The following is the third in a series of three articles to help you understand important options you may have regarding your personal wealth and the effects of income and death taxes on your estate.
[subhead Part Three] Building a profitable business over the years can be a personally and financially rewarding experience. Selling the business, however, can be troublesome because of capital gains tax on the sale. Ironically, the very growth in value that made the business successful eventually penalizes the owner who eventually wishes to sell it.
This doesn’t have to be the case. There’s a way to transfer appreciated stock in a closely held business without giving up control of any of the wealth it represents. To see how, let’s look at Frank Thomas and Thomas Construction Company.
Thomas started his general contracting company when he was in his early 30’s and worked hard over the years to make it grow. Now, some three decades later, his company employs 50 people, and he anticipates annual sales of $3 million. With his dream of building a successful business realized, he and his wife are now looking at retirement.
But what to do with the company? He’s already had one offer to buy it. An associate offered him $2.5 million-$1.5 million for the stock, and another $1 million for a consulting contract and an agreement not to compete. Thomas knew he would have to pay capital gain tax of about $400,000 on the sale of the stock. The other $1 million for his consulting services and non-compete contract would be treated as $1 million of ordinary income, resulting in a further income tax liability of at least $350,000.
After paying tax on the sale of the stock, the Thomases would end up with only about $1.1 million. This amount would produce about $86,000 per year of income-a far cry from the current $180,000 combined earnings. They agreed that they needed at least $150,000 of income to be comfortable, and there was no way that they could arrive at that amount by selling the company. So they said no.
Soon afterwards, another associate mentioned a strategy by which the Thomases could sell the business (or only a part of it) and minimize or bypass capital gain tax altogether. The strategy called for using a charitable gift (They could also use a local community foundation). Here are the objectives they set, and the way they achieved them all using a charitable remainder trust (CRT).
The Thomases wanted to:
1. Transfer the business with a minimum of tax.
2. Generate income of at least $120,000 per year from the sale-of-stock portion of the sale price. This income, when combined with income from their consulting and non-compete contracts, would meet their needs.
3. Maintain adequate liquid assets.
4. Leave a sizable charitable gift to the local community.
5. Provide an inheritance of at least $1 million for their children.
To achieve these objectives, the Thomases first create a charitable remainder trust, naming themselves trustees, then transfer their stock to the trust. (They could also give the stock directly to a qualified charitable organization, such as a community foundation.) For making this contribution, they receive an income tax deduction of about $268,000. This will be used to offset part of their taxable income in the year of the sale. Next they negotiate on behalf of the trust to sell the stock. The buyer pays the trust $1.5 million for the stock.
As trustees of the trust, the Thomases then invest the $1.5 million from the sale of stock in a diversified portfolio of securities. In return, the trust will pay them 8 percent of the value of the trust each year, providing some $120,000 per year in income. The Thomases will also receive additional income for a specified number of years from the consulting contract.
The Thomases set aside $21,295 per year to fund a life insurance trust (sometimes called a “wealth replacement trust”) to provide their children with a $1 million inheritance.
This plan will continue to provide them an income for as long as either of them lives. At the second spouse’s death, the assets remaining in the CRT will be paid to the charity or charities of their choice. At that same time, the wealth replacement trust will produce $1 million that will pass to their heirs free of income and estate tax.
With this plan, the Thomases soon realize the many benefits of using a CRT as a financial planning tool…. benefits to them, their family and community.
This article is adapted by permission of Renaissance Inc.
Copyright 1991 Renaissance Inc.
© Copyright 1996 Los Altos Community Foundation. All rights reserved.