Own a family business?…. Want to transfer it to your kids? Then you’ll love this article. It’s about an old IRS letter ruling that is one of my favorites. It might be labeled “the lazy man’s way to plan your business transfer.” The ruling shows you how to take advantage of some favorable tax law while avoiding pitfalls. Good stuff! 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 Letter Ruling 9116031.
But wait, the ruling has one redeeming quality. Really! First, the facts: Joe, his wife Mary and their children owned all the stock in a family business. Joe died in 1990 and Mary inherited all of his stock. (Note: Mary’s tax basis – for computing capital gains – is the fair market value (FMV) of the stock on the day Joe died. For example, if the FMV was $1 million and she sold it for $1 million, there would be no capital gains tax.) Mary immediately sold all of her stock back to the corporation.
Here’s the general rule: When you or any member of your 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 any position as an officer or director), the redemption is treated as a sale (gets favorable capital gains treatment, instead of being a dividend). Since Mary sold all (stock she owned before Joe died and stock she inherited from him) of her remaining interest in the corporation, the purchase by
the corporation of her shares was considered a bone fide sale (redemption) and not a dividend… a big tax victory.
When all the smoke cleared, not only had Mary escaped a big dividend income tax bill, but she has succeeded in effectively transferring the business to her children. How? Since the kids now owned all the remaining issued and outstanding stock, they owned 100 percent of the business. To sum up: Mary walked off with a near-tax-free capital gain, (the price paid to Mary for the stock was a bit more than the exact FMV of the stock inherited from Joe) while the kids walked off with the business. A fantastic tax result.
Here’s some more good stuff about succession planning. Over the years, we have used the above ruling dozens of times with real-life clients and have nicknamed the strategy “The little guy redemption technique.” Here’s why. We use it when the seller is (1) in a very low or zero income tax bracket; (2) the stock price is (by a sort of rule-of-thumb) $600,000 or lower and (3) the seller is not worth enough to have a potential estate tax problem.
For example, the last one we did was for $380,000 for Dad #1, who owned 5% of the stock. The corporation redeemed all the stock paying the full $380,000 with a note payable over 10 years with interest at 6% on the unpaid balance.
Simple! Effective. Really a nice little flow of spendable cash for Dad #1, whose total net worth was only $800,000.
Let’s change the facts, just a bit. Dad #2 (a real client from New York) is in the highest income tax bracket and estate tax bracket. Tax heaven would be to transfer his interest in the corporation (valued at $3 million) tax-free to his kids.
Dad #2’s succession plan must be centered around a strategy called an intentionally defective trust (IDT). An IDT is a tax-saving machine. It’s tax-free to DAD #2. Best of all the “buyer” of the stock (Dad’s kids) do not pay a single penny for the stock. Instead, the kids get
the stock – tax-free – as a beneficiary of the IDT.
The lesson to be learned. Never, but never sell your stock to your kids, unless you are a little guy (as spelled out above). If transferring the stock of your family business to one or more of your children will be a tax burden to (a) you or (b) the children or (c) (in most cases) both, it is a must to find out just how much the family will save in taxes using an IDT. The rule of thumb: The savings are over $600,000 for every $1 million of the stock’s price. In real life, Dad #2 and his kids saved $1,920,000 in taxes (on a stock price of $3 million).
Any questions concerning your own succession planning, browse my website: www.taxsecretsofthewealthy.com. Or in a hurry, call Irv (847-674-5295).

Many of the columns I write and the seminars I give deal with family business succession planning. Can you guess the most common succession situation and related problems?… Getting the business from Dad and/or Mom to one or more of their kids. Yes, that’s where the action is. And it’s easy – because there is only one decision maker, typically Dad – compared to the subject matter of this article, where there is more than one decision maker.
What’s the subject of this article?…. Business succession involving two or more brothers owning pieces of the same family business. Or it could include sisters. Nephews. Or other relatives. Or one (ore more) nonrelated business owners. All or any combination are included in the following.
It’s sad but true: Brothers disagree. Particularly in business. (We use brothers in the example because that is the most common situation. But if you, the reader, have a different relationship with your business co-owner (for example uncle, cousin or just a nasty person) then substitute it for “brother.” The transfer problems and the solutions are identical).
More often than not, brothers do well running the business together. Yet, try to talk to them about any kind of succession planning… total disagreement.
Most of the time price (of their interest in the business) is the stumbling block. The older brother (or the one who wants out for whatever reason) wants a “too high” price. Deadlock! Year after year. So, nothing happens.. That is until someone gets hit by the final bus. Then it’s too late. The lawyers and , all too often, the courts take over.

Result: Lengthy wrangling. Expensive costs, very expensive fees. Nobody wins.
Following is a solution that works about nine out of ten times. Except for the names everything you are about to read actually happened. Here’s the story: Three brothers – Ed, Ted and Fred – each owned one-third of Success Co. Their Dad left the business to the three boys when he died 31 years ago. Ed and Ted have worked in the business all their adult lives. Fred never worked even a day at Success Co.
Ed (from Wisconsin but winters in Florida) has a son and daughter who work in the business; Ted has one son in the business. Ed and Ted want their kids to continue the business The three young business kids thrive in the business and ultimately want to take over.
Success Co. is an S corporation. (If it had been a C corporation, we would have elected S status). We then recapitalized Success Co. (a tax-free tactic), issuing 300 shares of voting stock and 9,000 shares of nonvoting stock. Each of the three brothers now owned 100 shares of voting stock and 3,000 shares of nonvoting stock.
Ed sold his 3,000 shares of nonvoting stock to an intentionally defective trust (IDT). An IDT is defective in the sense that it is not recognized for income tax purposes (making the sale tax-free), but it is recognized for estate tax purposes. That’s it, a three-step succession plan: (1) be or become an S corporation, (2) recapitalization and (3) sale to IDT. As the beneficiaries of the IDT, Ed’s two kids wind up owning the nonvoting stock, while Ed keeps control via the voting stock.
Of course, Ted – simultaneously with Ed – used the same succession plan to transfer his nonvoting stock to his business son. About seven months later, Fred followed his brothers with an identical plan to get his nonvoting shares to his two kids (not in the business). Fred liked the tax-free sale and getting the value of the nonvoting shares out of his estate.

Note: An IDT saves the family about $700,000 in taxes for each $1 million of fair market value of the business stock being transferred. It’s one of the best tax strategies I have ever used for a client who wants to transfer his business to the kids, yet keep control.
An insurance-funded buy/sell agreement was entered into by the kids, which should avoid any future controversy and is designed to keep the stock in the family (should one of the kids get divorced).
The plan worked. Great! But why doesn’t it work all the time if it’s so wonderful? The noncooperating shareholder can (and sometimes does) hold up the plan in two ways: (1) refuses to sign an S election when the corporation is a C corporation (no signature, no S election), and (2) votes against the recapitalization (and you need the vote).
Even if the “bad-guy” brother tries to wreck the plan as described above, there are other ways – short of legal action – to get your personal succession job done without the signature or vote of all shareholders. We’ll explore these ways in a future article.
Do you have a brother-type succession problem at your business? If so, you are invited to join the reader test…. To solve your problems. We will write up the results of the test and report back to you in this column.
To participate, please send the following information by courier (send copies, do not send original documents) for each owner who is cooperating:
1. Personal. A financial statement for you and your spouse.
2. A family tree. Your name and birthday. Same for your spouse, kids and grandchildren (indicate which kids are in the business).
3. For the business. Your last year-end (a) financial statement and (b) a list of stockholders.
Send to Irv Blackman, Succession Test, 4545 W. Touhy Ave., #602, Lincolnwood, IL 60712. (If you have a question – concerning your own business succession problem – call Irv: 847-674-5295).