Think taxes, economics and human emotions.
Almost all readers of this column who contact me with tax problems are owners of a family business. Each has a unique story, and most would make a fascinating TV drama.
Typically, their problems fall into one of three categories: taxes, economics or human emotions. The following case studies illustrate all of the above.
Case 1: Joe wants to give his kids, Sam and Sue, who work at Success Co., a stock bonus. Sue is single; Sam is married.
Problem: Stock could be marital property.
Solution: The stock bonus is okay for Sue, but not for Sam. Here's why: Sam is married and the stock would be marital property, half of which, in case of divorce, would belong to Sam's wife. Ouch! Divorce is the most common "human" problem that plagues family businesses.
Property received prior to marriage is non-marital property (good); property acquired after marriage, received as compensation or paid for with funds that were earned after marriage is marital property (bad, if there's a divorce); and property received after marriage by gift or inheritance is non-marital property (good).
Case 2: Jack wants to sell his company to his son Sid.
Problem: The insane tax burden Jack and Sid will suffer. If the price is $1 million, Sid must earn about $1.6 million and suffer about $600,000 in income tax. And Jack will be hit with about a $150,000 capital gains tax. Only $850,000 left!
Solution: Transfer the stock from Jack to Sid using an "intentionally defective trust." The transaction is tax-free to both Sid and Jack; when Sid receives the stock it is considered a gift under the law, avoiding the marital property trap in Case 1, and Success Co. is out of Jack's estate.
Case 3: About 90% of Jim's wealth is tied up in Success Co., which he transferred to his son Sean (who runs the business) using an IDT.
Problem: What if Jim and his wife live to age 85 or 95? Will they be able to maintain their lifestyle?
Solution: Have Success Co. create a death benefit agreement or wage continuation plan that kicks in after Jim is paid in full by the intentionally defective trust and is no longer receiving a salary from Success Co. When Jim dies, his wages stop and his wife then gets the wages for her life.
Case 4: Of Jake's four kids; only two work for Success Co.
Problem: How is he fair to the non-business kids?
Solution: The easy solution, when there are enough assets, is to give non-business kids non-business assets or simply acquire enough life insurance to accomplish equality. It's important to note that once there is more than one shareholder for Success Co., you must have what we call a "unit buy/sell agreement." So, if you hate your son-in-law, this type of agreement assures he will never own a piece of the family business.
Case 5: Jerry and his three business kids all receive compensation from Success Co.
Problem: Their fringe benefits must be the same as all other employees or the IRS "discrimination" monster will raise its ugly head.
Solution: Form a new management company, freeing Jerry and the business kids from the discrimination rules. Then they can have their our own pension plan, health care plan, long-term care, etc.
Case 6: Success Co. earns over $1 million a year.
Problem: Owner Jeff can't think of any way to get more deductions to reduce taxable income.
Solution: Form a "captive insurance company," an insurance company that insures risks that normal property and casualty insurance will not cover, such as loss of a key vendor, customer or employee; strikes; warranty of goods or services; war or change in regulations. If Success Co. pays a $500,000 premium to the captive company, Success Co. deducts the entire premium amount and the captive receives the money tax-free and invests it.
Finally, a caution that applies to each of these case studies: All of the opportunities, rules, exceptions and an occasional trap have not been covered in detail. So, only work with an experienced professional.