Blackman on Taxes
Many Family Business Owners Fear Succession Planning; Lets Calm Those Fears
Following are six questions that lead the fear-factor parade:
1) How high will my income tax/capital gains taxes be if I sell to the kids (or employees) now?
2) If I don’t sell now, how much will the increasing value of the business increase my estate-tax liability?
3) What if the kids mess up? Will I get paid? Will I be able to maintain my and my spouse’s lifestyle?
4) Will the bank let me off the hook for the business loans that I guaranteed?
5) How can I treat my nonbusiness children fairly?
6) What’s the number one fear? Control! It is rare that a business owner is willing to give up control of his business.
Here’s an example of the control-fear factor at work: About one out of every three business owners who ask me to do their estate plans own 51 percent of their business, while the kids own the other 49 percent. Why 51 percent? The fear of losing control. Few professionals know what to do to calm the control fear.
Our job, as consultants, is to come up with solid (accepted by the IRS) solutions that will calm the business owner’s fears. Following is a true-life example of a business owner (Joe) of this column. 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.
1) Keep control for as long as Joe lives. Joe owns 100 percent of the stock of Success Co. (an S corporation). We recapitalized (having voting and nonvoting stock) Success Co. so Joe retained 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 nonvoting stock will transfer to the kids.
If Joe had owned only 51 percent 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 5100 shares of the nonvoting stock.
2) Transfer Success Co. to Sam now (freeze the value) without getting beat up with income/capital-gains taxes. Sell the nonvoting 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 5 to 8 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 a dollar to own the nonvoting stock.
An IDT wins taxwise over a typical sale to Sam. The huge tax burden on Sam for a typical sale disappears. For example, if the income-tax rate is 40 percent (state and federal combined), Sam must earn about $167, 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.
3) 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., is well liked by his fellow employees, but does not have what it takes to manage the business. Joe and Mary want to keep Success Co. in the family, so Sam is the only choice. But what to do about management?
David, the key employee, is the logical choice. We created a nonqualified 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 dies—without owning 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. Joe had absolute control (owned all the voting stock) but never (two years after the sale to the IDT) has found a reason to exercise the control.
Joe continues to work, at full salary, but only works half days. The intent is for Joe to cut his salary and days worked once his IDT note is paid in full.
Success Co. has grown in sales and net profit since David took over.
4) Remove Joe’s bank guarantee for Success Co.’s loans. A meeting at the bank caused the term-loan provisions to be rewritten, removing the guarantee once the IDT loan to Joe was paid.
5) Treat the nonbusiness children fairly. Besides Success Co., Joe and Mary have only $4.5 million in other assets, not enough to treat their daughter, Susan, equally, which is their definition of fairly. Remember, Success Co. is an S corporation and every year the IDT will receive a dividend from Success Co. equal to that year’s profit.
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. MF
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