Did you notice that the title of this article does not say “sell?” Instead, it says “transfer.” We’ll use Joe, owner of Success Co., as an example of why you should not sell your business to your kids.
In this case, Joe’s son, Steve, wants to buy Success Co. for $1 million. Now, follow these simplified tax numbers: Steve must earn about $1.66 to have $1 left to pay to Joe (typically 40 percent in income tax—State and Federal—on $1.66 is 66 cents in tax). Steve cannot deduct any portion of this $1 because the purchase of stock is a non-deductible capital expenditure.
If Success Co. is a C corporation, any interest paid by Steve is generally non-deductible. However, Steve can make all the interest deductible simply by having Success Co. elect S corporation status.
What about Joe? Steve pays his dad that $1 (plus interest). Joe must pay a capital gains tax (typically 15 percent) on the dollar and pay his top tax bracket (say 40 percent) on the interest income. Okay, Joe has 85 cents left after paying the capital gains tax on the $1. If Joe doesn’t spend that 85 cents, the IRS gets as much as 55 percent (using 2011 rates) for estate taxes when Joe dies. That’s another 47 cents for the tax monster, leaving Joe’s heirs with only 38 cents.
Let’s review: Steve must make $1.66 for Joe to leave his family 38 cents. Or, using the actual values, Steve must make $1,660,000, while Joe’s family only gets $380,000. That is lousy tax planning.
Now, let’s put some meat on ‘dem bones. Suppose Success Co. is worth $6 million. Yes, Steve has to earn $10 million ($6 million times 1.6667) for this family to keep $3.8 million. That’s nuts.
Fortunately, the tax law has a flaw, offering a way to transfer your business to your kid(s). If you are lucky enough to own a family business that is currently enjoying big profits or larger profits each year, the sooner you make the transfer, the better. You will freeze the value of your business and stop the potential loss of estate taxes on your increasing wealth.
Unfortunately, most family businesses are suffering reduced profits (even losses) in these tough economic times. Obviously, the value of such businesses is at a low point, giving you a window of opportunity to make a tax-advantaged transfer to your kid(s).
Let’s walk through the simple three-step process for transferring your business, yet keeping absolute control of the company for as long as you want.
The first step is to recapitalize Success Co. so it is immediately replaced by 100 shares of voting stock and 10,000 shares of non-voting stock. This is a tax-free transaction. Now, Joe can keep the 100 shares of voting stock and control over the company, and he can transfer the 10,000 shares of non-voting stock to Steve.
If you are a C corporation, the next step is to elect S corporation status. Success Co. is already an S corporation.
The final step in the transfer process is for Joe to sell his non-voting stock to an intentionally defective trust (IDT). Some advantages of doing this include:
• It is a huge discount for tax purposes. The non-voting stock has a value of about 60 percent of the stock’s real value. For example, if Success Co. is really worth $7 million, the non-voting stock would have a value—for tax purposes—of only $4.2 million (after a 40-percent discount of $2.8 million).
• It is tax-free to Joe. The IDT will pay for Joe’s non-voting stock with a $4.2 million note. The note will be paid, including interest, to Joe by the IDT, using dividends from Success Co. Typically, it takes 5 to 8 years to pay off the note. All the payments received by Joe for the note plus interest are tax-free.
Wait, it gets better. When the note is paid off, the trustee of the IDT distributes the non-voting stock to the trust’s beneficiary (Steve) with no tax consequences. Steve saves $2,772,000. (This is 66 percent of $4.2 million, using the formula at the beginning of this article.)
The ultimate transfer of the stock to Steve is not considered a gift for tax purposes, leaving your annual gift exclusion ($13,000) and lifetime exemption ($1 million)—double if you are married—available for other estate planning (tax-saving) strategies.
An IDT is a big deal for community-property states (such as Texas and California). The stock transfer to Steve is not in the community, which means Steve’s wife has no interest in the stock. (Yes, this can be a big deal if Steve gets divorced.)
An IDT works just as well if you want to transfer all or a portion of your business to other people, most commonly other shareholders (related or not), employees (usually the one or two top, key people) or even a tax-advantaged sale to a buyer of Success Co.
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