Get Minority Discounts On Your Firm's Stock

ITS ALWAYS A good day when you can beat up the IRS legally. Its even better when you can pummel it with its own rules. The issue concerns the value of your business for tax purposes. Suppose you have four kids (all work in the business, Success Co.). If you wait until you die, then leave 25% of Success Co. to each of the kids, the IRS will focus on the total value of 100% of the business. Whats the

IT’S ALWAYS A good day when you can beat up the IRS legally. It’s even better when you can pummel it with its own rules.

The issue concerns the value of your business for tax purposes. Suppose you have four kids (all work in the business, Success Co.). If you wait until you die, then leave 25% of Success Co. to each of the kids, the IRS will focus on the total value of 100% of the business. What’s the result? No discount for a minority interest.

Let’s get to the beat-up-the-IRS part: Suppose you transfer Success Co. to your four kids, 25% to each, during your life. Finally, the IRS agrees with us: The focus is on each one-quarter of the business being transferred separately to each child. The shares transferred to each child are entitled to a minority discount.

With minority discounts, combined with discounts for general lack of marketability running in the 40% to 45% range, stop for a moment and figure out what a lifetime transfer of your business might save your family in taxes.

If you want to save taxes but don’t want to give up control of the business, you are perfectly normal and typical of the closely held family business owners who seek our advice. The answer is a “recapitalization.” This is a tax-free maneuver where you wind up owning all the voting stock (say 100 shares) and all the nonvoting stock (say 10,000 shares). Now you can give each of your four kids 2,500 shares of the nonvoting stock of Success Co. You get a minority discount. You also keep control.

Suppose Success Co. is worth $10 million. You recapitalize with 100 voting shares and 10,000 nonvoting shares. After your recapitalization, those 10,000 nonvoting shares, for tax purposes, are only worth about $5.5 million to $6 million, after discounts. Hey, 55% (the highest gift/estate tax bracket in the year 2011) times the $4 million in discounts means you just eliminated $2.2 million in estate tax.

A typical recapitalization

Joe, age 65, realizes he must create a succession plan to transfer his business (Success Co.) to the next generation. I start by asking Joe to list his objectives. Here are the five most important objectives the typical owner lists:

1. Slow down, but stay active at Success Co., until his last breath;

2. Maintain his lifestyle (and his wife’s) for as long as either lives;

3. Transfer Success Co. to son Sam, the only child active in the business, but keep control of the business;

4. Wants Sam to be able to run Success Co., free of any interference from his brother or sister who are not active in the business; and

5. Wants to reduce or eliminate, if possible, current income and capital gains taxes and estate taxes.

If you have similar objectives, you are typical. Following is an easy-to-implement succession plan.

First, elect S corporation status. Now Joe can take all the profits of Success Co. without getting hit with a double tax. If Success Co. needs the money, Joe can loan it back to the business, which pays him interest on the loan, giving him another source of income.

Joe can now cut down on the time he puts in and lower his salary. A smaller salary saves money in many ways: lower payroll taxes and eliminate the unreasonable compensation issue (a sore point with the IRS if Joe slows down but takes his old, full salary).

Then recapitalize Success Co. by issuing voting and nonvoting stock.

Let’s say Joe winds up with 10,000 shares of nonvoting stock and 100 shares of voting stock (all common stock). Over time, Joe gives the nonvoting stock to his three kids. Joe can give $11,000 to each child each year, or a total of $33,000. Since Joe is married, double the amount to $66,000 per year without any gift tax consequences. What are the objectives Joe accomplished?

Joe reduces his estate by a minimum of $66,000 a year. Remember, if Joe gives $66,000 of stock away this year, but that same stock is worth $150,000 (or whatever the value might be) when he dies, he has reduced his estate by $150,000.

Since Joe gifts only the nonvoting stock, he stays in full control of Success Co.

Joe will leave the voting stock to Sam when he dies. Also, an insurance-funded buy/sell agreement gives Sam the funds to buy the stock owned by his brother and sister. Thus, when control passes to Sam, there will be no interference from his siblings.

The above plan eliminates any income tax or capital gains tax on the transfer. The estate tax will be completely avoided after eight years of stock gifting.

The succession plan described above for Joe is the classic plan for a business owner with a net worth of about $2.5 million (or less) and his business is valued in the $1.5 million range (or less). Of course, one size does not fit all. If either your net worth is more than $2.5 million, or your business is valued at more than $1.5 million, then an intentionally defective trust is used as the tax-free transfer strategy instead of the annual gifting strategy used by Joe. An IDT eliminates all taxes.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL 60606; tel. 312/207-1040, or via e-mail at [email protected].

TAGS: Taxes