Succession planning can have tragic tax results. Say you want to sell your business, Success Co., to your son, Sam, for $1 million. That price is subject to three taxes.
1. To afford the business, Sam must earn $1.666 million; in a 40 percent tax bracket, he must pay $666,000, so there is $1 million left. 2. Sam pays you $1 million for your stock (assume zero tax basis). Your capital gains tax is $200,000. Now only $800,000 is left. 3. At your death, the IRS can get as much as $440,000 in estate tax. Only $360,000 is left. Sam must earn $1.666 million (or more) for your family to receive $360,000.
This is almost good news compared to how Sam gets beat up economically. He cannot deduct a penny of that $1.666 million. He’s stuck with a $666,000 income bill, and he loses the time value of the money for the rest of his life. Suppose Sam, now 36 years old, lives to be 78. If he can earn 6 percent (after taxes) on his capital in Success Co., it will double every 12 years. In 42 years, that $666,000 loss could amount to $8 million. Just double $666,000 three and a half times. This is why you don’t want to sell your business to your kids.
Consider two stories from our clients. Lenny Little’s business, Little Co., is worth $550,000. His net worth is $1.4 million. He makes a good living but doesn’t think being worth $2 million someday—including a $200,000 life insurance policy—is possible. Lenny and his wife, Mary, want to sell the business to their daughter, Liz.
In Lenny’s succession plan, he does not sell to Liz. Instead, he does the following.
- Elects S corporation status.
- Gives Liz one share of Little stock.
- Enters into a buy/sell agreement assuring Liz that only she can buy the business (right of first refusal).
- Does nothing more concerning the stock while he is alive.
- Wills all of his stock to Liz (ignoring the buy/sell agreement).
- Cuts his salary as he slows down in his later years. This saves payroll taxes, which run in the 16 to 20 percent range.
The profits of Little Co. (an S corporation), rather than a high salary, are available to Lenny. When he takes $1 less in salary, there is $1 more in profits. S corporation dividends give him more spendable dollars (no payroll taxes) than salary. The plan allows Lenny and Mary to maintain their lifestyle. They will have more spendable dollars than a sale of Little Co. to Liz would have produced. When Joe dies, Liz owns Little Co., and she didn’t pay one penny for it.
Now consider Ben Big. Ben’s business, Big Co., is worth $10 million, and he wants to sell it to his son, John. Ben’s net worth is $18 million.
In Ben’s succession plan, he does not sell to John. Instead, the following happens.
- Big Co., an S corporation, is recapitalized (ten shares of voting stock and 10,000 shares of nonvoting stock), tax free.
- An appraiser values the nonvoting stock at $6.3 million (after discounts).
- The nonvoting stock is sold to an intentionally defective trust (IDT) for $6.3 million. The IDT pays Ben with a $6.3 million note. John is the beneficiary and will get all of the nonvoting stock when the note is paid.
- Ben wills the voting stock to John.
The note is paid off as the IDT receives its share of Big Co.’s S corporation profits. Ben receives the entire $6.3 million, plus interest, free of any capital gains or income tax.
When Ben dies and leaves the voting stock to John, he will own all of Big Co. without paying out one cent to acquire the stock. Of course, Ben controls Big Co. (via the voting stock) until he draws his last breath.
In summary, never sell your business to a member of the family. Instead, transfer it tax-free—no income tax, gift tax or estate tax.