Blackman on Taxes
Do You Want Your Business to Continue?
Most successful business owners have two loves in their life: their family and their business. With rare exceptions, it’s family first.
But what about the business? I’ve asked this question hundreds of times to the Joes of the business world: “Do you want your business to continue?”
A loud ‘Yes’ is always the answer. The longer Joe has been in business and the more success the business has enjoyed, the louder and more passionate the ‘Yes’. Yet, Joe is troubled.
What’s Joe’s problem? Simply put, he has a succession-plan problem. After my 45 years of experience, it is clear that all long-term successful business owners have basically the same succession problems. But Joe doesn’t realize it, because he thinks that his problems are unique. Let’s start by spelling out the three most common succession-plan problems Joe usually has, all of which seem to him to be unsolvable:
1) How do I sell/transfer my business to my business kid(s) without getting killed by taxes?
2) How do I treat the nonbusiness kid(s) fairly?
3) How do I sell my business to my key employee(s) when they have no money? This problem arises when Joe has no child—or other relative—to take over the business.
Let’s use a real-life example. Joe, a reader from Kansas, is the poster-boy of a successful business owner of his generation. Started from scratch. Built a successful business, Success Co., and wants to transfer it to Sam, his son. Joe married Mary right after high school. Both are 68. Joe works hard and plays hard. He’s rich, but doesn’t feel rich. In general, he’s a happy camper, but his complete package (estate/wealth-transfer plan/succession plan) is a disaster. Mary knew it and prevailed upon Joe to call me.
Joe had five types of assets:
1) Success Co., $6.5 million;
2) A residence worth $700,000;
3) Rollover IRA, $900,000;
4) Other assets, mostly real estate and liquid investments, $3.5 million; and
5) Life insurance on Joe, death benefit of $800,000.
For estate-tax purposes, if Joe died and his wife Mary predeceased him, his estate would be worth $12.4 million. (Note: Joe is no longer insurable; Mary is.) Taxes at Joe’s death, using his present wealth-transfer plan and 2011 tax rates would be about $5.5 million.
What are Joe’s goals?
1) “Want Mary and I to maintain our lifestyle for as long as we live;”
2) “Transfer Success Co. to my son Sam, paying the least amount of tax, as soon as possible, yet I want to control it for as long as I live;”
3) “Have each of my two daughters (not in the business) receive an equal amount of our estate, the same as Sam receives;” and
4) Then Joe, with an I-know-it-can’t-be-done laugh, asked, “Irv, can you get all of my assets to my family with no reduction for taxes?”
The first step, requiring five strategies, was to reduce the value of Joe’s assets for estate-tax purposes, yet keep him in control. Without covering every detail and nuance of the plan, this is what we did on an asset by-asset basis:
1) Sold Success Co. to an intentionally defective trust (IDT)—only the nonvoting stock (which we created) was sold, while Joe kept all the voting stock, so he kept absolute control. The IDT is a magnificent strategy that allows us to transfer a family business to any person tax-free;
2) Transferred his residence to a qualified personal residence trust;
3) Developed a profit-sharing plan (a magic bullet, which is discussed later);
4) Transferred all other assets—the real estate and liquid assets—to a family limited partnership; and
5) Transferred the life insurance to an irrevocable life insurance trust (ILIT).
These strategies lowered the total value of the five assets for estate tax purpose to about $6.5 million. We used up almost all of Joe’s and Mary’s unified credits ($1 million tax-free for each) in the process, leaving a potential tax liability, when Joe and Mary both die, of about $3.2 million.
Since we already have $900,000 of potential insurance proceeds parked in the ILIT, we need only about $2.3 million more of tax-free wealth to transfer all of Joe’s assets to his family, with all taxes paid in full, and accomplish Joe’s fourth goal. What to do? Joe was not insurable.
Here comes the second and final step. We decided to buy a $3 million second-to-die life insurance policy on Joe and Mary, using a subtrust as part of the profit-sharing plan. When both Joe and Mary pass on, the $3 million will go to Joe’s family—free of the estate tax—to pay any estate tax liability that may be due. Every one of Joe’s objectives will be accomplished and his entire lifetime wealth (more than $12 million) will go to his family with all taxes paid in full.
Although Joe was not insurable, my insurance consultant persisted with the insurance company and convinced it to accept Joe for second-to-die coverage (the full $3 million) with Mary.
And finally, assume that Joe has no kids in the business, but has a key employee—Ken, a smart, young guy who, as a practical matter, has really been running Success Co. for the past eight years. Just substitute Ken for Sam in the above plan. Joe’s results would be the same. In addition, we would add a wage-continuation plan for Joe, to take effect if he ever quit working or could no longer work. This plan would continue for as long as Joe lived and at his death for as long as Mary lived.
If your succession-plan problems are the same or similar to Joe’s, the above plan should be a starting roadmap of how to put in your own plan. If you have questions, just call me (847/674-5295). You are welcome to have your professional advisor on the line. MF
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