The easiest to learn what and what not to do with your B/S/A is via a real-life example. Here’s the story of Joe and his brother Sam. Each owns 50 percent of Success Co., an S corporation. Joe (age 51) has two sons; both finishing grad school; and, unfortunately, will never go into the business. Sam (age 45) has three young kids (10 or under); too early to tell if any will go into the business.
From here on, as you read this substitute your own numbers (value of your company and percentage you own). Now, a bit more about Success Co.:
It is worth about $10 million and continues to grow in value as profits increase…almost every year. The brothers built a little family business, which they bought from their dad, into a solid and growing moneymaker.
And, of course, they have a B/S/A. It is a typical document—I have reviewed hundreds just like it. The price of stock rises as value of Success Co. rises. So does the insurance funding (now at $5 million each on Joe and Sam). Both are prohibited from selling or transferring all or any part of their stock except to each other or to Success Co.
Sounds good, huh? If you have a B/S/A, bet you a nickel that it is the same or similar to the one Joe and Sam have for Success Co. For sure, this typical B/S/A—which you will soon see, is far from a winner—is better than being a member of the No-B/S/A Club.
Unfortunately, the sad truth is that a typical B/S/A enriches the IRS more than your family. Remember: The estate tax returns to a high of 55 percent in 2011). So let’s follow the numbers if Joe dies. Because of the B/S/A, Joe’s estate must sell his stock to Success Co. for $5 million (the amount of the insurance proceeds). A trust set up for Mary (Joe’s wife) winds up with the $5 million. No estate tax due now because of the marital deduction. So far, so good. But when Mary dies, the IRS will get 55 percent of the $5 million and probably more, because that $5 million—and other assets left to Mary—will throw off more income than Mary can spend. Too bad, but it is easy to see how the typical B/S/A guarantees the IRS a big payday.
Single? Then you get nailed for the estate tax when you die. Married like Joe? The IRS’s payday is deferred until your spouse dies.
What can you do to avoid this enriching-the-IRS-problem with a B/S/A? There are many actions, but following are two that will save you thousands or millions depending on the value of your business.
First, take advantage of the legal discounts available when valuing any business for tax purposes. The law, regulations and accepted practice by the IRS allow you two specific discounts: 1) discount for general lack of marketability (35 percent is the most common number) and 2) discount for minority interest (10 percent). Since Joe and Sam each own only 50 percent (neither has control) of Success Co., they are automatically entitled to a minority discount.
Now, follow the valuation wonders allowed by the tax law: Success Co. is worth $10 million ($5 milliion each for Joe and Sam). Typically, the two discounts total 40 percent, or $2 million. So, using the discounts allowed by the tax law makes Joe’s interest in Success Co. worth only $3 million, the fair market value (FMV), after discounts, for tax purposes. The B/S/A should be worded so that Joe (and Sam also) gets the higher of the FMV or the amount of insurance on his life. Now, Mary will only get $3 million from the insurance-funded B/S/A.
What about the other $2 million? Success Co. simply makes tax-free S corporation dividend distributions to Sam and Joe, which are used to buy another $2 million each in insurance coverage. Joe’s policy is owned by an irrevocable life insurance trust (ILIT), so Joe’s $2 million in insurance proceeds goes tax-free to his ILIT for Mary’s benefit. Sam’s policy is set up the same . Result: an estate tax saving of $1.1 million ($2 million times 55 percent) for Joe (same for Sam).
Second, reduce the amount of stock Joe and Sam own by gifting nonvoting stock (say 10,000 shares each) to their kids. Joe and Sam keep control of Success Co. by retaining the voting stock (say 100 shares each). An intentionally defective trust (IDT) is used to accomplish this tax trick. If Joe and Sam need the funds represented by the value of stock to maintain their lifestyle, the stock is sold to the IDT, instead of via a gift. The sale to the IDT is tax-free to Joe and his kids, saving $816,000 in income and capital gains taxes per each $1 million in FMV of the family business stock. (Did you substitute your family business estimated PMV? How much will an IDT save you and your family in taxes?) Either , gift or sale, the IDT makes the transfer tax-free to the kids and to you.
An IDT is s sure-fire to enrich your family instead of the IRS. If you intend to transfer all or part of your family business to your kids or other relative or employees, don’t take any steps toward implementing the transfer (by sale, gift or otherwise) until you find out how an IDT might work for you, your business and your family.
To help readers who have B/S/A or business-transfer problems or concerns, here is what we have arranged to do: If you have a B/S/A, send it, along with a copy of your company’s last year-end financial statement (all pages). If you don’t have a B/S/A but need one, or if you are thinking of transferring your business, send the financial statement and a list of shareholders (or partners). Make sure to include all phone numbers (business, home and cell). Send to Irv Blackman, Buy-Sell/Transfer Review, Blackman Kallick Bartelstein LLP, 10 South Riverside Plaza, 9th Floor, Chicago, IL 60606. Or in a hurry, call Irv at 847/674-5295. MF