Guaranteed!

Let’s set-up the typical family-business situation we see at least 100 times every year. Joe, who is married to Mary, owns Success Co. Sam, their son, runs the business and someday will replace Joe. They have other children who are not active in the business.

The traps are listed here in order of the most serious and most frequent blunder.

The marital deduction. After Joe’s death, Mary will own Success Co. or a large portion of it in her own name or in some kind of marital trust. That’s great, when Joe dies. No estate tax. But when Mary goes, the IRS gets its pound of flesh. Remember, the marital deduction only defers tax; it’s not intended to be a tax saver.

A Section 303 redemption. Success Co. can redeem as much of Joe’s stock as necessary, free of any income or capital- gains tax to pay Joe’s (or Mary’s) death taxes and other estate costs. Sounds good. But the fact is, the money that comes out of Success Co. goes straight to the IRS.

Section 6166. Because Success Co. is a major asset in Joe’s (or Mary’s) estate, the estate tax can be paid in installments for up to 15 years with interest at a very low rate. Not only does the IRS get the estate tax, it now gets (even though a low percentage) interest to boot.

Normally this column tells you what to do to win the tax game, as opposed to telling you what not to do. OK, then. Here’s what you must do to check your estate plan and know it’s right for you and your family:

• The strategies you use must be initiated during your life (such as gifts, a grantor retained annuity trust or a family limited partnership), not at death (the three traps described in this article).

• When the entire plan is in place, your advisor should show you clearly that your total wealth will go to your family without being reduced in value by even one dime of estate taxes.

• Your advisor must get you into some kind of tax-free environment, such as an irrevocable life-insurance trust or some kind of charitable trust, immediately.

• You control your assets for as long as you live (or at least as long as you want) with the use of voting/nonvoting stock, a family limited partnership or various trusts.

• Finally, your assets are protected from creditors and lawsuits.

Congress in 1998 buried an old and onerous gift-tax killer rule. Yet few people are aware of the tax-saving advantages of the new law.

First, some background. Gifts to your spouse are sheltered by an unlimited marital deduction, no matter how much the gift — during life or at death — there is no gift tax or estate tax. For lifetime gifts to all other individuals, the first $12,000 ($24,000 if married) is also exempt from tax.

A gift-tax return is generally not required for gifts qualifying for the marital deduction. On the other hand, a gift-tax return must be filed for all gifts in excess of $12,000 per donee (the person receiving the gift) per year.

Just like your income-tax return, your gift-tax return is due on April 15. For example, taxable gifts made in 2005 should have been reported on a gift-tax return filed by April 15, 2006. The IRS has three years from the date a gift-tax return is filed to make a gift-tax assessment. So, if the IRS decides four years down the road that a gift was worth more than the value shown on your timely filed gift-tax return, it’s out of luck. The IRS cannot assess any additional tax on the gift.

In the past, there was a catch.

Again, some background. The estate and gift taxes are unified so that a single graduated rate schedule applies to cumulative lifetime and death transfers. As a result, the final tax on your estate depends on the amount of taxable gifts made during your life.

The more lifetime taxable gifts, the higher your estate tax.

Sad but true, the courts allowed the IRS to revalue gifts — even after death — in order to determine the decedent’s estate tax. While it was too late to assess additional gift taxes on the gift (because the three-year time period had run out), the revalued gift could bump the estate into a higher tax bracket and cost — often huge — additional estate-tax dollars.

If the IRS claimed that a lifetime gift — very often the stock of a family business — was seriously undervalued, the tax on the estate would skyrocket. The estate had a tough time proving that a business valuation made years earlier (5, 10, 15 years or more) was and is still correct.

OK, let’s hear the drumroll for the new law:

For gifts made after Aug. 5, 1997, the IRS can no longer revalue lifetime gifts for estate-tax purposes. You must only jump through one hoop: report the gift on a gift-tax return. The value of the gift must be shown on the return or disclosed on the return or an attachment in a manner adequate to disclose to the IRS the nature of the gift.

After three years, the IRS (and you) are bound by the values shown on the return.

The door is, however, still open for the IRS to revalue some gifts:

• Any gift made prior to Aug. 6, 1997;

• A gift-tax return is filed, but the gifts are not properly disclosed or reported;

• Gifts not shown on a return;

• No gift tax return was filed because you thought the gift was worth $12,000 or less.

Here’s what to do for absolute protection:

Except for cash gifts under $12,000, report all gifts — particularly gifts involving the stock or an interest in any kind of family business or partnership — on a timely filed gift-tax return.

The more you are worth, the more your estate plan should include a well-thought-out lifetime plan, which includes a gifting program to the next generation.

Generally, cash gifts are a no-no. Leveraged gifts (usually involving a family limited partnership (FLIP), intentionally defective trust (IDT) or one or more of the dozens of life insurance strategies, are smart. They beat up the IRS legally and keep you in control of the gifted assets for as long as you live.

Gifting (using an FLIP, IDT or life insurance) is only one of 22 strategies used to legally avoid the estate tax. Learn how and when to use all the strategies —whether you are worth $2 million or $20 million.

I love the Web site for a different reason. Whenever I’m stuck and don’t know what to write for the column, a quick review of e-mails from readers who visited the site gives me plenty to write about.

Following is a wonderful example from a Web site visitor.

We’ll call him Joe.

Joe, 61, the owner of a profitable family business, Success Co., filled out a form on the Web site that included this question: “What are your most burning problems or questions?”

Joe typed in the following four goals:

• Selling the business to a son and nephew.

• Keeping control of the company until it’s paid for.

• Eliminating balance-sheet debt.

• The least possible tax liability to myself and them.

Next, I called Joe. He gave me a bit more information.

Then he shipped even more information. We talked again.

Here’s the full story.

Joe was about to execute a plan that would have put him into the chamber of tax horrors, but he decided to contact me first, via the form on my Web site.

Following is the plan Joe’s lawyer and CPA had suggested:

Joe’s son, Sam, and nephew, Nick, would each buy one share of Success Co. stock from Joe for $1,000. Actually, the $2,000 for the two shares was a fair price. Then Success Co. would buy the balance of Joe’s stock for $2.25 million (also a fair price), plus interest of 6 percent on the unpaid balance.

What’s wrong with this picture?

Aside from selling the business, none of Joe’s other three goals was accomplished:

• Joe would have had no control

• The balance sheet would be destroyed with a $2.25 million debt.

• Worst of all, the tax liabilities would hurt Joe and strangle Success Co.

Let’s take a closer look at the tax liabilities. First, Joe’s capital gain would be $2.2 million. At 15 percent, he would get hit with a $330,000 tax bill. Ouch!

Next, let’s look at the real tax disaster for Success Co. — really Sam and Nick because they would own Success Co. State and federal income taxes would total about 41 percent. Call it 40 percent because the state tax is deductible.

Are you ready for a shock?

Success Co. would have to earn $3.66 million and pay income taxes of $1.66 million to have the $2.2 million to pay Joe for his stock — plus that blasted 6 percent interest. Crazy, isn’t it?

We happily killed the above plan. Instead, we created the following three-step plan:

• We recapitalized the company (created 100 shares of voting stock and 10,000 shares of nonvoting stock), a tax-free transaction.

• Success Co. elected S corporation status, also tax-free.

• Joe sold the 10,000 nonvoting shares to an intentionally defective trust (IDT).

Let’s see how using the IDT accomplished all of Joe’s goals:

• He stays in control by keeping 100 percent of the voting stock.

• Success Co.’s balance sheet is free of any liability after the transfer of the stock.

• Best of all, Joe escapes paying tax on the sale of the nonvoting stock to the IDT. The entire transaction is tax-free to Joe.

And what are the tax consequences to Success Co., Sam and Nick? All tax-free. The future earnings of Success Co.

will be used to pay the $2.2 million price (actually a note payable due from the IDT) for the nonvoting stock, plus interest.

When the note (estimate will take six to eight years) is fully paid, the IDT trustee will distribute all the nonvoting stock to Sam and Nick — tax-free!

It is estimated that more than 1 million family-business owners face the same problem — creating the right succession plan — as Joe and Success Co.

Sadly, the wrong succession plan causes tax mega-disasters for both the owner and the next generation.

Here’s the story the CPA told me:

Joe was about to buy the stock of a C corporation for $2.2 million payable over eight years plus interest at prime, all evidenced by a note. In addition, another $600,000 was to be paid by the C corporation to be divided between a covenant not to compete (for three years starting immediately) and a consulting contract (the CPA was not sure that the seller was really going to consult) to the seller for three years. The idea was to make the $600,000 deductible as paid.

Joe intended to get the money to pay the principal and interest on the $1.2 million note by taking a bonus twice a year when the note payments became due.

Fortunately, the CPA called before any papers were signed. Without getting into every nook and cranny of the proposed transaction, here is a list of the most obvious tax blunders that would have befallen Joe and his C corporation.

– The bonuses to Joe almost certainly would have been attacked by the IRS as unreasonable compensation (Joe intended to take $250,000 to $275,000 as regular compensation, plus the bonuses).

– The interest to be paid by Joe is considered investment interest, which is deductible only to offset investment income (Joe had none). In effect, all of that beautiful interest would have been nondeductible.

– An employee or consultant already has a duty not to compete. Paying the seller for consulting is OK (assuming the amount is reasonable). So if the seller actually worked and got reasonable compensation, it would be deductible. On the other hand, if the seller really did not consult, none of the consulting payments is deductible. In any event, the amount of the covenant is not deductible over the three-year payment or not-to-compete period; instead, it can be written off only over 15 years.

Again, without attempting to cover every detail, here is how the transaction will be done:

– Joe will elect S corporation status. Now Joe can take tax-free S corporation dividends to pay the note. The interest, because of the S corporation status, is now deductible on Joe’s personal tax return as a business expense. The unreasonable-compensation problem is eliminated.

– The interest rate will be raised to two points over prime and reduce the covenant amount dollar for dollar. The consulting contract will run for only the period of time that the seller actually consults, and that will be paid for same. After the consulting period is over, the covenant not to compete will kick in.

One warning: Whether you’re buying or selling a business, work only with experienced and knowledgeable professionals. Pretend you’re having a heart transplant, and seek out the best professional help you can find. If you are selling your S corporation to one of your kids, he or she can deduct the interest (see Letter Ruling 9215013).

An S corporation is almost always the best route when you are transferring — by sale or otherwise — your business to your kids.