Irv Blackman Irv Blackman
Independent Financialservices Professsional

Estate Planning Turns into Lifetime Planning

February 1, 2011

The story you are about to read has all the ingredients to make you cheer, applaud and cry. Yes, it’s an estate-planning story. But more than that, it’s an inspiring story of one man’s courage. Mr. Courage recently called and asked me to create his estate plan, quickly, because he has cancer and thought he should get his affairs in order. Mr. Courage was upbeat and has remained so through the entire planning process.

To get started, Mr. Courage’s wife, Mary, sent me information I had requested concerning their business and family. Included in the package was a surprise document (SD) that blew my socks off. More about that SD later.

First, the basic facts for the estate-planning story: Mr. Courage is 56 yr. old, Mary is six months older and active in the business, Potential Co. They have four kids, but only one, Sam (age 26), is active in the business. The company includes one key employee, Sid.

Potential Co., an S corporation owned 100 percent by Mr. Courage, earned $180,000 for the last full fiscal year, yet had a negative equity of $232,000.

Mr. Courage, his son Sam and Sid had a written business plan, but not yet a signed legal document, for Mr. Courage to sell Potential Co. to Sam and Sid for $2 million. Each would sign a note for $1 million.

Note: Any business owner intending to sell his business to his children or employees should read what follows carefully. You are about to become a happy seller.

This story of Mr. Courage is just an extreme example of typical succession planning (transferring a business), when the business owner wants to sell to either his children or employees. Almost als, the kids or the employees do not have any money. So, like it or not, the business owner must get paid in installments over a number of years. The buyers pay the seller with a note.

Two problems are immediately created. First, the buyer’s balance sheet is totally destroyed for years to come. Also, the buyer must use the business’s cash flow to pay the note. This sad fact makes it difficult—sometimes impossible—to obtain a bank loan needed to fund future growth of the business.

Second, the tax consequences of the transaction create a disaster for the buyer. Here’s why. Suppose the price for the business is $1 million and the tax rate (state and federal combined) is 40 percent. This means that the buyer must earn $1.667 million and pay $667,000 in taxes and have $1 million left to pay the seller.

Further, Sam and Sid must earn $3.3 million, pay $1.3 million in income tax in order to pay off their combined $2 million note.

So what did we recommend to Mr. Courage? Instead of an installment sale, we used an intentionally defective trust (IDT), which allowed Sam and Sid to use Potential Co.’s future cash flow to purchase the business.

An IDT is tax-free to the buyer. Also, the seller pays no capital-gains tax on the gain realized from the transfer of the stock to the buyer. In addition, the personal balance sheets of Sam and Sid will not show a liability for the purchase price of Potential Co. Banks usually finance a profitable business, but almost als require the guarantee of the business owner.

Now let’s talk about Mr. Courage’s surprise document (SD): A strategic plan for Potential Co. created with the help of Sam and Sid. This plan is awesome, thorough and detailed, covering the short- and long-term. It’s accompanied by a budget that sets monthly revenue and profit goals for two years. And, thankfully, Potential Co. is hitting those budget numbers. Profit before taxes for the first full year should approach $500,000.

Considering this success story, I want you to focus on two things if you own a business that will ultimately be owned by your children or employees.

Do not (and I mean never) sell your business to your kids. Use an intentionally defective trust to save a ton of taxes.

Yes, your estate plan should do the traditional stuff: wills, trusts, appropriate insurance, etc. Put it in the safe and forget about it. The most important plan regardless of your age is your lifetime plan. Its purpose is to maximize your wealth for as long as you live. It should help maintain your lifestyle, educate your children and perhaps your grandchildren, create a buy/sell agreement for the kids to make sure the business stays in the family, maximize the profitability of the business and minimize income tax. MF

Industry-Related Terms: Transfer
View Glossary of Metalforming Terms

Technologies: Management


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