Solve Stressful Tax and Emotional Problems When Transferring the Business to Your KidsMarch 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 ProblemWhen 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.