Today, family-owned businesses face new challenges when transferring ownership to children or other family members.

During the owner’s lifetime, appropriate successors must be groomed to take over. This process can take many years, and must be carefully thought out. And once that successor has been identified, steps should be taken to prevent him from becoming dissatisfied and leaving the company. Compensation to key people, including family members, must be kept attractive. But increasing compensation is not as simple as it sounds. You, as the majority stockholder, may want to maintain a substantial income, while reinvesting assets to continue growing the business. There might not be enough money for everyone to be totally satisfied.

Yet another problem might be the expectation of family members or key employees to obtain an equity interest in the business before you’re willing to relinquish it. Once the owner’s objectives are understood, sorting out the best method to pass a family business on to the next generation must be identified. These methods typically include:

  • Transfer of control to appropriate successors.
  • Reduction of gross estate.
  • Retention of assets that will provide adequate retirement income.
  • Transfer of future appreciation in the value of the business.
  • Liquidity for the estate.

Let’s discuss the three main methods available to transfer a business.

The first method, installment sales, basically exchanges an asset having potential for appreciation with a note having a fixed value. The growth potential of the business is removed from the estate. Any installments not yet paid at the seller’s death are included in the seller’s gross estate at their present value. If the seller consumes or gives away installments as they are paid, additional reduction in the gross estate can mean lower estate taxes.

A self-canceling installment note (SCIN), the second method, is similar to an installment plan, but the sales agreement provides for automatic cancellation of the note and any additional payments due after death. The purchase price of a SCIN is increased to reflect this risk. SCINs are not included in the seller’s gross estate.

The third method, a private annuity, stops payment to the seller at death. Consequently, no unpaid amounts are included in the seller’s gross estate. IRS valuation rules for annuities are based on actuarial factors. If the value of the annuity based on the actuarial tables is less than the fair market value of the business asset purchased, the IRS thinks a gift was made.

The Company As A Gift

Owners might try to give shares of stock to family members as gifts during their lifetime. Unfortunately, due to the limits of the present annual exclusion of $10,000 — $20,000 with gift splitting — owners often find this method impractical. Making gifts of a business also raises a problem of valuing the assets at the time of each gift. These valuations must be made in order to determine minority discounts, lack of marketability discounts and whether the annual exclusion has been exceeded. A “wait-and-see” approach is often implemented to avoid paying gift taxes, which delays the tax until their death.

Other techniques to “give” away stock include:

  • Family limited partnerships, which can protect the family wealth, provide a tool for reducing the size of your estate and still allow you to retain control and management of the assets as the general partner. You create the Family Limited Partnership, which must have a valid business purpose, and transfer assets to it. The FLP is comprised of General Partner (GP) interests and Limited Partner (LP) interests. You (or a corporation created by you) typically retain GP and LP interests.

    The GP has all the management responsibilities and unlimited liability. GPs can pay themselves a reasonable salary for these managing duties. The LPs, on the other hand, have no management responsibilities. The LP interests usually cannot be liquidated without the consent of the GPs, or freely sold or transferred. This lack of control and marketability causes the LP interests to have a discounted value.

    You can make discounted gifts of LP interests to your children or grandchildren (or trusts for their benefit). The discounted value of LP interests allows you to leverage your transfers for gift tax purposes. Each parent’s $625,000 (1998) exemption amount could be used to avoid gift taxes at this time.

    The GPs control the business, including any income distributions. This is one of the features that helps provide additional protection from outsiders.

  • GRATs can balance gifts between generations — you get an annual annuity payment; your heirs get the balance of the trust after its term (a specified number of years). A GRAT is an irrevocable trust in which the grantor retains the right to an annual annuity payment for a specific period of time. The payment must be a specific dollar amount paid at least annually, regardless of trust earnings. The right to this annual income is called the retained interest. IRS tables are used to determine the value of the retained interest. Only the IRS’ projected value of the remainder interest, full fair market value less the value of the retained interest, is considered a gift and subject to gift taxes. If the trust estate is worth more than the IRS’ projection after the trust term, and if the grantor survives the trust term, the additional value passes to your heirs free of estate and gift taxes.

    Since only a portion of the full value of the property is subject to gift taxes, the unified credit may be used more effectively. After the trust is created, no further contributions are permitted. The gifts may reduce your net estate, which reduces your estate taxes. Your heirs receive your net estate after estate taxes and expenses, plus the remainder value of the GRAT.

    If you die before the end of the trust term, the trust property is taxed in your estate. However, if you die after the term of the trust, the property should not be taxed in your estate. You want to choose a term long enough to minimize gift taxes, but short enough that you will outlive the trust to avoid estate taxes.

    Planning For Succession

    Considerable thought must go into business succession planning.

    Attribution rules must be observed. Under the family attribution rules, stock owned by certain family members of the shareholder’s family is considered owned by the person redeeming it. The redemption of all stock actually held is not a complete redemption and a capital transaction, but a partial redemption and is treated as a dividend. Once again, a wait-and-see approach is often implemented to avoid paying gift taxes, which delays the tax until their death.

    Life insurance trust is another planning area that requires thought. In general, the proceeds of a life insurance policy pass free of probate unless the beneficiary of the policy is the insured’s estate. If the insured’s estate is the beneficiary, the proceeds of the policy are payable to them, and are subject to the probate process.

    The value of any policies owned by an individual at death are subject to estate taxes. If an individual possesses certain rights, known as incidents of ownership, over a policy insuring his or her own life, the proceeds of the policy are generally included in the individual’s gross estate for estate tax purposes at their death.

    Frequently, a couple will think they are safe from estate taxes if they own policies on each other. It may not be the case. Take for example the husband who is the owner and beneficiary of a policy on his wife. The wife dies first. The husband generally receives the proceeds of the life insurance policy free of income and estate taxes, but the funds remaining at his death become part of his gross estate for tax purposes.

    Life insurance policies are often transferred to an irrevocable trust, in order to avoid the estate taxes that may result from owning a policy or from holding incidents of ownership in one. Other objectives may also be accomplished by such a transfer.

    Be aware of the pitfalls of life insurance in a trust. The grantor cannot terminate or change the terms of an irrevocable life insurance trust once it has been established. Also, he does not have access to the funds in it.

    If the insured transfers an existing policy and then dies within the next three years, the proceeds of the policy are included in the estate for estate tax purposes under the “three year rule” of IRC section 2035. To avoid this possible pitfall, the trustee of the life insurance trust often purchases a new policy using cash in the trust, so that the insured is not transferring a policy to the trust.

    IRC section 6166 allows an executor to defer payment of a portion of the estate taxes that represents a closely held business, if the business consists of more than 35 percent of the adjusted gross estate. For purposes of the 35 percent test, if two or more businesses are involved, and 20 percent or more of the value of each business is included in the gross estate, the business can be aggregated.

    Payment can be deferred for up to five years at which time the first of a maximum of 10 annual payments becomes due. During the five years of deferral, the interest on the unpaid tax balance is due annually. Starting in year five, the tax plus interest installments are due annually.

    If an estate qualifies under Section 6166, a 4 percent interest applies to the amount of tax due on the first $1 million in business interest. The excess bears interest at the regular rate applied to extensions and deficiencies.

    Beginning in 1998, the interest rate assessed on the tax due on the first $1 million in taxable value of the closely held business will be 2 percent. Any excess tax will bear interest at 45 percent of the rate applicable to extensions and deficiencies.

    There are several pitfalls of Section 6166, which include:

    1. Section 6166 is difficult to plan for its use. The estate may no longer qualify if non-business assets appreciate faster than business assets, or the value of the business declines.

    2. An IRS lien may be placed on the business. This may free the executor of personal liability for the estate tax, but may also hurt the business and its financial statements.

    3. Full amount of deferral may become due if:

    • a payment is late or missed;
    • more than 50 percent of the assets from the business are withdrawn; or
    • more than 50 percent of the value of the business interest is sold, exchanged or distributed to anyone other than the beneficiary who is entitled to receive the interest.

    Qualified Family-owned Business

    A qualified family-owned business may qualify for an exclusion of up to $1.3 million reduced by the applicable exclusion amount. A proposed technical corrections bill, if passed, would slightly change the qualified family-owned business exclusion. The decreasing exclusion would then correlate to the increasing unified credit rather than the applicable exclusion amount.

    The requirements for a “family-owned business exclusion” are very complex. The following is a summary of some of the major provisions.

    • The business exclusion is only available for family-owned businesses transferred at death. (It’s not available for lifetime transfers.)
    • The decedent’s interest in the family-owned business must exceed 50 percent of the adjusted gross estate (adjustments for lifetime gifts). This is the so-called “50 percent test.”
    • The business interest must pass to qualified heirs — either family members or 10-year employees.
    • In addition, there are special “material participation” requirements. The decedent and/or family members must own and manage the business for five of the previous eight years prior to death. Also, qualified heirs and/or the qualified heir’s family must own and manage the business for 10 years subsequent to death.
    • If the business is sold within 10 years of death, other than to a member of the qualified heir’s family, tax savings are recaptured.

    A family-owned business can be sold or gifted during one’s lifetime. A business can be transferred at death through provisions of a will, trust or buy-sell arrangement. The family’s entire estate plan will be affected by some of the choices outlined in this article. The roles of your attorney, estate planner and insurance agent are critical to design a plan that meets your full objectives and can be readily implemented to help achieve family harmony and business continuity.

    This article summarizes some of the important legal and tax issues associated with business and estate planning. It is not intended to provide legal or tax advice. For more information, consult your personal attorney, estate planner and insurance agent.