How to Sell Your Business to Your Key Employee

With an Intentionally Defective Trust (IDT), owners can sell their businesses tax-free while protecting their buyers.

Columns From: 10/17/2012 Modern Machine Shop,

Editor's Commentary

From the monthly column: Blackman on Taxes
What do you do when a business owner wants to sell his or her business to an employee, but that employee does not have the money to fund the purchase? That is the case with Joe, age 62, who owns Success Co. and wants to sell the business to his key employee, Ken, age 38. What to do?
 
Joe decides to consult his lawyer, Lenny. Joe tells Lenny, “Ken and I have agreed on a price for Success Co. Ken will pay $4.2 million over eight years with 4.5-percent interest on the unpaid balance. The average before-tax profit of Success Co. for the last three years is $840,000, but the trend is up. My tax basis for Success Co.’s stock (an S corporation) is $800,000. What’s the best way to structure the sale?”
 
Joe has several concerns: He fears run-away inflation and wants to ensure that he and his wife can maintain their lifestyle. He also has an obligation to pay for the college education of four more grandkids, having already paid for the three oldest.
 
Joe always left the bulk of his profits in Success Co. to grow the business. He and his wife have two homes (one in Indiana worth about $1.3 million, and another in Florida worth about $1.4 million). A variety of other assets total about $850,000, including $475,000 of liquid investments.
 
Lenny advises Joe to structure the sale as an installment sale for tax purposes. Joe will not pay any tax on the $3.4 million capital gain until he actually gets paid by Ken.
 
Not satisfied, Joe goes to see his CPA, Cal, who explains the tax consequences of an installment sale. Subject to Congress changing the tax rates, the rates will rise for ordinary income (which includes the interest income Joe will receive) and capital gains. Simply put, Joe would be clobbered with federal taxes, plus Indiana would get its state income tax.
 
Cal explains that Ken will also encounter two problems: a tax problem and an economic one. Assume the combined state and federal income tax burden is 44 percent. Ken must earn more than $6 million, and pay nearly $1.85 million in taxes, to have the $4.2 million to pay Joe. The final blow is that the unpaid balance will always bear interest. That’s the tax problem.
 
The economic problem is that Ken’s personal financial statement must now show a liability of $4.2 million, destroying his personal balance sheet and making it almost impossible for Success Co. to borrow money for growth.
 
One strategy, an Intentionally Defective Trust (IDT), solves the problems for buyer and seller and enables Joe to keep control of Success Co. until he is paid in full. The solution that follows assumes that Joe will sell all the stock he owns (100 percent) of Success Co. to Ken. The solution is a simple two-step process:
 
Step 1: Do a recapitalization (just a fancy name for creating voting and non-voting stock) to create, say, 100 shares of voting stock, which Joe keeps to maintain control, and 10,000 shares of non-voting stock, which ultimately will be transferred to Ken.
 
Step 2: An IDT is used to transfer the non-voting stock to Ken. Joe creates the IDT and sells all 10,000 shares of his non-voting stock to the trust for $4.2 million. The IDT now owns the non-voting stock, and Joe has a $4.2 million note receivable (payable from the IDT). The cash flow of Success Co. (which must be or become an S corporation) is used to pay off the note, plus interest.
 
Ken is the beneficiary of the IDT. When Joe’s note is paid off, the trustee will distribute the non-voting stock to Ken. Then, Ken buys the 100 voting shares from Joe for a nominal price (say $1,000). Ken now owns 100 percent of Success Co. In addition, the IDT can purchase insurance on Ken, so that in the event of his death, the insurance proceeds would pay any amount still due Joe.
 
So what is an IDT? It is the same as any other irrevocable trust, with one big difference:
The trust is not recognized for income tax purposes. The result under the Internal Revenue Code is that every penny the seller receives is tax-free—no capital gains tax on the note payments and no income tax on the interest income.
 
An IDT can also be used to buy out fellow stockholders, to transfer the business to your child and to transfer to more than one employee or child.
 
When your children are involved, an IDT offers several advantages:
 
• The fair market value of the non-voting stock can be discounted by about 40 percent.
 
• You can gift or sell all or a portion of the stock (voting and non-voting) to the IDT.
 

• The trustee of the IDT can be instructed to keep possession of the non-voting and the voting stock (if in the trust). This way, if your beneficiary child gets divorced, his/her spouse will have no interest in the stock.  

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