A family business is more than just a business. It’s a livelihood, a life’s savings, a retirement plan, an inheritance, and a legacy. Family businesses face many challenges that require careful planning. Perhaps the greatest challenge is passing the business from one generation to the next and allowing it to successfully grow into the future. While a careful plan can help ensure the successful transfer and continued viability of the business, a lack of planning could effectively end the business during this critical juncture. Parents passing the business to the next generation generally have three areas of concern in common: economic benefit, control of the business, and tax reduction. The confluence of these concerns creates a complex environment that requires careful planning and a sound strategy.
Families and individuals engage in business to earn a profit, or an economic benefit. Exactly who gets to enjoy this economic benefit, when, and how much are key questions in family business ownership and transfer. For instance, while aging parents may want to exit the day-to-day operation of a business, they may still rely on the business earnings for their retirement. In this case, simply transferring the business to the next generation may leave the parents strapped as they face retirement. Careful planning can allow the next generation to own and operate the business without relegating mom and dad to the poorhouse.
Perhaps the most fundamental consideration of business ownership is knowing who is going to make the business decisions and who is going to have control. While the business owner may want to transfer the family concern to the next generation, he or she may still have reservations about whether the next generation will be able to effectively run the business. Children may need time to acclimate to managing the business day-to-day and to learn the intricacies of the market. As such, many owners may wish to transfer control gradually and retain some ability to manage, or at least guide, the business after it has transferred.
In any business transfer, taxation is the constantly looming specter. While the goal of tax reduction is simple enough, the difficulty lies in the complexity and interplay amongst all the relevant taxes. It is beyond the scope of this article to provide an in-depth dissertation of the U.S. federal tax system, but a perfunctory explanation of the relevant taxes may be worthwhile.
There are three main taxes that a business owner must contend with when passing a business to the next generation, including the gift tax, the estate tax, and the income tax. The gift tax is a tax paid by the giver on all gifts made during life. While the gift tax has several exemptions that prevent most people from paying it during their lifetime, the general rule is the larger the gift, the larger the tax. The estate tax is the sibling of the gift tax, and it is a tax paid by an estate (the economic remnant of a deceased person) on transfers made at death. Similar to the gift tax, the larger the estate, the larger the tax. The estate tax can be especially disruptive because it can force sales of the assets that it’s trying to transfer, just to afford to pay the tax. Finally, the income tax is a tax paid by a person who earns money through work, return on investments, or sale of an asset. The income tax, which makes up the backbone of the U.S. tax system and is, therefore, hardest to avoid, comes into play when a business owner sells his or her business to the next generation (or anyone else, for that matter).
How do these considerations of economic benefit, control, and tax reduction coalesce and work together in planning to transfer the business to the next generation? The general answer is that, while it is possible for a family business owner to simply gift the whole business to the next generation all at once, family business succession strategies tend to move the business from one generation to the next in carefully delineated portions and according to a time schedule. Moreover, business transfers also commonly incorporate legal structures—such as trusts, contracts, and corporate forms—to carefully parcel out economic benefit, control, and take advantage of tax benefits.
The following structures and strategies are commonly used to transfer business to the next generation within a family.
Traditionally, the most favored mechanism for transferring a business within the family has been the Family Limited Partnership (FLP). In a limited partnership, ownership is divided between general partners who control the business and have an economic benefit, and limited partners who have an economic benefit, but no control. In this strategy, the owner transfers the family business to a limited partnership structure and takes all general and limited partnership interests, thus retaining all control and economic benefit in the business. Then, over time, the owner gifts the limited interests to the next generation while retaining the general interests. These gifts will transfer the economic benefit to the next generation while keeping control with the owner, with such gifts receiving preferential tax treatment (known technically as Sec. 2704(b) discounts). When the owner is ready, he or she can transfer the general interests (as well as any remaining limited interests) and complete the transfer. If done right, the FLP gives over economic benefit in a managed fashion, transfers control only when the owner is ready, and minimizes transfer taxes.
The traditional dominance of the Family Limited Partnership has been challenged in recent years by an emerging estate planning strategy, the Intentionally Defective Grantor Trust (IDGT). The IDGT is a highly sophisticated strategy that takes advantage of a discrepancy amongst the estate, gift, and income taxes. While the operations of the IDGT are highly technical, the general idea is that the owner can “sell” his or her business to a trust he or she controls in exchange for a promissory note. Because of the aforementioned discrepancy in the tax code, the putative sale does not create an income tax burden. However, the result is that the business is now outside of the owner’s estate where it can grow, in exchange for a promissory note inside the estate that shrinks over time. Switching a growing asset for a diminishing asset will minimize estate tax. Moreover, the owner can maintain control of the business through trusteeship of the trust and the trust can distribute economic benefit of the business to beneficiaries of the trust under terms chosen by the owner. The IDGT is an extremely technical legal maneuver that requires a high-level attorney to draft and implement. But, if done right, the IDGT can meet all goals of economic benefit, control, and tax reduction.
While the FLP and the IDGT are the standard bearers of family business succession planning, a number of other strategies can work in specific circumstances or work as effective supplements to these core structures. For instance, a Buy-Sell Agreement is a contract whereby the owner promises to sell and the next generation promises to buy the business upon the occurrence of a specific event, typically the death of the owner. In such an event, the sale is usually funded by the proceeds of a life insurance policy on the owner’s life in favor of the next generation. The Buy-Sell Agreement may be an effective backstop if an owner dies unexpectedly and the arrangement can be rather tax efficient due to the income tax preferences for life insurance proceeds and sales at death.
If the owner’s primary concern is the estate tax, the Grantor Retained Annuity Trust (GRAT) may be an effective way to move value out of the estate over time. The GRAT is a “gift-splitting” strategy in which the business owner gives a large gift to the next generation through a trust. In order to minimize the effect of the gift tax on that large gift 1) the business owner takes back all of the principal value of the gift over time and 2) when the business owner is done taking back all of the principal, the next generation receives what is left in the trust—that is, the appreciation value—gift and estate tax free. Though it may seem convoluted, the effect of the GRAT strategy is to move appreciation value from the owner to the next generation without a gift, estate, or income tax. If the family business is likely to grow substantially in the near future, the GRAT can be an effective way to move the appreciation value to the next generation and reduce the eventual sting of the estate tax.
There are other strategies available, but they remain relatively rarer. Two uncommon strategies are the Self-Cancelling Installment Note (SCIN) and the Private Annuity. The general idea is that both of these structures can be used to sell the business from the owner to the next generation, with the next generation providing long-term (or even lifetime) income back to the owner/seller. From a tax perspective and in the world of estate planning, these strategies play actuarial games that amount to making a bet on the owner/seller’s life. Depending on the strategy, the benefit of these structures will increase tremendously if the owner/seller lives much longer or dies much sooner than expected.
Finally, if the owner wants to benefit more people than the next generation with the fruits of the family business, there are tax-preferred structures that include third parties in the transfer. For example, if the owner wants to benefit the business’s employees, a structure such as an Employee Stock Ownership Plan (ESOP) allows the owner to sell a portion of the business for his employee’s benefit, tax deferred. On the other hand, if the owner wants to benefit a charity, a structure such as a Charitable Remainder Trust (CRT) or a Donor Advised Fund may allow the owner a substantial tax advantage as reward for his or her altruism. These strategies may spread the business around outside the family, but if executed properly as a supplement to another strategy (such as a FLP or IDGT), they will still allow control and primary economic benefit of the business to stay in the family while offering tax benefits.
The structures and strategies outlined in this article are sophisticated ways of transferring economic benefit and control of a family business to the next generation while reducing potential taxation. Each requires effective drafting by an attorney and potential oversight by an accountant. Anyone interested in pursuing one or more of these strategies should reach out to a skilled First Bank Wealth Planner or a First Bank Wealth Advisor for more information.
Charles Claver is the Senior Vice President and Family Wealth Advisor at First Bank Wealth Management. Charles may be reached at (310) 887-0100 or via email at [email protected]. CA Insurance License #0H05975.