When Your Professional Says,April 1, 2010
I’ll bet the farm that this article will save many business owners who want to transfer the family business to their kids a ton of taxes.
Let’s set the stage by quoting an e-mail a reader sent to me: “Mom is 82 with an estate worth about $20 million. Included is an S corporation valued at $1 million for IRS purposes. My dad started the company and ran it until he died two years ago.”
“Sam, my brother, and I, Larry, are the only heirs and want to continue to run the company. You state in your articles that the estate tax can be avoided completely. Mom has excellent tax attorneys and CPAs who say it can’t be done with an S corporation…they have done what they can…but my brother and I will end up with a $7 million tax bill payable over 15 years.”
Let’s set up the problem the it comes up most often (the business owner is married), what most professionals get wrong, and finally the solution.
Here’s the typical problem: Joe (married to Mary) owns Success Co., which is worth $10 million. Steve, Joe’s son, runs Success Co. The plan proposed by Joe’s professionals is for Steve to buy Joe’s stock for $10 million, to be paid over 10 years.
Steve must earn about $16 million and pay $6 million in income tax to have the $10 million to pay Joe. Joe must pay about 1.5 million in capital gains tax—only $8.5 million left. So, Steve must earn $16 million for Joe’s family to keep $8.5 million. That’s nuts.
Lesson No. 1—A sale of all (or even a portion) of your stock to your kids is a lousy idea for tax purposes.
Sometimes professionals use various strategies (most likely a stock redemption or stock purchase agreement) requiring insurance on Joe’s life as a means to move the company stock to Steve. Better than lesson no. 1, but the IRS will collect estate taxes on every dime of that life insurance (roughly $4.5 million to the IRS on $10 million of insurance using 2009 tax rates). In most real-life cases the insurance is either too much (stock was gifted to Steve while Joe was alive) or too little (Success Co. just kept growing in value).
Lesson No. 2—Life insurance can play an important part in your estate planning, but never use it in a business succession plan to move your company stock to your business kids. You’ll als guarantee the IRS a big pay day when you die.
Now, let’s give credit to the professionals Sam and Larry’s mom are using. They avoided the pitfalls in lessons 1 and 2. True, there would be an unnecessary $7-million estate-tax bill, but they jumped on Section 6166 of the Internal Revenue Code, which allows certain business owners to pay their estate-tax liability over a 15-yr. period, plus a low rate of interest (not deductible) on the amount of estate tax due. Never in my 50-plus years of practice have I used Section 6166 as part of an estate plan, because it cannot save a penny of taxes and just stretches out the time of payment.