The Family Business Saga

The typical owner of a family business usually faces three problems: taxes, economics and human emotions. Here are seven case studies that examine these issues.

The typical readers of this column with tax problems are family business owners. Each has one or more problems that typically fall into one of three specific categories: taxes, economics or human emotions. It is not uncommon for the same person or family to have problems that fall into multiple categories.

Case Study #1.

Joe has two kids (Sue and Sam) who work at Success Co. Joe wants to give them a stock bonus. Sue is single, and Sam is married.

• Problem: Stock could be marital property.

• Solution: The stock bonus is okay for Sue, but not for Sam. In the case of divorce, a judge can say that half belongs to Sam’s wife.

Remember: Any property received prior to marriage is nonmarital property; any property acquired after marriage that is received as compensation or paid for with funds that were earned after marriage is marital property; and if you receive the property after marriage by gift or inheritance, it is nonmarital property.

Case Study #2.

Jack wants to sell Success Co. to his son Sid.

• Problem: Jack and Sid will suffer a high tax burden. For example, say the price of the company is $1 million. Sid must earn about $1.6 million because about $600,000 will go to the income tax. Jack will be hit with a $150,000 capital gains tax.

• Solution: Transfer the stock from Jack to Sid using an intentionally defective trust (IDT). This provides three big advantages: The entire transaction is tax-free to Sid and Jack; the stock is considered a gift under the law; and Success Co. is out of Jack’s estate.

Case Study #3.

About 90 percent of Jim’s wealth is tied up in Success Co., which Jim transferred to his son Sean using an IDT.

• Problem: What if Jim and/or his wife live to be 85 or 95? Will they be able to maintain their lifestyle?

• Solution: Have Success Co. create a death benefit agreement (DBA), which is really a wage continuation plan. The DBA kicks in after Jim is paid in full by the IDT and is no longer receiving a salary from Success Co. When Jim dies, his DBA wages stop, and his wife receives the reduced wages for the rest of her life.

Case Study #4.

Jake has four kids: two work for Success Co. and two do not.

• Problem: How do you treat the non-business kids fairly?

• Solution: The easy remedy is to give the non-business kids non-business assets, which can include the business real estate if not owned by Success Co. Or, you can acquire enough life insurance (if mom and dad are both insurable, acquire second-to-die life insurance because premiums are much less than single life) to accomplish equality.

Case Study #5.

Jerry and his three business kids all receive their compensation from Success Co.

• Problem: Their fringe benefits must be the same as all other employees or the IRS “discrimination” monster will raise its ugly head.

• Solution: Form a new management company. This frees Jerry and the business kids from the discrimination rules. Then, they can gain fringe benefits including their own pension plan or 401(k); health care plan; health insurance, long-term care and sales promotion.

Case Study #6.

Success Co. makes more than $1 million a year.

• Problem: Jeff can’t think of any more deductions that would reduce taxable income.

• Solution: He should form a captive insurance company, which is a real insurance company that covers risks his normal property and casually insurance company will not insure. These include loss of a key vendor, customer or employee; strikes; warranty of your goods or services; and change in law, rules or regulations.

Let’s say Success Co. pays a $500,000 premium to the captive. Success Co. deducts the entire $500,000, but the captive receives the same amount (tax-free) and invests the $500,000. The earnings are also usually tax-free. Also, the captive structure allows Jeff to enjoy significant savings on his property and casualty insurance expense.

Remember: The larger your company’s before-tax profit, the more tax dollars you can avoid losing them to the IRS.

Case Study #7.

You have a large amount—say $500,000 or more—in a qualified plan such as a 401(k) profit-sharing plan or an IRA.

• Problem: At current rates, the IRS can wind up with 70 percent of your plan funds and your family only receives 30 percent.

• Solution: In most cases you have a choice: a subtrust or a retirement plan rescue (RPR). Which one you choose depends on your age, amount in your plan, your goals and other factors. For example, we used a subtrust to turn an after-tax 401(k) plan amount of $300,000 into $4.5 million of tax-free wealth. Also, an RPR was used to turn a rollover IRA with a $652,000 balance into $3.75 million of tax-free wealth for the kids and grandkids.

Each subtrust and RPR is designed to meet the client’s exact goals. Either strategy is an opportunity to turn a potential tax disaster into a tax victory. The IRS loses, and you win.