To sign a buy-sell agreement (BSA) and put it into a safe or drawer is a big mistake. An even bigger mistake is to not even have a BSA. When a shareholder/partner dies, the IRS and the lawyers typically get more than the deceased person’s family, while the surviving owner faces a nightmare of expensive uncertainty.
The easiest way to learn what to do with your (corporate) BSA is via a real-life example: Joe and his brother Sam each own 50 percent of Success Co. Joe has two sons that will never go into the business. Sam has three children younger than 10, so it is too early to tell if any will go into the business.
The company is worth about $10 million, and it continues to grow in value as profits increase. As the price of stock rises, so does the value of Success Co. Insurance funding, which is now at $5 million each on Joe and Sam, also increases. Both brothers are prohibited from selling or transferring all, or any part, of their stock with the exception of selling/transferring to each other or to the company because they have a typical BSA.
So, let’s follow the numbers if Joe gets hit by a bus. Joe’s estate must sell his stock to Success Co. for $5 million (the amount of the insurance proceeds) because of the BSA. A trust set up for Mary (Joe’s wife) winds up with the $5 million. When Mary dies, though, the IRS will get 55 percent of the $5 million.
Here are two ways to avoid enriching the IRS with a BSA:
First, take advantage of the legal discounts available when valuing any business for tax purposes. The law, regulations and accepted practice (by the IRS) allow you two specific discounts: (1) the discount for general lack of marketability (most commonly 35 percent) and (2) the discount for minority interest, which is 10 percent. Remember, because Joe and Sam each own only 50 percent (neither has control) of Success Co., they are automatically entitled to a minority discount.
Now, follow the valuation wonders allowed by the tax law: Success Co. is worth $10 million ($5 million each for Joe and Sam). Typically, the two discounts total 40 percent (or $2 million). So, using the discounts allowed by the tax law makes Joe’s interest in Success Co. worth only $3 million, which is the fair market value (FMV) after discounts for tax purposes. The BSA should be worded so that Joe (and Sam) gets the higher of the FMV or the amount of insurance on his life. Now, Mary will only get $3 million from the insurance-funded BSA.
What about the other $2 million? Success Co. simply makes tax-free, S-corporation dividend distributions to Sam and Joe, which are used to buy another $2 million each in insurance coverage. Joe’s policy is owned by an irrevocable life insurance trust (ILIT), so Joe’s $2 million in insurance proceeds goes—tax-free—to his ILIT for Mary’s benefit. Sam’s policy is set up the same way. This results in an estate tax saving of $1.1 million ($2 million times 55 percent) for Joe (same for Sam).
Second, reduce the amount of stock Joe and Sam own by gifting non-voting stock (say 10,000 shares each) to their kids. Joe and Sam keep control of Success Co. by retaining the voting stock (say 100 shares each). An intentionally defective trust (IDT) is used to accomplish this tax trick. If Joe or Sam needs the funds represented by the value of stock to maintain their lifestyle, the stock is sold to the IDT, instead of via a gift. The sale to the IDT is tax-free to Joe and his kids, saving $816,000 in income and capital gains taxes per each $1 million in FMV of the family business stock. Either way—gift or sale—the IDT makes the transfer tax-free to the children and to you.
An IDT is a sure-fire way to enrich your family, instead of the IRS. If you intend to transfer all (or part) of your family business to your kids (or other relatives or employees), don’t take any steps toward implementing the transfer (by sale, gift or otherwise) until you find out how an IDT might work for you, your business and your family.