Irv Blackman Irv Blackman
Independent Financialservices Professsional

Succession Planning—Often Your Achilles Heel—How to Avoid the Pain

May 1, 2010
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Two phone calls in the same week from readers rang my (it’s-time-to-write-a-succession-planning-article) bell. The first call is a succession planning horror story. The caller unnecessarily loses millions to the IRS. The second call makes me want to explode: another spent-a-lot-of-money-on-lawyers-and-still-don’t-know-what-to-do tax tragedy.

First, we’ll spell out the facts behind each call, then the succession problems, and finally, you’ll be surprised by the simple solutions in both cases.

If you are a business owner with a succession plan problem, chances are you are about to learn how to avoid your own Achilles’ heel pain, and avoid losing a ton of taxes to the IRS.

The first caller (Joe) sold his business (Success Co.) to his sons (Sam and Sid) four years ago for $3 million, payable over eight years, plus interest at 5.25 percent on the unpaid balance. Today the balance due is $1.4 million.

Let’s assess the tax damage to Joe and his sons. First the boys: Sam and Sid are in a 40-percent tax bracket (state and federal combined). To have $1 million (after-tax) to pay their dad, they must earn $1.66 million, then pay $660,000 in income tax. Since the price is $3 million, the ultimate income tax burden to the boys will be $1,980,000 (3 x $660,000). 

How will Joe be taxed? Well, his tax basis for his Success Co. stock (100 percent of the company) was $287,000 (let’s round it to $300,000). So, Joe’s capital gain over the eight years will be $2.7 million ($3 million less $300,000). What’s his capital gains tax? A mere $405,000 ($2.7 million x 15 percent).

Can you believe this tragic tax picture? The boys must make $4,980,000, while the family gets eaten alive by a tax burden of $2,385,000 ($1,980,000 for Sam and Sid, plus $405,000 for dad). Only $2,595,000 remains of that $4,980,000—truly a tax travesty.

Note: Since the boys can deduct the interest paid to their dad, while Joe must pay tax on this interest, the net tax result is a wash.

Now, the $2,385,000 question—Is there some that Joe and the boys could have avoided that $2,385,000 tax? The answer is a yes!

Joe should have transferred the stock to Sam and Sid using an intentionally defective trust (IDT). An IDT is a simple, quick and easy strategy: Joe sells the Success Co. stock to the IDT for a $3 million note. The cash flow of Success Co. is used to pay the note, plus interest. When the note is paid, the trustee distributes the stock to the beneficiaries, Sam and Sid. Neither Sam nor Sid pay even one penny in taxes for the stock. Because an IDT is intentionally defective for income-tax purposes, Joe, courtesy of the IDT tax law, receives the entire $3 million plus interest tax-free—not one cent in capital gains tax or income tax.

Note: The interest paid to Joe via the IDT is not deductible.

The tax savings are $2,385,000 as explained above. It should be noted that the transaction is structured in such a that Joe keeps control of Success Co. until the day he dies or until paid in full, his choice.

My advice: Want to sell your closely held business stock to your kids or other relatives, key employees or fellow nonrelated stockholders? Look into an IDT.

Now, let’s take a look at the second caller’s problem. Sam owns 10 percent of Good Co., and is one of a total of 10 stockholders (I nicknamed them the “Big Ten”) each owning 10 percent of Good Co. All are children of four brothers who started the business years ago.

The Big Ten are all in their 50s, healthy and each has one or more of their own kids.

Here’s the current scorecard concerning whether any of the Big Ten’s kids might ultimately join Good Co.:

  1. Three of the Big Ten already have one or more of their kids in the business.
  2. Three know for sure that none of their kids will work for Good Co.
  3. It’s a we-don’t-know-for-sure issue for the remaining four.

What do they do about a succession plan for Good Co.? Everybody, including the many professional advisors the Big Ten have consulted, is stumped. The problem is the same or similar when you have multiple shareholders.

Following is the succession plan that we create when there are multiple shareholders (using Good Co. as an example):

  1. Each shareholders is treated as owning 100 percent of his 10 percent of the company stock. Each shareholder is given the freedom to deal with the stock he owns, provided it does not interfere with the operation of the company or the other shareholders.

    For example, Sam (the caller) has a son (Tom) working for Good Co. Sam will continue to work for Good Co. He can sell (probably using an IDT), gift or leave his stock to Tom when he dies, or some combination. The point is that Sam should not be forced by the Good Co. buy/sell agreement to sell his stock to the company or his fellow stockholders when he retires or dies.

  2. Those shareholders who currently have no children working at Good Co. would be a party to a buy/sell agreement, which is insurance funded. Each time one of the Big Ten dies, the policy death benefit would be used to buy the deceased’s stock.
  3. What happens when a No. 2 shareholder (no kids in business) becomes a No. 1 shareholder (now has a kid(s) join the Good Co. workforce)? The new No. 1 shareholder is no longer subject to the terms of the buy/sell agreement, and (if he wants to) can buy his insurance policy from the company for its cash surrender value.

Remember, it would take a large book to cover every possible succession situation, but what is interesting, in practice, the above information (about the two callers) will solve about 98 percent of the succession problems I have seen over the past 40 years. Still have a question, call Irv at 847/674-5295. MF
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