRS siphons off another 35 percent, 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 status) 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.