Keep the Family Business in the Family

Columns From: Modern Machine Shop,

Posted on: 2/18/2013

Consider this strategy to protect your successor’s money in the event of divorce.

Editor's Commentary

From the monthly column: Blackman on Taxes

Putting together a business succession plan always has been and probably always will be the single biggest problem for the successful business owner. When issues of succession and divorce come together without proper pre-planning, it’s even more complicated. Especially if you want to keep your family business “in the family.”

Consider the hypothetical example of Success Co.

One year into Sam and Gretchen’s marriage, Sam’s father, Joe, sold him the family business for $2.8 million. Over the years, Sam managed Success Co. to increased sales and profitability. After 12 years, Sam and Gretchen decided to end their marriage. The divorce court judge ruled that Sam’s interest in Success Co. was worth $6 million and Gretchen was entitled to half.

With a proper succession plan in place, Joe could have kept the business truly in the family. It is estimated that as many as 50 to 60 percent of all marriages in the United States end in divorce, and it is not wise to ignore these numbers when giving gifts to your children or grandchildren, or transferring your business. You want to work toward a succession solution that, done right, always works out the way you want it to, whether the child you hand your business over to stays happily married or gets tangled up in a messy divorce.

Before the Solution, Consider the Goals

As a successful business owner transferring his company to one or more children, Joe has at least three goals:
1. Get Success Co. out of his estate by transferring it to his kid(s) in a tax-effective manner.
2. Keep control of Success Co. for as long as he lives.
3. Make sure that all Success Co. stock stays in the family for as long as a family member manages the company, both during Joe’s life and after he is gone.

If he can accomplish the above three goals, Joe will have executed the perfect succession plan. This clearly requires lifetime planning, not just estate planning, which is really death planning. Remember, you have little or no control over what happens in your adult children’s personal lives; however, you can have control over what happens to your business. The question is, how long can you control it and still accomplish the other two goals listed above?

The Solution

The solution is to use a strategy called an intentionally defective trust (IDT). An IDT is like any other irrevocable trust, but it is “intentionally defective” for income tax purposes. Let’s walk through the four-step process of creating an IDT for Joe/Sam/Success Co.

Step 1. Joe, who owns 100 percent of Success Co., recapitalizes the company. He creates two types of stock: a) 100 shares of voting stock that Joe keeps and that enables him to retain total control of Success Co. (an S corporation), and b) 10,000 shares of nonvoting stock, which now represents nearly 100 percent of the value of the company.

Step 2. Joe creates the IDT then sells the non-voting shares of Success Co. to the trust at fair market value. Tax law allows various discounts totaling 40 percent for the nonvoting stock, or $400,000 per $1 million. So if Success Co. is valued at $10 million, the discount would be $4 million and Joe could sell all the non-voting stock to the IDT for only $6 million.

Step 3. The IDT has no funds at this time but pays Joe with a $6 million note at a low interest rate, as allowed by the IRS (currently in the 1-percent range). To do this, the trust uses S-corporation dividends paid to it by Success Co. Joe receives the entire $6 million plus interest tax-free; he pays no capital gains on the principal note payments and no income tax on the interest income because the IDT is disregarded for all income tax purposes. At current tax rates, the tax savings are about $200,000 per $1 million, or $1.2 million on the $6 million sale price.

As Joe’s successor, Sam pays nothing on the note because the IDT, not Sam, owns it. Sam is the beneficiary of the IDT, however.

Step 4. Once the note is paid off, the non-voting stock usually is distributed to the trust’s beneficiary—in this case, Sam. But to provide divorce protection for Sam, a trustee is directed to keep the stock in trust for as long as the trustee deems it to be in Sam’s best interest. Should Sam get divorced, the stock can continue to belong to the trust, not Sam, and the stock’s value will not play into the divorce settlement.

An IDT is an extremely flexible strategy and can be used to buy out fellow stockholders, to sell your business to a key employee or employees, and for almost any business succession problem you can think of. As stated above, tax savings at current rates should be about $200,000 per $1 million of the sale price.

There are many nuances to IDTs and potential tax traps, but a professional advisor experienced in this area of the tax law should be able to help you maneuver through the process. 



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