How to Solve Your Succession Planning Problem So Your Family Wins -- Every Time

If you own or run a family business – a business you want to continue after your leadership ends – then this article is must reading.

The problem is clear: You need a succession plan. Yet, with all your years of experience, you have never done a succession plan. If you are typical, you have some ideas but don’t know how to put a plan in place. The purpose of his article is to show you how.

Let’s start with the three most basic succession plan problems: (1) who will own the company? (2) who will run the company? and (3) who will have control of the company (not day-to-day operating control, but legal voting control)? Chances are you now enjoy all three. Often explaining to my client how (in the perfect succession plan) three different individuals might own, run and control the company (but more than one person can own), gets the succession ball rolling.

Let’s start an example. We’ll call the company “Success Co.” and the owner “Joe” (who owns 100% of Success Co. and runs it). Joe, like any other family business owner, has three basic choices, when it comes to determining who will finally own Success Co.:

  1. One or more family members (66%)
  2. One or more key employees (24%)
  3. Some third party (or company) to whom Success Co. will be sold (10%)

Note: The percentage after each choice is what I see in my practice in real-life succession plans. This article ignores the other possibilities – merger, combination of family and key employees, Joe keeping part of the ownership, and other ways – that do not come up often in practice.

My experience over the years is that each of the hundreds of succession plans I have helped create has had some unique twist. So, yes… it’s a fact: Succession planning (with one exception) does not have a one size fits all solution. Who (when and how) will ultimately own your company drives the exact terms of your succession plan. So, what’s the exception? Taxes! To be specific, income taxes and estate taxes. You’ll read the tax solution toward the end of the article.

A suggestion: As you read, zero in on the fact situation described below that best fits your circumstances. This is a huge subject… all that is contained in this article cannot apply to any one family, person or business.

Now, back to our example. This article focuses on Joe’s first choice: family. The following four family situations come up in practice on a regular basis:

1. Joe has no children or none of his children (even those now working in the business) could run Success Co. Of course, one or more of these kids could own all or part of Success Co. if a professional manager ran the company (rarely done).

2. One child, Sam, (Joe’s only child) works for Success. Co. and Joe is confident that Sam could run the company.

3. Two or more children and all are in the business. Most of the time Joe wants each of them to own an equal number of shares (i.e. 50/50 if two children in the business, 1/3 if three children, etc.). This creates a special problem: There must be a clear leader (with voting control) to make the final business decisions.

Here’s how we solve this problem: We create voting stock (say 100 shares) and nonvoting stock (say 10,000 shares). This is a tax-free transaction and is simple to get done. The technical name is a recapitalization. As long as Joe is alive, he keeps the voting stock and has absolute control of Success Co. Of course, the nonvoting stock, which we will deal with later in greater detail, goes to the business kids. When Joe goes to the big business in the sky, 51 shares of the voting stock (and control) goes to Sam (or the other child who is the clear leader). Sam’s nonvoting shares would be reduced by the exact number of extra voting shares he receives… now all of the business children would be equal.

4. There is one (or more) child in the business and one (or more) nonbusiness child. This common situation drives Joe crazy. Typically, Joe wants the stock of Success Co. to go only to the business children. The nonbusiness children get other assets owned by Joe. Of course, we have the same problem as in #3 above (treating all of the kids equally). Often there are not enough other assets (value of these assets is small compared to large value of Success Co.) to accomplish the “treat-‘em-equal" goal. Second-to-die life insurance is the first choice to get to the equalization goal for the nonbusiness kid(s). But what if Joe (or his wife) is not insurable (because of health or age)? Or if insurable the premiums are just too high for Joe’s cash flow? If either the (a) not insurable problem or (b) premiums problem is your unwelcome bedfellow, call or email me and I’ll walk you through the easy-to-do solution (which unfortunately requires a rather long explanation).

The tax problems

The tax cost of the wrong succession plan is a never-ending expensive nightmare. Let’s run the numbers by example: Joe sells Success Co. for $1 million to Sam. Assume the tax rates are 40% for income tax (35% federal and 5% state) and 50% for estate tax. You can be sure the geniuses in Washington will change the rates, which will alter the tax computation a bit… Oh, but the concept (as well as the lousy tax results) will remain the same.

Suppose Joe’s tax basis for Success Co. is zero. Okay, let’s follow the numbers (all numbers are rounded) starting with Sam. He must earn $1.7 million… pay $.7 million in income tax… leaving $1 million, which Sam pays to Joe. With the top capital gains tax rate at 15% (most likely going up), Joe must pay the tax collector $150,000… He only has $850,000 left.

To summarize: Sam must earn $1.7 million and after taxes, his dad only has $850,000 left. Outrageous!

Stop for a moment. Apply the numbers in the example to the value of your company. If your company is worth $6 million, your kid(s) must earn $10.2 million for you to have only $5.1 million left. Yes, it’s expensive to do it wrong.

Now here are some facts that will blow you away: Would you believe that 90% of family businesses finally create a succession plan that sells their business to the kids exactly like the above example. Less, than 10% avoid the above tax trap by making lifetime gifts. Less than 1% do it right.

How to do Your Succession Plan Right

It’s actually a two-step process. Let’s say the value of your business is $7 million. For ease of following the numbers, let’s use a $1 million price.

Step #1. Recapitalize Success Co., so you have 100 shares of voting stock (which you keep along with absolute control) 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.

Step #2. Sell your nonvoting stock to an intentionally defective trust (IDT) for $600,000. The trust pays you in full with a $600,000 note, plus interest. 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 receive until the note is paid is tax free: no capital gains tax on the $600,000 note payments and no income tax on the interest income you receive. The cash flow of Success Co. is used to pay off the note, plus interest.

How does Sam fare when Joe uses an IDT to transfer Success Co. to him? Sam is the beneficiary of the IDT. 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.

But instead of distributing the nonvoting shares to Sam, the trustee is instructed to hold the shares for Sam’s benefit. Why not distribution? Because if Sam gets divorced the judge cannot see the shares in Sam’s name, and his now ex-wife will never have an interest in Success Co.

Two more points that make an IDT shine: (1) Remember, the illustration above where Sam must earn $1.7 million for every $1 million of the price for Success Co. to pay his dad? Well, using an IDT Sam does not pay even one cent to acquire the shares. The cash flow of Success Co. is used to make all payments. (2) Suppose Joe needs life insurance (to pay estate taxes, provide funds to help equalize the inheritance of the nonbusiness children, or for any other purpose). A portion of Success Co.’s cash flow received by the IDT can be used to pay the premiums. As a result Joe can buy life insurance without ever writing a personal check to pay premiums. The policy can be on Joe’s life only or second-to-die (with his wife).

And finally

An IDT can be used, as described in the above example to transfer Success Co. to more than one child (including nonbusiness children if desired). Can the IDT strategy be used to transfer Success Co. to one or more employees? Of course, but typically the price used is the full value (before discount) of the nonvoting stock (Joe keeps the voting stock until he is paid in full.)

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

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… find another advisor.

Irv Blackman is a CPA and lawyer with more than 51 years of experience in estate planning, business succession and asset protection. He is happy to asnwer questions from Pavement readers so contact Irv at (847) 674-5295, [email protected] or through