If you own or run a family business, a business you want to continue after your leadership ends, then you need a succession plan.
Let’s start with the three most basic succession plan problems: (1) Who will own the company? (2) Who will run the company? (3) Who will have control of the company, legal voting control)? Chances are you now enjoy all three. Often explaining to my client how three different individuals might own, run and control the company, but more than one person can own, gets the succession ball rolling.
Here’s an example. Joe owns 100% of Success Co. and runs it. Joe has three basic choices, when it comes to determining who will finally own Success Co.:
1. One or more family members (66%)
2. One or more key employees (24%)
3. Some third party (or company) to whom Success Co. will be sold (10%)
Please be aware that the percentage after each choice is what I see in my practice in real-life succession plans.
My experience over the years is that each of the succession plans I have helped create has had some unique twists. So, it’s a fact that succession planning does not have a one size fits all solution. Who will ultimately own your company drives the exact terms of your succession plan. Taxes are the exception of course!
Our example focuses on Joe’s first choice: family. The following four family situations come up in practice on a regular basis:
1. Joe has no children or none of his children (even those now working in the business) could run Success Co. Of course, one or more of these kids could own all or part of Success Co., if a professional manager ran the company.
2. One child, Sam, (Joe’s only child) works for Success. Co. and Joe is confident that Sam could run the company.
3. Two or more children and all are in the business. Most of the time Joe wants each of them to own an equal number of shares, such as 50/50 if two children in the business. This creates a problem: There must be a leader with voting control to make the final business decisions.
To solve this problem we create voting stock (say 100 shares) and non-voting stock (say 10,000 shares). This tax-free transaction, recapitalization, is simple to get done. As long as Joe is alive, he keeps the voting stock and has absolute control of Success Co. The non-voting stock, which we will deal with later in greater detail, goes to the business kids. When Joe goes to the big business in the sky, 51 shares of the voting stock (and control) goes to Sam or the other child who is the clear leader. Sam’s non-voting shares would be reduced by the exact number of extra voting shares he receives. Now all of the business children would be equal.
4. There is one (or more) child in the business and one (or more) non-business child.) Typically, Joe wants the stock of Success Co. to go only to the business children. The non-business children get other assets owned by Joe. Of course, we have the problem of treating all of the kids equally. Often, there are not enough other assets to accomplish the “treat-them-equal goal.” Second-to-die life insurance is the first choice to get to the equalization goal for the non-business kid(s). But what if Joe is not insurable? Or if insurable, the premiums are just too high for Joe’s cash flow? If these problems apply to you, call me and I’ll walk you through the solution.
The tax problems
The tax cost of the wrong succession plan is a nightmare. Let’s run the numbers by example: Joe sells Success Co. for $1 million to Sam. Assume the tax rates are 40% for income tax (35% federal and 5% state) and 50% for estate tax.
Suppose Joe’s tax basis for Success Co. is zero. Okay, let’s follow the numbers starting with Sam. He must earn $1.7 million, pay $.7 million in income tax, leaving $1 million, which Sam pays to Joe. With the top capital gains tax rate at 15%, Joe must pay the tax collector $150,000. He only has $850,000 left. So, Sam must earn $1.7 million and after taxes, his dad only has $850,000 left. Outrageous!
Apply the numbers in the example to the value of your company. If your company is worth $6 million, your kid(s) must earn $10.2 million for you to have only $5.1 million left.
Here are some facts that will blow you away: Would you believe that 90% of family businesses finally create a succession plan that sells their business to the kids exactly like the above example. Less, than 10% avoid the above tax trap by making lifetime gifts. Less than 1% do it right.
Do it right
It’s a two-step process. Let’s say the value of your business is $7 million. For ease of following the numbers, let’s use a $1 million price.
Step No.1: Recapitalize Success Co., so you have 100 shares of voting stock and 10,000 shares of non-voting stock. Under the tax law, the non-voting stock is entitled to a series of discounts (total of 40%), which makes the value of Success Co. only $600,000.
Step No. 2: Sell your non-voting stock to an intentionally defective trust (IDT) for $600,000. The trust pays you in full with a $600,000 note, plus interest. What is an IDT? It is the same as any other irrevocable trust, with one big difference. The trust is not recognized for income tax purposes. The result under the Internal Revenue Code is that every penny you receive until the note is paid is tax free. No capital gains tax on the $600,000 note payments, and no income tax on the interest income you receive. The cash flow of Success Co. is used to pay off the note, plus interest.
How does Sam fare when Joe uses an IDT to transfer Success Co. to him? Sam is the beneficiary of the IDT. When the note is paid off the trustee can distribute the non-voting shares to Sam (because Joe is now legally paid off and completely out of the non-voting share picture). Joe still owns all of the voting stock and has absolute control of Success Co.
But instead of distributing the non-voting shares to Sam, the trustee is instructed to hold the shares for Sam’s benefit. Why not distribution? Because if Sam gets divorced the judge cannot see the shares in Sam’s name, and his now ex-wife will never have an interest in Success Co.
Two more points that make an IDT shine: Remember the illustration above where Sam must earn $1.7 million for every $1 million of the price for Success Co. to pay his dad? Well, using an IDT, Sam does not pay even one cent to acquire the shares. The cash flow of Success Co. is used to make all payments. Suppose Joe needs life insurance. A portion of Success Co.’s cash flow received by the IDT can be used to pay the premiums. As a result Joe can buy life insurance without ever writing a personal check to pay premiums. The policy can be on Joe’s life only or second-to-die (with his wife).
An IDT can be used to transfer Success Co. to more than one child (including non-business children if desired). Can the IDT strategy be used to transfer Success Co. to one or more employees? Of course, but typically the price used is the full value (before discount) of the non-voting stock (Joe keeps the voting stock until he is paid in full).
Can the same IDT strategy be used to buy out fellow stockholders? Yes!
Every possible use of an IDT in succession planning is not covered in this article. Nor is every nuance, tax trap or exception covered.
One warning: If your professional advisor ignores the use of an IDT in your succession planning run and find another advisor. You are welcome to call me (Irv) at 847-674-5295 if you have any questions.
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.