Almost all readers of this column who contact me are owners or part owners of a family business. Each one has a unique family business story that would make for an exciting, interesting and fascinating real-life television drama.
The typical owner has one or more problems, which the family can't solve. The problems typically fall into one or more of three specific categories: taxes, economics or personal. If you have any connection to a family business, you should enjoy spotting one or more of these problems in the following mini-case studies.
The problems in these case studies come up most often, involve the most amount of money or are cases that most professional advisors don't know what to do about. Each of the case studies includes the facts, problems and solution. My purpose is to clearly show you there is an easy and legal solution for each tough problem.
Case Study No. 1: Facts: Joe has two kids, Sue and Sam, who work at Success Co. Joe wants to give them a stock bonus. Sue is single, Sam is married. Problem: Stock could be marital property.
Solution: The stock bonus is okay for Sue, but not for Sam because Sam is married and the stock would be marital property, which a judge in the case of a divorce might say belongs one-half to Sam's wife.
Burn these three rules into your mind: Any property received prior to marriage is non-marital property; any property acquired after marriage that is received as compensation or paid for with funds that were earned after marriage is marital property, which is bad if there is a divorce; and if you receive the property after marriage by gift or inheritance, it is non-marital property. As you read this column, keep in mind that divorce is the most common personal problem that plagues family businesses.
Case Study No. 2: Facts: Jack wants to sell Success Co. to his son Sid. Problem: The insane tax burden Jack and Sid will suffer. For example, the price is $1 million, and Sid must earn about $1.6 million and suffer about $600,000 in state and federal income tax to have the $1 million to pay his dad. Jack will be hit with about a $150,000 capital gains tax. Only $850,000 left. He must earn $1.6 million to have only $850,000 left. Truly a tax travesty!
Solution: Transfer the stock from Jack to Sid using an intentionally defective trust (IDT). There are big advantages to an IDT. The entire transaction is tax-free to Sid, saving $600,000, and Jack, saving $150,000. When Sid receives the stock, it is considered a gift under the law, avoiding the marital property trap in Case Study No. 1, and Success Co. is out of Jack's estate. Jack keeps control of Success Co. by retaining a tiny amount of the shares: the voting stock. The non-voting stock is transferred to Sid.
Case Study No. 3. Facts: About 90% of Jim's wealth is tied up in Success Co., which Jim transferred to his son Sean, who runs the business, using an IDT. Problem: What if Jim and/or his wife live to the biblical age of 120, or 85 or 95? Will they be able to maintain their lifestyle?
Solution: Have Success Co. create a death benefit agreement (DBA), which is really a wage continuation plan. The DBA kicks in after Jim is paid in full by the IDT and is no longer receiving a salary from Success Co. When Jim dies, his DBA wages stop and his wife then gets the wages, usually a reduced amount, for her life.
Case Study No. 4: Facts: Jake has four kids. Two kids work for Success Co. and the other two kids do not. Problem: How do you treat the non-business kids equally, fairly or equitably?
Solution: When there are enough assets, the easy solution is to give the non-business kids non-business assets, which can include the business real estate if not owned by Success Co., or simply acquire enough life insurance (if mom and dad are both insurable, acquire second-to-die life insurance because premiums are much less than single life) to accomplish equality. Sorry, but often and for many reasons the easy insurance solution won't work. In real-life practice there is always a solution, but the possible facts are endless and each solution must be specially designed for your unique family situation.
Once there is more than one shareholder, including the kids, for Success Co., a “unit buy/sell agreement” is needed. If you hate your son-in-law or daughter-in-law, this type of agreement assures you they will never own a piece of the family business.
Case Study No. 5: Facts: Jerry and his three business kids all receive their compensation from Success Co. Problem: Their fringe benefits must be the same as for all other employees or the IRS “discrimination” monster will raise its ugly head.
Solution: Form a new management company. This frees Jerry and the business kids from the discrimination rules. Then awesome fringe benefits abound: your own pension plan or 401(k), health care plan, insurance and long-term care and sales promotion. A nice little twist on this is if you are or can become a resident of a no-income tax state, like Florida or Nevada, you can deduct the management fee paid in the income-tax state where the business is located, but the entire fee is tax-free in say Florida. Cool!
Case Study No. 6: Facts: Success Co. makes over $1 million a year. Problem: Neither Jeff nor his advisors can think of any way to get more deductions to reduce taxable income.
Solution: Form a captive insurance company. You create the Captive — a real insurance company that insures risks your normal property and casualty insurance company will not insure like loss of a key vendor, customer or employee, strikes, warranty of your goods or services, war, change in law, rules or regulations.
Let's say Success Co. pays a $500,000 premium to Captive. Success Co. deducts the entire $500,000, but Captive receives the same amount tax-free and invests the $500,000, and the earnings are usually tax-free. Also, the Captive structure allows you to enjoy significant savings on your property and casualty insurance expense. The larger your company's before-tax profit, the more tax dollars you can keep instead of losing them to the IRS.
Case Study No. 7: You have a large amount, say $500,000 or more, in a qualified plan like a 401(k), profit-sharing plan or IRA. Problem: At current rates (income tax and estate tax) the IRS can wind up with 70% of your plan funds. What might the numbers look like? A $1 million IRA can enrich the IRS by $700,000. Outrageous!
Solution: In most cases you have a choice: a subtrust or a retirement plan rescue. Which one you go with depends on your age, amount in your plan, your goals and other factors. A few examples should get your greed glands flowing. For example, we used a subtrust to turn an after-tax 401(k) plan amount of $300,000 into $4.5 million of tax-free wealth. We also used an RPR to turn a rollover IRA with a $652,000 balance into $3.75 million of tax-free wealth for the kids and grandkids.
Each Subtrust and RPR is designed to meet the client's exact goals. Either strategy is an opportunity to turn a potential tax disaster into a tax victory. What's most interesting is that both strategies are easy to do. The IRS loses, and you win!
Finally, a caution that applies to each of the above seven case studies: All of the opportunities, rules, exceptions and an occasional trap have not been covered in detail. Therefore, only work with an experienced professional who has implemented the strategy many times. Want more information? Browse www.taxsecretsofthewealthy.com or call me (Irv) 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 go to www.taxsecretsofthewealthy.com.