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Sell Your Business to a Key Employee--Tax-Free for Both of You

By: Irv Blackman

Friday, April 1, 2016
 

Own all or part of a closely held business? Someday the succession-plan buzzer will go off. You would like to see the value of your business in your personal bank account. Wouldn't it be nice if all of those dollars came to you tax-free?

It can be done legally. An intentionally defective trust (IDT) is the strategy that makes the transfer tax-free. This article zeros in on a transfer to a key employee. Why? In practice, a key employee is the logical choice when no close relative of the owner is in the picture. But there are a couple of challenges: The employee has no money, and very few professionals know how to implement an IDT. What to do?

Let's take a look at an actual case. Joe, age 64, wants to sell his business, Success Co., to Cy, a key employee who actually runs Success Co. but has no money to fund the purchase. Joe goes to see his lawyer, and explains, “Cy and I have agreed on a price for Success Co., $5.7 million to be paid over 10 years with 4-percent interest on the unpaid balance. My tax basis for Success Co.’s stock (an S corporation) is about $500,000. What’s the best way to structure the sale?”

Joe’s lawyer advises the use of an installment sale. Why? Joe will not pay tax on the $5.2 million capital gain or interest income until he actually gets paid by Cy.

The Tax Cost of an Installment Sale

Joe’s lawyer explains the tax consequences of an installment sale: The top rate for ordinary income is 39.6 percent, which includes the interest income Joe will receive. Capital gains (long-term) are taxed at 20 percent. Simply put, Joe would be clobbered with federal taxes as well as state income tax.

Now what about the tax cost for Cy? Joe’s lawyer explains that Cy also gets clobbered. Let’s lower the price of Success Co. to $1 million to make the numbers easier to follow. If the income tax burden (state and federal combined is 44 percent), Cy must earn $1.78 million, paying about $780,000 in taxes, to have the $1 million to pay Joe. Now remember to multiply these numbers by 5.7 (the price for Success Co. is actually $5.7 million). Also remember, the unpaid balance always bears taxable interest.

In addition, Cy’s personal financial statement must now show a liability of $5.7 million, making it almost impossible for Success Co. to borrow money for growth, as banks want a personal guarantee from the owner.

Disappointed, Joe—an avid reader of this column—called me.

IDT Solves the Problems

An IDT solves these problems for both seller and buyer, and allows Joe to keep control of Success Co. until he is paid in full. The control solution is a simple two-step process:

1) Perform a recapitalization (a fancy name for creating voting and nonvoting stock) to create 100 shares of voting stock, which Joe keeps to maintain control, and 10,000 shares of nonvoting stock, which will be transferred to Cy via the IDT.

2) Joe creates the IDT and sells all 10,000 shares of his nonvoting stock to the trust for $5.7 million, which is paid in full with an interest-bearing note. The IDT now owns the nonvoting stock and Joe has a $5.7 million note receivable from the IDT. The future cash flow of Success Co. will be used to pay off the note, plus interest.

What is different about an IDT? It is the same as any other irrevocable trust, except that the trust is not recognized for income-tax purposes. The result: Under the Internal Revenue Code, every penny you (the seller) receive is tax-free: no capital-gains tax on the note payments, and no income tax on the interest income. With an IDT, every $1 million of price for Success Co. saves about $195,000 in taxes. Here, given the $5.7 million price, the savings add up to about $1.112 million.

Cy is the beneficiary of the IDT, and when Joe’s note is paid off, the trustee will distribute the nonvoting stock to Cy. Then, Cy buys the 100 voting shares from Joe for a nominal price, say $1,000. Cy now owns 100 percent of Success Co.

Does an IDT work for a transfer to your kids? Yes, just substitute your child's name for Cy in the above example. When one or more of your children is involved, an IDT offers two more important advantages:

1) The fair-market value of the nonvoting stock can be discounted by about 40 percent. For example, if Success Co. is worth $10 million, the nonvoting stock can be valued for tax purposes at about $6 million.

2) The trustee of the IDT is instructed to keep the nonvoting stock, so if your child, who is the IDT beneficiary, gets divorced, his or her spouse will have no interest in the stock.

Also, the same IDT strategy can be used to buy out fellow stockholders. So, if your professional advisor ignores the use of an IDT in your succession planning, get a second opinion.

If you have a unique succession problem that is not covered in this article, contact me. MF

 

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