Winning The Transfer/Succession Game

Your business represents pure wealth (in current dollar value) and produces a stream of income to support you (and probably other members of your family). Someday, a portion of this pure wealth, which usually grows a bit in value each year, must go to the IRS.


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Your business represents pure wealth (in current dollar value) and produces a stream of income to support you (and probably other members of your family). Someday, a portion of this pure wealth, which usually grows a bit in value each year, must go to the IRS.

This article tells you about an old but wonderful tax case—TCM 1989-231—and how we have used it to make business owners happy.

Here’s the story: Clara Winkler died, leaving stock in the family business to her children. Some of the stock was voting, some nonvoting. Clara’s estate valued all the shares at $20 per share. The IRS pushed for a $46 value for the voting stock and $42 for the nonvoting stock.

The Tax Court compromised in an interesting way, valuing the voting stock at $38 per share (closer to the IRS figure) and the nonvoting stock at $25 per share (very close to the estate’s figure). Both the IRS and the court agreed on one thing: nonvoting stock has a lower value than voting stock.

Based on the Winkler case, we use this three-step strategy to significantly shrink the cost of the tax.

Step 1—Recapitalize your corporation by turning in all of your voting common stock and exchanging it for new voting common stock (let’s say, 1,000 shares) and new nonvoting common stock (let’s say 99,000 shares). This is a tax-free transaction that works for both S corporations and C corporations.

Step 2—Transfer the 99,000 shares of nonvoting stock to your children. Since the nonvoting stock is worth less per share than the voting stock, you can give more shares without owing any gift tax.

An important side note: Never sell the stock to your kids. It is always an expensive tax mistake.

Step 3—Select the method to transfer (really give) the nonvoting shares to the kids.

Here are the three methods we use:

  • Outright gifts, which are typically limited to $12,000 per child per year from each parent for a total of $24,000.
  • A grantor retained annuity trust (GRAT) or
  • A sale (actually a form of gift) to an intentionally defective trust (IDT). This is currently the most popular method.

When the value of the business is $1 million or more, use an IDT. When using an IDT, the tax savings average $807,000 per $1 million of the value of the business being transferred. For example, if you are transferring a business worth $2 million, then an IDT will save you and your kids more than $1.6 million.

One warning: Transferring to your kids using this three-step process is easy and inexpensive. However, be certain to work with a knowledgeable professional. If the professional even talks about a traditional sale to your kids (you know, the kid buys your stock and pays you in real dollars), then run and find another professional. Otherwise, you will be triple-taxed.

Let’s examine how this strategy accomplishes many family business goals. First, the parents: Owning only voting stock, they stay in absolute control of the business. Either the GRAT or the IDT gives them a flow of tax-advantaged income, yet the nonvoting stock is removed from their estates.

Now, the kids: Whether in the business or not, they own the nonvoting stock. We use a buy-sell agreement to get all of the stock into the hands of the business kids after dad and mom have passed on. In the end, only the business kids own the business and the nonbusiness kids get their fair share of the family wealth in other assets.

A High-Five Business Valuation Victory For The Good Guys
How much would you pay for property worth $100,000 if you had to spend $25,000 to fix it up, and to pay commissions, special taxes and so on? Clearly, you would have to pay less than $75,000 if you want to turn a profit.

Yet, over the years the IRS and the courts didn’t understand basic economics in the real world and how to answer the above question. Now they do. Here’s the story:

Let’s set up the scenario that is repeated almost every time business owners want to sell their businesses. If you are a potential buyer, then you are generally willing to pay more for the individual assets owned by the corporation than the corporation’s stock. Why? You do this for two reasons: (1) to obtain a higher tax basis for the low-basis assets owned by the corporation and (2) to avoid hidden and contingent corporate liabilities.

Now, let’s look at the seller’s side of the coin. After the acquired company sells its assets, it will owe corporate income tax on any gain. On the other hand, if the shareholders sell their stock, then they will pay less tax (15 percent capital gains rates). The low-tax basis of the assets stays with the corporation. When the buyer (really your acquired corporation) sells these assets, the corporation will be socked with those high corporate tax rates on the gain.

Despite this reality, the IRS and the courts have never allowed a reduction in the value of corporate stock for potential taxes due on a future asset sale or corporate liquidation. The good news is that two 1998 cases allowed such a discount for the first time and those well-reasoned decisions are still the law today.

Case #1—Estate of Artemus Davis (110 TC 530-1998). Mr. Davis, one of the founders of the Winn-Dixie grocery chain, created a holding company to own some of his publicly traded Winn-Dixie shares. Mr. Davis gave about a 26 percent interest in the holding company to each of his two sons. At the time of the gift, the holding company owned $70 million of Winn-Dixie stock and $10 million of other assets.

Mr. Davis claimed three discounts on his gift tax returns to report the transfers: lack of marketability; minority interest; and for the corporate taxes due if the Winn-Dixie stock were to be sold. The total of these discounts reduced the value of the gifted stock by more than 60 percent when compared to the real dollar value of the holding company’s assets.

The IRS rejected the valuation and assessed additional gift taxes of $5.2 million. Mr. Davis fought the IRS. When he died, his estate continued the fight. Fortunately, the Tax Court held that a discount for taxes must be allowed. The court saw no way the holding company could avoid the taxes and allowed discounts totaling 50 percent of the value of the assets.

Case #2—Irene Eisenberg (155 F3d 50–1998). In this case, the corporation owned real estate that it rented to third parties. The Second Circuit concluded that a similar discount (like the Davis case) for taxes was appropriate in valuing stock of a holding company.

When a client owns real estate and/or marketable securities and wants to transfer them during life as a gift or for estate tax purposes we often use a family limited partnership (FLIP) to beat the IRS legally. If you have a significant amount of investment property, then look into a FLIP.

When an owner wants to transfer a business to family members, we suggest a tax strategy that combines a valuation discount with an intentionally defective trust (IDT). The tax result of an IDT is that the owner can pass the business tax-free (essentially paying no income, gift or estate tax). However, the owner maintains control of the business for as long as he or she lives.