A great article about estate planning for family business owners titled, "Warding off Analysis Paralysis," starts out reading like a good-news, bad-news story. First, the good news: "Approximately 90% of U.S. businesses are family firms… more than 17 million family businesses… employing 62% of the U.S. workforce."
And now the bad news: "Unfortunately, only a little more than 30% of family businesses survive into second generation. By the third generation, only 12% will be family-controlled."
The article written by David Leibell and Daniel Daniels was published in the June 2011 issue of Trusts & Estates. It is a masterpiece, focusing exclusively on the technical aspects involving family business succession, the complexity of the law and why many business owners as a result, are overwhelmed (got "analysis paralysis"), then sadly never do an estate or succession plan.
Almost as bad, in my experience, the hundreds of family business estate plans that I have reviewed (gave a second opinion) just did not accomplish the goals of the business owners, their families or their businesses. Generally, three types of problems raise their ugly heads: tax, economic and human. Sooner or later, one or more of these problems doom most family businesses… adding to the unfortunate statistics.
The information that follows is a road map that first clearly identifies each problem and then shows you how to solve it. Although each family business succession real-life situation is unique, after creating and reviewing hundreds of plans over the yeas, the problems (and the solutions that follow) tend to be common to almost all family business succession plans.
Keep in mind that when working with real business owner clients, the technical stuff is the easy part… my job is simple: know the law and how to implement it. What's the hard part? Hands down, the human stuff (emotions, greed, control, jealousy and on and on), which is often ignored, causes the most problems. Sorry, but miss or mishandle the human factors, and your plan -- no matter how technically correct -- will ultimately crash and burn.
Just how do you start? A simple statement of the exact facts and circumstances makes the problems easy to identify. So, let's start with a basic fact situation -- comes up often in real life -- and we'll build from there.
A basic fact pattern: Joe (married to Mary) owns 100% of Success Co., a family business. His only child Sam is a chip off of the old block... actually runs Success Co., which Joe wants to transfer to him. Success Co. is worth $8 million (professionally valued), making about $1.5 million per year before tax. Sam is married. Joe is still active, draws a $375,000 salary and has no intention of ever retiring (but will slow down).
Typical -- but wrong -- succession plans: The two most common succession plans we see in practice for the Joes of the world are: (1) Success Co. is sold to Sam on an installment basis for $8 million or (2) Joe sells 49% of Success Co. to Sam for $4 million (rounded) and keeps 51% of the stock, so he can keep control. Plan (2) is an obvious loser -- 51% of Success Co. is still in Joe's estate. Setting aside the control issue for a moment, let's analyze plan (1). Joe is not treated too badly, he walks off with a capital gain: his tax basis is tax-free and the balance an acceptable 15% (could go higher in the future) capital gains tax.
What about Sam? He gets killed with two severe problems: a tax problem and an economic problem. Let's lower the price of Success Co. to $1 million for ease of following the numbers. Assume the income tax burden (state and Federal combined is 40%). It's hard to believe, but Sam must earn $1.667 million, pay $667,000 in taxes to have the $1 million to pay his dad, which is subject to capital gains tax. That's the tax problem… And oh yes, multiplied in this case by 8 (remember Success Co. is worth $8 million). On top of all that, the unpaid balance will always bear interest.
What's the economic problem? Sam's personal financial statement must now show a liability of $8 million, destroying his personal balance sheet.
But wait! (A drumroll please)
One strategy solves not only the tax and economic problems, but also a significant human problem: Joe keeping control of Success Co.
The solution is a simple two-step process:
Step 1: Do a recapitalization (just a fancy name for creating voting and nonvoting stock)… say 100 shares of voting stock, which Joe keeps to maintain control and 10,000 shares of nonvoting stock, which will be transferred to Sam.
Step 2: An intentionally defective trust (IDT) is the technical weapon of choice to transfer the nonvoting stock to Sam. Actually, Joe creates the IDT and sells all 10,000 shares of his nonvoting stock to the trust. At what price? It must be fair market value (FMV). The recapitalization puts a whole new set of IRS approved rules into play. The rules are called the "discounting rules." Properly done (easy to do for an IRS okay), the discounting rules give you a 40% discount for the nonvoting stock. This makes the FMV of Joe's sale of the 10,000 shares of nonvoting stock $4.8 million (after the 40% discount on $8 million). The IDT now owns the nonvoting stock and Joe has a $4.8 million note receivable (payable from the IDT). The cash flow of Success Co. (must be an S corporation or became an S corporation) is used to pay off the note, plus interest.
The payments received by Joe, both principal and interest are tax-free, under the IDT rules. What's the tax and economic result?... every $1 million of price for Success Co. will save about $190,000 in taxes. Here (with a $4.8 million price) the savings are $912,000.
One more awesome IDT strategy: Sam is the beneficiary of the IDT. Typically, when Joe's note is paid off, the trustee would distribute the nonvoting stock to Sam. Instead, we have the trustee continue to hold the stock for Sam's benefit. Should Sam get divorced, his now ex-wife would not share in the value of the nonvoting stock because it is not an asset that Sam owns. Neat!
The above little tricks of the trade -- solve the tax, economic, control and divorce problems -- hold constant in the more complex fact situations that follow. The use of the recapitalization and discounting results also remain the same.
The more children Joe has, the more challenging the human problems become. So, let's take a look at different situations, causing different human problems, when Joe has two or more children.
Situation #1. Joe has three kids, all in the business. (Note: It could be two kids or any number more, but all are in the business). Now, here's the problem: Joe wants to typically treat them equally, so each would get one-third of the nonvoting stock as beneficiaries of the IDT. But what happens when Joe goes to heaven? And who gets the voting stock?
Experience has taught us that voting control must go to the clear leader of the three business kids. But what about treating the kids equally? 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 nonvoting shares. Result: Sam has control, but each of the three kids has exactly the same number of shares.
Situation #2. Joe has two or more kids and one (or more) is in the business and one (or more) is not. Of course, as is typical, Joe wants to treat all the kids -- business kids and nonbusiness kids -- equally. What happens if the value that each business kid will get is more than Joe can give to each of the nonbusiness kids? (Note: a common problem when Joe just does not have enough nonbusiness assets for the nonbusiness kids because of the large value of Success Co.) What to do?
The most common solution is to buy life insurance. Since Joe is married, the choice is to buy second-to-die life insurance on Joe and Mary. The premiums are generally about 40% less than single life on Joe.
So, job one is to buy the type of insurance that gives us the most death benefit for the least amount of premium cost. The next job 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. (making the nonbusiness kids shareholders, but only temporarily, so they can be bought out when the life insurance proceeds are collected after both mom and dad are gone).
Let's summarize: Joe (no matter how many kids he has and whether they are in or out of the business) (1) transferred Success Co. to the business children… tax-free … while keeping control; (2) eliminated the tax and economic problems that normally plague a business transfer and (3) solved the human problems that typically destroy family businesses.
It is important to note that this article does not cover every possible situation we see in practice. So, if you have a unique succession problem that is not covered in this article, contact me (Irv) at (847) 674-5295).
IRVING L. BLACKMAN has been practicing accounting and law more than 50 years, specializing in wealth transfer, business succession and valuation. He was a founding partner of Blackman Kllick Bartelstein LLP, CPAs, one of the largest accounting firms in the country, and is a member of the Illinois Society of CPAs, American Institute of CPAs and the American Speakers Association, among other organizations. Blackman has authored 21 books on taxation and penned hundreds of articles for trade publications. His company, Tax Secrets of the Wealthy, is headquartered in Naples, FL. He may be contacted at (847) 674-5295 or Irv@IrvBlackman.com.