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? You don’t want to give up control! This article will show you how to keep control, how to get Success Co. out of your estate tax-free, and how to deal with some problems that can plague the transfer of a family business.
In this example Joe (married to Mary) owns 100% of Success Co. His son Sam runs Success Co., which Joe wants to transfer to him. Success Co., professionally valued at $9.5 million, grows in sales and profits almost every year. Joe’s lawyer and CPA advised him 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 following transfer plan is a road map that clearly identifies each problem and then shows you how to solve it.
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. Transfer nonvoting stock. Exactly how is revealed later and Joe keeps the voting stock (and absolute control).
The Punishing Tax Cost of a Sale
If Joe sells Success Co. to Sam, each $1 million of the price will be socked with three taxes:
- Sam must earn $1.666 million. The 40% income tax (federal & state) nails Sam for $666,000; only $1 million left.
- Sam pays Joe $1 million for stock (assume zero tax basis). Joe’s capital gains tax enriches the IRS by $200,000; now only $800,000 is left.
- At Joe’s death, the IRS siphons off another 35% ($280,000) for estate taxes… only $520,000 left. It’s nuts! Sam must earn $1.666 million for Joe’s family to receive $520,000.
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 (IDT). 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.
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 Corp. or elect S Corp. 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 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. Bless the IDT!
More Tax and Economic Magic Using an IDT
- 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.
- 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.
- Joe has two nonbusiness kids 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. IDT to the rescue! The trust buys the policy, pays the premiums (so it would take longer to pay off the note) and the two nonbusiness kids are the beneficiaries (via the IDT) of the policy’s death benefit.
Joe called the concept, “Tax Magic.”
Irv Blackman is a CPA and lawyer with more than 51 years of experience in estate planning, business succession and asset protection. This article does not attempt to cover every possible transfer situation. Contact Irv at (847) 674-5295, Irv@IrvBlackman.com, or through www.IrvBlackman.com, or via fax (847-674-5299) if you have questions or a unique tax situations.