I'll bet the farm that this article will save many business owners, who want to transfer the family business to their kids, a ton of taxes.
Let's set the stage by quoting an e-mail a reader sent me: “Mom is 82 with an estate worth about $20 million. Included is an S corporation, recently valued at $1 million for IRS purposes. My dad started the company and ran it until he died two years ago. Sam, my brother, and I, Larry, are the only heirs and want to continue to run the company. You state in your articles that the estate tax can be avoided completely. Mom has attorneys and CPAs who say it can't be done with an S corporation. They have done what they can, but my brother and I will end up with a $7 million tax bill payable over 15 years.”
Next, let's set up the problem the way it comes up most often: No. 1 — the business owner is married; No. 2 — what most professionals get wrong; and No. 3 — the solution.
Here's the typical problem: Joe, married to Mary, owns Success Co., which is worth $10 million. Steve, Joe's son, runs Success Co. The plan proposed by Joe's professionals is for Steve to buy Joe's stock for $10 million (to be paid over 10 years).
Steve must earn about $16 million, and pay $6 million in income tax to have the $10 million to pay Joe. Joe must pay about $1.5 million in capital gains tax, only $8.5 million left. Steve must earn a stratospheric $16 million for Joe's family to keep $8.5 million. That's nuts.
Lesson No. 1: A sale of all or even a portion of your stock to your kids is a lousy idea for tax purposes. Sometimes professionals use various strategies requiring insurance on Joe's life as a means to get the company stock to Steve. The IRS will collect estate taxes on every dime of that life insurance (roughly $4.5 million to the IRS on $10 million of insurance, using 2009 tax rates). In most real-life cases, the insurance is either too much or too little.
Lesson No. 2: Life insurance can play an important part in your estate planning, but never use it in a business succession plan to get your Success Co. stock to your business kids. You'll always guarantee the IRS a big pay day when you go to the big business in the sky.
Now, let's give credit to the professionals Larry's mom is using. They avoided the pitfalls in Lessons No.1 and No.2. True, there would be an unnecessary $7 million estate tax bill, but they jumped on Section 6166 of the Internal Revenue Code, which allows certain business owners to pay their estate tax liability over a 15-year period, plus a low rate of interest (not deductible) on the amount of estate tax due. Never in my 50-plus years of practice have I used Section 6166 as part of an estate plan because it doesn't save a penny of taxes, it just stretches out the time of payment.
In every case, my network of professionals has been able to pass all of each client's wealth to their heirs 100% intact (no tax or all taxes paid in full).
Lesson No. 3: Never use Section 6166 as part of your overall estate tax plan. Instead, create a comprehensive plan to eliminate the estate tax.
Now let's turn to the solution for the typical family business owner, who wants to transfer his business to his kids. Most business owners have four kinds of assets: the business, a residence, funds in a qualified plan and investments.
The solution, which is really a system to create a comprehensive plan, requires two plans: first a traditional will and trust (one for Joe and one for Mary). This is really a death plan. It cannot save you a dime in taxes. It just defers the estate tax blow until both Joe and Mary have gone to heaven. The second plan is a lifetime plan. Let's look at the lifetime-plan strategies most often used in practice. The system uses strategies that are implemented during your life and are based on the assets you own.
Business: We use an intentionally defective trust (IDT), which means the trust is intentionally defective for income tax purposes. What does this accomplish? The transfer of the Success Co. stock, typically non-voting stock, while Joe keeps the voting stock and control, is tax free. The tax savings — compared to selling the stock to the kids — usually is $456,000 per $1 million of the value of Success Co. ($5,016,000 for Larry's mom; $4,560,000 for Joe).
Residence: The most common strategy is called “50/50.” We transfer the title of each residence by having 50% owned by Joe's traditional trust and the other 50% owned by Mary's trust. We get about a 30% discount for estate tax purposes (for example a $600,000 house is only valued at $420,000 in the estate). Larry's mom cannot take advantage of this (her husband is gone).
Funds in qualified plans: These funds are double taxed. The IRS winds up with about 70%, the family only 30%. For example, $1 million in a rollover IRA will yield $300,000 to the family. We use strategies like a subtrust or retirement plan rescue to boost that $300,000 to the $2 million to $7 million range, all tax-free, depending on age and health of the business owner (and spouse if married).
Investments: A family limited partnership (FLIP) is almost always the strategy of choice. The value of the assets transferred to the FLIP are discounted about 35% for tax purposes. Hey, $1 million of intrinsic value is worth only $650,000 for tax purposes and yields estate tax savings of $158,000. This works for Joe and Larry's mom too.
The above lifetime-plan strategies usually kill the estate tax liability. But what if it doesn't? We fall back on one of about 20 life insurance strategies to create tax-free wealth (this is easier if you are married because you can buy second-to-die insurance, which cost much less in premiums than single life) to pay the estate tax.
What if the business owner is uninsurable (and so is his wife if married)? We then use a strategy called a charitable lead trust to create tax-free wealth for the heirs. That's exactly what Jacqueline Kennedy — who was uninsurable — did to get her heirs about $250 million tax-free.
Lesson No. 4: The system as described above always works whether you are young or old, married or single, insurable or uninsurable. If your professional does not eliminate your estate tax burden, get a second opinion.
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. If you have questions, call him at 847/674-5295, e-mail him at [email protected], or visit www.taxsecretsofthewealthy.com.