Want to transfer your business to your kids? A good place to start is an old IRS letter ruling that is one of my favorites. Years ago, I labeled it, "The lazy man's way to plan your business transfer." The ruling shows you how to take advantage of favorable tax laws while avoiding dangerous pitfalls. Good stuff!
But at the outset, you should know that there is a bit of a problem to using the technique—you see, you must drop dead before your family can enjoy the benefits of this helpful bit of tax law: Letter Ruling 9116031.
But hold on, the ruling has some redeeming qualities. First, the facts: Joe and his wife, Mary, together with their children owned all the stock in a family business, Success Co. Joe died in 1990 and Mary inherited all of his stock. Mary immediately sold all of her stock back to Success Co.
Here's the general rule you must burn into your mind: when you or any member of your immediate family sells stock back to your corporation (called a "redemption"), the redemption is usually taxed as a dividend… a tax disaster.
But there is a special tax-saving exception for a family member who has owned the stock for 10 years (or more): If he/she divests all interest in the company (including complete resignation of any position as an officer or director), the redemption is treated as a sale. Since Mary sold all of her remaining interest in the corporation, the purchase by the corporation of her shares was considered a bona fide sale (redemption) and not a dividend… a big tax victory. And a fantastic tax result… low capital gains tax, instead of high-taxed ordinary income. When all the smoke cleared, not only had Mary escaped a big income tax bill, but she had succeeded in effectively transferring the business to her children. How? Since the kids owned all the remaining issued and outstanding stock, they now owned 100 % of the business. To sum up: Mary walked off with a near-tax-free capital gain, while the kids walked off with the business without spending a dime. Sometimes even tax-life can be good.
To this day, we still use this old-time transfer strategy when the capital gains tax will be about $25,000 or lower. What should be done if the tax is higher? Well, there is more than one way to skin the transfer cat. So, when the transfer to the kids might kick up a large capital gains tax (for a large and valuable family business the tax often runs $1 million or more), you should look into an intentionally defective trust (IDT), which did not even exist back in 1990. An IDT can transfer your business—tax-free—for the entire family: mom and dad and the successor kids. And a few extra bonuses. You can do an IDT while you're alive, keep control for life and totally escape the tax collector. Yes, tax life can be good.