Tax Secrets of the Wealthy: Business succession

The best way to transfer your share of a closely held corporation when you and the other shareholders don’t get along

Article Highlights

  • Can you guess the most common succession situation and related problems?
  • Their dad left the business to the three boys when he died 31 years ago.
  • An insurance-funded buy/sell agreement was entered into by the kids, which should avoid any future controversy and is designed to keep the stock in the family (should one of the kids get divorced).

Many of the columns I write and the seminars I give deal with family business succession planning. Can you guess the most common succession situation and related problems? Getting the business from dad and/or mom to one or more of their kids. Yes, that’s where the action is.

And it’s easy — because there is only one decision maker, typically dad — compared to the subject matter of this article, where there is more than one decision maker.

What’s the subject of this article? Business succession involving two or more brothers owning pieces of the same family business. Or it could include sisters. Nephews. Or other relatives. Or one (ore more) non-related business owners. All or any combination are included in the following.

It’s sad but true: Brothers disagree. Particularly in business. (We use brothers in the example because that is the most common situation. But if you, the reader, have a different relationship with your business co-owner [for example uncle, cousin or just a nasty person] then substitute it for “brother.” The transfer problems and the solutions are identical).

More often than not, brothers do well running the business together. Yet, try to talk to them about any kind of succession planning; total disagreement.

Most of the time price (of their interest in the business) is the stumbling block. The older brother (or the one who wants out for whatever reason) wants a “too high” price. Deadlock! Year after year. So, nothing happens. That is until someone gets hit by the final bus. Then it’s too late. The lawyers and, all too often, the courts take over.

Result: Lengthy wrangling. Expensive costs, very expensive fees. Nobody wins.

Following is a solution that works about nine out of 10 times. Except for the names everything you are about to read actually happened. Here’s the story: Three brothers — Ed, Ted and Fred — each owned one-third of Success Co. Their dad left the business to the three boys when he died 31 years ago. Ed and Ted have worked in the business all their adult lives. Fred never worked even a day at Success Co.

Ed (from Wisconsin but winters in Florida) has a son and daughter who work in the business; Ted has one son in the business. Ed and Ted want their kids to continue the business. The three young business kids thrive in the business and ultimately want to take over.

Success Co. is an S corporation. (If it had been a C corporation, we would have elected S status). We then recapitalized Success Co. (a tax-free tactic), issuing 300 shares of voting stock and 9,000 shares of nonvoting stock. Each of the three brothers now owned 100 shares of voting stock and 3,000 shares of nonvoting stock.

Ed sold his 3,000 shares of nonvoting stock to an intentionally defective trust (IDT). An IDT is defective in the sense that it is not recognized for income tax purposes (making the sale tax-free), but it is recognized for estate tax purposes. That’s it, a three-step succession plan: 1. Be or become an S corporation; 2. Recapitalization; and 3. Sale to IDT. As the beneficiaries of the IDT, Ed’s two kids wind up owning the nonvoting stock, while Ed keeps control via the voting stock.

Of course, Ted — simultaneously with Ed — used the same succession plan to transfer his nonvoting stock to his business son. About seven months later, Fred followed his brothers with an identical plan to get his nonvoting shares to his two kids (not in the business). Fred liked the tax-free sale and getting the value of the nonvoting shares out of his estate.

Note: An IDT saves the family about $700,000 in taxes for each $1 million of fair market value of the business stock being transferred. It’s one of the best tax strategies I have ever used for a client who wants to transfer his business to the kids, yet keep control.

An insurance-funded buy/sell agreement was entered into by the kids, which should avoid any future controversy and is designed to keep the stock in the family (should one of the kids get divorced).

The plan worked. Great! But why doesn’t it work all the time if it’s so wonderful? The non-cooperating shareholder can (and sometimes does) hold up the plan in two ways: 1. Refuses to sign an S election when the corporation is a C corporation (no signature, no S election); and 2. Votes against the recapitalization (and you need the vote).

Even if the “bad-guy” brother tries to wreck the plan as described above, there are other ways — short of legal action — to get your personal succession job done without the signature or vote of all shareholders. We’ll explore these ways in a future article.

Do you have a brother-type succession problem at your business? If so, you are invited to join the reader test. To solve your problems. We will write up the results of the test and report back to you in this column.

To participate, please send the following information by courier (send copies, do not send original documents) for each owner who is cooperating:

1. Personal. A financial statement for you and your spouse.

2. A family tree. Your name and birthday. Same for your spouse, kids and grandchildren (indicate which kids are in the business).

3. For the business. Your last year-end financial statement and a list of stockholders.

Send to Irv Blackman, Succession Test, 4545 W. Touhy Ave., #602, Lincolnwood, IL 60712. If you have a question concerning your own business succession problem call Irv at (847) 674-5295.

Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at wealthy@blackmankallick.com or call 417-9732. His Web site is taxsecretsofthewealthy.com.

© 2009 marconews.com. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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