Suppose you own and run a family business, and have decided the time has come to step down and transfer ownership to the next generation. You want the business out of your estate to save estate taxes, but you don’t want to give up control. This article will show you how to 1) keep control of your company, 2) get it out of your estate tax-free and 3) deal with some collateral problems that plague the typical transfer of a family business.
Let’s start with a fact pattern that comes up often in real-life family businesses: Joe owns 100 percent of Success Co. His son Sam actually runs the company, and Joe wants to transfer it to him. Success Co. has been professionally valued at $9.5 million, and has grown in sales and profits almost every year. Joe is advised by his lawyer and CPA to sell the business to Sam, stopping the growth of potential estate taxes. Joe agrees but can’t stand the thought of giving up control.
The following transfer plan is a road map that first clearly identifies each problem and then shows how to solve it. Although each real-life business succession situation is unique, the problems and the solutions tend to be common for almost all family business transfer plans.
Retaining control of the business operations is a two-step process. Let’s say Success Co. is worth $1 million. In step one, Success Co. is recapitalized. Joe now has 100 shares of voting stock and 10,000 shares of nonvoting stock. Under tax laws, the nonvoting stock is entitled to a series of discounts totaling 40 percent, which makes the value of Success Co. for tax purposes only $600,000. (Because Success Co. is really worth $9.5 million, that 40-percent discount would amount to $3.8 million, so for tax purposes Success Co.’s actual value is only $5.7 million.)
In step two, the nonvoting stock is transferred to Sam through an intentionally defective trust (IDT), and Joe keeps the voting stock and absolute control of the company.
Beating the Punishing Cost of a Sale
There are three tax consequences for selling the business to Sam outright. First, for every $1 million Joe is to receive for the sale of Success Co., Sam must actually earn $1.666 million. The 40-percent in federal and state income taxes will nail him for the $666,000, so only $1 million will be left. Second, when Sam pays Joe the $1 million for his stock, the IRS will get $200,000 in capital gains tax, leaving Joe and his estate with only $800,000. Finally, at Joe’s death, the IRS will siphon off another 35 percent, or $280,000, for estate taxes, leaving only $520,000 of the original $1 million. In a nutshell, Sam must earn $1.666 million in order for him and the rest of Joe’s heirs to receive $520,000 after Joe’s death.
Instead of an outright sale of Success Co. to Sam, Joe should sell the nonvoting stock of
the company to an IDT for the $5.7-million
discounted value. Joe then will get paid in full with an interest-bearing note from the IDT.
An IDT is the same as any other irrevocable trust, with one big difference: it is not recognized for income tax purposes. The result under the Internal Revenue Code is that every penny Joe receives from the sale to the IDT is tax-free—no capital gains tax on the note payments and no income tax on the interest income received.
Sam is named as the beneficiary of the trust and has no obligation to pay the note. Instead, cash flow from Success Co. (which must be an S corporation or elect S corporation status) is used to pay the note and interest. When the note is paid off, the trustee can distribute the nonvoting shares to Sam. Joe still owns all of the voting stock, however, and therefore retains absolute control of the company. Typically, Joe will gift the voting shares to Sam if and when Joe retires. Should Joe’s death come first, these shares will be bequeathed to Sam.
Joe and Sam will save about $200,000 in taxes for each $1 million of Success Co.’s price.
More Benefits from an IDT
An IDT can offer other tax and economic benefits as well. Suppose Sam is married and Joe is concerned that, if Sam gets divorced, his ex-daughter-in-law will end up with a piece of Success Co. The IDT trustee can be instructed to hold the stock in the trust for Sam’s benefit, taking it out of the divorce court’s jurisdiction.
If Sam were to buy Success Co. outright, the obligation to pay the $5.7 million sale price would destroy his personal balance sheet. Using an IDT eliminates any personal liability for Sam.
Finally, Joe has two other children who are not involved in the family business, but at his death he wants them to be treated equally to Sam. Joe doesn’t have enough other assets to cover this and, although a second-to-die life insurance policy with his wife, Mary, is the answer, the annual premium payments would be a drain. The IDT buys the policy and pays the premiums, and Joe’s two other children are the beneficiaries of the policy’s death benefit via the IDT.