How to Solve Common Estate-Planning Problems

When planning your estate, you are likely to run across one of the following problems: taxes, economics or humans.


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The following describes solutions to some of the most common problems with family business succession plans I have seen over the years. Taxes, economics and humans can all doom a family business.
Keep in mind that the technical stuff—implementing an estate plan—is the easy part. The hard part is the human stuff. Emotions like greed and jealousy are often ignored, even though they cause most estate-planning problems. If you mishandle the human factors, even the best plan will ultimately crash and burn.
So how do you start? A simple statement of the exact facts and circumstances makes the problems easy to identify. Let’s start with a basic situation, and we’ll build from there:
Joe (married to Mary) owns 100 percent of Success Co., a family business. He wants to transfer the business to Sam, his only kid, who runs the company. Success Co., an S corporation, is worth $8 million and makes about $1.5 million per year before taxes. Joe, who is still active in the business, draws a $375,000 salary and has no intention of ever retiring.
Common succession plans solve only the tax and economic issues. Here is a plan that also solves the human issue of letting Joe keep control of Success Co.
• Step 1: Do a recapitalization (create voting and non-voting stock). Joe keeps control of 100 shares of voting stock and transfers 10,000 shares of non-voting stock to Sam.
• Step 2: Create an intentionally defective trust (IDT) to transfer the non-voting stock to Sam. Actually, Joe creates the IDT and sells all 10,000 shares of his non-voting stock to the trust at a fair market value (FMV) of $8 million. The recapitalization puts a new set of IRS-approved rules into play. The rules are called the “discounting rules,” and they give a 40-percent discount for the non-voting stock. This makes the FMV of Joe’s sale of 10,000 shares of non-voting stock $4.8 million (after the 40 percent discount). The IDT now owns the non-voting stock, and Joe has a $4.8 million note receivable (payable from the IDT). The cash flow of Success Co. is used to pay off the note, plus interest.
The payments received by Joe are tax-free under the IDT rules. So the tax/economic result is that for every $1 million, the company will save about $190,000 in taxes. With a $4.8 million price, the savings are $912,000.
Here’s another awesome IDT strategy: Sam is the beneficiary of the IDT. Typically, when Joe’s note is paid off, the trustee distributes the non-voting stock to Sam. Instead, we have the trustee hold the stock for Sam’s benefit. Should Sam get divorced, his ex-wife would not share in the value of the non-voting stock because it is not an asset that Sam owns.
The above little tricks of the trade—strategies for solving tax, economic, control and divorce problems—hold constant in the more complex situations that follow. The use of recapitalization and discounting rules also remains the same. For example, let’s take a look at different situations when Joe has two or more children:
• Situation 1: Joe has three business kids who he wants to treat equally, so each gets one-third of the non-voting stock as a beneficiary of the IDT. This works until Joe goes to Heaven. After that, who gets the voting stock?
Voting control must go to the clear leader of the three business kids. Assume Sam is the clear leader. Here’s how to solve the problem: Sam gets enough extra voting shares to have control of Success Co. and is then shorted an equal number of non-voting shares. The result is that Sam has control, but each of the three kids has exactly the same number of shares.
• Situation 2: Joe has two kids. One is in the business and the other is not. What happens if the business has more value than Joe’s other assets?
The most common solution is to buy life insurance. Since Joe is married, the choice is to buy second-to-die life insurance on himself and Mary. The premiums are generally about 40-percent less than single life on Joe.
So, the first step is to buy insurance that gives Joe the most death benefit for the lowest premium. The next step is to find the premium dollars. Rarely does Joe’s plan call for him to use his own dollars. When an IDT has been created, we use the funds the trust gets from Success Co. to pay the premiums. If Joe has money in a 401(k), IRA or other qualified plan, we use those funds. Sometimes, if there is no other choice, we will use the funds of Success Co. and make the non-business kids temporary shareholders. Then they can be bought out when the life insurance proceeds are collected after both mom and dad are gone.

No matter how many kids Joe has (or whether they work for the business), he is able to transfer Success Co. tax-free to the business children, while keeping control. He has also eliminated the tax and economic problems that normally plague business owners. Finally, he has solved the human problems that can destroy family businesses.