Mr. Courage Leads the Way

The story you are about to read has all the ingredients to make you cheer, applaud and cry. Yes, it’s an estate planning story. But more than that, it’s an inspiring story of one man’s courage.
Webster’s dictionary defines courage as the “ability to conquer fear or despair.” The hero – let’s call him Mr. Courage – of this story is a real-life perfect example of that definition.

Mr. Courage, a long-time reader of this column, called and asked me to do his estate plan… quickly. “Why quickly?” I asked. He replied, “Because I have cancer.” The doctor would not (or maybe could not) give an exact time frame as to how long Mr. Courage might live, but thought getting his affairs in order was a good idea. Never once during our initial phone call – or those that followed – did Mr. Courage even give a hint that he was or would become downtrodden. In a word, he was upbeat. Mr. Courage explained his attitude this way, “How lucky I am to know that the end may be near, yet have time to put my house in order.” Wow!

The very next day a package arrived via courier (sent by Mr. Courage’s wife Mary) with the information I had requested concerning Mr. Courage, Mary, their business and their family. Included in the package was a surprise document (SD) that blew my socks off. More about that SD later.

First, the basic facts for the estate planning story. Mr. Courage is 56-years old. Mary is six months older and is active in the business, Potential Co. They have four kids, but only one, Sam (age 26), is active in the business. There is one key employee, Sid who is considered like family.

Potential Co. (an S corporation owned 100% by Mr. Courage) made $180,000 for the last full fiscal year, yet had a negative equity of $232,000. “Small potatoes,” you’ll say.
But Mr. Courage, Sam and Sid had a plan, in writing (but not yet a signed legal document) for Mr. Courage to sell Potential Co. to Sam and Sid for $2 million. Each of the boys would sign a note for $1 million.
Note: As you will see later, the $2 million price (which seems high) is actually a bargain.

Do you (the reader of this column) intend to sell your business to your kid(s) or employee(s)? If so, read what follows carefully. You are about to become a happy seller. This story of Mr. Courage is just an extreme example of typical succession planning (transferring a business), when the business owner wants to sell the business to either his kids or employees. Almost always, the kids or the employees don’t have any money. So, like it or not, the business owner must get paid in installments over a number of years.

The buyer [kid(s)/employee(s)] pays the seller with a note. Two problems are immediately created. First, the buyer’s – already slim net worth – balance sheet is totally destroyed for years to come. Also, the buyer must use the cash flow of the business that was purchased to pay the seller’s note. This sad fact makes it difficult – sometimes impossible – to get a bank loan (needed to fund the future growth of the business).
Second, the tax consequences of the transaction are a disaster for the buyer. Here’s why. Suppose the price for the business is $1 million and the tax rate (State and Federal combined) is 40%. The sad fact is that he buyer must earn $1.667 million dollars and pay $667,000 in taxes to have $1 million left (to pay to the seller).

Here are the horrible consequences: Sam and Sid must earn $3.333 million, pay $1.333 million in income tax in order to pay off their $2 million notes. (Apply those astronomical tax numbers to any business sale/or purchase you are contemplating). It’s nuts. What did we do?… Instead of an installment sale, we used an (intentionally defective trust) (IDT). This IDT strategy allows Sam and Sid to use the future cash flow of Potential Co. to purchase the business. An IDT is tax-free to the buyer. Also, the seller pays no capital gains tax on the gain realized from the transfer of the stock to the buyer. An IDT puts more dollars in the seller’s pocket, after taxes… while the buyer pays no taxes.

In addition, the personal balance sheets of Sam and Sid will not show a liability for the purchase price of Potential Co. Banks usually finance a profitable business, but almost always require the guarantee of the business owner (the stronger his/her balance sheet, the better). Now let’s talk about that surprise document (SD). But first a reminder – that regular readers of this column know – concerning lifetime planning: For years I have preached that an estate plan is incomplete unless it includes a comprehensive lifetime plan: the unknown period of time from the day you begin to think about an estate plan until the day you get hit by the final bus.

What is, Mr. Courage’s SD?… A Strategic Plan for Potential Co. that was created with the help of Sam and Sid. This Strategic Plan is awesome. Thorough. Detailed (but only 18 pages long). It covers the short-term and the long-term. It has, is and should continue to have a positive impact on many lives for two or more generations. The plan is accompanied by a budget (really a detailed spread sheet setting revenue and profit goals for each month for two years). Hallelujah! Potential Co. is hitting those budget numbers. If the numbers hold – and every indication is that they will – profit (before taxes) for the first full year will be in the $500,000 range.

Wait, there’s more. Toward the end of the SD is a brilliant analysis of the market place Potential Co. serves. Great demographics. Potential gross income for 100% of the market. That they can capture 25% of the market… and how they will do it. If they do it, Sam and Sid, will become mega-millionaires.
I’m bett’n the boys will make it.

You’ll notice that this article does not include any details about the estate plan we created for Mr. Courage and Mary. I did it on purpose. Why?… Want you to focus on two things if you own a business that will ultimately be owned by your kid(s) or employee(s) (or both). First. Do not (and I mean never) sell your business to your kids. Use an intentionally defective trust. You and the kids will save a ton of taxes.
Second. Yes, your estate plan should do the traditional stuff: will(s), trust(s), appropriate insurance, etc. Put it in the safe and forget about it. The most important plan (no matter what your age) is your lifetime plan. The purpose of the lifetime plan is to maximize your wealth (while you control your wealth – particularly your business – for as long as you live). Your lifetime plan should solve, for example, such problems as: maintaining your lifestyle (and your spouse’s) for as long as you live; educate your kids or grandkids; create a buy/sell agreement for the kids to make sure the business stays in the family (in case of divorce); maximize the profitability of the business and minimize income tax.

Of course, your lifetime plan and estate plan must dovetail. This means that all of your wealth – no matter how large it might grow – should go to your family (kids and grandkids in most cases). Simply put, if you’re worth $7 million when you die, every dollar of that $7 million to your family (all taxes, if any, paid in full)… if $70 million, then $70 million. Go ahead, fill in your own “guestimated number.”

Finally, say a prayer for Mr. Courage.

In your second marriage…or about to marry…or have significant other.

After business hours the American male business owner likes company… female company. My experience – as a tax planner – with guys who have lost their former brides (via death or divorce) could fill a book. A big book. From a tax-planning viewpoint, once the first (could be second, third, etc.) marriage ends, the ex-husband falls into one of three distinct categories. Each category requires different economic and tax strategies. Let’s take ‘em one at a time.

Already married the second (third, etc.) time around

This is by far the biggest group… with the biggest estate tax problems, economic problems and a host of other potential problems. Following is a partial list of the most common facts and circumstances that cause the problems (later we’ll discuss how to solve these never-ending problems). Joe’s new bride is Mary.

1. Age difference: two 60-year-olds (or any other close ages) is a different tax ballgame as compared to when Joe is 15 (or more) years older than Mary.
2. Health issues (When serious, tax planning must be hurried).
3. Kids: The possibilities are endless… only Joe has kids (from prior marriage); only Mary has kids; both have own kids; it’s a triple-header… his/hers and our kids; the kids get along with each other or don’t; kids love or hate the step-parent; kids marry and some or all of the family hates the son-in-law or daughter-in-law; Joe adopts Mary’s kids or does not; and we could go on and on.
4. There is no premarital agreement… or there is one (that leaves Mary little or nothing). It’s nice when the marriage lasts for the long-term, has been great and both Joe and Mary want to ignore all (or part) of the premarital documents.
5. One or more of the kids (could be his/hers or ours) is in the business and one or more of the kids are not. There are two major issues: (a) When there is more than one kid who will ultimately own the business, how do you treat the business kids equally (or some other ratio that you want), yet give control to the clear leader (assuming there is a clear leader) when dad retires or dies? (b) How do you treat the business kid(s) and non-business kid(s) fairly?
6. And finally, the major problem facing the typical Joe and Mary: Joe wants to provide for Mary (really maintain her lifestyle) if he gets hit by the proverbial bus first… but he wants to leave as much as possible to his own kids.

NOTE: The above does not pretend to cover every problem between him and her in any second marriage, but it covers the six problems seen most often in a real-life estate planning practice.

Let’s solve the toughest problem (6. above) first. A QTIP (qualified terminable interest property) is the perfect solution. In a nutshell, here’s the two-step strategy:

• Step #1: Joe transfers his business – tax-free – to the business kids using an intentional defective trust (IDT). The IDT gets Joe’s business out of his estate while Joe is alive, yet Joe keeps control of the business until he draws his last breath.
• Step #2: All of Joe’s other assets – typically the resident(s), the IRA(s) [all other qualified plans – such as a 401(k) or profit-sharing plan – have been rolled into an IRA during Joe’s life] and investment type assets (such as real estate, stocks, bonds and other investments) go into the Q-TIP at Joe’s death. Mary has a life estate: living in the residence to the day she dies and enjoying the income from the other assets for as long as she lives. No estate tax is due at Joe’s death. What happens when Mary dies? The Q-TIP show is over. All of the assets go to Joe’s children (and/or grandchildren). Estate tax is now due based on the value of the assets that pass to the children (or grandchildren). Second-to-die life insurance usually is
  purchased on Joe and Mary to cover the estate tax due when Mary dies. The premiums on second-to-die life insurance are significantly less than buying insurance on only Joe’s life. Also, the death benefit comes immediately after the second of Joe and Mary dies… when that ornery estate tax is due. The documents – the will and trusts – that contain the rest of the estate plan for Joe and Mary have the appropriate clauses and language to deal with each and every of the problems and issues listed above. Over the years, with the exception of curing health issues and settling family quarrels, the provisions in the various estate planning documents (usually a trust) solve the items listed above.
  Once we finish the planning for clients in this second marriage category, the clients are amazed. We continually hear comments like “Wow!”… “Ingenious!”… “Didn’t think you could do it.” Should the truth be known it’s not a matter of smarts. But experience is really our secret. We’ve done it before… hundreds of times.

NOTE: If you have a health issue, start your estate planning NOW. Time becomes critical. As a result, we service health-issue clients first and fast.

NOTE: How do we keep the kids equal, yet give control to the clear leader when transferring Joe’s business?… We create voting (say 100 shares) and non-voting stock (say 10,000 shares). The clear leader gets enough extra voting shares to have voting control and is shorted an equal number of non-voting shares.

Ready to tie the knot…again

Do it. But before you say “I do,” the about-to-be bride and groom must… MUST sign a prenuptial agreement. Failure to do so makes a lot of unhappy campers… particularly the spouse with the most wealth.

If the marriage becomes a winner, it’s easy to blow off the prenuptial and play the estate planning game as described above in Category #1.

You have a significant other

When I ask, “Will you marry down-the-road?”… the answers vary from “No,” to “Maybe,” to “Someday.” Or some variation.
Whatever the answer when the relationship is solid and for the long-term, then Joe is committed to taking care of Mary (maintaining her lifestyle if she outlives Joe). What’s the estate tax problem? Because Joe and Mary are not married, there is no marital deduction… No Q-TIP. If Joe dies before Mary, the estate tax is due NOW. With a Q-TIP (we learned in Category #1), the monster estate tax is not due until both Joe and Mary have gone to heaven.

So what is the plan? We create a Q-TIP-type trust. We fund the trust with the assets needed to maintain Mary’s lifestyle: typically the residence and income producing assets. Mary has a life estate only, living in the residence and receiving the income from the assets. At her death the assets go to Joe’s kids and grand kids. The only fly in the ointment is that the estate tax is due at Joe’s death. When Joe is insurable, insurance on his life is the simple answer . Of course, the policy death benefit (D/B) must be set up (usually an irrevocable life insurance trust) so none of the D/B is subject to estate tax.
One final comment: The many problems (and the even more solid tax-winning solutions to those problems) of this article’s subject matter cannot be covered in just one article. So be warned: Start your planning – call and make an appointment today – with an experienced professional. Done right, everyone – except the IRS – wins. Done wrong, only you – and your loved ones – lose.

Have a question?… Call me (Irv) at 847-674-5295.