Successful Succession

Two reader scenarios illustrate the dos and don’ts of estate planning.


Two phone calls in the same week from readers rang my “it’s-time-to-write-a-succession-planning-article” bell. The first call was a succession planning horror story. The caller unnecessarily lost millions to the IRS. The second call made me want to explode. It was another “spent-a-lot-of-money-on-lawyers-and-still-don’t-know-what-to-do” tax tragedy.
Let’s spell out the succession problems of each call and the surprisingly simple solutions in both cases.
The first caller, Joe, sold his business, Success Co., to his two sons four years ago. The price was $3 million, payable over eight years, plus interest at a rate of 5.25 percent on the unpaid balance. Today the balance due is $1.4 million.
Let’s assess the tax damage to Joe and his sons. First, the boys are in a 40-percent tax bracket. Breaking this down, to have $1 million after-tax to pay their dad, they must earn $1.66 million, then pay $660,000 in income tax. So for the $3 million price, the boys’ income tax burden will be $1,980,000 (3 × $660,000). Severe tax pain!
How will Joe be taxed? Well, the tax basis for his Success Co. stock (100 percent of the company) was $287,000 (let’s round it to $300,000). So, Joe’s capital gain over the eight years will be $2.7 million ($3 million less $300,000). What’s his capital gains tax? A mere $405,000 ($2.7 million × 15 percent).
Can you believe this tragic tax picture? The boys must make $4,980,000, while the family gets eaten alive by a total tax burden of $2,385,000. (Note: The boys can deduct the interest paid to their dad, but Joe must pay tax on this interest, so the net tax result is a wash.)
Now, the $2,385,000 question: Is there some way that Joe and the boys could have avoided that tax? The answer is a resounding YES! How? Joe should have transferred the stock to his sons using an intentionally defective trust (IDT). Joe sells the Success Co. stock to the IDT for a $3 million note. The cash flow of Success Co. is used to pay the note, plus interest. When the note is paid, the trustee distributes the stock to the beneficiaries. The boys don’t pay one penny in taxes for the stock. An IDT is intentionally defective for income tax purposes, so Joe receives the entire $3 million, plus interest tax-free—not one cent in capital gains tax or income tax.
The tax savings is $2,385,000, as explained above, and the transaction is structured so that Joe keeps control of Success Co. until the day he dies or until paid in full—his choice. My advice: If you want to sell your closely held business stock to your kids, look into an IDT.
Now, let’s take a look at the second caller’s succession problem. Sam owns 10 percent of Good Co. He is one of 10 total stockholders (I nicknamed them the “Big Ten”), each owning 10 percent of Good Co. All are children of four brothers who started the business years ago.
The Big Ten are all in their 50s and healthy, and each has one or more children. Here’s the current scorecard concerning whether any of them will join Good Co: Three (of the Big Ten) already have one child or more in the business, three know for sure that none of their children will work for Good Co and the remaining four don’t know for sure.
What do they do about a succession plan for Good Co.? Everybody, including the many professional advisors the Big Ten have consulted, is stumped.
Family-owned businesses that have two or more stockholders should listen. The problem is similar when you have multiple shareholders, whether two or ten (or more).
Following is the basic succession plan that we create when there are multiple shareholders (using Good Co. as an example):
• Each shareholder is treated as owning 100 percent of his or her 10 percent of the company stock. So each shareholder is given the freedom to deal with the stock he or she owns, as long as it does not interfere with the operation of the company or the other shareholders.
For example, Sam has a son, Tom, who is already working for Good Co. Sam will continue to work for Good Co. He can sell (probably using an IDT), gift or leave his stock to Tom when he dies. The significant point is that Sam should not be forced by the Good Co. buy/sell agreement to sell his stock to the company or his fellow stockholders when he retires or dies.
• Those shareholders who currently have no children working at Good Co. would be a party to a buy/sell agreement, which is insurance funded. Each time one of the Big Ten dies, the policy death benefit would be used to buy the deceased’s stock.
• What happens when a shareholder with no children in the business now has children join the Good Co. workforce? Then he or she is no longer subject to the terms of the buy/sell agreement and can buy his or her insurance policy from the company for its cash surrender value. I know, I know! You have a question about your specific succession problem. Remember, it would take a large book to cover every possible succession situation. However, the information from these two callers will solve about 98 percent of the succession problems I come across.