Two Business-Succession-Plan ThrillersOne Doom, One Boom

December 1, 2008

Here are two client tax stories, with almost identical facts, describing transfer of a family business to the kids. One caused a financial-tax train wreck; the second a tax-free victory.

If you own all or a portion of a closely held business and are about to, or will someday, sell or transfer your interest in the business to one or more family members or employees, read this article carefully. You’ll learn the wrong and right to make the transfer and literally save more taxes—income, capital gains and estate combined—than the actual fair market value of your business interest being transferred.

Both stories started with a phone call from a column reader. The first call came from Joe in Chicago, IL.

About a year ago, Joe sold 100 percent of his business, Success Co., to his son Sam for $5 million, payable by Sam over an 8-yr. period, plus interest. Joe’s tax basis of Success Co., started by Joe 28 years earlier for $9000, was near zero. For our purposes we’ll assume his tax basis is zero. Let’s take a look at the tax damage when Joe sells his Success Co. stock to Sam. Assume that the price is $1 million and both Joe and Sam are in the highest tax bracket. Also assume that the combined state and federal income tax rate is 40 percent—5 percent state and 35 percent federal.

Here’s how you figure the tax cost for the $1 million price:

1) Sam must earn $1.66 million and pay $666,000 in income tax (40 percent times $1,666,000). Sam has $1 million left, which he pays to Joe.

2) Then Joe must pay $150,000 in capital gains tax (at 15 percent) on his $1 million sales price. Sad, but Joe only has $850,000 left after taxes. The tax loss to the family is $816,000 ($666,000 + $150,000) for the $1 million stock price.

Ask your CPA to compute your exact tax loss if you actually sell your business to your kids. Of course, your CPA must use a) your correct tax basis, b) your correct state income tax rates and the actual price for your stock. This must be fair market value or the IRS might complain. Now you know how the heartless tax law can beat you up if you sell your business to your kids like Joe did. Fortunately, there is a better .

The second call came from Hank, a Texan who wanted to sell his business, Big X, to his daughter Liz. What a pleasure when the client calls before erring in the transaction. We explained to Hank and Liz how an intentionally defective trust (IDT) is used to transfer a family business to the kids or employees quickly, easily, and best of all, tax-free. No need to make any computations.

If you intend to sell all or a portion of your busness to your kids, here’s how to determine your tax savings, which are $816,000 (as explained in the first story) per each $1 million of the stock price. Just have your CPA use your tax basis, state income tax rate and price for the business. Then use an IDT.

One more point when using an IDT: We used nonvoting stock (10,000 shares to make the IDT transfer), while Joe kept the voting stock (100 shares) so he maintains absolute control of Success Co. for as long as he lives.

An IDT is one of the few perfect tax strategies in the tax world—no downside. If you have questions for exactly how an IDT would work for your specific situation, you, or your professional advisor, can call me at 847/674-5295. MF

Industry-Related Terms: Point, Transfer
View Glossary of Metalforming Terms

Technologies: Management


Must be logged in to post a comment.
There are no comments posted.

Subscribe to the Newsletter

Start receiving newsletters.