Tax Secrets: Real-life succession planning

After Joe went to the big business in the sky, his estate and business succession plan (for Success Co.) turned into a tax nightmare.

Read this article carefully. Chances are you'll be saying, "I'm Joe," more than once.

Joe’s facts before he died.

Joe (married to Mary) has three adult kids: Sam, started working at Success Co. after college and two non-business kids. Joe and Mary told their advisors three core goals: (1) Sam should own 100 percent of Success Co.; (2) treat the three kids equally; and (3) pay as little as possible in taxes.

Joe’s advisors (lawyer and CPA) as part of Joe's plan sold Success Co. (an S corporation) to Sam for $12 million (its fair market value). Sam paid Joe in full with a $12 million note, payable in semi-annual installments over 10 years, plus 4.5 percent interest on the unpaid balance.

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Immediately before the sale of Success Co., Joe’s significant assets were (in $ millions): Success Co. ($12); 401(k) plan ($2.1); various investments ($12.1), including cash or cash-like investments ($9.1) and real estate leased to Success Co.; two homes ($1.5) ; for a total of $27.7 million.

Since Joe and Mary had $9.1 million in liquid assets, plus the future cash from the $12 million note and interest from the sale of Success Co., the professionals figured there was plenty of liquidity to pay estate taxes. So Joe's lawyer and CPA agreed that no additional planning was necessary.

Note: Both Joe and Mary were healthy.

Now the horror story. Joe died suddenly (heart attack). Let’s take a look at the impact of Joe’s death on each of his family members.

Sam’s situation was a disaster. Difficulty to pay price. For ease of explanation, say the price is $1 million. How much must Sam earn to pay that $1 million? Would you believe $1.655 million to the IRS using an income tax rate of 39.6 percent.

Let’s apply the $1 million example to Sam’s situation. He will ultimately pay almost $8 million (12 X $655,000) in taxes to pay off the $12 million note. Simply put, Sam must earn almost $20 million, before tax, to pay off the note. Plus interest. And don't forget, most states get tax for both principle and interest.

Outrageous!

Under current law, Mary's liability for the $27.7 million value of Joe's estate would be about $6.7 million.

Forgotten in the plan, until Mary died. What Joe and Mary should have done?

Lack of room prevents me from covering every point, issue and possibility. But following are the most important strategies that would have allowed all of Joe’s $27.5 million to go to his family, all taxes paid in full.

1. An intentionally defective trust (IDT). First, a recapitalization of Success Co. (100 shares of voting stock, kept by Joe; and 10,000 shares of nonvoting stock to be sold to the IDT). Now the discount allowed is 40 perecnt, resulting in a price to Sam of only $7.2 million. The entire transaction is tax-free to Joe. What’s the cost to Sam? Zero; not one penny.
2. Profits (really cash flow) of Success Co. will be used to pay the $7.2 million note.
3. Life insurance. Since Joe and Mary were insurable, we would have bought about $8 million (to be free of all taxes) in second-to-die life insurance.
4. Family limited partnership (FLIP). Only $11 million would be transferred to a FLIP. The IRS allows a 35 percent discount making the FLIP assets worth only $7.15 million for tax purposes.
5. Gifting program. Joe and Mary have 8 grandkids; all together with the 3 kids, we have 11 noses. The maximum annual tax-free gift is $14,000. So Joe and Mary together could make a $28,000 gift to each nose or a total of $308,000 per year.

Want to learn move about this fascinating subject? Browse my website, taxsecretsofthewealthy.com. Or, if you are in a hurry, call me (Irv) at 847-767-5296 or email me at irv@irvblackman.com with your questions or concerns.