The Law of Non-Reciprocal MeaningDon Shaughnessy
When people do a deal, each expects to get what they want from the arrangement. Sometimes that leads to unnecessary and fruitless conflict. In the end, neither gets what they want. In lawyer talk, it is a good deal because they are equally unhappy.
Sometimes there is a way to get what everyone wants. Maybe more. Instead of looking at what the deal is, look at what the deal means. You will find that it means different things to each party and the deal is how they will get those things. When you start from meaning, new alternatives become apparent.
What follows is a highly simplified example and is not intended to be advice of any kind. It is intended to be the basis for discussions with knowledgeable advisers aware of your specific resources and desires.
Father (age 62) wants to sell the family business to one of three children. It is worth $4,000,000 ($600,000 in taxes due.) He owns other assets worth another $2,000,000 after taxes have been paid on them. The other two children are not involved in the business. He wants all three to be treated equally. Each will get $1,800,000 from his estate.
He wants to invest the after tax proceeds from the sale and spend about $9,000 per month from the income. He will need to earn about 6% to achieve that
Father’s meaning – An estate for the children of $1,800,000 each, and $9,000 per month to spend.
Wants to buy and $4,000,000 is a fair price.
Child’s meaning. Own the business with no debt after 20 years, Pay about $28,000 per month for 20 years at 6%. (Assumed to a bank, but parent might do it too with slight variations.)
Here’s where it gets interesting.
Over 20 years, the child will pay $6.7 million of which $2.7 is tax deductible interest and the rest is capital. To pay that much you need $10,100,000 of corporate pretax income and you get what exactly?
- An estate of $5.4 million. $1.8 million for each child.
- Looking from the buying child’s viewing point, it means $3.6 million to the siblings. Of that $2,000,000 is made up of other assets, so only $800,000 each will necessarily come from the business sale.
Question. Does it make sense to use $10,100,000 of pretax income to pay someone $9,000 a month of spending money when they are alive, pay two siblings each $800,000 (they split the other $2 million) when the parent dies and get an inheritance of $1,800,000 cash? That is $500,000 per year that cannot be used in the business.
Revising the question to address meaning. If we assume there is no commercial risk to the business, how much pretax income would it cost to supply $9,000 per month after taxes, guarantee two payments on death of $800,000 each, and pay $600,000 of income taxes.
Using a freeze instead of a sale. $9,000 per month paid as a dividend requires about $205,000 per year of corporate pretax income. The $2.2 million due at death is satisfied with guaranteed life insurance for about $90,000 of corporate pretax income. Total about $300,000. A lot less than $500,000.
From the buying child’s place, either way, the result is that the business is paid for, taxes due are remitted and each sibling gets $1.8 million. Only the cost to acquire the result is different. It is 40% lower, but you give up the $1.8 million cash inheritance. If you want that, bump the insurance to $4,000,000 and pay an additional $75,000 or so of earnings toward the premium. That would still leave it around 25% less costly.
There are two points of interest.
- Addressing the meaning of the transaction exposes alternatives.
- Use pretax income to compare the cost of the alternatives because that is where all the money will come from.
Freezing a corporation is a well known and straightforward tactic. The insurance assumes a 62 year old male nonsmoker in standard health.
As with all transactions, there are many other details and alternatives and some may be important. Like some cash up front, like an Individual Pension Plan and a lower rate on the dividend, or some other salary/dividend mix format for father. Most can be worked out as long as the parties are addressing the meaning of the deal.
Meaning matters. Do not get stuck on the form of the deal or a particular number.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org