Succession planning for the family business

Two phone calls in the same week from readers gave me reason to write a succession planning article. The first caller told me a succession planning horror story: The caller lost millions to the IRS. The second caller’s story made me want to explode: The caller spent a lot of money on lawyers and still doesn’t know what to do. In this month’s column, I’ll spell out the facts behind each call, then the succession problems, and give you the simple solutions for both cases.

Two phone calls in the same week from readers gave me reason to write a succession planning article. The first caller told me a succession planning horror story: The caller lost millions to the IRS. The second caller's story made me want to explode: The caller spent a lot of money on lawyers and still doesn't know what to do.

In this month's column, I’ll spell out the facts behind each call, then the succession problems, and give you the simple solutions for both cases.

The first caller, Joe, sold his business, Success Co., to his sons, Sam and Sid, four years ago for $3 million, payable over eight years, plus interest at 5.25% on the unpaid balance. Today the balance due is $1.4 million.

Let's assess the tax damage to Joe and his sons. First the boys: Sam and Sid are in a 40% tax bracket (state and federal combined). To have $1 million (after-tax) to pay their dad, they must earn $1.66 million then pay $660,000 in income tax. Since the price is $3 million, the ultimate income tax burden to the boys will be $1,980,000 (3 x $660,000). Severe tax pain!

How will Joe be taxed? Well, his tax basis for his Success Co. stock (100% of the company) was $287,000 (let's round it to $300,000). So, Joe’s capital gain over the eight years will be $2.7 million ($3 million less $300,000). What’s his capital gains tax? A mere $405,000 ($2.7 million x 15%).

Can you believe this tragic tax picture? The boys must make $4,980,000, while the family gets eaten alive by a total tax burden of $2,385,000 ($1,980,000 for Sam and Sid, plus $405,000 for dad). Only $2,595,000 left out of that $4,980,000. This is truly a tax travesty! Since the boys can deduct the interest paid to their dad while Joe must pay tax on this interest, the net tax result is a wash.

Now, the $2,385,000 question — is there some way that Joe and the boys could have avoided that $2,385,000 tax? The answer is yes! Joe should have transferred the stock to Sam and Sid using an intentionally defective trust (IDT). An IDT is a simple, quick and easy strategy: Joe sells the Success Co. stock to the IDT for a $3 million note. The cash flow of Success Co. is used to pay the note, plus interest. When the note is paid, the trustee distributes the stock to the beneficiaries: Sam and Sid. Neither Sam nor Sid pay even one penny in taxes for the stock. Because an IDT is intentionally defective for income tax purposes, Joe (courtesy of the IDT tax law) receives the entire $3 million, plus interest tax-free, not one cent in capital gains tax or income tax. The interest paid to Joe via the IDT is not deductible.

The tax savings is $2,385,000 as explained above. It should be noted that the transaction is structured in such a way that Joe keeps control of Success Co. until the day he dies (or until paid in full).

My advice is that if you want to sell your closely held business stock to your kids, other relatives, key employees or fellow nonrelated stockholders look into an IDT.

Now, let’s take a look at the second caller's succession problem: Sam owns 10% of Good Co. He is one of a total of 10 stockholders (I nicknamed them the "Big Ten"), each owning 10% of Good Co. All are children of four brothers who started the business years ago. The Big Ten are all in their 50s, healthy and each has one or more of their own kids.

Here's the current scorecard concerning whether any of the Big Ten's kids might ultimately join Good Co.:

  • Three of the Big Ten already have one or more of their kids in the business.
  • Three know for sure that none of their kids will work for Good Co.
  • It’s a we-don't-know-for-sure issue for the remaining four.

What do they do about a succession plan for Good Co.? Everybody, including the many professional advisors the Big Ten have consulted, is stumped.

Now, all you family owned or closely held businesses that have two or more stockholders, listen up. The problem is the same (or similar) when you have multiple shareholders, whether two, 10 or more.

Following is the basic succession plan that we create when there are multiple shareholders, using Good Co. as an example:

No. 1.: Each shareholder is treated as owning 100% of his 10% of the company stock. So each shareholder is given the freedom to deal with the stock he owns, as long as it does not interfere with the operation of the company or the other shareholders.

For example, Sam has a son, Tom, already working for Good Co. Sam will continue to work for Good Co. He can sell, probably using an IDT, gift or leave his stock to Tom when he dies or some combination. The significant point is that Sam should not be forced by the Good Co. buy/sell agreement to sell his stock to the Company or his fellow stockholders when he retires or dies.

No. 2. : Those shareholders who currently have no children working at Good Co. would be a party to a buy/sell agreement, which is insurance funded. Each time one of the Big Ten dies, the policy death benefit would be used to buy the deceased’s stock.

No. 3.: What happens when a No. 2 shareholder (no kids in business) becomes a No. 1 shareholder (now has kid(s) join the Good Co. workforce)? The new No. 1 shareholder is no longer subject to the terms of the buy/sell agreement, and (if he wants to) can buy his insurance policy from the company for its cash surrender value.

I know, I know! You have a question about your specific succession problem. Remember, it would take a large book to cover every possible succession situation. But what is interesting, in practice, the above information will solve about 98% of the succession problems I have seen over the past 40 years.

If you still have a question, call me at 847-674-5295.

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