The succession of a family business, whether to other family members or to unrelated third parties or employees, is an important and involved process and must take into account many factors - including the continuing financial needs of the owner and the owner's spouse, family dynamics, continued successful operation and management of the business, and complicated estate planning and tax issues.
In general, the succession of a family business may take the form of a sale or a gratuitous transfer. In the case of the former, the owner will experience a significant liquidity event that triggers income tax issues. In the case of the latter, the owner will typically be making bequests or gifts of interests to children or other family members, either outright or in some restricted form (e.g., in trust), that trigger federal estate and gift tax issues. Both forms of business succession present unique issues and planning opportunities. This article touches upon some of the estate planning issues associated with family business succession in light of federal estate and gift taxes.
To understand some of the estate planning issues, one must have a very basic understanding of the federal estate and gift tax regime.
In general, the first $2 million - i.e., the applicable exclusion amount for federal estate tax, which is scheduled to increase to $3.5 million in 2009 - of a decedent's assets are shielded from federal estate tax; the amount in excess of $2 million is taxed at a rate of 45 percent. Transfers during lifetime for less than fair market value are subject to federal gift tax to the extent they exceed the lifetime $1 million applicable exclusion amount for federal gift tax. However, an individual may transfer up to $12,000 per year to as many individuals as he or she chooses free of federal gift tax - i.e., the annual exclusion amount for gift tax, which may be doubled for married individuals who agree to gift-split. The available applicable exclusion amount for federal estate tax is reduced to the extent the applicable exclusion amount for federal gift tax is used for lifetime gifts. Outright transfers to spouses do not trigger federal estate or gift tax due to the unlimited marital deduction. Transfers that "skip" a generation (e.g., to grandchildren) may be subject to the federal generation-skipping transfer tax.
In light of the above regime, the value of a family business interest being transferred has a significant impact on the planning involved. Moreover, valuation may be affected by transfer restrictions in shareholder or partnership agreements, and by discounts for minority interest and lack of marketability. Consequently, business succession planning often involves leveraging strategies designed to transfer wealth from one generation to the next at lower values for federal estate and gift tax purposes using available valuation discounts. Once properly transferred, any subsequent appreciation avoids federal estate tax when the former owner dies.
Common Estate Planning Strategies
Whether transferring interests in a business by gift or by sale, family issues and dynamics must be considered. For example, from an estate planning perspective, most owners wish to treat their children equally. However, oftentimes, not all children participate in the family business and the owner may not want non-participant children to receive an interest therein. In many instances the family business is the owner's most significant holding, and there are not sufficient other assets to equalize the shares of the owner's estate passing to non-participating children.
One option may be to allow all of the children to be equal owners, with the children directly involved in the business receiving voting interests and the remaining children receiving non-voting interests. Another option may be to purchase life insurance through an irrevocable life insurance trust that will inure to the benefit of those children not receiving a business interest, yet keep the value of the life insurance out of the insured business owner's estate when he or she dies.
Various strategies are available to facilitate business succession depending on whether the owner wishes to make lifetime transfers (gifts) or transfers that occur at death. Transfers that occur at death require the owner to consider, among other things, the liquidity needs of the estate and the income needs of the surviving spouse.
In situations where the owner ultimately wants the children to receive the business but he or she is concerned about the surviving spouse's needs, a special kind of trust (a qualified terminable interest property trust, or QTIP Trust) can be created under a decedent's Will. A QTIP Trust qualifies for the unlimited marital deduction (thereby deferring federal estate tax on the assets placed therein until the second spouse dies) and would provide for all of the trust income (including business income) to pass to the surviving spouse during lifetime. Upon the spouse's death, the remainder of the QTIP Trust, including the family business interests, can pass to the next generation as dictated by the Will. At that time, the closely held business interests may be eligible for valuation discounts based on the rationale discussed above.
The owner's estate planning goals need to be coordinated with any shareholder or partnership agreement. These agreements typically provide two methods of addressing the death of an owner - i.e., (a) the redemption agreement (allowing the company to redeem a deceased shareholder's stock from the estate); and/or (b) the cross-purchase agreement (allowing the other co-owners to purchase the decedent's interests).
The tax rules regarding redemptions are fairly complex. Redemption proceeds are generally treated as either a dividend (taxable as ordinary income) or an exchange (subject to capital gain or loss). However, when a redemption occurs as a result of the death of a shareholder of a closely held corporation, special rules under Section 303 of the Internal Revenue Code (Code) allow exchange treatment if various requirements are met. This is significant because stock included in a decedent's estate receives a basis for income tax purposes stepped-up to the date of death (or alternate) value, allowing for the possibility of a sale soon after death where little or no capital gain would be realized (whether by redemption or cross purchase). Conversely, in the case of a lifetime transfer, the donee takes a carryover basis from the original owner.
The federal estate tax can place a significant burden on a deceased shareholder's estate and, in turn, on the company where there are insufficient liquid assets to pay the tax. However, under certain circumstances, the Code provides some flexibility with respect to payment of tax on an estate holding a closely held business interest. In general, if the gross estate of a deceased U.S. citizen or resident includes the value of an interest in a closely held business, and the value of that interest exceeds 35 percent of the value of the estate, the executor may elect to pay part or all of the federal estate tax in up to 10 equal installments.
In contrast to transfers on death, lifetime transfers require the owner to consider, among other things, his or her own future income needs, as well as the needs of his or her spouse, and whether or not the owner wants to retain some control over the business. Gifting to the next generation within the annual gift tax exclusion amount ($12,000 per donee, or $24,000 for spouses gift-splitting) can be a powerful tool when transferring interests in a closely held business over time. However, it can limit the owner's ability to transfer rapidly appreciating assets to the next generation in a timely manner.
If the owner wishes to transfer the value of the business during lifetime but wants to retain control, the business could be recapitalized into voting (1 percent) and non-voting interests (99 percent). Thereafter, the owner could retain voting shares while transferring the value of the business in the form of non-voting shares (after application of valuation discounts) to the children, thereby also removing future appreciation on the non-voting interests from his or her estate.
An outright sale of the business to the children is also an option; however, this may trigger significant capital gains tax for the owner and a substantial cash crunch for the buyer. To ease the financial burden and provide the owner with a stream of income, the deal might be structured as an installment sale where a self-canceling installment promissory note is taken for the sale price; the note terminates at the seller/owner's death and, therefore, there should be no value included in the note holder's estate. Alternatively, where the business owner has a life expectancy shorter than the assumptions in the valuation tables, the business interest could be exchanged (for adequate and full consideration, meaning that the present value of the annuity equals the value of the stock transferred) for a private annuity providing for a series of payments based on the seller/owner's life expectancy for the remainder of his or her life; the annuity payments terminate at the seller/owner's death and the unpaid amounts should not be included in the annuitant's estate.
More sophisticated lifetime estate planning options may also be available to the owner of a closely held business looking to transfer assets to the next generation in a tax efficient manner. For instance, a grantor retained annuity trust (GRAT) allows a business owner to receive a guaranteed annuity amount from the trust after transferring business interests at a highly discounted value (taking into account not only the valuation discounts discussed above, but also a discount for the actuarial value of the future interest of the trust passing the children) out of his or her estate. In addition, an intentional grantor trust (IGT) can be structured in conjunction with an installment obligation so as to remove future appreciation of the business interest from the owner's estate while avoiding any gain on the sale of such interest to the IGT.
In the case of Subchapter S corporations, Electing Small Business Trusts (ESBTs) and Qualified Subchapter S Trusts (QSSTs) are specifically intended to be eligible S corporation shareholders and they facilitate estate planning that allows for the transfer of such shares to the next generation while removing the value thereof from the transferor's estate.
In sum, with proper planning and follow-through using common techniques, a family owned business can be transferred from one generation to the next in a tax efficient manner with minimal disruption of the business and/or the family.
Russell J. Ressler is a Partner in the Trusts, Estates & Personal Planning Practice Group of Stradley Ronon Stevens & Young, LLP. He can be reached at (215) 564-8086.