How to solve your family succession-planning problem

Succession planning does not have a one-size-fits-all solution. As a result, zero in on the facts described below that best fits your circumstances.

Do you own or run a family business? A business you want to continue after your leadership ends? Then this article is must reading. Let’s start with an example: Joe owns 100 percent of Success Co.  He has three basic choices, when it comes to determining who will finally own Success Co.:

  • One or more family members.
  • One or more key employees.
  • Some third party (or company) to whom Success Co.   will be sold.

Yes, it’s a fact; succession planning does not have a one-size-fits-all solution.  As a result, zero in on the facts described below that best fits your circumstances.
The following four family situations come up often in practice:

  • Joe either has no children or none of his children could run Success Co.  Of course, (one or more) of these kids could own all or part of Success Co., if a professional manager ran the company (actually done, but rarely).  
  • One child, Sam, (Joe’s only child) works for Success.  Co., and Joe is confident that Sam could run the company.
  • Two or more children and all are in the business.  Most of the time Joe wants each of them to own an equal number of shares (i.e.  50/50 if two children in the business)

This last example, however, creates a special problem.  When more than one child is in the business, there must be a clear leader (with voting control) to make the final business decisions.  Here’s how we solve this problem: We create voting stock (say 100 shares) and nonvoting stock (say 10,000 shares).  This is a tax-free transaction.  Joe keeps the voting stock and control of Success Co.  The nonvoting stock goes to the business kids.  When Joe goes to the Big Business in the Sky, 51 shares of the voting stock (and control) goes to Sam (the clear leader).  Sam’s nonvoting shares would be reduced by the exact number of extra voting shares he receives.

There is one (or more) child in the business and one (or more) nonbusiness child.

This common situation is also a problem.  Typically, Joe wants the stock of Success Co.  to go only to the business children.  The nonbusiness children get other assets owned by Joe.

Of course, we have the same problem as in treating all of the kids equally.  Often, there are not enough other assets (small value compared to value of Success Co.) to accomplish the “treat-‘em-equal goal.” Second-to-die life insurance is usually the choice to get to the equalization goal for the nonbusiness kid(s).

The tax problems

The tax cost of the wrong succession plan is a never-ending-expensive nightmare.  Let’s run the numbers by example: Joe sells Success Co.  for $1 million to Sam.  Assume the tax rates are 40 percent for income tax (35 percent federal and 5 percent state) and 40 percent for estate tax.

Suppose Joe’s tax basis for Success Co.  is zero.  OK, let’s follow the numbers (all numbers are rounded).  Sam must earn $1.67 million, pay $0.67 million in income tax, leaving $1 million, which Sam pays to Joe.  Joe must pay a capital gains tax of $200,000.  Only $800,000 left.

Crazy! Sam must earn $1.67 million and after taxes, Joe only has $800,000 left.  Outrageous! And when Joe passes another 40 percent, ($320,000) goes to the estate tax monster.

Stop.  Apply the numbers in the example to your company.  Yes, it’s expensive to do succession planning wrong.

Succession planning done right

It’s actually a two-step process.  Let’s say the value of your business is $7 million.  To keep it simple, let’s use $1 million.

1.  Recapitalize Success Co.: You have 100 shares of voting stock (which you keep for control) and 10,000 shares of nonvoting stock.  The nonvoting stock gets discounts (total of 40 percent), which makes the value of Success Co.  (for tax purposes) only $600,000.

2.  Sell your nonvoting stock to an intentionally defective trust (IDT) for $600,000.  The trust pays you in full with a $600,000 interest-bearing note.  What is an IDT? The same as any other irrevocable trust, except the trust is not recognized for income tax purposes.  The result is that every penny you receive until the note is paid, is tax-free: No capital gains tax and no income tax on the interest income.  The cash flow of Success Co.  is used to pay off the note, plus interest.

Sam is the beneficiary of the IDT.  When the note is paid off the trustee distributes the nonvoting shares to Sam.  Joe still owns the voting stock and controls Success Co.  for life.

And finally ...

Can the IDT strategy be used to transfer Success Co.  to one or more employees? Of course.  But typically the price is the full value (before discounts) of the nonvoting stock.  (Joe keeps the voting stock until he is paid in full.)

Can an IDT be used to buy out fellow stockholders? Yes.

Every possible use of an IDT in succession planning is not covered in this article.  Nor is every nuance, tax trap or exception covered.

You (and your advisor) are welcome to call me if you have any questions, (847) 674-5295).  Or email me:

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