Succession Plan Solutions

With the right plan, you can ensure that the business you worked so hard to build will live on even after you retire.


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If you own or run a family business, and you want that business to continue after your leadership ends, you need a succession plan. Although succession planning does not have a one-size-fits all solution, if you are like Joe, who owns 100 percent of Success Co. and would like it live on after he retires, you have three basic options for what to do with your business: transfer it to one or more family members, one or more key employees, or some third party.

The following four family situations come up often in practice:

1. The owner either has no children, or none of his children want to or are capable of running the company after his departure. Of course, perhaps one of them could still own all or part of the company, if a professional manager actually ran its day-to-day operations. This is rarely done, however. Instead, this situation prompts the second and third transfer options above. 

2. The owner has only one child, who already works for the company and is capable of running it. This may be the most clear-cut scenario. The only question is how to transfer ownership to that child in the most tax-effective manner.

3. Two or more of the owner’s children are involved in the business. In most of these 
cases, the owner wants each of the children to own an equal number of shares of the business. This creates a problem, however, in that there must be a clear leader (with voting control) to make final business decisions.

Here’s how we typically solve this problem when it arises: We create voting stock (say 100 shares) and non-voting stock (say 10,000 shares). This is a tax-free transaction. The owner of the company keeps the voting stock and control of the company, while the non-voting stock is dividing evenly among the children. When the owner dies, 51 shares of the voting stock, and control of the company, goes to the child who has been identified as the “clear leader.” That child’s non-voting shares are then reduced by the exact number of extra voting shares he receives.

4. At least one of the owner’s children works for the business and is capable of taking over, but the owner also has one or more other children who are not involved in the company. This is a common scenario, and it is also problematic. Typically, the owner will want stock in the company to go only to the children involved in the business, while those who are not involved in the business get other assets that he owns. Of course, often there are not enough other assets to meet the usual goal of treating each child equally. Purchasing second-to-die life insurance can make up the difference.

The Tax Problems
The tax costs associated with using the wrong succession plan can produce a never-ending, expensive nightmare. 

Say Joe sells Success Co. to his only child, Sam, for $1 million. Assume the tax rates are 40 percent for income taxes (35 percent federal and 5 percent state) and 40 percent for estate taxes. Joe’s tax basis for Success Co. is zero. To pay his dad that $1 million and cover the $670,000 in income taxes, Sam must earn $1.67 million. And Joe will have to pay a capital gains tax of $200,000, leaving him with only $800,000 for the company. Then, when Joe dies, another 40 percent of that $800,000 ($320,000) will go to the estate tax monster.

Yes, it’s expensive to do succession planning the wrong way.

The Right Way
The right succession plan is actually a two-step process:

Step 1. Recapitalize the business so that there are 100 shares of voting stock (which the owner keeps in order to maintain control of the company) and 10,000 shares of non-voting stock. The non-voting stock is entitled to discounts to its value of 40 percent for tax purposes. In the case of Success Co., valued at $1 million, this means its value for tax purposes is only $600,000.

Step 2. Sell the non-voting stock to an intentionally defective trust (IDT) for $600,000, which will be paid to the owner, in full, with an interest-bearing note. An IDT is the same as any other irrevocable trust except that it is not recognized for income tax purposes. As a result, every penny that the owner receives until the note is paid off is tax free—no capital gains tax and no income tax on the interest income. The company’s cash flow is used to pay off the note, plus interest.

In the case of Success Co., Sam is named the beneficiary of the IDT, so when the note is paid off, the trustee will distribute the non-voting shares to him, but Joe will still own the voting stock and control the company for the rest of his life.

Can the IDT strategy be used to transfer a company to one or more of its employees? Of course it can, but typically the sale price will be the full value of the non-voting stock (before discounts), and the owner will keep the voting stock until he is paid in full. An IDT also can be used by a stockholder to buy out other stockholders.

This article does not cover every possible use of an IDT in succession planning, nor does it describe every nuance, tax trap or exception. It does offer the family business owner a starting point, however.