Various studies point to about 70 percent of the wealth in the United States stemming from first-generation business owners. Very little wealth in America comes from inheritance. Unfortunately, much of that first-generation wealth is lost. Poor planning is a key factor.
Indeed, a joint study by Forbes and Societe Generale released in 2014 found that roughly 60 percent of the wealthiest American families fell from that “wealthiest” status over just one generation.
Conversations with a wide range of business owners reveals a common problem: little or no tax planning. The underlying causes for the lack of tax planning are many and varied. But, in the end, many business owners fit into one of two categories.
The first category is the start-up. The owners have the singular focus of driving enterprise value. They pull all-nighters as if cramming for a final exam. They are relentless. Like a race horse they are charging forward. And then . . . about 30 days before the sale of their firm . . . the little issue called “tax” pops into their consciousness for the very first time.
Why should it? Often, these entrepreneurs are just a few years out of college and have been working for little to no salary. Until that point, what taxes have they ever really had to deal with? Then, the $10 million pay-off hits them. For those who are just a stone’s throw away from Stanford, Governor Jerry Brown will be looking for somewhere around $1.3 million of that pay-off.
The second category is the owner of an old line firm. Maybe the company is in manufacturing or construction or printing or you name it. It could be that the business is a first-generation firm or has been in the family since great-grandpa. Whichever it is, this type of organization has been producing a stream of net income for years and the owners are all too familiar with taxes.
These owners have vowed to themselves that they are not going to make the mistakes of prior generations. They intend to exit the firm in five years. They have lead time to plan. They are going to sit down with appropriate tax planners and they are going to map this thing out. But, they have five years. So, it can stay on the back burner for now.
At the four-year point, they reaffirm the date that they will start to shop the firm. They commit to sitting down with their planners and they are going to tackle it. They are going to beat the IRS at their own game. Yep. But, they have four years. So, it can stay on the back burner for now.
While the power to govern trust law is seen as a power reserved to the states and not a topic of the U.S. Constitution, trust law is a topic of some states’ constitutions. Recently, there have been arguments by certain well-respected legal theorists and authors that long-tenured trusts violate state constitutions with provisions prohibiting “perpetuities.” Last week, the Nevada Supreme Court put the issue to bed.
The first trusts were enabled under the Roman Statutes of Institutions roughly two thousand years ago. The types of trust we tend to think about today see their genesis in England several hundred years ago. And, it was just prior to this that England enacted statutes that enabled a type of property ownership called an “entailment,” which is often but not always related to noble titles.
For those who are familiar with the wildly successful television series Downtown Abbey, in the first season, the Earl of Gratham’s heir died with the sinking of the Titanic. Typically, if a noble died without an heir, the noble’s title is extinguished. And, typically, the original grant of title identified the method of establishing one’s heirs . . . who were male. The original grant set forth a pattern of inheritance of the title. So, the Earl needed to track down the next in line to be his heir, if anyone even qualified under the terms of the original grant. What Robert Crawley, Earl of Grantham, had to deal with was an entailment.
In the late 1600s, we come across a real-life inheritance problem. Under the entailment system, the Duke of Norfolk’s first son would inherit his title and his lands. The Duke’s first son was mentally impaired and was without children. The Duke wanted his title and lands to pass directly to his second son. So, he created a trust. But, he thought, if I can accomplish this, why not create a trust that will dictate the flow of his title and estate over the next 200 years. One of the likely heirs under the terms of the entailment objected.
The House of Lords tried the case. The ruling of the court was that the specific trust having a term of 200 years had the effect of frustrating the Crown’s grant of entailment. So, the trust was held invalid. What was to become known as the Rule Against Perpetuities evolved over several subsequent cases. The Common Law rule is generally stated that property must vest, if at all, within a term defined by lives in being plus 21 years. In essence, you can keep assets locked up in trust forever.
In some cases, individual states have repealed the Rule Against Perpetuities by statute. In other cases, individual states have codified the rule via a statute. In still other cases, individual states have included a generalized prohibition of perpetuities in their respective state constitutions. Nevada is one such state that has a generalized prohibition of perpetuities in its state constitution. While Nevada’s constitution does not define a perpetuity, Nevada’s legislature has: 365 years.
Because the term of years that the Nevada legislature has enacted is longer than that contemplated by the Common Law rule, some legal scholars argue that the term of years that the Nevada legislature has specified violates the Nevada constitution. Last week, Nevada’s Supreme Court held that the 365-year term enacted by the legislature complies with the Nevada’s constitutional prohibition.
A fundamental concept recognized by our Founding Fathers was a key tenet of our system of jurisprudence: a constitution provides a framework around which the legislature builds laws. Certainly, there are express commands and express prohibitions in a constitution. “Congress shall make no law respecting . . .“ But, specific laws are left to the legislature and not dictated by a constitutional convention. Nevada’s legislature has codified the definition of “perpetuity.”
And, so the cycle repeats until . . . about 30 days before the sale of their firm . . . they realize that they never got around to that planning. Different from the start-up entrepreneurs, these business owners have always had tax planning on their minds but simply did not get around to it.
The reality of it all is that time is perhaps the biggest factor in tax planning. The earlier you plan for the sale of your business, the more likely it is that you might achieve a more favorable tax outcome. If you are thinking about it now, start your planning now. Certain tax strategies might reduce the tax burden of a business sale by as much as 75%. But, typically, such strategies have certain timelines embedded in them and the business owner must get structures in place and the clock ticking to garner such results. Now, pick up the phone . . .
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