How to sell your business to an employee

Own all or part of a closely held business? Someday the succession plan buzzer will go off. You would like to see the value of your business — in dollars — in your personal bank account. Wouldn't it be nice if all of those dollars came to you tax free? No income tax, no capital gains tax.

Yes — it can be done, and legally too. With the IRS accepting the entire transaction. The strategy that makes the transfer tax-free is called an intentionally defective trust (IDT). This article zeros in on a transfer to a key employee. Why? In practice a key employee is the logical choice (when no close relative of the owner is in the picture), but there are two problems:

1.) The employee has no money.

2.) Very few professionals know how to implement an IDT.

Here’s an example: Joe, age 64, wants to sell his business, Success Co., to a key employee, Cy, who actually runs Success Co., but, as is usually the case, has no money to fund the purchase.

Joe goes to see his lawyer, Lenny. Joe tells Lenny, “Cy and I have agreed on a price for Success Co …. $5.7 million (to be paid over 10 years with 4% interest on the unpaid balance). My tax basis for Success Co.’s stock (an S corporation) is about $500,000. What’s the best way to structure the sale?”

Lenny advised Joe to use an installment sale. Reason, Joe will not pay tax on the $5.2 million capital gain or interest income until he actually gets paid by Cy.

Tax cost of installment sale          

Next, Lenny explained the tax consequences of an installment sale. The top rate for ordinary income is 39.6%, which includes the interest income Joe will receive. Capital gains (long-term) are at 20%. Simply put, Joe would be clobbered with Federal taxes, plus Kansas State income tax. Please note, even if Congress changes the tax rates, the concept (lousy tax results) will remain the same.

What about the tax cost for Cy

Lenny explained that Cy gets killed with two problems: tax and economic. Let’s lower the price of Success Co. to $1 million to ease following the numbers. If the income tax burden (State and Federal combined is 44%), Cy must earn $1.78 million, pay $780,000 in taxes to have the $1 million to pay Joe. And oh, yes, multiplied in this case by 5.7 (remember the price for Success Co. is $5.7 million). Also remember, the unpaid balance always bears taxable interest. That’s the tax problem. Ouch!

What’s the economic problem? Sam’s personal financial statement must now show a liability of $5.7 million, destroying his personal balance sheet… and making it almost impossible for Success Co. to borrow money for growth (banks want a personal guarantee from the owner).

Disappointed, Joe — an avid reader of this column — called me.

IDT to the rescue

An Intentionally Defective Trust (IDT) solves the problems for both seller and buyer. An IDT solves not only the problems outlined above, but also a significant human problem: how can Joe keep control of Success Co. until he is paid in full? The control solution is a simple two-step process.

Step 1: Do a recapitalization (just a fancy name for creating voting and non-voting stock)… say 100 shares of voting stock, which Joe keeps to maintain control and 10,000 shares of non-voting stock, which will be transferred to Cy via the IDT.

Step 2: Joe creates the IDT and sells all 10,000 shares of his non-voting stock to the trust for $5.7 million, which is paid in full with an interest-bearing note. The IDT now owns the non-voting stock and Joe has a $5.7 million note receivable (from the IDT). The future cash flow of Success Co. will be used to pay off the note, plus interest.

What is different about an IDT? It is the same as any other irrevocable trust, except the trust is not recognized for income tax purposes. The result: Under the Internal Revenue Code every penny you (the seller) receive is tax free: no capital gains tax on the note payments, and no income tax on the interest income.

Every $1 million of price for Success Co. saves about $195,000 in taxes. Here (with a $5.7 million price) the savings are about $1.112 million.

Cy is the beneficiary of the IDT. When Joe’s note is paid off, the trustee will distribute the non-voting stock to Cy. Then, Cy buys the 100 voting shares from Joe for a nominal price (say $1,000). Cy now owns 100% of Success Co.

As a transfer to your kids?

Yes, it works exactly as explained above. Just substitute your child's name for Cy in the above example. When one (or more) of your children is involved, an IDT offers two more important advantages:

 1.) The fair market value of the non-voting stock can be discounted by about 40%. For example, if Success Co. is worth $10 million, the non-voting stock can be valued for tax purposes at about $6 million.

2.) The trustee of the IDT is instructed to keep the non-voting stock, so if your child (who is the IDT beneficiary) gets divorced, his/her spouse will have no interest in the stock. Please note that the same IDT strategy can be used to buy out fellow stockholders.

One warning: If your professional advisor ignores the use of an IDT in your succession planning get a second opinion! If you have a unique succession problem that is not covered in this article contact me, Irv, by e-mail ([email protected]), or call me (847-674-5295).

Irv Blackman, CPA and lawyer, is a retired partner of Blackman Kallick 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.taxsecretsoftheewealthy.com.