Tax Secrets: Do it wrong and the IRS wins
This article is written to every owner of a closely held family business. Sooner or later, the message becomes crystal clear: You must transfer your business (Success Co.) And if you’re typical, the transfer will be made to one or more of your children. [In second place are transfers to one (or more) key employees.] What’s the most common form of transfer? Hands down the transfer method you select is to sell Success Co. to your kids or employees.
Let’s follow the triple-tax hit to your family when you – as a business owner (Joe) – sell to your child (Sam) or an employee. Suppose Sam will pay Joe an amount equal to the fair market value of Success Co. over a period of years, plus interest.
The tax tragedy starts with Sam. Since he can’t deduct the cost of the stock from his current income, he is forced to first earn the money, pay the tax and has only the balance to pay Joe. That’s tax number one.
What happens when Joe receives the payments? The interest is fully taxable as ordinary income. The profit on the sale of the stock is taxable as a capital gain. That’s tax number two.
Let’s review the stock purchase tax damage so far in round numbers. Sam must earn about $165,000 subject to a $65,000 income tax bite (including state tax) for every $100,000 of the sales price paid to Joe. If Joe’s tax basis for the stock is $10,000 he must pay capital gains tax of about $18,000 on the $90,000 profit. How much does Joe have left? Only $82,000. Truly a tax disaster ($93,000 in taxes for the family on a $100,000 sales price). Apply those numbers to an estimated value of your family business; truly a tax horror.
A side note: By the way, a smart tax move if Success Co. is a C corporation, is to elect S Corporation status. This move accomplishes two purposes: (1) the interest paid to Joe becomes deductible by Sam, and (2) corporate profits can be withdrawn by Sam, free of a dividend tax, to pay Joe for the stock.
What happens when Joe dies? The after-tax profit from the stock sale ($82,000) will be subject to the estate tax. Probably (using 2017 rates) another 40 percent tax slice (taking $32,800) and leaving $49,200 for Joe’s heirs. And that’s tax number three. To summarize: Only $49,200 is left for the family out of every $100,000 of the business sale price … a lousy tax deal.
Yes, it’s sad but true, your family can get clobbered for three taxes if you make the mistake of selling your family business stock to your kids. Properly done, most business owners transfer their business to their kids without losing any dollars to the IRS.
Just what is the proper way to do it? The answer is a strategy that is not only legal – accepted by the IRS – but is easy to do. The strategy is called an “intentionally defective trust” (IDT). When you use an IDT the transfer is income tax-free to both the buyer (Sam) and the seller (Joe). Go back and take a look at the $100,000 price example earlier in this article. Simply put, an IDT saves you every penny of the potential capital gains tax on the sale of your business to your kid(s), or to your key employee(s). Take a few minutes, call your CPA to help you do the math for your own potential business sale.
Would you like more information on how to transfer your business? Or how an IDT can work for you? Check out my website, taxsecretsofthewealthy.com. In a hurry? Call me (Irv) at 847-767-5296. Or email me: firstname.lastname@example.org. I’ll walk you through how to structure a transfer of your business to your kids(s) or employee(s).