I’ve heard this repeatedly, working with family-owned auto dealers across the country. Especially when talking about estate taxes, the sentiment expressed strongly is, ‘I’ve paid millions of dollars in income taxes over the years and now they want to tax me again at 40%! How do I prevent this tax from forcing my family to sell my dealership group just to be able to pay the estate tax??’
You Have Control Over How Much Estate Tax Your Family Will Pay
Good news – you can reduce your estate tax significantly! I recently met with a client I’ll call Phil (not his real name) I’ve worked with for over 30 years during which time his net worth has grown from less than $10M to $250M. If Phil’s family had to pay his estate tax today, the rate they would pay is 6%! Since the rate is 40% the tax on $250M would be $100M – not $15M which is the estimated taxes this family would be paying if due today. How is that possible?
COMMITMENT AND VISION – First of all, it takes commitment and a vision that is bigger than your current situation. You’ve got to care about preserving your legacy, providing for the continuation of your dealership group and/or protecting generational wealth. Years ago, I met with a very successful auto dealer in his late 70’s and after an hour’s conversation I said, “It appears you don’t give a damn what happens” and he agreed. He either couldn’t care less what happens, or he didn’t want to spend the time, money and emotional energy required to address his succession challenges, or he was pretending to not care because he didn’t know what to do. The IRS loves this attitude.
Bad news – It takes time to make the changes necessary to dramatically lower your estate taxes, so you can’t wait until the last minute.
In the early years of my succession planning career, another auto dealer on our first meeting said, “My father died and paid no estate taxes – that’s what I want to do.” I then said, “That’s great but you’re about $40M late to the party.” His father had included him in ownership of the dealership group right from the start so most of the growth occurred in the son’s estate. Again, most auto dealers are not willing to do that.
Phil – “I Don’t Want to Give Up Control nor Do I Ever Want to Have to Ask My Kids for Money”
Most people want to reduce their estate taxes, but not if it means losing control or the ability to maintain their lifestyle. You’ve worked hard all your life and have earned the right to enjoy life in the manner to which you’ve become accustomed. So, how did Phil have his cake and eat it too?
Phil was building his dealership group when we began working together. He had three sons and a daughter all involved in the dealership group and he wanted to make sure they had the opportunity to continue his family dealership legacy. This vision was a huge motivator in his willingness to discuss options that would ultimately reduce his estate taxes. The last thing Phil wanted was to see the estate taxes become a burden crippling the business or even worse creating a forced sale. “I’ve bought out competing dealerships who were financially vulnerable and I didn’t want to put my children in the same predicament.”
We began by addressing the “what if” questions to protect his family and dealership group should something happen prematurely. Phil was building his dealership group, so he had a lot of debt and was not liquid. He protected his family and business by purchasing life insurance so they would be able to manage the debt and pay the estate tax under this “what if Phil and his wife died scenario”.
Phil’s Estate Was Poised for Rapid Growth, Creating Opportunity for Planning
FAMILY LIMITED PARTNERSHIP – Phil knew that just paying off the debt on his real estate was going to add millions of value to his estate, thus raising the tax bill on which the rate was 50% at the time. Among the options we discussed was to utilize a Family Limited Partnership (FLP) to own Phil’s real estate (today we’d likely use a Limited Liability Company – LLC). This allowed Phil to control the real estate which he transferred into the FLP. Since the real estate was highly leveraged, the equity was minimal, but the upside was substantial.
Knowing he was going to be able to pay off the mortgages and he expected significant growth, this was the time to transfer assets to his children. Phil understood he could gift a portion of the non-voting interest in the FLP and retain the ability to wheel and deal with his real estate. He was not depending on the real estate for spendable cash, as he was paying down debt and leveraging the real estate to buy more real estate. Bottom line, he gifted his children 60% of the real estate at minimal value and positioned 60% of the expected future growth to be excluded from his estate.
It Takes Time to Prepare and Be Ready to Take Action
Years went by as we reviewed his plan, anticipated where his estate would grow, examined planning options, answered his questions and prepared to strike when the timing was right and he was ready. Phil is a careful thinker who wanted to fully understand the pros and cons of each decision. His commitment to meeting no less than annually was critical to positioning him to take action at the right time.
QUALIFIED PERSONAL RESIDENCE TRUST – Phil owned a vacation home which fit the description of real estate likely to explode in value – it was on water. Whether on a lake, river or the ocean, waterfront property usually has great upside potential. I asked Phil if he could set up a trust that would allow he and his wife to enjoy this property for the rest of his life, and be able to sell or exchange the property for a different property, and by doing so would remove it from his taxable estate, would he be willing to consider this planning? Phil said, “absolutely” and elected to utilize a Qualified Personal Residence Trust (QPRT) to transfer this property over a ten-year period to his children via this trust. Because Phil had to live to the end of the ten-year term of the trust to remove the property from his estate, the gift tax consequences were minimized. For a small gift (using a portion of his lifetime exemption) he transferred a property that has increased in value many times over since he set up the QPRT. All of that appreciation is outside of his taxable estate. He and his wife, Dorothy, continue many years later to enjoy the property and they pay their children rent, but this is just another way they are minimizing the growth of their estate.
RESTRUCTURING THE DEALERSHIP GROUP – Knowing his dealership group was also likely to experience major growth, we discussed preparing the dealership group’s ownership structure to allow Phil to stay in control and at the same time transfer significant equity. We recapitalized the stock into voting (2%) and non-voting (98%). Also, knowing his dealership group is cyclical, we examined when the best time was to make a gift of stock. Again, there were multiple discussions preparing him to understand his options and the impact on his income and his business. No way was Phil going to jeopardize his ability to run his dealership group or control his cash flow or handcuff his ability to maintain his lifestyle.
When he experienced a down market, we valued his dealership group, and particularly the non-voting stock (allowing for discounts for lack of marketability and lack of control). Phil then elected to transfer 20% of the non-voting stock to his children through a combination of gifts and selling stock. His children would receive the gifted 10% and purchase 10% so they received 20% of the S-corp profits on which they were able to meet the payments on the note for the 10% they were purchasing. Phil continued to own the 2% voting stock, so he had 100% control over his dealership group. He also received 80% of the S-corp distributions plus the payments from his children for the10%. Over the years Phil allowed his children to purchase additional amounts of non-voting stock. The net result was Phil continued to be in charge, controlling all decisions including cash flow, acquiring and selling dealerships, his income, whether or not to make distributions, etc. The net result was the tremendous growth the dealership group was experiencing was not going to be taxed in Phil’s estate.
Spousal Lifetime Access Trusts (SLAT) – “Because I’m Not Willing to Transfer $30m of Assets to My Children.”
Knowing Phil felt he had transferred enough assets to his children, we utilized a SLAT which allowed Phil to transfer assets in this trust to his wife, Dorothy. While Dorothy is living and they are still married, Phil and Dorothy enjoy the benefits of the trust assts. These SLAT assets and any appreciation are outside their taxable estate. The downside is if Dorothy dies, the assets in the SLAT now pass to their children via the trust. Therefore, it was imperative before we utilized the SLAT, we examined his estate and Phil determined it is large enough to provide him with sufficient assets, other than the assets in the SLAT. The beauty of a SLAT is you get to utilize your lifetime exemption to reduce your estate taxes while retaining the assets for Dorothy’s benefit (and Phil while Dorothy is alive).
As is the case with all the planning ideas described in this article, you must utilize the services of an attorney and CPA skilled in estate tax planning. All the planning ideas described in this article are being utilized by planning professionals nationwide and must be done according to what the law dictates. Failure to do so can have significant tax implications.
Phil is committed to his family and dealership group winning, not the IRS. As a result of the planning he has done over many years, his family will pay 6% taxes instead of 40%. His family and dealership group are secure financially. Isn’t that what you want?!
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