Tax Secrets of the Wealthy: A tale of two clients

At last, a way to transfer your business, tax free, to your children

Succession planning has always been and still is a hot topic. Let’s start with a classical fact pattern and the tragic tax results that are sure to follow for the uninformed.

The facts: You want to sell your business (Success Co.) to your son (Sam) for $1 million. The tax results: The $1 million price is subject to three taxes.

1. Sam must earn $1.666 million; at a 40 percent (State and Federal) income bracket, must pay $666,000; only $1 million left.

2. Sam pays you $1 million for your stock (assume zero tax basis). Your capital gains tax is $150,000; now only $750,000 left.

3. At your death, the IRS can get about $400,000 for estate tax, only $350,000 left. It’s nuts! Sam must earn $1.666 million (or more) for your family to receive $350,000 (or less).

Wait! The above is almost good news compared to how Sam gets beat up economically. Sorry, Sam cannot deduct one penny of that $1.666 million. So, he’s stuck with a $666,000 income bill, and he loses the time value of that money for the rest of this life. Suppose Sam, now 36 year old, lives to be 78 (or 42 more years). If Sam can earn 6 percent (after taxes) on his capital in Success Co., his capital will double every 12 years. Want to guess what that $666,000 total loss could be in 42 years? Would you believe $8 million? Just double $666,000, 3 1/2 times.

Play with the numbers any way you like. You don’t want to go there (sell your business to your kids).

What to do? Following are two real-life war stories from our private client files.

First, the story of Lenny Little: Lenny’s business, Little Co., is worth about $550,000. His total net worth is $1.4 million. Lenny makes a comfortable living, but doesn’t think being worth $2 million someday – including a $200,000 life insurance policy – is possible. Lenny is 60 years old. So is his wife Mary. Lenny wants to sell his business to his daughter Liz.

Lenny’s succession plan. Lenny does not sell Little Co. to Liz. Instead, he creates the following plan:

1. Elects S corporation status.

2. Gives one share of Little Co. stock to Liz.

3. Enters into a buy/sell agreement assuring Liz that only she (right of first refusal) can buy the business.

4. Nothing more concerning the stock is done while Lenny is alive.

5. Lenny’s will leaves all of the Little Co. stock to Liz (in effect, ignoring the buy/sell agreement).

6. Lenny, cuts his salary as he slows down in his later years. This saves payroll taxes. A big deal. Remember, payroll taxes run in the 16 percent to 20 percent range. For example, a $50,00 salary kicks up about $9,000 in payroll taxes.

Results of plan. The profits of Little Co. (an S corporation) are available to Lenny instead of salary. Every time Lenny takes $1 less in salary there is $1 more in profits for Little Co. Remember this: S corporation dividends give you more spendable dollars (no payroll taxes) than salary.

The plan allows Lenny and Mary to maintain their lifestyle.

When Joe dies, Liz owns Little Co. She didn’t pay one penny for it. Best of all, Lenny and Mary will have more spendable dollars during their lives than a sale of Little Co. to Liz would have produced.

Now, the story of Ben Big. Ben’s business, Big Co., is worth about $10 million and he wants to sell it to his son Sam. Ben’s total net worth is $18 million.

Ben’s succession plan. No sale of Big Co. to Sam. Here’s the plan Ben created:

1. Big Co., already an S corporation, was recapitalized (10 shares of voting stock and 10,000 shares of nonvoting stock). A recapitalization is tax-free.

2. A professional appraiser valued the nonvoting stock at $6.3 millions (after discounts).

3. The nonvoting stock was sold to an intentionally defective trust (IDT) for $6.3 million. The IDT paid Ben with a $6.3 million note. Sam is the beneficiary of the IDT and will get all of the nonvoting stock when the note is paid in full.

4. Ben leaves the voting stock to Sam in his will.

Results of plan. The note will be paid off as the IDT receives its share of Big Co.’s S corporation profits. Ben will receive the entire $6.3 million, plus interest, free of any capital gains tax or income tax.

Sam will ultimately (when Ben dies and leaves the voting stock to Sam) own all of Big Co. without paying out one cent to acquire the stock. Of course, Ben controls Big Co. (via the voting stock) until he draws his last breath.

In summary. Never, and I mean never (there are no exceptions) sell your business to a younger member of your immediate family. Instead, transfer it tax-free (no income tax. No gift tax. No estate tax).

This article does not cover every nuance, rule, exception and tax trap. Warning: Only work with an experienced and qualified expert when solving your succession/transfer problems.

Now you know the stories of Lenny and Ben. What about your story?

As regular readers of this column know, for over 30 years, we have done various reader tests from time to time. But this test is different. You are invited to join the test, but only if you meet one or both of the following criteria:

1. You want to sell or transfer your business to your kid(s); or

2. You have two (or more) children and one (or more) is in the business and one (or more) is not in the business, and you want to know how to treat the nonbusiness kids fairly.

If you want to participate, please send the following information by courier (send copies, do not send originals):

1. For your business. (a) Your last year-end financial statement and (b) list of stockholders.

2. Personal. Your personal financial statement (for you and your spouse).

3. A family tree. Your name and birthday. Same for your spouse, kids and grandchildren.

Send to Irv Blackman, Succession/Estate Plan Test, 4545 W. Touhy Avenue, Apt. 602, Lincolnwood, IL 60712. (If you have question call Irv – 847-674-5295). What’s our job?... To create the right plan for you, your family and your business, and to coordinate the efforts of your local professionals.

Okay, that’s our plan to help you do your tax plan. Let’s hear from you. The results of the test will be reviewed (without violating confidentiality) in this column.

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 or call 417-9732. His Web site is

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

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