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, they 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 could this happen?
In the fall of 2015, Bob had 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, who had advised him for years, to discuss their options. Bob and Marge did not have a financial adviser as Bob had always managed their investment portfolio himself.
Bob’s attorney advised him to establish a Charitable Remainder Trust (CRT). Making a donation to the CRT could help reduce income taxes and estate 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. The publicly traded company’s shares were valued at $10 per share or $2.3 million. Therefore, Bob would reduce his taxable estate by $2.07 million ($2.3 million – $230,000 = $2.07 million). Also, Bob 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.
But the IRS disallowed most of the tax savings from the CRT, because Bob had not started his financial planning soon enough. He established the CRT after he had received the LOI from the purchaser instead of establishing his estate plan well in advance of the sale of his company. 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. By establishing the CRT after he had signed a binding LOI gave the appearance to the IRS that the CRT was nothing more than a scheme to evade taxes.
What should Bob and Marge have done to prevent the IRS problem?
First, Bob should have started his business exit planning including estate planning as early as possible before the sale of his company. Many wealth planning experts recommend that planning should begin from one to five years before the sale of the company
Second, had Bob hired a Registered Investment Adviser (RIA) early in the exit planning process, the adviser would have examined Bob and Marge’s entire financial picture, assessing Bob’s and Marge’s goals. That would have been the time to establish the CRT and 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 Bob’s and Marge’s goal of supporting their alma mater.
“Bob should have started his planning at least six months in advance of receiving the LOI. Anything less could spell trouble with the IRS,” said Shelley Ford, a financial adviser with Morgan Stanley Wealth Management.
She continued, “Bob should have engaged key advisers including an exit-planning M&A consultant, a trust and estate planning attorney, a transaction attorney to guide the negotiations of the transaction and corporate and personal tax advisers to give expert advice on how and when to establish their estate plans in anticipation of Bob selling his company.”
Scott Fleming, regional president – Rocky Mountain region for BNY Mellon Wealth Management, agreed.
“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,” Fleming said. “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.”
Fleming continued, “Strategies often examined are a Grantor Retained Annuity Trust, a Grantor Retained Interest Trust, a Grantor Retained Unit Trust, an Intentionally Defective Grantor Trust, Irrevocable Life Insurance Trust, Charitable Lead Trust and potentially a Family Limited Partnership.”
Unfortunately, Bob made a number of mistakes that could have been avoided had he sought specific professional advice. And while his attorney and accountant tried to give good advice, they were not experts in estate planning and wealth preservation. Bob and Marge paid the price for not hiring experts.
Article Created by: Denver Post