Business Relationships Part 2


(Part 1)
The Brooks Family, Chapter Two

David had moved to Florida and changed most of this contact information, but Tom’s son, Jack, knew that David would keep his cell phone number and be attentive to it. He was correct.

The call came late one evening in 2006. Jack explained what had happened in the five years that David had not been involved with the family. The business was not doing well as the recession had hurt sales. Dad had to put personal money into the business just to keep things going. Jack and his sister were also worried that Tom might have some unstated health issues. Jack said, “Dad is now ready to make up for lost time and get his estate in order.” Jack also told David that as a family they had gone to several seminars (at David’s suggestion) presented by the New England Institute for Family Business that David helped found several years before. David agreed to help and stated that the first step was to obtain and review all the current financial information. David had learned many times that clients’ memories are not always accurate. He had found on several occasions that the title to real estate was actually not as stated by the property owner.

(In one case an inn was not owned by the S corp. as the sole shareholder thought. The title had never been transferred to the corporation as planned. In that case the concept that once you find one error indicates that others probably follow was true. There the form 2553 used to elect S corp. status was also never filed as was discovered by an IRS agent auditing the corporate and personal tax returns. These lessons taught David to always ask to see original documents or copies of original documents including deeds, wills and trusts, and beneficiary designations for life insurance policies and retirement plans. )

To David’s surprise, Tom promptly mailed David all the requested documents and spent two hours on the phone talking about what he wanted to do for the children and grandchildren. David reminded him that he had not always followed through with previous plans. Tom promised that it would be different this time.

David then had what he needed to create a plan for Tom and his family: Accurate and complete facts and a clear statement of Tom’s goals. David knew that incomplete or inaccurate facts could lead to poor advice so he was always very careful. Tom also let David know that he would use a very competent estate attorney which was a great relief to David. Quality lifetime financial planning necessitates a team of competent professionals.

Tom Promised it Would be Different This Time

One of the documents he received was a memorandum from Tom’s current accountant who suggested selling the family business to the children using an installment sale. He placed a value of $20 million dollars on the business. He suggested that Tom sell 75% of the voting stock to the children for $15 million dollars less a 20% discount, for the fact that the stock had no ready market. He also mentioned that there would be no discount for a minority interest since Tom was selling 75% of the stock to family members.

David did not want to offend that accountant but pointed out to Tom that using an installment sale to transfer stock to family members is just not the way to do it. He also corrected the other accountant by informing Tom that the determination of a minority interest is at the recipient level and recipients do not have to be added together even if they are family members. In this case it would be more reasonable to use a 40% discount when valuing the stock to be transferred to the children as each would be receiving a minority interest. Of course, David recommended against selling any voting stock.

David prepared a comprehensive planning document, distributing it to Tom and his attorney to make sure that the facts were correct and Tom’s goals were accurately stated. Second, David knew it was essential that Tom’s attorney agree with the suggestions or help modify them if needed. Tax and succession planning are often not the only issues present in complicated transactions. This was a franchised business so great care had to be taken to make sure any applicable terms of the franchise agreement were heeded. In fact, there were some restrictions and some approvals needed before the business ownership could be transferred.

David’s plan contained many parts including:

  1. A plan for removing most of the value of the business from Tom’s estate but allowing him to keep control of the business. This involved the sale of the S Corp. stock to an intentionally defective trust.
  2. Two Qualified Personal Residence Trusts (one for his New Hampshire residence and the second one for the property in Lovell, Maine).
  3. Creating a new family limited partnership to be the recipient of most of Tom’s other investment assets.
  4. A plan for the long-term family occupancy of the family compound at Kezar Lake.

Tom wanted to substantially reduce his estate, pay no income, gift, or estate taxes, and keep control of the business. He was worried also about the prospect of the divorce of either of his children and the in-law gaining part of the business. David listened carefully and suggested the following:

  1. Recapitalize the S Corp. to have 10,000 shares of stock, 9,900 shares of nonvoting stock, and 100 shares of voting stock.
    • Renew the lease between the corporation and the existing family partnership for the land. The original lease had expired so the partnership could have claimed ownership of the buildings, but for several reasons it was decided to renew the lease. One reason was to be sure the trust for the children would have control of the land as Tom still owned 90% of the limited partnership and had a history of not fully completing family transfers.
  2. Have the business professionally valued with a secondary opinion of the value of the non-voting stock to be gifted to the trust using appropriate discounts.
    • A valuation was needed to support the value of the 10% stock interest to be given to the trust and to protect against any claim that the sale transaction was a bargain sale and hence a gift to the extent of the bargain.
  3. Create and execute an intentionally defective trust (grantor trust) with carefully drafted provisions to protect all parties.
    • Give 10% of the overall business value in non-voting stock to the trust for the benefit of the two children and possibly grandchildren.
    • The trust could have a Crummey power to allow the gifts to be treated as gifts of a present interest in order to qualify for gift tax annual exclusions.
  4. Sell the remaining non-voting stock to the trust in exchange for a 15-year note guaranteed by the children.
    • The 15-year term was calculated to be long enough for the cash profits going to the trust, as the S corp’s principal owner, to pay off the note principal and interest plus have a modest amount of leftover cash. The note had no prepayment penalty so it could be paid off early if needed.
    • The note also had a hardship clause to allow the note to be extended for the future payment of any note payments which could not be made.
    • The sale would not be subject to income tax as Tom and the trust are treated as the same tax person. However, the sale would be a legal transfer of ownership.
  5. Execute a carefully drafted shareholders’ agreement with provisions to protect against a marital divorce and provisions of what to do in case of a problem between the two children. In effect, they would create a business pre-nup agreement that delineates which locations each child would get if the business had to be split up.
  6. Execute employment agreements for each of the children with severance provisions and protection from the note guarantee in case they were fired.

The result was that Tom removed nearly $20 million from his estate with no income tax, no gift tax (used a small amount of his lifetime $5 million exemption), and no estate tax. Two caveats: First, Tom knew he had to spend the note payments received so that his estate would not build back up– that was easy for him as he reduced his $450,000 salary to $50,000 and was used to spending even more than $450,000 net of taxes each year. Life in New Orleans was expensive. Second, Tom was still the income tax owner of the stock, so he had to report the S corp. income each year on his tax return and pay the tax. It was pointed out that this also was a method to reduce his estate. He sometimes forgot about this feature, usually around April 15th of each year.


This was Tom’s pride and joy, a farm with 100 acres of timber which he nurtured like a vegetable garden. He had all the best equipment, sparing no expense to harvest mature trees, thin younger stands of hardwood and softwood, and haul the wood to a lumber yard for sale or to be cut up for firewood. He was not an educated forester but had learned a lot from his father and uncle about proper forest management. It was a beautiful parcel of land. He knew his son and family loved it there and would be great stewards of the property after he passed away.

David suggested a qualified personal residence trust. Tom liked the idea and David suggested the following:

  1. Have the property appraised.
  2. Create and execute the appropriate form of trust.
    • A term of years had to be chosen (in this case 10 years) during which Tom would live always in the home, pay its real estate taxes, and otherwise maintain the property. At the end of the ten years the property  would pass to the responsibility of an independent trustee from whom Tom would have the right to rent the property.
  3. The transfer to the trust is a gift, in this case to Tom’s son. The value of the gift is a function of the value of the property, Tom’s age, and the initial term of the trust. The longer the term, the less the value is of the gift. (There can also be a factor for a remote contingent interest to get into the equation for people who like the technical stuff. )
  4. Tom has to live the 10 years in order to remove the value of the property from his estate. The risk of not living 10 years can be protected by purchasing a life insurance policy on Tom in an irrevocable trust to have a cash fund available to pay the estate tax on the property.
  5. Tom and David would make sure other assets were dedicated to Tom’s daughter to make up for this gift to her brother. Parents almost always want to keep a balance.

Tom purchased the Kezar Lake property in 1985. It had once been a summer girl’s camp but in the early 1980’s it had suffered financially and was closed. Tom purchased it at a very good price. At first, he used it just as a place to stay went he went hunting, usually on Joe McKeen Hill across the lake. He had a special spot on a beech ridge that allowed him to select the buck he wanted to haul out of the woods. While hunting he was a patient man; otherwise he was anything but patient. Tom’s property was close to that of Stephen King whose bad luck while walking on Route 5 in North Lovell is well known.

Over the years, Tom upgraded the buildings that were useful to him and built a magnificent log cabin for himself. The children and grandchildren were frequent visitors and probably expected all of this to be theirs someday, but no one dared to ask Tom his plans. He told them what he wanted them to know and when. He seemed sometimes to contradict himself especially as he got older but maybe that was on purpose.

At this point, David suggested that Tom create a qualified personal residence trust to own this property. This time the trust beneficiaries would be both of his children with provisions for his grandchildren as well. The same procedure was used as with the New Hampshire residence: an appraisal; creation of the trust; choosing the appropriate term; here having provisions for interfamily sales (bloodlines to be followed), and provisions to protect descendants and the property from divorces.

When a family of multiple generations have a property that they want to preserve for the family, it is often appropriate to call that property A FAMILY COMPOUND. It always made sense to use this phrase to David, as it alerted him to the need for special planning. FAMILY COMPOUNDS fail to continue in the way the creators of the compound envisioned usually for the following reasons:

  • The cost of upkeep becomes too expensive for the family.
  • One or more family units cannot come up with their share of annual expenses.
  • One or more family units just do not have the opportunity to use the property and do not want to share the costs.
  • Too many family units exist and there is not enough space for all to be there at once which is usually only a problem on long holiday weekends: Memorial Day, Fourth of July, and Labor Day.
  • Some individual family members do not get along.
  • There is a vast difference between family units as to what is considered ‘cleaning up’ after a stay.
  • Personal property (not compound property) such as boats is not treated respectfully.

David suggested to Tom that he plan for each of these potential problems in the trust he created. Tom did the following:

He placed the property in the trust and at year 10 placed $350,000 in the trust in addition, as an ‘endowment’ to fund future capital improvements, maintenance, real estate taxes, and insurance expenses of the trust. This endowment cured the potential liquidity problem for the family and any individual family unit as well. The trust incorporated a set of operating rules that were allowed to be amended by a vote of 65% of the family units. Included in the initial set of rules were procedures for: scheduling time at the property; settling conflicts with the schedule; requiring that a housekeeping service come in after each visit and clean; having the cost of any “special” cleaning  billed directly to an offending family); setting up a schedule for major repairs and a reserve system in addition to the endowment if ever needed.

David always worried when he recommended some of these provisions that the rules would seem onerous and cause the family to lose some of the enjoyment of a property. However, David had seen two family compounds on Kezar Lake fall apart because of the problems cited in his planning document to Tom. The benefit of cautious planning outweighed the risk of ‘anxiety.’

(To be continued)

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David Hawkes (aka David Reed) is a tax, financial planning, family & small business consulting expert. He has worked with thousands of clients and saved them millions of dollars in taxes over the course of his career. David is also a former minority shareholder of the Boston Red Sox.