Relieving Stress

To the outside world, Joe is a guy that has it all: a great family; a large, profitable business; and seats on the boards of directors for another large business, a bank and a national charity. He is a respected, well-liked mover and shaker.

In private, however, Joe is troubled, anxious and perplexed. Why? In a word: succession. That is, Joe is worried and unsure about how to transfer Success Co., the successful business that he started from scratch, to his two sons.

Joe’s sons, Sam and Cy each have worked for the company for more than 14 years. They still have a bit to learn, but they are competent and run the day-to-day operations and completely manage the business when Joe and his wife, Mary, go to Florida for the winter. When Joe is in the office, he spends most of his time on customer relations and bringing in new business.

About four years ago, the topic of succession came up at one of the company’s regular weekly planning meetings. Joe promised his sons he would transfer Success Co. to them in five years, although he would like to keep control of the company for as long as he lives.

As the five-year period is drawing to a close, Joe has three major concerns:

1. How, exactly, will he get Success Co. out of his estate, yet maintain control of the company for as long as he lives?

2. Between the two sons, Sam has turned out to be the clear leader. How can Joe pass voting control to Sam after his death without breaking his promise to split the company 50/50 between his two sons?

3. Fortunately, Joe and Mary like their two daughters-in-law. But in the event that one or both of the sons divorce, how do they prevent an ex-daughter-in-law from winding up with a piece of the business?

These last two concerns in particular keep Joe up at night. (The sad fact is that the same three concerns, or similar ones, keep most family business owners up at night as they approach the time when they must plan for their company’s succession.)

Joe consulted with his CPA and long-time lawyer, but they were unable to come up with solid solutions to these specific issues. Do such solutions exist? Yes! Although each of the following solutions are separate, designed to fit the exact, unique circumstances and goals of the family, the business and the owner, they also are intertwined. These particular solutions address each of Joe’s three main concerns.

Transfer the Company, Keep Control
Success Co. has been professionally valued at $15 million. Revenue has been increasing about 10 percent per year, and profits rise accordingly, as does the value of the company. To address Joe’s first concern, the actual transfer of the business, he should set up an intentionally defective trust (IDT) transaction. 

First, Success Co. should be recapitalized into 10,000 shares of non-voting stock and 100 shares of voting stock. Under tax laws, the non-voting stock is entitled to a series of discounts totaling $6 million, which makes its value for tax purposes $9 million.

Next, Joe’s advisor should set up an IDT, which purchases all the non-voting stock from Joe with a $9 million note that will be paid (plus interest) using the company’s future cash flow. Success Co. is now out of Joe’s estate, but he retains the 100 shares of voting stock and, therefore, control of the company.

The IDT transaction is tax-free for Joe, Sam and Cy, saving them about $1.8 million in income and capital gains taxes.

Establish a Leader, Split Profits
After Joe dies, his voting stock should go to his sons, but the transaction should be structured so that Sam (the clear leader) gets one extra share of voting stock, thus receiving control of Success Co. He should be shorted one share of non-voting stock, however. Sam and Cy will share company profits 50/50.

Protect Against Divorce
Should either or both of Joe’s sons divorce, he wants to ensure that neither of their former spouses is able to walk away with a stake in the family business. No matter how likely or unlikely this is, the key to preventing this from happening is to properly draft the IDT. Normally, the trustee would distribute the stock in the trust to its beneficiaries (here, Sam and Cy) as soon as the note is paid in full. Joe’s trustee should be instructed to keep the non-voting stock in the trust even after the note is paid. This will give Joe’s sons the benefits of ownership (specifically, the distribution of profits from Success Co., an S corporation), without technically being owners of the company. This, naturally, keeps the stock out of reach of the “divorce devil.”

Owners always worry about their businesses, especially as they approach retirement or consider their own mortality. It is natural to feel stress about the many aspects one needs to consider when planning for the transfer of a business. As always, we recommend you work with an experienced advisor who is well-versed in this area and can help alleviate your stress.