FDR, the 32nd president, said in 1933, "Fear paralyzes those who succumb to it." Some things are downright scary. Try taxes … especially estate taxes. Can you guess what area in estate tax planning causes the most anguish? Hands down it's business succession.
Over the years, I have consulted with hundreds of business owners. (A little side note: Last year I worked with a business owner in Vermont, which accomplished a long-sought-after goal for my practice: creating an estate plan for a business owner in each of the 50 U.S. states.)
Most successful business owners started their business from scratch. Many took over the business from their dad or other relative. Some bought the business. Few came to be the owner in some other way. All share a common future (no exceptions): someday they will have to pass the management baton.
Whether the reason for stepping down is age, illness, a desire to travel or play more golf, give into your wife's pleading to "spend more time with me," or a host of other reasons, the fear factor is almost always a player. The following are the six questions (yes, there are many more) that lead the unwelcome-fear-factor parade:
- How high will my income tax/capital gains taxes be if I sell to the kids (or employees) now?
- If I don’t sell now, how much will the increasing value of the business increase my estate tax liability?
- What if the kids mess up? Will I get paid? Will I be able to maintain my (and my spouse’s) lifestyle?
- Will the bank let me off the hook for the business loans that I guaranteed?
- How can I treat my non-business daughter (Susan) fairly?
- What is the No. 1 fear? Control is. It is rare that a business owner is willing to give up control of his business even if you satisfy the owner with a perfect answer to all of his other questions and concerns.
Here's an example of the control-fear factor at work: About one out of every three business owners who call me to do their estate plans own 51% of their business while the kids own the other 49%. Why 51%? Because of the fear of losing control. Worst of all, in my experience, few professionals know what to do to calm the control fear. Read on, to learn the simple solution.
Let's face it, the author of this article has neither the power nor the know how to change human nature, which includes the fear factor. Yet experience, having done hundreds of business succession plans, has taught us how to get the succession job done and done right. Our job, as consultants, is to come up with solid (accepted by the IRS) solutions that will calm the business owner’s fears.
Just how do we do that? We take every fear, question or concern that you, as an owner, have and turn it into a goal. Then we show you how to apply the correct strategy (that we have used over and over again for other owners) to accomplish each of your goals.
Following is a true-life example of Joe, a reader of this column and business owner. Joe is married to Mary. His son Sam (age 31) works in the family business (Success Co.). David (age 36 and the key employee) — not related to the family — has natural business instincts, is respected by the employees and helps Joe run Success Co. Let's list Joe’s fears and concerns, which we have turned into goals.
• Goal No. 1 is to keep control for as long as Joe lives. Joe owns 100% of the stock of Success Co. (an S corporation). We recapitalized (a fancy word for having voting and nonvoting stock) Success Co. so Joe now has 100 shares of voting stock and 10,000 shares of nonvoting stock … a tax-free transaction. The strategy is for Joe to keep the voting stock (and control) to the day he dies. The non-voting stock will be transferred to the kids. It should be pointed out that if Joe had owned only 51% of Success Co., the strategy would work the same, but after the recapitalization, Joe would own only 51 shares of the voting stock (keeping control) and 5,100 shares of the nonvoting stock.
• Goal No. 2 is to transfer Success Co. to Sam now (freeze the value) without getting beat up with income/capital gains taxes. Sell the non-voting stock to an intentionally defective trust (IDT). The tax beauty of an IDT is that Joe legally avoids capital gains tax on the sale (say the price is $8 million, paid with a note, and the profit is $6 million). No capital gains tax is owed on the $6 million profit and no income tax is due on the interest Joe is paid on the $8 million note. Typically the note is paid in full over five to eight years, using the cash flow of Success Co. When the note is paid in full the trustee of the IDT distributes the stock to the trust beneficiary (Sam). As you can see Sam never pays even a dollar to own the nonvoting stock. Neat!
An IDT sure wins tax wise over a typical sale to Sam since the huge tax burden on Sam for a typical sale disappears. For example, if the income tax rate is 40% (state and federal combined), Sam must earn about $167 dollars, pay $67 in income taxes to have $100 left to pay his dad. With an $8 million price, Sam must earn more than $13 million to pay Joe the $8 million. Ouch! So bless the IDT.
• Goal No. 3 is to make sure that Joe and Mary can maintain their lifestyle for as long as they live. First, a little more information: Sam does a good job as one of 80 employees at Success Co. He is well liked by his fellow employees, but simply does not have what it takes to now or ever manage the business. Yet, Joe and Mary want to keep Success Co. in the family, so Sam then is the only choice. But what to do about management? David, the key employee, is the logical choice. We created a non-qualified deferred compensation plan that gives David the benefits of ownership — a share of the profits gets paid if he gets sick (covered by insurance) and $1 million (again insured) for his family if he gets hit by a bus all without owning any Success Co. stock.
David immediately took over as president of Success Co. and took over the day-to-day management of the company. Joe continued as chairman of the board and consulted with David regularly. Interesting, Joe technically had absolute control (owned all the voting stock) but never (so far, two years after the sale to the IDT) found a reason to exercise the control. Joe continued to work, at full salary, but only worked half days. The intent is for Joe to cut his salary and days worked once his IDT note is paid in full. An interesting note: Success Co. has grown in sales and net profit since David took over.
• Goal No. 4 is to remove Joe's bank guarantee for Success Co.'s loans. This was easy. A meeting at the bank caused the term-loan provisions to be rewritten, removing the guaranty once the IDT loan to Joe was paid.
• Goal No. 5 is to treat Susan (the non-business child) fairly. Besides Success Co. Joe and Mary have only $4.5 million in other assets, not enough to treat Susan equally, which is their definition of fair. Remember, Success Co. is an S corporation and every year the IDT will receive a dividend from Success Co. equal to about that year's profit. Here’s the strategy: We had the IDT buy second-to-die life insurance on Joe and Mary. Susan is the beneficiary of the IDT for the amount of the insurance, enough to treat Susan fairly. Where do the premium dollars come from? The dividend distributions, each year, are first used to pay the insurance premiums, and the balance to pay the $8 million IDT note.
Finally, let me point out that most succession plans are similar to the hundreds of others we have done through the years. Yet each one, like Joe’s above, has some unique fears, problems and concerns. Do you have a business succession fear/problem with a unique twist? We would like to write about your story and the proper solutions (without revealing your identity) in a future column. Please contact me by fax (847-674-5299), phone (847-674-5295) or e-mail ([email protected]). I'd love to hear your story. In the meantime, if you have a question concerning the succession of your closely held business, 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 on the Web at WWW.TAXSECRETSOFTHEWEALTHY.COM.