Mom or Dad wants to transfer the family business to one or more of the children. But the money to fund the buyout at the death of the parent/stockholder —insurance on the parent’s life — is in the wrong place.

Here’s a foolproof way of getting the job done, according to an IRS letter ruling:

The father, Joe, worked with his son, Sam, in a business founded by Joe. The stock of the corporation was owned 25 percent by Joe, 4 percent by Sam and the balance by five other children not active in the business.

Joe had two main objectives: First, to have his stock go to Sam after his death and, second, to make sure that his wife, Mary, would be financially secure for the rest of her life.

Joe and his son developed a plan to accomplish these objectives. They entered into a buy-sell agreement requiring Sam to buy his father’s shares from his estate after his death at fair market value. To fund the purchase, Sam would use the proceeds of a life insurance policy on his dad’s life.

The corporation owned the insurance policy and paid the premiums. Joe intended to buy the policy from the corporation for its cash-surrender value and gift the policy to his son. From then on, Sam would pay all premiums. Great news!

The IRS ruled that, under these conditions, Sam could collect the insurance proceeds income tax-free (IRS Letter Ruling 8906034).

There are two more tax goodies that flow as a result of this ruling.

One, when Sam buys Joe’s stock from his estate, the sale of the stock by the estate is income tax-free.

Why? Under the tax law, the estate gets a new tax basis equal to the stock’s fair market value at the date of Joe’s death.

Two, since Mary is the beneficiary of Joe’s estate, there is no estate tax. Why? An estate is entitled to a 100 percent marital deduction for all property passing to a spouse, Mary in this case.

What could be better? No income tax. No estate tax.

Sam owns 100 percent of Joe’s stock.

Mary is financially secure.

Perfect!

Recently, I visited a successful family business in North Carolina, owned by a semi-retired 64-year-old named Joe and run by his son, Sam, a 36-year-old.

Joe called me. He wanted a second tax opinion for a business transfer plan and an estate plan put in place by Sam (with the advice of his professional advisors, the “best” estate planning team in the county) almost two years ago.

Wow, this patient was really sick (running a high tax fever, bleeding lots of tax dollars).

This is the story of the symptoms, the diagnosis and the “magic tax potions” that cured the patient.

First, the facts:

Joe owns 98 percent of two corporations: a profitable S corporation (Success Co.), which operates a string of stores, and a C corporation (a tax-paying corporation, called R/E Co.), which owns real estate leased to Success Co.

The real estate has an income tax basis of $1 million, but a current fair market value of about $6 million. Sam owns the remaining two percent of the stock of both corporations. Each of the corporations is the owner and beneficiary of a separate $1 million insurance policy on Joe’s life.

Four more little details:

• Joe’s second wife, Mary, is 45 years old and they have a premarital agreement that gives Mary the income from one-half of the value of Joe’s assets at his death for as long as Mary lives. But get this: none of the stock of Success Co. can be used to provide Mary her income.

• An artificially low price in a buy/sell agreement would force Joe’s estate to sell his stock in Success Co. back to Success Co. and the same for R/E Co. (Result: Sam would then own 100 percent of both corporations.)

• Joe has two other grown children who are not in the business.

• Joe is not insurable.

The diagnosis:

• The $1 million in life insurance payable to R/E Co. would kick up an unnecessary alternative minimum tax.

• The full $2 million of insurance would be included in Joe’s estate because he controls both corporations, but the $2 million (less the alternative minimum tax of about $150,000) would belong to the corporations, not Joe’s estate.

• There are not enough liquid assets to satisfy the obligation to Mary. Worse yet, if the obligation to Mary is met, there would be zero dollars (outside of the corporations) to pay an estimated $3.5 million estate tax liability. Simply put, the estate would be broke.

Our objectives to cure Joe’s tax illness are clear:

• Reduce the value of Joe’s estate.

• Get cash to fund the obligation to Mary.

• Pay the estate tax.

Here are the five major tax medicines I recommended to cure Joe’s business transfer and estate plan:

• Merge R/E Co. into Success Co. This maneuver is tax-free. R/E Co. is worth about $6 million as a real estate investment company but, as part of the operating company, its value is reduced by at least $2 million for estate tax purposes. Estate tax saving — over $1 million.

• Transfer the nonvoting stock (created after the merger) to a grantor retained annuity trust (GRAT), which reduces the value of Success Co. by about 40 percent for estate tax purposes. This maneuver saves about $.5 million in estate taxes.

• Joe takes the $2 million in insurance policies out of the corporations and gives it to his children. Result: The value of Joe’s estate drops about $2 million and will save another $1 million plus in estate tax.

• Change Joe’s will to put the entire estate tax obligation on the children. The $2 million in income tax-free/estate tax-free insurance proceeds will handle the entire estate tax load when Joe dies.

• Make sure Joe’s will qualifies for the 100 percent marital deduction for Mary’s one-half share, thus deferring any estate tax on this portion of Joe’s estate until Mary dies. Yes, there are other details and nuances in the plan, including gifts to Joe’s children, but these five tax medicines cured the patient.

What’s the lesson to be learned from this true-life Joe/Sam/Mary story? Always, yes always, get a second opinion after your estate plan is done, preferably before any documents are signed.