by Kevin M. Flatley, Esq.
Private Bank at Bank of Boston
Some years ago, two brothers came to my office intent upon selling their business. They each were to receive $1 million and were prepared to pay what today would be a 28 percent federal capital gains tax including better than a ten percent capital gains tax to the Commonwealth of Massachusetts. This meant a $300,000 tax payment from each of them.
Instead of paying this tax, they simply sold all their corporate assets and the buyer also bought their corporate name. This left them with a “personal holding company,” the remains of their old company, but with a new name. The personal holding company held nothing but cash.
Our first reaction is that this is no bargain for these individuals; they will be taxed twice on their income, once at the corporate level and a second time as the income is paid to them as dividends. Further, we assume that eventually someone is going to pay the capital gains tax. Our two brothers, however, never paid taxes on their income at the corporate level; and when they died some years ago, the death resulted in the forgiveness of all capital gains. The reason is that the brothers took advantage of two major benefits of the tax law.
First, if a company invests in common and preferred stock of another company, 70 percent of the income generated by dividends is free from corporate tax. Second, capital gains are forgiven and assets can be sold after our death without incurring a gain.
Over the years, we have seen this arrangement work for a number of our clients. At The Private Bank, we ordinarily invest our clients’ assets in a mix of municipals and common stocks. With a personal holding company, we look for dividend income (not interest income), so typically we substitute preferred stocks for our usual municipal holding.
If the brothers were selling their company today, they would be left with a personal holding company of $1 million and would pay no capital gain except on the sale of individual corporate assets. Therefore, most of the $1 million would be kept intact and might be invested half in preferred stocks and the other half in common stocks. The company then would have dividend income in the range of $50,000. With a 70 percent exclusion, $35,000 of this income would not pay corporate income tax; the remaining $15,000 would pay a corporate income tax, except to the degree of the corporation’s deductible expenses for money management, auditing expenses, and a small executive salary.
When the $50,000 is distributed to the shareholders, this income will be taxable. But the income would also be taxable if the $1 million had been put in the bank or into treasuries. With common and preferred stock holdings, there is a good prospect for growth in both the shareholders’ capital as common stocks grow. There is the further prospect for a growing income stream as companies increase their dividends.
When a brother dies, his share of the company can be liquidated and the $1 million capital gain is eliminated. In the case of my clients, they even went one step further: they added their personal holding company stock to a revocable living trust and avoided probate in the process.
Of course, there are always caveats. If you want your principal during your lifetime, you will pay a tax if shares of the personal holding company are sold. Further, the tax law always changes the taxability of dividends at the corporate level, although this provision has been in place for decades. Also, while we like to think the stock market will grow over time, investing in common and preferred stocks does imply a degree of risk taking. Finally, there is talk in Congress about taxing capital gains at death. If this occurs, you can always liquidate your personal holding company later.
So before you sell your business, explore with your CPA and lawyer whether a personal holding company will work to your advantage.
Reprinted with permission of the UMass Family Business Center, online at http://www.umass.edu/fambiz.