Some things are downright scary. Try taxes — especially estate taxes. Can you guess what area in estate tax planning causes the most anguish? Hands down it’s business succession.
All successful business owners share a common future (no exceptions): someday they must pass the management baton. Most fear that day.
The 32nd president, FDR, said, “Fear paralyzes those who succumb to it.”
Following are six questions that lead the unwelcome fear-factor parade:
1. How high will my income tax/capital gains taxes be if I sell to the kids (or employees) now?
2. If I wait to sell, how much will the increasing value of the business raise my estate tax liability?
3. Will I get paid? Will I be able to maintain my (and my spouse’s) lifestyle?
4. Will the bank let me off the hook for business loans I guaranteed?
5. How can I treat my non-business child, Susan, fairly?
6. What’s the number one fear? Control! It is rare that a business owner is willing to give up control of his business.
About one out of every three business owners who call me to do their estate plans own 51 percent of their business while the kids own the other 49 percent. Why 51 percent? Hey, the fear of losing control.
Unfortunately, I have neither the power nor the knowhow to change human nature, which includes the fear factor. Yet experience — having done hundreds of business succession
Plans — has taught me how to get the succession job done and done right. My job is to come up with solid (also accepted by the IRS) solutions that will calm your business owner fears.
How do I do that? Take every fear question you have and turn it into a goal. Then show you how to apply the correct strategy (that I have used over and over again for other owners) to accomplish each of your goals.
Here’s a true-life example. A reader/business owner of this column is married to Mary. His son Sam (age 31) runs — and will someday own — the family business (Success Co.).
Here is a list of Joe’s fears, which we have turned into goals.
No. 1: Keep control for life. Joe owns 100 percent of the stock of Success Co. (an S corporation). We recapitalized (a fancy word for having voting and non-voting stock) Success Co. Joe now has 100 shares of voting stock and 10,000 shares of non-voting stock, a tax-free transaction. The strategy allows Joe to keep the voting stock (and control) to the day he dies. The non-voting stock will be transferred to Sam (No. 2, following).
It should be pointed out that if Joe had owned only 51 percent of Success Co., Joe would own only 51 shares of voting stock (keeping control) and 5,100 shares of non-voting stock.
No. 2: Transfer Success Co. to Sam now (freeze the value) without getting beat up with income/capital gains taxes. Sell the non-voting stock to an intentionally defective trust (IDT). The tax beauty of an IDT is that Joe legally avoids capital gains tax on the sale (say the price is $8 million — paid with a note — and the profit on the sale is $6 million). No capital gains tax is owed on the $6 million profit and no income tax is due on the interest Joe is paid on the $8 million note
Typically the note is paid in full over five to eight years, using the cash flow of Success Co. When the note is paid in full, the IDT trustee distributes the non-voting stock to the trust beneficiary (Sam). Sam never pays even a dollar to own the nonvoting stock. Neat!
For every $1 million of your company's price, your tax savings will be about $190,000. For example, Success Co. worth $8 million yields tax savings of $1.52 million. So bless the IDT.
No. 3: Make sure that Joe and Mary can maintain their lifestyle for as long as they live. Joe continues to work every day, at full salary, but for less hours. The intent is for Joe to cut his salary and days worked once his IDT note is paid in full.
No. 4: Remove Joe’s bank guarantee for Success Co.’s loans. That was easy. A meeting at the bank caused the term-loan provisions to be rewritten, removing Joe's guaranty once the IDT loan to Joe was paid.
No. 5: Treat Susan (the nonbusiness child) fairly. Remember, Success Co. is an S corporation and every year the IDT will receive a dividend from Success Co. Here’s the strategy: We had the IDT buy second-to-die life insurance on Joe and Mary. Susan is the beneficiary of the IDT for the amount of the insurance, enough to treat Susan fairly. The dividend distributions, each year, are first used to pay the insurance premiums, and the balance to pay the IDT note.
Finally, let me point out that most succession plans are similar to the hundreds of others I have done through the years. Do you have a business succession fear/problem? We would like to write about your story and the proper solutions (without revealing your identity) in a future column. Please contact me by fax 847-674-5299, phone 847-674-5295 or email [email protected]. I’d love to hear your story.
If you have a question concerning the succession of your closely held business, call me (Irv) or email me.
Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847/674-5295, e-mail [email protected], or on the Web at: www.taxsecretsofthewealthy.com.