A Real-Life Succession-Planning Horror Story
Sam, the 37-yr. old son of Joe (recently deceased owner of the family business Success Co.) recently called me. For Sam, his mother Mary and the rest of the family, Joe’s estate plan and business-succession plan had turned into an economic and tax tragedy.
First, the facts. Joe and Mary raised three kids: Sam, and two adult kids not involved with the family business. The three core goals Joe and Mary laid out for their estate plan:
• Sam should ultimately own 100 percent of Success Co. (an S corporation);
• Treat the three kids equally; and
• Pay as little as possible in taxes to the IRS.
Joe’s lawyer and CPA completed his planning early in 2005. Success Co. was sold to Sam for $12 million. Sam paid his dad in full with a note, to be paid in semiannual installments over 10 years, plus 4.5 percent interest on the unpaid balance.
Before the sale of Success Co., Joe’s assets were (in millions):
Success Co. $12.0
401(k) Plan $2.1
Real estate leased to Success Co. $1.4
Other investments $1.6
2 homes $1.5
The lawyer created a traditional estate plan with an A/B trust (often called a family trust and a marital deduction trust). Since Joe and Mary had a $2 million second-to-die policy (and $9.1 million in liquid assets, plus the future cash from the $12 million note and interest from the sale of Success Co.), the professionals figured there was plenty of liquidity to pay estate taxes. So, the lawyer and CPA agreed that no additional planning was necessary.
While Joe and Mary were healthy in 2005, Joe died suddenly in 2007. Let’s look at the economic and tax impact of Joe’s death on each of his family members.
Sam’s situation was a disaster from the day the Success Co. sale papers were signed. While the $12 million value for Success Co. was fine according to an appraisal, the price between father and son is wrong, because the IRS allows a 35-percent discount for nonpublic businesses such as Success Co. So, for tax purposes, the right price should have been $8 million, reducing Joe’s taxable estate by $4 million. In the end, he ultimately will pay more than $8.4 million in taxes to pay off the $12 million note. Simply put, Sam must earn in excess of $20 million, before tax, to pay off the note. Plus interest.
Further, while Sam managed to grow Success Co.’s sales and net profit, he could have increased sales more, but Joe’s bank refused to increase Success Co.’s line of credit without Joe’s usual guarantee. Why? Sam’s obligation to pay off the $12-million note destroyed his personal balance sheet. As a result, Sam’s guarantee was worthless.
For Mary, the 100-percent marital deduction (everything to Mary, except $2 million to the family trust) spared Joe’s estate from any tax due at his death. However, the entire family was in shock when their lawyer told them the estate taxes would be in the $10 million range when Mary died.
Here’s the final blow: Estate tax on the $850,000 in Mary’s estate when she dies will be about $300,000. Then, only $550,000 remains. For each $1 million of the note, Sam must earn $1.7 million for the family to wind up with only $550,000. For the entire $12 million, Sam’s earnings must exceed $20 million for the family to receive $6.6 million. The two nonbusiness kids were forgotten until Mary died.
What should Joe and Mary have done?
Here are the strategies that would have allowed all of Joe’s $27.5 million to go to his family, all taxes paid
1) An intentionally defective trust (IDT). First, a recapitalization of Success Co. (100 shares of voting stock, kept by Joe, and 10,000 shares of nonvoting stock to be sold to the IDT). Now the discount is 40 percent, resulting in a price to Sam of only $7.2 million. The entire transaction is tax-free to Joe: no capital gains tax, no income tax on interest received.
2) Life insurance. Since Joe and Mary were insurable in 2005, they should have bought about $11 million (set up to be free of all taxes) in second-to-die life insurance. The 401(k) funds would be used to implement a strategy called retirement-plan rescue to purchase $6 million of life insurance, while the IDT would purchase $5 million. The premiums would be about $10,500 per $1 million.
3) Family limited partnership (FLIP). The investment assets total $12.1 million, but only $11 million would be transferred to a FLIP. The IRS allows a 35-percent discount, making the FLIP assets worth only $7.15 million for tax purposes.
4) Gifting program. Joe and Mary have eight grandkids, in addition to their three kids. In 2005, the maximum tax-free gift was $11,000, so together Joe and Mary could make a $22,000 gift to each, or a total of $242,000/yr.Want to learn move about this fascinating subject? Browse my website, www.taxsecretsofthewealthy.com. MF
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