This is a war story. A true one. It involves a real-life family business owner, Joe, with real-life problems.
Joe was advised by his lawyer and accountant to sell his business, Success Co., to his daughter for $1.8 million. He called me for a second opinion before signing the papers. My guess is that Joe’s problems and, more importantly, the solutions, apply to millions of small family businesses.
These are the goals Joe outlined at our consulting meeting:
1. Retire (quit working) next month when he will be 65.
2. Sell Success Co. to his daughter Susan. (She works in the business and her husband Sam is already in charge of the day-to-day operations).
3. Somehow get a flow of income from the business for himself and his wife Mary (will be 65 in four months) for as long as they live.
4. Save income and estate taxes.
5. Control his assets, including Success, for as long as he lives.
6. Treat his two non-business children fairly.
If you own a family business and are reaching retirement age, this is a must read. But first, a few more important facts that surfaced as I questioned Joe and reviewed the papers he brought to the meeting. A quick eyeball valuation (taking legal discounts allowed under the tax law) indicated that the business was worth in the $1.1 million to $1.2 million range for tax purposes. The business is likely to enjoy modest growth in value (about 5 percent per year). All of Joe’s other assets — including his residence ($350,000), 401(k) ($650,000), investments ($500,000) and life insurance of $600,000 — total $2.1 million. All of the assets were held in joint tenancy by Joe and Mary. Mary was the beneficiary of Joe’s insurance and the 401(k).
Success Co., a regular, tax-paying C corporation usually wound up with annual before-tax profit of about $300,000 to $400,000 after paying Joe a $175,000 salary.
Rather than write about all of the technical problems Joe has, let’s short-cut to the solutions. Then, it’s your job to get to a competent consultant to take care of the details to nail down your own particular solutions.
Following is what I advised Joe — goal-by-goal — to do:
1. Retire: Convinced Joe not to totally retire. But he slowed down (from 60-70 hours a week to three half days a week). He now averages 18 to 20 hours a week. Even took a six-week vacation abroad with Mary. Still loves going to work.
Joe’s salary is now down to $2,500 per month, plus his usual fringe benefits (customer entertainment, conventions, car and medical insurance for him and Mary). No, Joe and Mary are not on Success Co.’s health insurance plan; Medicare and supplemental coverage are cheaper and usually better. Call me if you have any questions on this point.
2. Sell Success Co.: Sorry, no sale to Susan. Instead, we “sold” half of Success Co. (but only nonvoting stock) to an intentionally defective trust (IDT). The sale to the IDT is tax-free. You’ll learn more about the why and how of the IDT as you read further.
3. Flow of income: Success Co. elected S corporation status. With Joe’s reduced salary Success Co. should make $400,000 to $500,000 per year. Half ($200,000 to $250,000) would go to Joe and Mary as dividends. These dividends, plus Joe’s salary, Joe’s and Mary’s Social Security, and their investment income will provide more income than they need to maintain their lifestyle. In addition, Joe will be collecting $500,000 plus interest from the sale to the IDT (details in 4d. follows).
4. Save income and estate taxes: First, income tax. Not selling Success Co. (using the IDT instead) to Susan will save Joe about $350,000 in income tax.
Next, saving (actually, eliminating in this case) estate tax is a bit more complex; yet easy to do. Following are the various strategies we used:
A. Eliminate joint tenancy for all properties. Joe and Mary should each wind up owning, in their separate names, about one-half, in value of all assets owned (including the stock of Success Co.). The trick is for each spouse to own at least $1 million in their own name at the time of their death. In this way, a husband and wife can reduce the estate bite to zero on the first $2 million of their assets if their wills are properly drawn. By the way, if the wills are wrong, the estate tax on that $2 million in property is a minimum of $435,00 (using 2011 estate tax rates). Can your business or family afford a $435,000 hit?
B. We recapitalized Success Co., a tax-free transaction. Joe now owns all (100 shares) of the voting stock and half (5,000 shares) of the nonvoting stock. Mary owns the balance (5,000 shares) of nonvoting stock.
C. We had Success Co. professionally appraised. The 100 shares of voting stock were valued at $100,000. The 10,000 shares of nonvoting stock was appraised at $1.8 million, before discounts. Various discounts (for lack of marketability, minority interest and nonvoting stock) reduced the value of the nonvoting shares to $1 million (all figures are rounded for convenience) for tax purposes. D. Joe sold his 5,000 shares of nonvoting stock to an “intentionally defective trust” (IDT) and received a $500,000 note (with interest of 6 percent), issued by the IDT, as payment in full. The IDT will use its share of the S corporation dividends to pay off the note, plus interest, to Joe. Susan is the beneficiary of the IDT and will receive the 5,000 shares of nonvoting stock after the note is paid.
E. We transferred the residence to a “qualified personal residence trust” (QPRT), which will remove it from Joe’s and Mary’s estate, yet they can live in it for as long as either is alive.
F. We created a “subtrust” as part of the 401(k). The subtrust purchased $2.5 million of second-to-die insurance on Joe and Mary. The annual premium payments of $37,750 will be paid by the subtrust. The $2.5 million death benefit will be free of income tax and estate tax.
G. Joe dropped the $600,00 of insurance on his life, pocketing $73,000 (tax-free) in cash surrender value (CSV) and saving $4,800 per year in premiums.
H. Joe created an “irrevocable life insurance trust” (ILIT) to purchase $1 million of additional second-to-die insurance. The $15,100 annual premium will be paid using the CSV ($73,000) and annual savings ($4,800) in G above. If necessary, funds from the FLIP [following] will be used to pay premiums. The $1 million death benefit will be tax free to the ILIT and Joe’s heirs.
I. We formed a “family limited partnership” (FLIP). Joe’s investments, primarily a $450,000 piece of real estate rented to Success Co. for $54,000 per year (Success Co. pays the real estate tax and other building expenses), were transferred to the FLIP. Any excess cash developed by Joe and Mary would be transferred to the FLIP. These funds would always be available to Joe and Mary if needed.
Any property in the FLIP would receive a discount of about 35 percent for tax purposes. For example, the $450,000 building would only be valued at $300,000 for tax purposes.
J. We had Success Co. create a “death benefit agreement” that would require Success Co. to pay Mary $75,000 per year when Joe died. Payments would stop when Mary died.
K. What was the result of our IRS-accepted tax planning maneuvers? Joe and Mary reduced their estimated estate tax liability from $1,275,000 to ZERO.
Should the value of Joe’s and Mary’s combined estates threaten to exceed $2 million (and cause an estate tax), a gift program is waiting in the wings: Joe and Mary can each give $12,000 per year ($24,000 total) to each of the kids and grandkids (there are five and counting.). Note: The $12,000 will increase to $13,000 in 2009.
5. Control assets: Joe will control his assets as follows: Success Co. via the voting stock; the residence as the trustee of the QPRT; direct the investments of this 401(k) account; and as the only voting general partner of the FLIP.
6. Treat kids fairly: The wills and trusts (for Joe and Mary) were drawn in such a way as to have all of Success Co. stock go to Susan, then $2 million of the final estate assets to (remember, there is $3.5 million of insurance) each of the two non-business kids, and any excess, one-third to each child.
Now a warning: Every detail, nuance, rule and possible tax trap of Joe’s and Mary’s plan is not given. Make sure you work with only qualified and experienced experts.
Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein, LLP (CPAs) and Chairman Emeritus of the New Century Bank (both in Chicago). Contact Irv at 847-674-5295 or firstname.lastname@example.org. Vist taxsecretsofthewealthy.com.