Axial | FORUM
By Gary Miller, GEM Strategy Management, Inc. | January 5, 2017
Any investment banker, wealth manager, or exit planning consultant will tell you that advance preparation is key to a successful M&A transaction.
What they may not mention is that poor exit planning can lead to significant financial consequences for your family. The below scenario tells the story of Bob, a business owner who ended up losing more than half a million dollars thanks to an IRS audit after the sale of his business.
Home from a long cruise, Bob and Marge stopped by the post office to pick up their mail. One letter stood out — a notice from the IRS stating that it had disallowed a tax deduction of $547,400 from the couple’s 2015 personal tax return. In addition to owing back taxes on the disallowed amount, Bob and Marge also owed penalties and interest. An IRS audit that began eight months earlier examining the sale of their business had led to this devastating news.
How Did This Happen?
In the fall of 2014, Bob sold his business for $23 million in a cash and stock sale to a publicly traded company. During the transaction process, Bob received a binding Letter of Intent (LOI) from the purchaser. After negotiating some of the fine points of the terms and conditions, Bob signed the LOI. Followed by the successful due diligence review, the sale closed.
Once Bob had signed the LOI, he and Marge began seriously thinking about what they were going to do with the money from the sale. Bob called his accountant and his family practice attorney, both of whom had advised him for years, to discuss their options. Bob and Marge did not have a financial advisor, as Bob had always managed their investment portfolio himself.
Bob’s attorney advised him to establish a charitable remainder trust (CRT). A CRT is an irrevocable trust that generates a potential income stream as the donor to the CRT, or other beneficiaries, with the remainder of the donated assets going to the donor’s charity). Making a donation to the CRT, could help Bob and Marge reduce personal income taxes and estates taxes, avoid capital gains taxes on the donation, and receive income from the trust for the next 20 years. They were thrilled and decided to donate 10 percent of the $23 million from the sale to their alma mater. Bob donated 230,000 shares of stock to the trust with a cost basis of $1 per share or $230,000 total. The publicly traded company’s shares were valued at $10 per share or $2.3 million. Therefore, this enabled Bob to reduce his taxable estate by $2.07 million ($2.3 million – $230,000 = $2.07 million). Bob also avoided paying the capital gains tax of 23.8 percent on the appreciation of the donated stock. Bob and Marge elected to receive 7 percent of the earnings from the $2.3 million trust generating about $161,000 of taxable income per year for the next 20 years — a win-win for all.
The IRS Penalty
In the fall of 2015, the IRS requested that Bob provide documentation surrounding the CRT. After the IRS review was completed, 8 months later, Bob and Marge received the unwelcome letter from the IRS.
They had disallowed most of the tax savings from the CRT, because Bob had established the CRT after he had received the LOI from the purchaser. The IRS held that the CRT had violated the Anticipatory Assignment of Income Doctrine which was adjudicated in 1930 by the Supreme Court to limit tax evasion. Because Bob established the CRT after he had signed a binding LOI, the IRS assumed that the CRT was nothing more than a scheme to evade taxes.
What Should Bob Have Done Differently?
First, Bob should have started his business exit planning including estate planning as early as possible before the sale of his company. Though the law does not specify how long in advance an owner should begin his estate planning, many wealth planning experts recommend that planning should begin from one to five years before the sale of the company. “Bob should have started his planning at least six months in advance of receiving the LOI. Anything less could spell trouble with the IRS,” says Shelley Ford, a financial advisor with Morgan Stanley Wealth Management.
Scott Fleming, regional president at BNY Mellon Wealth Management, agrees. “Wealth planning should begin as early as possible, with a team of experts to examine all of the available income and estate tax savings strategies, to avoid what happened to Bob and Marge. Had they started their planning early enough, they could have examined a number of income and estate planning strategies in order to meet their personal goals and at the same time avoid/defer income and estate taxes.”
Second, hiring a Registered Investment Advisor (RIA) early in the exit planning process would have given Bob and Marge the opportunity to assess their goals and establish the CRT well in advance. While his family attorney and accountant tried to give good advice, they were not experts in the field of estate planning and wealth preservation.
In addition to the CRT, an RIA may have also recommended a Donor Advised Fund (a charitable giving vehicle sponsored by a public charity that allows the donor to make a contribution to that charity and be eligible for an immediate tax deduction) to reduce income taxes and to achieve one of Bob’s and Marge’s goals of supporting their alma mater.
Unfortunately, Bob made a number of mistakes that could have been avoided had he sought professional advice early in the process — and he paid the price for these missteps.