The IRS has finally come over to our side on how-to-value-your- closely-held business issue that will save you and your family a bundle of taxes.
Here's the victory story. For over 20 years, we have been screaming at the IRS, "We are entitled to take a minority discount when a majority owner of a closely held business transfers one or more minority interests to one or more of his/her children or grandchildren." Many courts agreed with us, but not the IRS.
Now the IRS agrees. This is the current IRS position: "A minority discount will not be disallowed solely because a transferred interest, when aggregated with interests held by family members, would be part of a controlling interest."
Let's translate. Suppose your business is valued at $3 million. Everyone agrees with the valuation. Even the IRS. We would typically take a discount for general lack of marketability (usually in the 35 percent range) and an additional discount for minority interest bringing the total discounts to 45 percent or $1,350,000 ($3,000,000 x 45 percent). This means that the value of your business for tax purposes is only $1,650,000 ($3,000,000 minus $1,350,000).
The IRS has accepted the marketability discount theory for years. Adding the minority discount theory puts you in the driver's seat. Now, the IRS can only argue the amount of the discount. If your discounts are reasonable (like the above), you are on solid ground. The stakes are high. Every dollar worth discount can save you and your family up to 55 cents in gift and estate taxes.
Tax Problem Turns Into Bonanza
First, here's the problem: Joe owned all the stock of Success Co., a C corporation. Success Co. started its fiscal year with $3.6 million in retained earnings (surplus), and $2 million in excess cash (not needed for operations) and now seven months later- had already accumulated another $1.2 million in excess cash. Business was great. (Joe, 58 years old, had struggled for many years to keep his business alive when all of a sudden-three years ago-the cash profits he always worked toward and dreamed of began to happen.)
Joe had a retained earnings problem. Big time. A dividend to Joe would cost 40 cents on the dollar. Doing nothing would give the IRS a shot at assessing the unreasonable accumulated earnings tax.
Here's the simple six-step solution: (1) We had Success Co. professionally appraised; (2) Joe gave $3 million worth of Success Co. stock to a charitable remainder trust (CRT); and (3) the CRT sold the stock back to Success Co. for $3 million in cash. (4) the CRT will invest the $3 million (Joe is the trustee) and give Joe a $240,000 (8 percent of $3 million) annuity every year for as long as Joe and his wife Mary live. After they are both gone, the balance in the CRT will go to Joe's family foundation.
Now let's check out the fantastic tax consequences: No dividend to Joe. No capital gains tax to Joe. None of the transaction will ever be subject to income tax, gift tax or estate tax. Joe immediately gets about a $1 million charitable deduction, which amounts to $400,000 in in-pocket cash income tax savings. Joe used this $400,000 tax saving and a portion of the $240,000 annual annuity (from the CRT) to buy a $6 million second-to-die life insurance policy on his and Mary's life. The policy is owned by an irrevocable life insurance trust (ILIT). The ILIT-actually Step 5-allows the $6 million to pass to Joe and Mary's family free of all taxes.
Oh yes, Step 6: Joe will elect S corporation status for next year.