Can you guess the number one question that readers of this column ask me? It is “Irv, how do I transfer my business to my kids without getting killed by taxes?”

Following is a true story of how to do your transfer right. Read slowly. Own a family business, chances are this story is about you.

Joe, owns Success Co. (An S corporation). Joe is married to Mary. His son Sam runs the business and owns one percent of the stock. Success Co. is worth about $8 million and has enjoyed about 10 percent net profit growth each of the past five years. This profit growth should continue. Joe’s total net worth is about $17.5 million.

Joe asked me to “give a second opinion” of the two plans suggested by his CPA and lawyer. The core of both plans was an $8 million life insurance policy on Joe's life.

Plan 1: The policy would be owned by Sam. Joe would gift Sam the annual premiums. At Joe’s death, Sam would buy Joe's shares from his estate for $8 million.

Plan 2: Success Co. would own the $8 million of insurance and would redeem Joe's shares from his estate.

For either plan, the final results would be the same: Sam would own 100 percent of Success Co. and the estate would have $8 million in cash (the life insurance proceeds) instead of $8 million in stock. Joe’s estate would owe no income tax on the sale of stock. Why? Because the estate would get a raised basis equal to the fair market value of Joe's shares on the date of his death. Second, no estate tax because the $8 million of insurance proceeds will wind up in Mary’s trust and receive the benefits of the 100 percent tax-free marital deduction.

Sounds pretty good. Joe liked it.

Did I like the plan? No!  Sorry, but two problems always cause us to turn (thumbs down on such plans. Why? Because (1) The value of the stock will probably continue to grow and the excess value over the current $8 million value will enrich the IRS by up to 40 cents (using 2017 estate tax rates) for each $1 of the excess. That's $400,000 per million in unnecessary estate tax. Ouch! (2) When Mary passes, the IRS is guaranteed a big payday; 40% of the $8 million in life insurance... the IRS would get $3.2 million and the family only $4.8 million. An outrage!

Note: The tax rates may change, thus changing the numbers a bit, but the concepts will stay the same.

Following is the three-step plan we put in place for Joe:

Step 1. We recapitalized Success Co. (100 shares of voting stock, 20,000 shares of nonvoting stock). Joe kept control of Success Co. by owning only the voting stock.

Then, Joe transferred his nonvoting stock – to an intentionally defective trust (IDT). The IDT gets the nonvoting stock to Sam, (using the cash flow of Success Co.) tax-free for Joe and Sam. No income tax. No estate tax.

Step 2. We used the $2.1 million Joe has in an IRA to implement a strategy called a “Retirement Plan Rescue” to acquire $6 million of second-to-die life insurance on Joe and Mary. We also created an irrevocable life insurance trust (ILIT) to own the insurance... so every penny of the $6 million in insurance will go to Joe's family tax-free.

Step 3. We created a family limited partnership (FLIP) to hold Joe’s investments and started an annual ($28,000 per child) gift-giving program of the limited partnership interests in the FLIP to Joe's two non-business children. The beauty of the FLIP is the 35 percent discount allowed by law, so for tax-purposes the value of the FLIP saves $520,000 in estate taxes. Cool!

The three-step plan we created increased the amount of wealth Joe will leave his family by an estimated $5.5 million.

Want to learn how to use the above strategies? Browse my website, or call 847-674-5295.

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