STORY TOOLS

• E-mail story
• Comments
• iPod friendly
• Printer friendly

More Business

• Women, Wisdom & Wealth: Past, present and future
• Tax secrets: Do you want to retire your business?
• Peak your profits: Wise potpourri

Share and Enjoy [?]

Do you have a buy-sell agreement? Thinking of signing one? Read every word of this article first.

Most buy-sell agreements come into being something like this: Meet with the lawyer, short discussion (probably a long discussion — very long — about how to price the stock), lawyer drafts agreement, parties (shareholders/partners) sign it, into the safe or drawer. A big mistake!

An even bigger mistake: The shareholders/partners can’t agree on the agreement terms (usually the we-could-not-agree-on-the-price stumbling block). An agreement never gets done. When one of the owners dies, the IRS and the lawyers typically get more than the deceased’s family. The surviving owner faces a nightmare of expensive uncertainty.

Okay then, if you have a buy-sell agreement, listen up. If you don’t have one, stop here and read the rest of what follows with your fellow business owners.

For simplicity, let’s assume the rest of this article is talking about a buy-sell agreement for a corporation (applies equally to an S corporation or a C corporation). The identical principles also apply to a partnership or limited liability company.

The easiest way to learn what to do and what not to do with your buy-sell agreement is via a real-life example. So, here goes: The story of Joe (a reader of this column) and his brother Sam. Each owns 50 percent of Success Co., an S corporation. Joe, age 51, has two sons; both finishing grad school; and, unfortunately will never go into the business. Sam, age 45, has three young kids (10 or under); too early to tell if any will go into the business.

From here on, as you read this, substitute your own numbers (value of your company and percentage you own).

Now, a bit more about Success Co.: It’s worth about $10 million. Continues to grow in value as profits increase — almost every year. The brothers built a little family business, which they bought from their dad, into a solid and growing moneymaker.

And, of course, they have a buy-sell agreement. Typical document. I have reviewed hundreds just like it. Price of stock rises as value of Success Co. rises. So does the insurance funding (now at $5 million each on Joe and Sam). Both are prohibited from selling or transferring (in any way) all or any part of their stock — except to each other.

Sounds good, huh? If you have a buy-sell agreement, bet you a nickel that it’s the same or similar to Joe and Sam’s. Still, it’s better than not having one.

Unfortunately, the sad truth is that a typical buy-sell agreement enriches the IRS more than your family (remember the estate tax returns to a high of 55 percent in 2011). So let’s follow the numbers if Joe (of course, would be the same for Sam) gets hit by a bus. Because of the buy-sell agreement, Joe’s estate must sell his stock to Success Co. for $5 million (the amount of the insurance proceeds). A trust set up for Mary (Joe’s wife) winds up with the $5 million. No estate tax due now (because of the marital deduction). So far, so good. But when Mary dies, the IRS will get 55 percent of the $5 million (probably more, because that $5 million — and other assets left to Mary — will throw off more income than Mary can spend. Too bad, but it is easy to see how the typical buy-sell agreement guarantees the IRS a great big payday.

Single? You get nailed for the estate tax when you die. Married? IRS’s payday deferred until your spouse dies?

What can you do to avoid this enriching-the-IRS-problem with a buy-sell agreement? There are many ways, but following are two ways that will save you thousands or millions (depending on the value of your business).

First, take advantage of the legal discounts available when valuing any business for tax purposes. The law, regulations and accepted practice (by the IRS) allows you two specific discounts: (1) discount for general lack of marketability (35 percent is the most common number) and (2) discount for minority interest (10 percent). Remember, since Joe and Sam each own only 50 percent (neither has control) of Success Co., they are automatically entitled to a minority discount.

Now, follow the valuation wonders allowed by the tax law: Success Co. is worth $10 million ($5 million each for Joe and Sam). Typically, the two discounts total 40 percent (or $2 million). So, using the discounts allowed by the tax law makes Joe’s interest in Success Co. worth only $3 million, the fair market value (after discounts) for tax purposes. The buy-sell agreement should be worded so that Joe (and Sam also) gets the higher of the fair market value or the amount of insurance on his life. Now, Mary will only get $3 million from the insurance-funded buy-sell agreement.

What about the other $2 million? Success Co. simply makes tax-free S corporation dividend distributions to Sam and Joe, which are used to buy another $ 2 million each in insurance coverage. Joe’s policy is owned by an irrevocable life insurance trust (ILIT), so Joe’s $2 million in insurance proceeds goes — tax-free — to his ILIT for Mary’s benefit. Sam’s policy is set up the same way. Result: An estate tax saving of $1.1 million ($2 million times 55 percent) for Joe (same for Sam).

Cool!

Second, reduce the amount of stock Joe and Sam own by gifting nonvoting stock (say 10,000 shares each) to their kids. Joe and Sam keep control of Success Co. by retaining the voting stock (say 100 shares each). An intentionally defective trust (IDT) is used to accomplish this tax trick. If Joe or Sam needs the funds represented by the value of stock to maintain their lifestyle, the stock is sold to the IDT, instead of via a gift. The sale to the IDT is tax-free to Joe and his kids, saving $816,000 in income and capital gains taxes per each $1 million in fair market value of the family business stock. Either way — gift or sale — the IDT makes the transfer tax-free. To the kids and to Joe and Sam.

An IDT is s sure-fire way to enrich your family, instead of the IRS. Really cool. If you intend to transfer all (or part of your family business to your kids (or other relative or employees), don’t take any steps toward implementing the transfer (by sale, gift or otherwise) until you find out how an IDT might work for you, your business and your family.

To help readers of this column who have a buy-sell agreement or business transfer problems or concerns, here is what we have arranged to do: (1) If you have a buy-sell agreement send it, along with a copy of your company’s last year-end financial statement (all pages). If you don’t, but need one, or if you are thinking of transferring your business, send the financial statement and a list of shareholders (or partners). Make sure to include all phone numbers (business, home and cell). Send to Irv Blackman, Buy-Sell/Transfer Review, Blackman Kallick Bartelstein LLP, 10 South Riverside Plaza, 9th Floor, Chicago, IL 60606.

---

Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at wealthy@blackmankallick.com or call 417-9732. His Web site is http://www.taxsecretsofthewealthy.com.