The following article on business succession planning appeared in the February 10, 2014 issue of Northern Nevada Business Weekly:
As a business owner, you will have to decide when will be the right time to step out of the family business and how you will accomplish a successful transition. There are many estate planning tools you can use to transfer your business. Selecting the right tool will depend on whether you plan to retire from the business or keep it until you die.
The transfer can be an emotional minefield where some family members are participants in the business and others are non-participants. Those participants may feel “obligated” to stay in the family business when they would rather do something else. In addition, the transfer can be complicated due to estate taxes, gift taxes and capital gains taxes.
Moreover, sometimes the family business is only profitable enough to support one child, even though the non-participants may believe the business’ finances should support them. Or, only some or none of your children may have the abilities or skills to run the business.
Transfer of the family business is further complicated when – as is frequently the case – the family business represents all or nearly all of the parents’ wealth. Passing the business on to one or more children, while treating all your children fairly, is not easy.
Transparency and communication are vitally important. To achieve the best result, the entire family should receive (1) an explanation of your plan and why you are undertaking a particular strategy; (2) sincere, personal discussions clarifying that you love them equally; and (3) a promise that you are doing your best to be fair to all, while ensuring the future viability of the business.
Here are the 2014 tax exclusion and exemption amounts to consider when analyzing the various alternatives available for the transfer of a family business:
- The annual exclusion for gifts is $14,000 per donee (meaning husband and wife can each gift $14,000 to a recipient); and
- The federal gift and estate tax exemption for transfers during life or at death is $5,340,000.
Business sale to the participating child through an installment sale. This is considered one of the simplest methods of transferring the family business to a child or children. You can sell shares or partnership interests to a family member. The benefit of this method is that installments payments can be made over time, which provides an income for you after your retirement. Another benefit is that the purchasing child can better manage his or her cash flow and does not have to come up with a large sum of money at once. However, you will incur capital gains if the business sells for more than what you have invested.
Gift the business to some children and give cash to the others. Gift taxes are likely to be incurred with this strategy. A more practical concern than paying gift taxes is the fact that you may not have sufficient cash to equalize the value of the business assets going to your other children. This dilemma can be solved with a sizeable life insurance policy which names the non-participant children as beneficiaries. There are various ways to handle the life insurance, including setting up an irrevocable life insurance trust so that the life insurance benefits are not included in your estate for estate tax purposes.
However, if you gift your business, your child will not benefit from the step-up in basis to the current fair market value that is allowed when the business is purchased or inherited. For capital gains tax purposes, your child will step into your shoes and own the business at the basis that you own the business. Assuming the business increases in value over time, your child’s capital gains taxes will be higher. Of course, if the business is never sold, capital gains taxes may not be a concern.
Divide the business: the participating children receive the operating company and the non-participants receive the land and/or buildings used by the business. You could retain the real estate but provide that your children who are not participating in the business inherit it. By retaining control of the real estate during your lifetime, you could collect rent from the operating business to provide income. Later, your children who inherit the facilities could charge rent to their siblings running the operating company. How well your children work together under this strategy depends on family dynamics.
GRAT or GRUT. A more sophisticated business succession tool is a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). GRAT/GRUTs are irrevocable trusts to which you transfer appreciating assets while retaining an income payment for a set period of time. At either the end of the payment period or your death, the assets in the trust pass to the other trust beneficiaries (the remainder beneficiaries). The value of the retained income is subtracted from the value of the property transferred to the trust (i.e., a share of the business), so if you live beyond the specified income period, the business may be ultimately transferred to the next generation at a reduced value for estate tax or gift tax purposes.
Intentionally defective grantor trust. Another sophisticated technique is use of an intentionally defective grantor trust (“IDGT”). The trust is intentionally defective so the grantor pays the income tax on the assets that are no longer considered part of the estate. You create the IDGT, lend the trust money to buy an asset (the business) you expect will appreciate significantly. In return for lending the trust money, you receive interest payments for a set number of years. The lower the interest rate, the less the trust must repay you — and the more your heirs stand to benefit.