Joe Robbie was one of the most astute businessmen in Florida. He amassed a fortune estimated to exceed $1 billion. He certainly knew that, like all of us, he was one heartbeat away from immortality. Yet, when the fateful beat came, everything he put together came apart - not because he did anything wrong, but because he didn't do anything, and that was wrong.
Robbie was 69 years old when he died. He had gone to work at age 18. When the Internal Revenue Service finished with his estate, 60% of all he had built up was torn down and placed in the hands of the U.S. government. When the Miami Dolphins team was sold in June of that year, the entire $150 million of proceeds went to pay a portion of the estate taxes. As a percentage of his life, we could say that he had worked everyday from age 38 until his death at 69 for the federal government!
Sigmund Freud is reputed to have said, "It is emotionally impossible for man to contemplate his own demise." This inability to deal with the reality of death produces an imagined state of immortality among many owners of businesses. In addition, many simply don't understand what actually happens and what the alternatives are when a principal of a business dies.
THE FANTASY: For many business owners, planning for estate taxes is a three-step process that happens something like this:
1. The founders' friendly advisers contrive a low valuation of the company.
2. A minimal amount of life insurance to cover some or all of the expected tax is purchased.
3. It's then left to the next generation to negotiate any differences with the IRS.
This formula usually falls short on all three counts, leaving the business' heirs in the unenviable position of battling for survival while working with the ultimate partner from hell: The Internal Revenue Service.
THE REALITY: The problems begin when the IRS values the estate, which it invariably does in cases involving substantial family companies. Any deliberate attempt to undervalue the business interest for tax purposes carries severe penalties. If the undervaluation is 50% or less, the valuation penalty is 25%; if the undervaluation is greater than 50%, the penalty is 40%. Additionally, there are penalties for the advisors as well!
A review of a large number of cases over the years by this writer reveals the folly of relying on a successful negotiation or court battle with the IRS. The review found that the court would generally award the IRS 70% of the value the IRS claims the business to be worth.
Moreover, these cases take an average of 4.7 years to litigate; interest and legal costs easily add another 25% to the bill. So much for any savings realized from a low valuation and an optimistic prognosis of one's fortunes challenging the IRS.
UNWANTED PARTNER: Estate taxes are due nine months following one's death. Yes, an installment arrangement is available, but consider the terms:
That portion of the tax attributable to an interest in a closely held business can be paid out over 14 years at an interest rate set quarterly by the IRS. Payment of a $1 million tax under the arrangement would require total payments of $2.4 million over the 14-year installment period. For a corporation netting 2% on sales, this represents 100% of the profits on $120 million in sales.
That's just the beginning. The children, as the succeeding generation, would effectively be in a 14-year partnership with the IRS whereby:
1. A lien is commonly placed on the business
2. The IRS has to approve all acquisitions, divestitures, addition to capital, dividends, and increases in compensation to any officer/shareholder exceeding 10%.
3. Financial statements may be required on a regular basis.
This "partnership" requires the payment of monthly amounts easily exceeding the children's combined salaries. They can also assume that their bank may not renew existing credit lines because of the IRS lien and the magnitude of the debt as shown on the liability side of the firm's balance sheet. As for the business, it is now in the hands of people who previously held no authority and are known to the banks, the suppliers and the employees simply as "the kids".
A BETTER PARTNERSHIP: In the typical situation, the founder undoubtedly has excellent legal and accounting advice. But imagine the reaction when these advisors announce that a certified check made payable to the Internal Revenue Service is required for $1 million and the family asks: "How?" "Where?" "From whom?" The advisors comment that surely "some provision must have been made." The deceased had told his family that his advisors had done an excellent job of estate planning, as indeed they did. There just isn't anyone in the room whose job it is to write the check.
Fortunately, it does not always end in such tragic fashion. In recent years, for those who can qualify, it has been possible to enter into a contract with one of several major life insurance companies under which the insurance company guarantees to pay a stipulated amount of estate tax (and other settlement costs).
In exchange for this guarantee, the estate owner agrees to deposit annually amounts of money equivalent to 1.5 to 6 percent of the tax bill (depending on age and health status). Regardless of the number of annual deposits made by the estate owner, the contract guarantees payment of 100% of the tax bill, at the exact moment it is tendered, even if death occurs after just one installment.
Should the estate owner survive to the end of about a ten to twelve-year installment payment period and tire of the arrangement, the insurance company guarantees to refund 100% of the money paid in.
These contracts are available to those who can qualify, up to age 85, and in virtually unlimited amounts. When the tax is paid to the IRS, under these guaranteed contracts, the funds are generally free of both income and estate taxes and produce, in effect, a discount on the tax bill to the deceased's family of amounts ranging from 20% to 80%.
The contract as described is ..... a life insurance policy!
(Joseph Blum's firm, J. F. Blum, CLU and Associates, “The Wealth Pre$ervation Company”, ™ of Weymouth, Massachusetts, specializes in estate preservation techniques. Joe is also the founder of the Northeastern University Center for Family Business and is past chairman emeritas of its advisory board.