CHICAGO — By any definition, Joe was a “success,” and so was his business, Success Co. Although Joe was a planner, after he died, his estate plan and business succession plan turned into an economic and tax tragedy—for son Sam, wife Mary and the rest of the family.
Sadly, I regularly get calls with the same or similar facts, always followed by painful and costly results. This article has a singular purpose: To make sure that not even one business owner/reader who wants to sell his business to one (or more) of his kids falls into the same economic nightmare and tax trap as Sam and Mary.
Joe and Mary have three children: Sam, who started working at Success Co. after college, and two others not involved in the business. The three core goals that Joe and Mary shared with their advisers were: (1) Sam should ultimately own 100% of Success Co.; (2) treat the three kids equally; and (3) pay as little in IRS taxes as possible.
Joe’s lawyer and CPA completed his planning in early January 2005. As part of the plan, Success Co. (an S corporation) was sold to Sam for $12 million (its fair market value). Sam paid his dad in full with a $12 million note, to be paid in semiannual installments over 10 years, plus 4.5% interest on the unpaid balance.
In January 2005, immediately before the sale of Success Co., Joe’s significant assets were (in $ millions):
Real estate leased to Success Co..…….1.4
The lawyer created a traditional estate plan with an A/B trust (often called a “family trust” and a “marital deduction trust”). Since Joe and Mary had a $2 million second-to-die policy (and $9.1 million in liquid assets, plus the future cash from the $12 million note and interest from the sale of Success Co.), the professionals figured there was plenty of liquidity to pay estate taxes. They agreed that no additional planning was necessary.
Joe died suddenly from a heart attack in 2007. So, what was the economic and tax impact on each of his family members?
Sam’s situation was a disaster from the day the sale papers were signed.
A. The price. The $12 million value for Success Co. was fine (Joe got a well-done professional appraisal). But the $12 million price, as between father and son, is wrong. Why?
The IRS allows a 35% discount—for lack of marketability—for nonpublic businesses. The right price should have been $8 million (rounded), reducing Joe’s taxable estate by $4 million. It also would have made Sam’s note payments much easier.
B. Difficulty to pay price. Let’s say the price is $1 million. Ever wonder how much Sam must earn to pay that? Would you believe $1.7 million? (The amount varies depending on the income tax rate of the buyer’s home state. In Sam’s case, it was over 7%.)
Result: Sam must pay $700,000 in federal and state taxes to have $1 million left to pay his dad.
Let’s apply the $1 million example to Sam’s situation. He will ultimately pay more than $8.4 million (12 X $700,000) in taxes to pay off the $12 million note. Simply put, Sam must earn in excess of $20 million, before tax, to pay off the note. Plus interest. Outrageous!
C. Destruction of personal balance sheet. Sam has done great, both before and after his dad died, as the owner/manager of Success Co. He increased sales and bottom-line net profit. He could have increased sales more, but the bank (the same one Joe had used for years) refused to increase Success Co.’s line of credit without Joe’s usual guarantee. Why? Sam’s obligation to pay off the $12 million note destroyed his personal balance sheet. As a result, Sam’s guarantee (required by the bank) was worthless.
Tomorrow: Mary and the other two children…