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Friday, May 3, 2024
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Case Studies |
Pecos Bill and the Silver Saddle
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Case:
Pecos Bill hailed from West Texas and loved the open range. Bill learned to ride horses almost as soon as he could walk. While still in his teens, Bill started to build saddles. By age 25, Bill was one of the premier builders of silver and leather saddles.
At first, Bill built custom saddles for people in West Texas. But as his reputation grew, riders from throughout the country and even overseas began to ask for his custom saddles. Bill gradually hired other workers and slowly expanded the business.
Since saddles and riding horses can involve considerable risks, Bill's CPA told him that he should incorporate. By creating a corporation, Bill could limit to the business assets the liability for an accident involving a rider thrown off a horse with one of his saddles. So Bill created the Diamond Saddle Corporation (DSC). DSC was a C corporation and filed its own tax returns.
After four decades and production of several thousand saddles, Bill reached the age of 65. He decided that it was time for an old cowpoke to ride off into the sunset. Over the years, Bill had received a number of offers for the company. He decided to sell the company to a very substantial buyer.
Since the buyer did not want to acquire the potential liability of the saddles that were currently being used, the buyer insisted on purchasing all the assets of DSC, rather than the stock of DSC. As a result, Pecos Bill ended up with $600,000 in cash inside the company. He decided to invest the $600,000 in public companies, and the stock he owns inside the company is now worth $800,000.
His CPA is concerned about excess liquidity, since the company no longer has active manufacturing and there is a $250,000 limit on liquid assets. Therefore, he tells Bill that they should develop a plan to reduce the public stock value to the $250,000 limit on liquid assets inside a corporation.
Question:
What can Bill do? Is there a tax-favored solution for him?
Solution:
Bill still owns the stock in DSC. His personal basis in the stock is $1,000. In addition, the corporation has a basis of $600,000 in the public securities that are now worth $800,000. If Bill were to simply liquidate the corporation and pay all of the funds to himself, there would be corporate level tax due on the $200,000 gain. This gain produces a federal and state income tax of approximately $70,000. The net cash remaining is then $730,000. Bill also would be taxed on the $729,000 of gain on his DSC stock.
Bill asks if there is a way to reduce his tax burden. His CPA suggests that it is indeed possible to transfer the DSC stock into a charitable remainder unitrust for Bill's life. After transferring the DSC stock into the charitable trust, Bill then can liquidate the corporation. The corporation will still pay the $70,000 in corporate tax. However, Bill bypasses the capital gain on his personal stock, and receives a charitable income tax deduction of over $250,000. This income tax deduction may be used over the next six years. Bill saves approximately $100,000 in capital gains tax and another $80,000-$100,000 in income taxes.
Bill is very pleased. With the tax savings at the personal level, he effectively offsets the tax payable at the corporate level and ends up with a sale of Diamond Saddle Corporation with no net tax.
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