DO YOU KNOW how to make a grown man cry? Tell him his business has been destroyed by fire, flood or God. Yes, a tragedy. Bad stuff. But most likely, the loss was insured; a bit of help. What is even more important, Joe Owner is there on the scene to assess the damage, to make plans and to start rebuilding. Chances are he will make the business bigger and better than ever before.
Here is Scene No. 2. Even the most successful, egotistical and immortal business owner (Joe) knows that some day he must go to the big business in the sky. That will not make him cry. Joe is too realistic for that. But tell him that after he is gone, his present plans or lack of a plan means the IRS will dismantle his business.
Is this realistic? Yes, crazy as it sounds. If you own a closely held business and don't pin down its value for tax purposes while you are alive, you are setting yourself up to be mugged by the IRS.
Every business must be valued for tax purposes. It is best to be done voluntarily, by you, the owner, during life. If not, the valuation will be done involuntarily, after death, by the IRS. The only "out" is to sell the business in a real transaction during your life.
For most business owners, selling doesn't make sense for many reasons. The two most common are that the owner wants to transfer the business to the kids; or he wants to keep on working until he passes on.
The message should be clear: Want to save your business and your family untold aggravation, not to mention savings of 55% (that will be the highest estate tax bracket in 2011)? Then do three things: Get your business appraised for tax purposes; put a transfer plan into place during your life; and dovetail the first two with your estate plan.
Here is an old IRS letter ruling that is one of my favorites. It might be labeled, "the lazy man's way to plan your business transfer." The ruling shows you how to take advantage of some favorable tax law while avoiding pitfalls. There is a bit of a problem to using the technique. You must drop dead before your family can enjoy the benefits of Letter Ruling 9116031.
But wait, the ruling has one redeeming quality. Really!
First, the facts: Joe, his wife Mary and their children owned all the stock in a family business. Joe died in 1990 and Mary inherited all his stock. ( Note: Mary's tax basis for computing capital gains is the fair market value of the stock on the day Joe died. For example, if the FMV was $1 million and she sold it for $1 million, there would be no capital gains tax.) The fact that Joe's tax basis, while he was alive, was $25,000 is immaterial. Mary immediately sold all her stock back to the corporation.
Here's the general rule: When you or any member of your family sells stock back to your corporation (called a redemption), the redemption is usually taxed as a dividend.
But there is a special tax-saving exception for a family member who has owned the stock for 10 years or more. If he or she divests all interest in the company (including any position as an officer or director), the redemption is treated as a sale (gets favorable capital gains treatment, instead of being a dividend). Since Mary sold all the stock she had owned before Joe died and the stock she inherited from him, the purchase by the corporation of her shares was considered a bona fide sale ( redemption) and not a dividend.
When all the smoke cleared, not only had Mary escaped a big dividend income tax bill, but she also had succeeded in effectively transferring the business to her children. Since the kids now owned all the remaining issued and outstanding stock, they owned 100% of the business. Mary walked off with a near-tax-free capital gain, (the price paid to Mary for the stock was a bit more than the exact FMV of the stock inherited from Joe) while the kids walked off with the business.
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]