A succession planning horror story

Got a phone call … the kind I dread. It was Sam, the 37-year old son of a family business owner (Joe). By any definition Joe was a "success." So was his business, Success Co.

Although Joe was a planner, after he went to the big business in the sky, his estate plan and business succession plan for the company turned into an economic and tax tragedy for Sam, for his mom Mary, and the rest of the family. Sadly, I regularly get calls with the same or similar facts, always followed by painful and costly results. This article has a singular purpose: To make sure that not even one business owner/reader of this column, who wants to sell his business to one or more of his kids, falls into the same economic nightmare and tax trap as Sam and Mary. So, listen, up. Chances are you’ll be saying, "I'm Joe," more than once.

Joe's facts
Joe and Mary have three kids: Sam who started working at Success Co. after college and two adult non-business kids. The three core goals Joe and Mary told their advisors were: Sam should ultimately own 100% of Success Co.; treat the three kids equally; and pay as little as possible in taxes to the IRS.

Joe's lawyer and CPA completed his planning in early January 2005. As part of the plan, Success Co. (an S corporation) was sold to Sam for $12 million (its fair market value). Sam paid his dad in full with a $12 million note, to be paid in semi-annual installments over 10 years, plus 4.5% interest on the unpaid balance.

In January 2005 immediately before the sale of Success Co., Joe's significant assets were (in $ millions):

Now, stop reading for a moment and substitute your own numbers. Then follow the solutions later in the article. You'll strike tax gold.

The lawyer created a traditional estate plan with an A/B trust (often called a "family trust" and a marital deduction trust). Since Joe and Mary had a $2 million second-to-die policy (and $9.1 million in liquid assets, plus the future cash from the $12 million note and interest from the sale of Success Co.), the professionals figured there was plenty of liquidity to pay estate taxes. So the lawyer and CPA agreed that no additional planning was necessary. Note: Both Joe and Mary were healthy in 2005.

The horror story
Joe died suddenly (heart attack) in 2007. Let's take a look at the economic and tax impact of Joe's death on each of his family members. Sam's situation was a disaster from the day the Success Co. sale papers were signed.

First, the price… The $12 million value for Success Co. was fine (Joe got a well-done professional appraisal). But the $12 million price, as between father and son, is wrong. Why?

The IRS allows a 35% discount, for lack of marketability, for nonpublic businesses like Success Co. So, for tax purposes, the right price should have been $8 million (rounded), reducing Joe's taxable estate by $4 million. Also would make Sam's note payments much easier.

Secondly, the difficulty to pay price... For ease of explanation, let's say the price is $1 million. Ever wonder how much Sam must earn to pay that $1 million? Would you believe $1.7 million (the amount varies depending on the income tax rate of the buyer's home state. Sam lives in a high-tax rate state, more than 7%. The result is that Sam must pay $700,000 in taxes (federal and state) to have $1 million left to pay his dad.

Let's apply the $1 million example to Sam's situation. He will ultimately pay more than $8.4 million (12 X $700,000) in taxes to pay off the $12 million note. Simply put, Sam must earn in excess of $20 million, before tax, to pay off the note. Plus interest.

Outrageous! This destroys Sam's personal balance sheet. Sam has done great: both before and after his dad died as the owner/manager of Success Co. He increased sales and bottom line net profit. He could have increased sales more, but the bank (same bank as Joe had used for years) refused to increase Success Co.'s line of credit without Joe's usual guarantee. Why? Sam's obligation to pay off the $12 million note destroyed his personal balance sheet. As a result, Sam's guarantee, required by the bank, was worthless. Note: Of course, if Success Co. had redeemed Joe's stock, the result would be the same because the liability on Success Co.'s books would destroy its balance sheet.

Fortunately, the 100% marital deduction (everything to Mary, except $2 million to the family trust) spared Joe's estate from any tax due at his death. But the entire family, especially Mary, was in a state of shock when their lawyer told them the loss to estate taxes would be in the $10 million range (the exact potential estate tax liability could not be determined because the estate tax rate depends on the year of death) when Mary goes to the big business in the sky.

Here's the final blow. As explained above, Sam must earn $1.7 million, pay $700,000 income tax (state and federal) to have $1 million to pay down the note. Joe is socked with a capital gains tax (15%). Only $850,000 left. Estate tax on the $850,000 in Mary's estate (when she dies) will be about $300,000. Then, only $550,000 remains. The full lost-to-taxes picture: for each $1 million of the note, Sam must earn $1.7 million for the family to wind up with only $550,000. Unbelievable! For the entire $12 million, Sam’s earnings must be more than $20 million for the family to receive $6.6 million. Lousy tax planning.

You may be wondering about the two non-business kids, they were forgotten in the plan, until Mary died.

What they should have done
Lack of room prevents me from covering every point, issue and possibility. But the following are the most important strategies that would have allowed all of Joe's $27.5 million to go to his family, all taxes paid in full.

1. An intentionally defective trust (IDT). First, a recapitalization of Success Co.: 100 shares of voting stock, kept by Joe, and 10,000 shares of non0voting stock to be sold to the IDT. Now the discount is 40%, resulting in a price to Sam of only $7.2 million. The entire transaction is tax free to Joe: no capital gains tax, no income tax on interest received. What's the cost to Sam? Zero… not one penny. Profits (really cash flow) of Success Co. are used to pay the $7.2 million note.

2. Life insurance. Since Joe and Mary were insurable in 2005, we would have bought about $11 million (set up to be free of all taxes) in second-to-die life insurance. The 401(k) funds would be used to implement a strategy called "retirement plan rescue" to purchase $6 million of life insurance while the IDT would purchase $5 million. Note: My insurance consultant said the premiums would be about $10,500 per $1 million.

3. Family limited partnership (FLIP). The investment assets total $12.1 million, but only $11 million would be transferred to a FLIP. The IRS allows a 35% discount making the FLIP assets worth only $7.15 million for tax purposes.

4. Gifting program. Joe and Mary have 8 grandkids, and all together with the three kids, we have 11 noses. The maximum tax-free gift was $11,000 in 2005. So Joe and Mary together could make a $22,000 gift to each nose or a total of $242,000 per year.

What's most interesting is every strategy listed above is easy to do and, when done right, accepted by the IRS. Just how can you protect yourself, your business and your family from becoming a victim like Joe, Mary and Sam?

When your professionals are done with your estate plan (must include a succession plan if you own all or part of a closely held business), ask them to show you how the plan passes all of your wealth, intact, to your heirs. For example, if you are worth $5 million the entire $5 million will go to your heirs, all taxes, if any, paid in full. If $50 million, the entire $50 million. Just substitute your own numbers. What if 100% of your wealth is not passed intact? Get a second opinion!

Want to learn move about this fascinating subject? Browse my website, www.taxsecretsofthewealthy.com.

Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at: WWW.TAXSECRETSOFTHEWEALTHY.COM.