A successful business owner’s dilemma...
How to invest your accumulated cash profits

BY IRVING L. BLACKMAN, CPA
Tax/succession specialist

Business owners have many legitimate complaints these days — taxes, regulations, competition (from home and abroad), can’t find good people. The list goes on and on. Always has, always will.

Yet the pride of the American capitalistic system is the successful family business. These entrepreneurs have found their way through, around or over the seemingly endless obstacles to become a “successful business owner.” An SBO for short.

For the purposes of this article, SBO s have excess funds to invest — other than back into the operation of their business, which produced the funds in the first place. Typically these excess funds are in one (or more) of three places:

• Still in the business
• In their (or spouse’s) name
• In a qualified plan (profit-sharing, 401(k), IRA or similar plan).

Over the years the quote that follows has been nicknamed the SBO s lament: “I know how to make money in my business. But when it comes to making money with my investment money, either I don’t have time to watch it, don’t know how to watch it or rely on my investment advisor. When the market is up, my advisors do fine. When it’s down they do lousy.”

For the past couple of years, the lament usually ends with, “Now the market is lousy (or down, or uncertain, or similar words). What should I do?”

(Note:Yes, millions of Americans — other than SBO s — have the same investment dilemma as SBO s: “Where do I invest my money?”)

Now, regular readers of this column know that your author is a tax planner who finds legal ways to avoid all types of taxes — particularly estate taxes. To do this requires — among other things — getting my client’s personal balance sheet.

Here’s what I can tell you that the balance sheets reveal about the investments of SBO s (and also other estate planning clients). Their success — or failure — in the stock market and a myriad of other investments, in general, mirrors the Dow Jones: Happy on the way up and painful on the way down. Usually, real estate investments are a winner.

Now what about that excess cash? Terrible results. Almost always the investments are conservative, divided between:

• CDs and money market funds
• Municipal bonds
• A “zillion” variety of annuities. After taxes and inflation, your net earnings on each would be as follows:
  • Investments — typically less than 3%, sometimes even negative.
  • Those income tax free bonds — not only have a low rate of return, but fall in value when interest rates rise
  • Annuities — I could fill a large book to describe all the varieties and, most of all, the complaints from clients. Never, not once, has a client told me that he/she is happy with the results of an annuity. (Sure would like to hear from a reader who has personally had a positive experience with any annuity.)

As you can imagine, almost every estate planning consultation with an SBO — and other clients — requires serious consideration concerning the client’s investments: safety, risk, tax consequences, rate of return and other factors. We discuss alternate investments, considering, among other things, profitability, risk and how taxed.

Currently, the most popular alternative investment is senior settlements (SS), also called Life Settlements. The following quote from The Wall Street Journal and USA Today (and other sources) tells you why SS are becoming such a popular investment.

“Life Settlements [has become a] trillion-dollar industry... dominated by institutional investors including Berkshire Hathaway (billionaire Warren Buffet’s company), AIG and CNA. Their pursuit of this market is related to the degree of safety, high yields in excess of 15% per year and the fact that a Life Settlement is not affected by market forces.

“Life settlements are a very good option for the investor that has as his or her investment philosophy a desire for a secure, safe and ‘no risk’ investment... It is for your ‘nest egg’ money... It is not considered a security by sec. Therefore, it is not normally provided as an investment option by stock brokers.”

Of course, your question is: “Can a little guy — as opposed to an institutional investor — invest in SS. Yes, it’s all made possible by a small publicly traded (on the NASDAQ) company. Its average rate of return on SS investments has been 16.28% per year on average during the company’s 14-year operating history.

If you want to make a killing on your investments, SS are not for you. But if a 16% plus rate of return, with no market risk is of interest to you (or your IRA, 401(k) or other qualified plan) fax me (847/674-5299) your name, address, phone numbers (business/home/cell) and estimated amount to invest ($50,000 minimum, for accredited investors).

Want to get real estate out of your corporation — tax free?

Do you have real estate in your corporation? If so, raise your hand and keep reading. About once a month, we get a call at the office asking a question something like this: “How can I get real estate out of my corporation without being taxed to death?”

Actually, we could write a small book about the various facts and circumstances that impact on how-to-remove-real estate from your corporation. The book would answer many questions. Stuff like:

• Are you a C corporation or an S corporation?
• Are there retained earnings?
• And how much?
• How much has the real estate appreciated?

And on and on. Each additional fact might change the tax strategy needed to answer the question. To cover all the possibilities is beyond the scope of this column. Instead, let’s set up the facts and circumstances that represent over 95% of the calls and the recommended solution to get-the-real-estate-out-of-the-corporation problem.

The typical facts and circumstances. Joe owns Success Co., a C corporation with a large amount of retained earnings and one or more pieces of real estate that has significantly appreciated in value. Most of the time the real estate has a building on it, but it could be vacant. (If Success Co. is an S corporation, it has a large amount of old C corporation earnings frozen in place, and the same real estate facts).

The solution. As you read what follows, keep in mind that you don’t have to know how to build a car in order to drive one. Put it another way: Don’t sweat the technical details; concentrate on the unbelievable favorable tax results.

Here’s the easy six-step process:

• Step 1 — Joe forms a family limited partnership (flip) outside of Success Co. Then, Success Co. contributes vacant land (if the land is improved, Success keeps the improvements as leasehold improvements) to the flip. The land is worth $1 million (of course, it could be any amount). In exchange, Success Co. receives (ownership of 99% of the flip) limited partnership interests). Joe contributes $10,000 in cash to the flip for a 1% general partnership interest. As the general partner Joe has all the voting rights and makes all the decisions.
  
• Step 2 — Success Co. leases the real estate from the flip for $100,000 per year.
  
• Step 3 — An independent appraiser values the flip interest (after applying a 40% discount for general lack of marketability) at $600,000. Yes, the $1 million land is only worth $600,000 — because it is in the flip — for tax purposes.
  
• Step 4 — Success Co. contributes 99% of its limited flip interests to a charitable lead trust (CLT) with the following terms: The flip will pay $99,000 per year to the CLT for eight years. (Note: Typically the CLT then makes contributions to Joe’s Family Foundation). Let’s pause to follow the money. Success pays $100,000 rent to the flip; the flip pays $99,000 to the CLT, which makes contributions to Joe’s foundation.
  
• Step 5 — First some information: According to IRS tables, the value of the annuity (the $99,000 to be received for eight years by the CLT) is $569,000. So, the value of the 1% remainder interest (the part of the flip still owned by Success Co. immediately after the gift of the flip to the CLT) is only $31,000 (the $600,000 discounted value of the land, minus the $569,000 value of the eight-year annuity gifted to the CLT, leaves $31,000 as the value of the remainder interest). Simply put, Success Co. owns an asset that according to the IRS is worth $31,000. Joe’s children buy the 1% remainder interest from Success Co. for $31,000.
  
• Step 6 — After eight years the CLT ends. Joe’s children, who are the beneficiaries of the CLT, receive and now own the 99% of the limited flip interests. Remember, they bought (and own) the other 1% from Success Co. eight years ago. The CLT and Success Co. are out of the picture. Better yet, the real estate is out of the corporation, owned 100% by Joe’s children. And there is a bonus: The real estate is also out of Joe’s estate. The entire transaction is tax-free to the flip, the CLT, Joe, the kids and Success Co. (might owe tax on the $31,000 sale).
  

Now one warning: The above is an easy way to get your real estate-tax-free-out of your corporation. But you must use experienced advisors who know how to dot the i’s and cross the t’s.

If you have a question concerning how to get real estate — or other assets, particularly cash or securities — out of your corporation, you are welcome to call Irv Blackman (847/674-5295) to discuss your exact situation.

Irving L. Blackman, CPA, is a founding partner of Blackman, Kallick, Bartelstein LLP and is a lawyer specializing in business succession and wealth transfer. Readers are welcome to contact him. He can be reached at 300 S. Riverside Plaza, Chicago, IL 60606; tel. 312/207-1040, e-mail wealthy@BlackmanKallick.com or website www.taxsecretsofthewealthy.com.