Overcoming the Fear of Succession Planning

Some things are downright scary, like taxes—especially estate taxes. Can you guess which area in estate tax planning causes the most anguish? Hands down, it’s business succession.


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Most successful business owners fear business succession. They are full of questions: How high will my income/capital gains taxes be if I sell to the kids (or employees) now? How much will the increasing value of the business increase my estate tax liability if I don’t sell now? What if the kids mess up? Will I get paid? Will I be able to maintain my (and my spouse’s) lifestyle? How can I treat my non-business children fairly? Will I be able to retain control over my business?
Control is the number one fear. One way to control that fear is to turn it into a goal. Then, the business owner should apply the correct strategy to accomplish each of his or her goals.
The following is a true-life example of Joe, a reader of this column and a business owner. Joe is married to Mary. His son Sam works in Success Co., the family business. David is a key employee but not related to the family. He has natural business instincts, is respected by the employees and helps Joe run Success Co.
We have taken Joe’s fears and turned them into a list of goals.
1. Keep control for as long as he lives. Joe owns 100 percent of the stock of Success Co. (an S corporation). We recapitalized (a fancy word for having voting and nonvoting stock) the company in a tax-free transaction so that Joe now has 100 shares of voting stock and 10,000 shares of nonvoting stock. The strategy is for Joe to keep the voting stock (and control) until he dies. The nonvoting stock will be transferred to the kids.
2. Transfer Success Co. to Sam now. The goal is to freeze the value without getting beat up with income/capital gains taxes. To do this, they sell the nonvoting stock to an intentionally defective trust (IDT). The beauty of an IDT is that Joe legally avoids capital gains tax on the sale. Say the price is $8 million—paid with a note—and the profit is $6 million. No capital gains tax is owed on the $6 million profit, and no income tax is due on the interest Joe is paid on the $8 million note.
Typically, the note is paid in full over five to eight years using the cash flow of Success Co. When the note is paid in full, the trustee of the IDT distributes the stock to the trust beneficiary (Sam). As you can see, Sam never pays to own the nonvoting stock.
An IDT wins over a typical sale to Sam because the huge tax burden on Sam for a typical sale disappears. For example, if the income tax rate is 40 percent (state and federal combined), Sam must earn about $167 dollars. That is, he must pay $67 in income taxes to have $100 left to pay his dad. With an $8 million price, Sam must earn more than $13 million to pay Joe the $8 million.
3. Make sure that Joe and Mary can maintain their lifestyle for as long as they live. First, a little more information: Sam does a good job as one of 80 employees at Success Co. He is well-liked by his fellow employees, but he simply does not have what it takes to manage the business. Yet, Joe and Mary want
to keep Success Co. in the family. Sam then becomes the only choice, but what to do about management?
David, the key employee, is the logical choice. We created a non-qualified deferred compensation plan that gives David the benefits of ownership—a share of the profits gets paid if he gets sick, and $1 million goes to his family if he gets hit by a bus.
In real life, this is how the cards fell: David immediately took over the day-to-day management as president of Success Co. Joe continued as chairman of the board and consulted with David regularly. Joe technically had absolute control but never found a reason to exercise it.
Joe continued to work at full salary, but only half days. The intent was for Joe to cut his salary and days once his IDT note was paid in full.
4. Remove Joe’s bank guarantee for Success Co.’s loans. The term-loan provisions were rewritten, removing the guarantee once the IDT loan to Joe was paid.
5. Treat Susan (the non-business child) fairly. Besides Success Co., Joe and Mary have only $4.5 million in other assets, which is not enough to treat Susan equally/fairly. (Remember, Success Co. is an S corporation, and every year the IDT will receive a dividend. equal to about that year’s profit.) We had the IDT buy second-to-die life insurance on Joe and Mary. Susan is the beneficiary of the IDT for the amount of the insurance, enough to
treat her fairly. Where do the premium dollars come from? The dividend distributions, each year, are first used to pay the insurance premiums, and the balance is used to pay the $8 million IDT note.
Finally, let me point out that although most succession plans are similar, each has unique fears, problems and concerns.