Irv Blackman Irv Blackman
Independent Financialservices Professsional

Solve Stressful Tax and Emotional Problems When Transferring the Business to Your Kids

March 1, 2015

Mike couldn’t sleep. He was troubled, anxious and perplexed. To the outside world, Mike is a guy that has it all: great family; large profitable business, Brady Co., that he started from scratch; and a seat on the board of another large business, a bank and a national charity. He is a respected, well-liked mover and shaker.

So, what could be wrong? The succession of Brady Co.

First, a bit of background: Mike has two sons (Greg and Peter) who have worked for Brady Co. for more than 14 years. They are competent—still have a bit to learn—and run the day-to-day operations of Brady Co., and completely manage the company when Mike and his wife Carol go to the Grand Canyon for the winter. Mike spends most of his work time on customer relations and bringing in new business.

About four years ago, at one of their regular weekly planning meetings, succession was the topic of discussion. Mike promised his sons that he would transfer Brady Co. to them in five years, 50/50 each, but he would like to keep control for as long as he lived.

Brady Co. is worth $15 million. Revenue increases about 10 percent per year and profits rise accordingly, as well as the value of the company.

Well, the end of the five-year period was getting close. Mike always had three major concerns:

1) How to get Brady Co. out of his estate, yet keep control for as long as he lives.

2) Between Greg and Peter, Greg has turned out to be the clear leader. How can Mike, after he’s gone, pass voting control to Greg without breaking his 50/50 promise?

3) Carol joins Mike in this concern: Fortunately, they like their two daughters-in-law. Yet, they fear that if one of the boys divorce, their then ex-daughter-in-law would wind up with a piece of Brady Co.

Mike consulted with his CPA and long-time lawyer...plenty of ideas, but no solution to the three main concerns. The last two issues—clear leader and possible divorce consequences—are what kept Mike up at night.

The sad fact is that the same (or similar) three concerns keep most family owners up at night when business succession hits center stage.

Is there a solution? Yes. Each solution must be separate—designed to fit the exact and unique circumstances and goals of the family, its business and the owner—but of necessity, be intertwined. Let’s take them one at a time.

Solving the Control Conundrum

Mike knew a lot about intentionally defective trusts (IDTs). He educated himself by reading this column. He knew what he wanted, but did not know how to get an IDT done.

Here’s how we structured the IDT transaction for Mike: First, we recapitalized Brady Co. (a fancy word for creating non-voting stock, 10,000 shares, and voting stock, only 100 shares). Next, we created the IDT, which purchased all of the non-voting stock for $9 million, after $6 million of various discounts, as allowed under the tax law. The IDT paid Mike in full with a $9 million note, which will be paid (plus interest) using the future cash flow of Brady Co.

The IDT transaction is tax-free for Mike, Greg and Peter, and will save them about $1.8 million in income and capital gains taxes. Brady Co. is now out of Mike’s estate, but he still has control via the voting stock.

Solving the Clear-Leader Problem

When Mike dies, his voting stock will go to the boys. The transaction will be structured so that Greg (the clear leader) receives one extra share of voting stock, thus enjoying control of Brady Co., but he will be shorted one share of non-voting stock. Also, satisfying Mike’s goal, Peter and his brother will share profits 50/50.

Note: I explained to Mike the three requirements to be named the clear leader: 1) Greg (without bragging) thinks he is the clear leader; 2) his brother Peter recognizes Greg as the leader; and 3) the employees of Brady Co. look to Greg as their leader.

Solving the Divorce Dilemma

The key to overcoming the divorce issue is to draft the IDT properly. Mike’s trustee is instructed to keep the non-voting stock in trust even after the note is paid in full. Normally, the trustee would distribute the stock in the IDT to the beneficiaries (Greg and Peter) as soon as the note is paid. With the trustee continuing to retain custody of the stock, Greg and Peter will get the benefits of ownership (distribution of profits from Brady Co., an S corporation) without technically being owners. So, the stock is out of reach of the divorce devil.

A warning: This article—for lack of space—does not attempt to detail all of the benefits, tax traps and nuances of succession planning. Be sure to work with an experienced advisor.

If you have a succession problem, visit, or call me at 847/674-5295.

Seven Most-Used Tax Strategies in 2014 will Work in 2015

Let’s look back at the 2014 tax year. Interestingly, 2014 is the first year in memory with no significant change in the tax law: neither income tax nor estate tax. So, for tax-planning purposes, 2015 should mirror 2014.

We analyzed clients’ files to determine the strategies most used in 2014 to legally beat up the IRS. These strategies rose to the top as the clear winners.

For ease of reading in every strategy, our tax hero is Joe, owner of Success Co., and all numbers are rounded.

1) Family Limited Partnership (FLIP). Joe owned $10 million of various investment assets: real estate, cash-like assets, stocks and bonds. After transferring these assets to the FLIP, the assets are only worth $6.5 million (because of a 35 percent discount allowed by the law) for tax purposes. Result: estate tax savings of $1.4 million.

2) Intentionally Defective Trust (IDT). Joe wants to transfer Success Co. to his son, Steve. Suppose Joe sells Success Co. (worth $10 million) to Steve. The result is a tax tragedy. Steve must earn about $17 million, paying $7 million in income tax, to have the $10 million to pay Joe. Then Joe must pay about $2 million in capital gains tax...only $8 million left. Steve must earn $17 million for Joe’s family to keep $8 million.

An IDT, under the Internal Revenue Code, allows the transfer (from Joe to Sam) to be tax-free to both of them. No income tax. No capital gains tax. Also, Joe keeps absolute control of Success. Co. for as long as he desires.

3) Captive Insurance Company (Captive). A Captive is a bona fide insurance company (property and casualty). For example, Success Co. (in a 40 percent—state and federal—income tax bracket) pays Captive (owned by Joe’s children) a $500,000 premium. Success Co. deducts the premium, so is only out-of-pocket $300,000. Captive receives the $500,000 tax-free and can invest the entire $500,000. Over the years your Captive will accumulate millions of dollars, which will ultimately go to the Captive owners (Joe’s kids) at only capital gains rates.

4) Retirement Plan Rescue (RPR). An RPR does two things: 1) avoids the double tax (income and estate) that qualified plan (i.e., profit-sharing, 401(k) and IRA) funds are subject to, and 2) uses the plan funds to create additional tax-free (no income tax, no estate tax) wealth. Typically, each $250,000 to $350,000 in the plan is used to create about $1 million of tax-free wealth. Have $250,000 or more in your IRA, 401(k) or other qualified plans? Look into an RPR.

5) Private Placement Life Insurance (PPLI). The prime purpose of PPLI is to turn your taxable investment profits and income (whether capital gains, dividends or interest income) into tax-free income. Imagine $1 million compounding tax-free over many years. If your have a large investment portfolio, you will be delighted with your PPLI.

6) Personal Residence “50/50 Title Strategy.” This strategy works on every residence you own. For example, you own a main residence worth $2 million and a country home worth $1 million. The 50/50 Title Strategy entitles you to a 30 percent discount, making your main residence worth only $1.4 million for estate-tax purposes. The country home value is reduced to $700,000. Result: $360,000 in estate tax savings simply by changing titles.

7) Premiums Financing (PF). This combines knowhow involving the tax law, a bank loan and the insurance industry. Result: You can buy a large insurance policy (either single life or second-to-die) with a death benefit of about $8 million to $100 million, depending on your age and health. You don’t pay premiums. Instead, bank loans pay the premiums, which are paid back when you die.

If you are worth more than $10 million, check out PF. You use your current wealth as leverage to create additional tax-free wealth without spending any of your current wealth. MF
Industry-Related Terms: Center, Run, Transfer
View Glossary of Metalforming Terms

Technologies: Management


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