Tax Secrets of the Wealthy: Enrich yourself; not the IRS

A look at buy/sell agreements

Do you have a buy-sell agreement? Thinking of signing one?... Read every word of this article first.

Most buy-sell agreements (B/S/A) come into being something like this: meet with the lawyer, short discussion (probably a long discussion – very long – about how to price the stock), lawyer drafts B/S/A, parties (shareholders/partners) sign it, into the safe or drawer. A big mistake!

An even bigger mistake: the shareholders/partners can’t agree on the B/S/A terms (usually the we-could-not-agree-on-the-price stumbling block). Result: a B/S/A never gets done; if done, it is never signed. When one of the owners dies, the IRS and the lawyers typically get more than the deceased’s family. The surviving owner faces a nightmare of expensive uncertainty. You never want to be a member of “the No-B/S/A Club.”

Okay then, if you have a B/S/A, listen up. If you don’t have one, don’t stop here. Read the rest of what follows with your fellow business owners.

For simplicity, let’s assume the rest of this article is talking about a B/S/A for a corporation (applies equally to an S corporation or a C corporation). The identical principles also apply to a partnership or limited liability company.

The easiest way to learn what to do and what not to do with your B/S/A is via a real-life example. So, here goes… the story of Joe (a reader of this column) and his brother Sam. The brothers share a winter home in Florida. Each owns 50% of Success Co., an S corporation in Indiana. Joe (age 51) has two sons; both finishing grad school; but unfortunately will never go into the business. Sam (age 45) has three young kids (10 or under); too early to tell if any will go into the business.

From here on, as you (the reader) read this, substitute your own numbers (value of your company and percentage you own). Now, a bit more about Success Co.: It is worth about $10 million. Continues to grow in value as profits increase….. almost every year. The brothers built a little family business, which they bought from their dad, into a solid and growing moneymaker.

Yes, they have a B/S/A. Typical document. I have reviewed hundreds just like it. Price of stock rises as value of Success Co. rises. So does the insurance funding (now at $5 million each on Joe and Sam). Both are prohibited from selling or transferring (in any way) all or any part of their stock… except to each other or to Success Co.

Sounds good, huh? If you have a B/S/A, bet you a nickel that it is the same or similar to the one Joe and Sam have for Success Co. For sure, this typical B/S/A (which you will soon see, is far from a winner) is way better than being a member of the No-B/S/A Club.

Unfortunately, the sad truth is that a typical B/S/A enriches the IRS more than your family (remember the estate tax returns to a high of 55% in 2011). So let’s follow the numbers if Joe (of course, would be the same for Sam) gets hit by a bus. Because of the B/S/A, Joe’s estate must sell his stock to Success Co. for $5 million (the amount of the insurance proceeds). A trust set up for Mary (Joe’s wife) winds up with the $5 million. No estate tax due now (because of the marital deduction). So far, so good. But when Mary dies, the IRS will get 55% of the $5 million (probably more, because that $5 million – and other assets left to Mary – will throw off more income than Mary can spend. Too bad, but it is easy to see how the typical B/S/A guarantees the IRS a great big payday.

Are you single?... you get nailed for the estate tax when you die. Married like Joe?... the IRS’s payday is deferred until your spouse dies?

What can you do to avoid this enriching-the-IRS-problem with a B/S/A? There are many ways, but following are two ways that will save you thousands or millions (depending on the value of your business).

First, take advantage of the legal discounts available when valuing any business for tax purposes. The law, regulations and accepted practice (by the IRS) allows you two specific discounts: (1) discount for general lack of marketability (35% is the most common number) and (2) discount for minority interest (10%). Remember, since Joe and Sam each own only 50% (neither has control) of Success Co., they are automatically entitled to a minority discount.

Now, follow the valuation wonders allowed by the tax law: Success Co. is worth $10 million ($5 milliion each for Joe and Sam). Typically, the two discounts total 40% (or $2 million for each half owned by Joe and Sam). So, using the discounts allowed by the tax law makes Joe’s interest in Success Co. worth only $3 million, the fair market value (FMV) (after discounts) for tax purposes. The B/S/A should be worded so that Joe (and Sam also) gets the higher of the FMV or the amount of insurance on his life. Now, Mary will only get $3 million from the current insurance-funded B/S/A.

What about the other $2 million?... Follow this simple tax-saving strategy: Success Co. simply makes tax-free S corporation dividend distributions to Sam and Joe, which are used to buy another $ 2 million each in insurance coverage. Joe’s policy is owned by an irrevocable life insurance trust (ILIT), so Joe’s $2 million in insurance proceeds goes – tax-free – to his ILIT for Mary’s benefit. Sam’s policy is set up the same way. Result: an estate tax saving of

$1.1 million ($2 million times 55%) for Joe (same for Sam).


Second, reduce the amount of stock Joe and Sam own by gifting nonvoting stock (say 10,000 shares each) to their kids. Joe and Sam keep control of Success Co. by retaining the voting stock (say 100 shares each). An intentionally defective trust (IDT) is used to accomplish this tax trick. If Joe or Sam needs the funds represented by the value of stock to maintain their lifestyle, the stock is sold to the IDT, instead of via a gift. The sale to the IDT is tax-free to Joe and his kids, saving $816,000 in income and capital gains taxes per each $1 million in FMV of the family business stock. (Here’s a little short cut to help you determine your potential tax savings: Did you substitute your family business estimated FMV? How much will an IDT save you and your family in taxes?) Either way – gift or sale – the IDT makes the transfer tax-free. To the kids… and to you.

An IDT is s sure-fire way to enrich your family, instead of the IRS. Really cool. If you intend to transfer all (or part of your family business to your kids (or other relative or employees), don’t take any steps toward implementing the transfer (by sale, gift or otherwise) until you find out how an IDT might work for you, your business and your family.

To help readers of this column who have B/S/A or business transfer problems or concerns, here is what we have arranged to do: (1) If you have a B/S/A send it, along with a copy of your company’s last year-end financial statement (all pages). If you don’t have a B/S/A but need one, or if you are thinking of transferring your business, send the financial statement, plus a list of shareholders (or partners). Make sure to include all phone numbers (business, home and cell). Send to Irv Blackman, Buy-Sell/Transfer Review, 4545 W. Touhy Ave., Apt. 602, Lincolnwood, Illinois 60712. Or in a hurry, call Irv at 847-674-5295.

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

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