Tax Secrets of the Wealthy: Solve your business succession problem

Article Highlights

  • Own a family business? Want to transfer it to your kids?
  • When all the smoke cleared, not only had Mary escaped a big dividend income tax bill, but she has succeeded in effectively transferring the business to her children.
  • Never, but never sell your stock to your kids, unless you are a little guy (as spelled out above).

Own a family business? Want to transfer it to your kids? Then you’ll love this article. It’s about an old IRS letter ruling that is one of my favorites. It might be labeled “the lazy man’s way to plan your business transfer.” The ruling shows you how to take advantage of some favorable tax law while avoiding pitfalls. Good stuff! There is a bit of a problem to using the technique: You see, you must drop dead before your family can enjoy the benefits of Letter Ruling 9116031.

But wait, the ruling has one redeeming quality. Really! First, the facts.

Joe, his wife Mary and their children owned all the stock in a family business. Joe died in 1990 and Mary inherited all of his stock. (Note: Mary’s tax basis — for computing capital gains — is the fair market value (FMV) of the stock on the day Joe died. For example, if the FMV was $1 million and she sold it for $1 million, there would be no capital gains tax.) Mary immediately sold all of her stock back to the corporation.

Here’s the general rule: When you or any member of your family sells stock back to your corporation (called a redemption), the redemption is usually taxed as a dividend — a tax disaster.

But there is a special tax-saving exception for a family member who has owned the stock for 10 years or more: If he/she divests all interest in the company (including any position as an officer or director), the redemption is treated as a sale (gets favorable capital gains treatment, instead of being a dividend). Since Mary sold all (stock she owned before Joe died and stock she inherited from him) of her remaining interest in the corporation, the purchase by the corporation of her shares was considered a bone fide sale (redemption) and not a dividend — a big tax victory.

When all the smoke cleared, not only had Mary escaped a big dividend income tax bill, but she has succeeded in effectively transferring the business to her children. How? Since the kids now owned all the remaining issued and outstanding stock, they owned 100 percent of the business. To sum it up: Mary walked off with a near-tax-free capital gain, (the price paid to Mary for the stock was a bit more than the exact FMV of the stock inherited from Joe) while the kids walked off with the business. A fantastic tax result.

Here’s some more good stuff about succession planning. Over the years, we have used the above ruling dozens of times with real-life clients and have nicknamed the strategy “The little guy redemption technique.” Here’s why. We use it when the seller is (1) in a very low or zero income tax bracket; (2) the stock price is (by a sort of rule-of-thumb) $600,000 or lower and (3) the seller is not worth enough to have a potential estate tax problem.

For example, the last one we did was for $380,000 for Dad No. 1, who owned 5 percent of the stock. The corporation redeemed all the stock paying the full $380,000 with a note payable over 10 years with interest at 6 percent on the unpaid balance.

Simple! Effective. Really a nice little flow of spendable cash for Dad No. 1, whose total net worth was only $800,000.

Let’s change the facts, just a bit.

Dad No. 2 (a real client from New York) is in the highest income tax bracket and estate tax bracket. Tax heaven would be to transfer his interest in the corporation (valued at $3 million) tax-free to his kids.

Dad No. 2’s succession plan must be centered around a strategy called an intentionally defective trust (IDT). An IDT is a tax-saving machine. It’s tax-free to Dad No. 2. Best of all the “buyer” of the stock (Dad’s kids) do not pay a single penny for the stock. Instead, the kids get the stock tax-free as a beneficiary of the IDT.

The lesson to be learned. Never, but never sell your stock to your kids, unless you are a little guy (as spelled out above). If transferring the stock of your family business to one or more of your children will be a tax burden to (a) you or (b) the children or (c) (in most cases) both, it is a must to find out just how much the family will save in taxes using an IDT. The rule of thumb: The savings are over $600,000 for every $1 million of the stock’s price. In real life, Dad No. 2 and his kids saved $1,920,000 in taxes (on a stock price of $3 million).

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.

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