The story you are about to read has all the ingredients to make you cheer, applaud and cry. Yes, it’s an estate planning story. But more than that: It’s an inspiring story of one man’s courage.
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Mr. Courage, a long-time reader of this column, called and asked me to do his estate plan quickly. “Why quickly?” I asked. He replied, “Because I have cancer.” Mr. Courage did not know how long he might live, but thought getting his affairs in order was a good idea. Never once during our initial phone call — or those that followed — did Mr. Courage give a hint that he was or would become downtrodden. In a word, he was upbeat. Mr. Courage explained his attitude this way: “How lucky I am to know that the end may be near, yet have time to put my house in order.” Wow!
The next day, a package arrived via courier (sent by Mr. Courage’s wife Mary) with the information I had requested concerning Mr. Courage, Mary, their business and their family.
Mr. Courage is 56 years old. Mary is six months older and is active in the business, Potential Co. They have four kids, but only one, Sam, is active in the business. There is one key employee, Sid, who is considered family.
Potential Co. (an S corporation owned 100 percent by Mr. Courage) made $180,000 for the last full fiscal year, yet had a negative equity of $232,000. “Small potatoes,” you’ll say.
But Mr. Courage, Sam and Sid had a plan, in writing (but not yet a signed legal document) for Mr. Courage to sell Potential Co. to Sam and Sid for $2 million. Each of the boys would sign a note for $1 million.
This story of Mr. Courage is an extreme example of typical succession planning (transferring a business), when the business owner wants to sell the business to either his or her kids or employees. Almost always, the kids or the employees don’t have any money. So, like it or not, the business owner must get paid in installments.
The buyer pays the seller with a note. Two problems are created. First, the buyer’s balance sheet is totally destroyed for years to come. Also, the buyer must use the cash flow of the business that was purchased to pay the seller’s note. This sad fact makes it difficult to get a bank loan.
Second, the tax consequences of the transaction are a disaster for the buyer. For example, suppose the price for the business is $1 million and the tax rate (State and Federal combined) is 40 percent. The buyer must earn $1.667 million dollars and pay $667,000 in taxes to have $1 million to pay to the seller. Consequently, Sam and Sid must earn $3.333 million and pay $1.333 million in income tax in order to pay off their $2 million notes.
What did we do? Instead of an installment sale, we used an intentionally defective trust (IDT). This IDT strategy allows Sam and Sid to use the future cash flow of Potential Co. to purchase the business. An IDT is tax-free to the buyer. Also, the seller pays no capital gains tax on the gain realized from the transfer of the stock to the buyer. An IDT puts more dollars in the seller’s pocket, after taxes… while the buyer pays no taxes.
In addition, the personal balance sheets of Sam and Sid will not show a liability for the purchase price of Potential Co. Banks usually finance a profitable business, but almost always require the guarantee of the business owner (the stronger his/her balance sheet, the better).
Now, for years I’ve preached that an estate plan is incomplete unless it includes a comprehensive lifetime plan – and Mr. Courage did this, too! A thorough, detailed strategic plan for Potential Co. was created with Sam and Sid’s help. It covers short-term and long-term and is accompanied by a budget detailing revenue and profit goals each month for two years. Hallelujah! Potential Co. is hitting those budget numbers. If the numbers hold—and every indication is that they will—profit (before taxes) for the first full year will be in the $500,000 range. And there’s more. Toward the end of the document is a brilliant analysis of the market Potential Co. serves: demographics, potential gross income for 100% of the market, a projection that they can capture 25% of the market, and a plan to do it. If they do it, Sam and Sid will become mega-millionaires.
I’m bett’n the boys will make it.
You’ll notice that this article does not include any details about the estate plan we created for Mr. Courage and Mary. I did it on purpose. I want you to focus on two things if you own a business that will ultimately be owned by your kid(s) or employee(s) or both.
First. Do not sell your business to your kids. Use an intentionally defective trust. You and the kids will save a ton of taxes. Second. Yes, your estate plan should do the traditional stuff: will(s), trust(s), appropriate insurance, etc. Put it in the safe and forget about it. The most important plan is your lifetime plan. The purpose of the lifetime plan is to maximize your wealth (while you control your wealth – particularly your business – for as long as you live).
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