“Yes!” they answer. The longer Joe has been in business and the more successful the business is, the louder and more passionate the answer. Yet, Joe is troubled.
Simply stated, Joe has a succession plan problem. All long-term successful business owners have basically the same succession problems, but Joe doesn’t realize this because he thinks his problems are unique. The three most common succession plan problems all seem unsolvable to Joe:
1. How to sell/transfer his business to his business kid(s) without getting killed by taxes?
2. How to treat the non-business kid(s) fairly?
3. How to sell his business to his key employee(s) if he/she/they don’t have any money? This problem occurs if Joe doesn’t have a child or another relative to take over the business.
Joe is the perfect poster boy for a successful business owner. He built a business from scratch called Success Co. that he wants to transfer to Sam, his son. In general, he’s a happy camper, but his “complete package” (his estate, wealth transfer plan and succession plan) is a disaster.
Joe basically has five types of assets: Success Co., valued at $6.5 million; a residence worth $700,000; a rollover IRA of $900,000; other assets, mostly real estate and liquid investments, amounting to $3.5 million; and a life insurance policy on Joe that includes a death benefit of $800,000. For estate tax purposes, if Joe got hit by the proverbial truck and his wife Mary predeceased him, his estate would be worth $12.4 million. Taxes at Joe’s death, using his present wealth transfer plan and 2011 tax rates, would be about $5.5 million.
Joe has four goals:
1. He wants his wife and himself to maintain their lifestyle for as long as they live.
2. He wants to turn Success Co. over to Sam as soon as possible, while paying the least amount possible in taxes. Yet, he wants to control the business for as long as he lives.
3. He wants each of his two non-business daughters to receive an equal amount of the estate—the same as Sam receives.
4. He wants all his assets to go to his family without being reduced by taxes.
The first step in achieving these goals was to reduce the value of Joe’s assets for estate tax purposes. This is what he did on an asset-by-asset basis:
1. He sold Success Co. to an intentionally defective trust (IDT)—only the non-voting stock was sold. Joe kept all the voting stock. The IDT is a strategy that allows us to transfer a family business to any person tax-free.
2. He transferred his residence to a qualified personal residence trust.
3. He made a profit-sharing plan (a magic bullet, which is discussed later).
4. He transferred all other assets—the real estate and liquid assets—to a family limited partnership.
5. He transferred the life insurance to an irrevocable life insurance trust (ILIT).
For estate tax purposes, these five strategies lowered the total value of the five assets to about $6.5 million. We used almost all of Joe’s and Mary’s unified credits ($1 million tax-free for each), leaving a potential tax liability of about $3.2 million when Joe and Mary both die.
With $900,000 of potential insurance proceeds already parked in the ILIT, we only need about $2.3 million more of tax-free wealth to get all of Joe’s assets to his family, with all taxes paid in full.
What to do?
Here comes the second step. We decided to buy a $3 million second-to-die life insurance policy (on Joe and Mary), using a sub trust as part of the profit-sharing plan. When both Joe and Mary have passed on, the $3 million will go to Joe’s family —free of the estate tax—to pay any estate tax liability that may be due.
Here’s one last thought: Assume that Joe has no kids in the business, but has a key employee (Ken, a smart, young guy who, as a practical matter, has really been running Success Co. for the past 8 years). Just substitute Ken for Sam in the above plan. Joe’s results would be the same. In addition, we would put in a wage continuation plan for Joe that would take effect if he ever quit working or could no longer work. This plan would continue for as long as Joe lived and for as long as Mary lived after his death.