Estate planning: Mr. Courage leads the way

The story you are about to read has all the ingredients to make you cheer, applaud and cry. Yes, it's an estate planning story. But more than that, it's an inspiring story of one man's courage.

Webster’s dictionary defines "courage" as the ability to conquer fear or despair. The hero, let’s call him Mr. Courage, of this story is a real-life perfect example of that definition. Mr. Courage, a long-time reader of this column, called and asked me to do his estate plan quickly.

"Why quickly?" I asked.

He replied, "Because I have cancer."

The doctor would not, or maybe could not, give an exact time frame as to how long Mr. Courage might live, but thought getting his affairs in order was a good idea. Never once during our initial phone call, or those that followed, did Mr. Courage even give a hint that he was or would become downtrodden. He was upbeat.

Mr. Courage explained his attitude this way, "How lucky I am to know that the end may be near, yet have time to put my house in order."

The very next day a package arrived via courier (sent by Mr. Courage's wife Mary) with the information I had requested concerning Mr. Courage, Mary, their business and their family. Included in the package was a surprise document that blew my socks off (more about that later).

First, the basic facts for the estate planning story: Mr. Courage is 56-years-old. Mary is six months older and is active in the business, Potential Co. They have four kids, but only one, Sam (age 26), is active in the business. There is one key employee, Sid who is considered like family.

Potential Co. (an S corporation owned 100% by Mr. Courage) made $180,000 for the last full fiscal year, yet had a negative equity of $232,000. Small potatoes, you may say. But Mr. Courage, Sam and Sid had a plan in writing, but not yet a signed legal document, for Mr. Courage to sell Potential Co. to Sam and Sid for $2 million. Each of the boys would sign a note for $1 million. Please note, as you will see later, the $2 million price, which seems high, is actually a bargain.

Do you (the reader of this column) intend to sell your business to your kids or employees? If so, read what follows carefully. You are about to become a happy seller.

This story of Mr. Courage is just an extreme example of typical succession planning (transferring a business), when the business owner wants to sell the business to either his kids or employees. Almost always, the kids or the employees don't have any money. So, like it or not, the business owner must get paid in installments over a number of years.

The buyer (kids/employees) pays the seller with a note. Two problems are immediately created. First, the buyer's (already slim net worth) balance sheet is totally destroyed for years to come. Also, the buyer must use the cash flow of the business that was purchased to pay the seller's note. This sad fact makes it difficult, sometimes impossible, to get a bank loan (needed to fund the future growth of the business).

Second, the tax consequences of the transaction are a disaster for the buyer. Here’s why. Suppose the price for the business is $1 million and the tax rate (state and federal combined) is 40%. The sad fact is that the buyer must earn $1.667 million dollars and pay $667,000 in taxes to have $1 million left to pay to the seller.

Here are the horrible consequences: Sam and Sid must earn $3.333 million and pay $1.333 million in income tax in order to pay off their $2 million notes. (Apply those astronomical tax numbers to any business sale/or purchase you are contemplating). It's nuts!

What did we do? Instead of an installment sale, we used an intentionally defective trust (IDT). This IDT strategy allows Sam and Sid to use the future cash flow of Potential Co. to purchase the business. An IDT is tax-free to the buyer. Also, the seller pays no capital gains tax on the gain realized from the transfer of the stock to the buyer. An IDT puts more dollars in the seller's pocket, after taxes while the buyer pays no taxes.

In addition, the personal balance sheets of Sam and Sid will not show a liability for the purchase price of Potential Co. Banks usually finance a profitable business, but almost always require the guarantee of the business owner (the stronger his/her balance sheet the better).

Now let's talk about that surprise document. But first a reminder concerning lifetime planning: For years I have preached that an estate plan is incomplete unless it includes a comprehensive lifetime plan: the unknown period of time from the day you begin to think about an estate plan until the day you get hit by the final bus.

What is Mr. Courage's surprise document? A strategic plan for Potential Co. that was created with the help of Sam and Sid. This strategic plan is awesome ... thorough, detailed, but only 18-pages long. It covers the short-term and the long-term. It has, is and should continue to have a positive impact on many lives for two or more generations.

The plan is accompanied by a budget (really a detailed spread sheet setting revenue and profit goals for each month for two years). Hallelujah! Potential Co. is hitting those budget numbers. If the numbers hold — and every indication is that they will — profit (before taxes) for the first full year will be in the $500,000 range.

Toward the end of the surprise document is a brilliant analysis of the market place Potential Co. serves, including great demographics, potential gross income for 100% of the market, that they can capture 25% of the market, and how they will do it. If they do it, Sam and Sid will become mega-millionaires.

I'm betting the boys will make it.

You'll notice that this article does not include any details about the estate plan we created for Mr. Courage and Mary. That's because I want you to focus on two things if you own a business that will ultimately be owned by your kids or employees or both.

First: Do not, and I mean never, sell your business to your kids. Use an intentionally defective trust. You and the kids will save a ton of taxes.

Second: Yes, your estate plan should do the traditional stuff: wills, trusts, appropriate insurance, etc. Put it in the safe and forget about it. The most important plan (no matter what your age) is your lifetime plan. The purpose of the lifetime plan is to maximize your wealth while you control your wealth — particularly your business — for as long as you live.

Your lifetime plan should solve, for example, such problems as maintaining your lifestyle, and your spouse's, for as long as you live; educating your kids or grandkids; creating a buy/sell agreement for the kids to make sure the business stays in the family (in case of divorce); and maximizing the profitability of the business and minimize income tax.

Of course, your lifetime plan and estate plan must dovetail. This means that all of your wealth — no matter how large it might grow — should go to your family (kids and grandkids in most cases). Simply put, if you're worth $7 million when you die, every dollar of that $7 million should go to your family (all taxes, if any, paid in full), if $70 million then $70 million. Go ahead and fill in your own "guesstimated" number. And finally, say a prayer for Mr. Courage.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein 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.

TAGS: Taxes