Joe couldn’t sleep. He was troubled, anxious and perplexed. To the outside world, Joe is a guy that has it all: great family, large profitable business (Success Co., that he started from scratch) on the board of directors of another large business, a bank and a national charity. He is a respected, well-liked mover and shaker.
So, what could be wrong?… In a word, “Succession” (of Success Co.).
First, a bit of background: Joe has two sons (Sam and Cy) who have worked for Success Co. for over 14 years. They are competent—still a bit to learn—but run the day-to-day operations of Success Co. and completely manage the company when Joe and his wife Mary go to Florida for the winter. Joe spends most of his time on customer relations and bringing in new business.
About four years ago, at one of their regular weekly planning meetings, succession was the topic of discussion. Joe promised his sons that he would transfer Success Co. to them in five years, 50/50 each, but that he would like to keep control for as long as he lived.
Success Co. is worth $15 million (professionally valued). Revenue increases about 10 percent per year and profits rise accordingly, as well as the value of the company.
Well, the end of the five-year period was getting close. Joe always had three major concerns:
- How to get Success Co. out of his estate, yet keep control for as long as he lives.
- Between Sam and Cy, Sam has turned out to be the clear leader. How can Joe, after he’s gone, pass voting control to Sam without breaking his 50/50 promise?
- Mary joins Joe in this concern: Fortunately, they like their two daughters-in-law. Yet, they fear that if one (or both) of the boys divorce, their then ex-daughter-in-law would wind up with a piece of Success. Co.
Joe consulted with his CPA and long-time lawyer… Lots of ideas, but no solution to the above concerns. The last two issues—clear leader and possible divorce consequences—are what kept Joe up at night.
The sad fact is that the same (or similar) three concerns keep most family owners up at night when their business succession time is at center stage. Why?… Search, as they do, but not able to find a solution.
Is there a solution?. A loud ‘YES’ to each of the three concerns. In practice, each solution must be separate (designed to fit the exact and unique circumstances and goals of the family, their business and the owner), but of necessity, are intertwined. Let’s take them one at a time, using Joe’s concerns as an example.
Joe knew a lot about IDTs. He educated himself by reading this column and the info on my website. He knew what he wanted, but did not know how to get an IDT done (nor did his professional advisors).
Here’s how we structured the IDT transaction for Joe: First, we recapitalized (a fancy word for creating non-voting stock—here 10,000 shares—and voting stock—only 100 shares) Success Co. Next, we created the IDT, which purchased all the non-voting stock for $9 million, after $6 million of various discounts, as allowed under the tax law. The IDT paid Joe in full with a $9 million note, which will be paid (plus interest) using the future cash flow of Success Co.
The IDT transaction is tax-free for Joe, Sam and Cy and will save them about $1.8 million in income and capital gains taxes. Success Co. is now out of Joe’s estate, but he still has control via the voting stock.
How to solve the “clear leader” problem
When Joe goes to heaven, his voting stock will go to the boys. The transaction will be structured so Sam (the clear leader) gets one extra share of voting stock, thus enjoying control of Success Co., but he will be shorted one share of non-voting stock… Also, satisfying Joe’s goal, Cy and his brother will share profits 50/50.
NOTE: I explained to Joe the three requirements to be named the clear leader: (1) Sam (without bragging) thinks he is the clear leader; (2) his brother Cy recognizes Sam as the leader: and (3) the employees of Success Co. look to Sam as their leader.
How to keep the divorce devil at bay
The key is to draft the IDT properly. Joe’s trustee is instructed to keep the non-voting stock in trust even after the note is paid in full. Normally, the trustee would distribute the stock in the IDT to the beneficiaries (here Sam and Cy) as soon as the note is paid. With the trustee continuing to retain custody of the stock, Sam and Cy will get the benefits of ownership (distribution of profits from Success Co., an S corporation) without technically being owners. So, of course, the stock is out of the reach of the divorce devil.
A warning: This article—for lack of space—does not attempt to detail all of the benefits, tax traps and nuances of succession planning. Just make sure you work with an experienced advisor.
Finally, if you have a business succession problem, you can get a ton of free information on my website: www.taxsecretsofthewealthy.com. Or have a question… Call me (Irv) at 847-674-5295.
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How to transfer your business (to your kids), yet keep control
When closely help with business owners call me for help with their business successions plan they typically have two goals:
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- keep control for long as they live
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When people of means contact me to help do their estate plans (or review their existing plans), they typically have two goals concerning their estate tax:
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