It happened again. But this time, a double header. Two separate calls — one from Nebraska, one from Virginia — concerning transferring family businesses to the kids.

Both callers got the same wrong advice from their professionals. Next to a wrong estate plan, a wrong family business succession plan creates the most tax pain and havoc (economic and otherwise) for the family.

Wrong transfer plans are expensive. Rarely can be fixed. Unnecessary. Only the IRS and lawyers profit. You lose.

This article pinpoints the problems, then gives you a step-by-step solution so your family never suffers the sad consequences of a wrong transfer plan.

The Facts

Joe — the caller from Virginia — is irrevocably in the highest income and estate tax bracket. He had his business (Success Co.) professionally valued... It is worth $14 million.

Joe's son (Sam), with help from Joe as needed, has been running Success Co. for years. Joe, after many meetings with his CPA and lawyer, decided to sell Success Co. to Sam for $14 million, payable over 10 years, plus interest at 4%. Success Co.'s cash flow can handle the payments to Joe.

When Joe's professionals explained the tax cost of a sale to Sam of the Success Co. stock, Joe was in a state of shock. He called me for a second opinion.

COMMENT: The above installment sale transfer plan is typical (and wrong) of what I see year after year from all parts of the country.

The Tax Cost of an Installment Sale Transfer

Here's how I explained the tax consequences (pain) to Joe: "If you sell Success Co. to Sam, each $1 million of the price will be socked with three taxes:

• Sam must earn $1.666 million. The 40% income tax (Federal and state) nails Sam for $666,000. Only $1 million is left.
• Sam pays you $1 million for your stock (assume zero tax basis). Your capital gains tax (20%) enriches the IRS by $200,000.... now only $800,000 is left.
• At your death, the IRS siphons off another 40%, or $320,000 for estate taxes... only $480,000 left. Crazy! Sam must earn $1.666 million for your family to receive $480,000."

NOTE: The amount of income tax due to your state of residence may be different than Joe's home state. State income tax rates vary from zero (like Florida and Nevada) to a high of 11% (Hawaii).

Wait, there can be more tax pain: 20 states (and the District of Columbia) have a state estate tax or inheritance tax. Indiana has the top rate: 20%. It is essential to check this possible robber-like state tax with your local professional.

Discounts are your friend

As you will see (later in the article), Sam will wind up with 10,000 shares of nonvoting stock, and Joe with 100 shares of (all the) voting stock.

Your valuation expert is entitled to take three distinct discounts for the nonvoting stock. Discount for:

• "Lack of marketability"... when selling publicly held stock, a phone call and the funds from the sale will be in hand in about three business days. A privately held company must first find a buyer and then agree to terms.
• "Minority interest"... Not being able to vote is the same as having a minority interest... or put another way, you do not have control.
• "Worth less than majority stock".... The courts have consistently held that a share of nonvoting stock is worth less than a share of voting stock.

Typically, the nonvoting stock discounts total about 40%, with agreement by the IRS. So, for tax purposes, the value of Success Co.'s 10,000 shares of nonvoting stock is only $8.4 million ($14 million, less a 40% discount of $5.6 million).

The Control Problem

But hold on, there's a stumbling block. Joe does not want to give up control. What to do?... Enter nonvoting stock, a two-step strategy.

• Step #1 — Joe exchanges all of his stock (common) for two types of common stock: voting common (say 100 shares) and nonvoting common (say 10,000 shares). This transaction, called a "recapitalization," is tax-free.
• Step #2 — Joe sells or gives the nonvoting stock (explained following) to Sam. Then, Joe owns less than 1 percent of all the stock (100 shares of voting stock), yet retains 100 percent of voting control.

The Magnificent Intentionally Defective Trust (IDT)

What is an IDT?... It is an irrevocable trust that is not recognized (intentionally defective) for income tax purposes.

Here's how it works in real-life practice: Joe sells all the nonvoting stock at its fair market value ($8.4 million after discounts) to the IDT. Sam is the beneficiary of the trust. The IDT pays Joe with an installment note for $8.4 million. The note bears interest. (Often we use the lowest amount allowed by the IRS, as published monthly... currently in the 2% range).

The cash flow of Success Co. is used to pay the note, plus interest. Success Co. (must be an S corporation) pays tax-free dividends to the IDT, which in turn pays Joe's note.

Now, what makes an IDT magnificent?... All the money Joe receives from the IDT is tax free: no capital gains tax on the note payments, no income tax on the interest.

What about Sam? He doesn't spend a dime, but when the note is paid in full, typically the trustee distributes the nonvoting stock to him (all tax-free). If Sam is married, the trustee is instructed to keep the stock in the IDT, to protect the shares in case Sam gets divorced.

Depending on the rate of tax for the state of residence of the business owner, an IDT saves about $190,000 per $1 million of the stock price (here with the stock price for Success Co. being $8.4 million, the tax savings will be about $1.6 million).

Typically, when Joe dies he will bequeath the voting stock to Sam (sometimes it's gifted or sold to Sam—for a nominal price—while Joe is alive).

This article does not attempt to detail—for lack of space—all of the benefits, tax traps or nuances of an IDT. In the hands of an experienced expert, IDTs are trouble free. Warning: Do not work with an advisor who does not know the ins and outs of these trusts.

Finally, if you have a succession plan problem please do it right. Keep my blood from boiling. Got a question: Call me, (Irv) at 847-674-5295 or email ([email protected]) me.