Publications

TRANSFERRING A FAMILY BUSINESS TO FAMILY

Business succession planning answers a host of questions that ought to be on the mind of any business person.  What happens to the business when you’re no longer running it?  Who’s going to manage the business when you no longer work the business?  How will ownership be transferred?  Will your business even carry on or will you sell it?

If you have a family business, you will likely need to address these issues, and orchestrate a smooth transition of your business at your death or retirement.  With family businesses, succession planning can be especially complicated because of the relationships and emotions involved - and because it is often difficult to convince the business owner to discuss transition and transfer issues.

It is estimated that between 50% and 70% of family-owned businesses do not survive the transition from founder to second generation. The federal estate tax plays a role in these losses, but failing to plan for the succession of the business plays an equally significant role.  Saving estate taxes is usually the after effect of planning for other goals, those being primarily a happy and comfortable retirement and a successful transition of the business to co-owners, family, or key employees in order to support the retirement.

Here’s an overview of some business succession techniques:

Give the Business Away

Giving your family business outright to your children is the simplest way to transfer it.  You can do this either during your life or at your death.  Besides simplicity, the advantages include:

  • Simplicity,
  • Avoiding third-party involvement,
  • Paying any federal gift tax sooner rather than the generally higher federal estate tax later when the business may have appreciated in value, and
  • Removing the dollars used to pay any federal gift tax from your estate.

But the outright gift of the entire business can be unfavorable because:

  • Distributing your assets fairly is difficult if all your children are not involved in the business and it makes up a dispropor­tionate share of your estate,
  • The transfer provides few liquid assets to pay the gift tax, all of which is imme­diately due,
  • You lose control of the business if you transfer all of it to your children, and
  • The transfer leaves little opportunity for discounting or freezing techniques.

Sell to Family

In an intra-family sale, you can sell the business to participating family members.  Here are some advantages:

  • The assets are frozen at fair market value on the sale date, removing future appreciation from your estate,
  • Neither the transfer nor the post-sale appreciation will trigger any gift or estate tax, assuming the business was properly valued,
  • Your total tax burden may be signifi­cantly lower even though you pay income tax on the sale, because federal income tax rates are generally lower than federal estate tax rates, and
  • The tax savings will be even larger if the sale qualifies for long-term capital gain treatment.

The disadvantages of an intra-family sale include:

•  Family members may not have the cash to buy the business, and
•  The alternative of an installment sale may result in some children owing money to siblings, possibly causing future trouble.

Use Self-Canceling Installment Notes

With self-canceling installment notes (SCINs), you sell your business for full and adequate consideration in exchange for an installment note, on the condition that the right to receive payments terminates on your death.  The sale price is based on fair market value, taking into account a premium for the possibility that you will not receive the entire expected payment stream.  Here are some advantages of SCINs:

  • The capital gains tax you pay will further reduce your taxable estate, and
  • With careful planning, the transaction will have no federal gift tax consequences and will exclude the transferred property from your estate and any future appreciation, as well as the unpaid principal balance due on the promissory notes that would result if you die before the notes are paid.

The disadvantages of this method include:

•  The transaction will not qualify if you are facing imminent death, and
•  A reverse freeze can occur if you survive the term and you get back the property’s fair market value plus the premium.

Sell to a Grantor Trust

In a grantor trust sale, you establish an irrevocable trust and sell the business to it in exchange for a note.  Here are some of the advantages of this method:

  • The trust is excluded from your estate for estate tax purposes even though it is a grantor trust for income tax purposes,
  • You recognize no gain or loss because the sale is disregarded for income tax pur­poses as a sale by you to yourself, and
  • The trust pays the note, with interest. While the payment goes back into your estate, the appreciation goes to the bene­ficiaries — such as your children — and is excluded from your estate.

The disadvantages of a grantor trust include:

  • Careful planning is warranted because this technique involves some risks,
  • Improper valuation may result in unin­tended gifts, and

Under some circumstances, the IRS may reject the transaction as a sham and rule that the property remains in your taxable estate.

Next Steps

As you can see, these various methods all have pros and cons.  Each provides different income tax and gift and estate tax benefits.  None can be evaluated in a vacuum.  But one consideration overrides all else: Your need to develop a plan for the protection and transfer of what might be your most valuable asset -- your business.

Please contact us for further information and help in planning your best course of action.

Powell Trachtman Logan Carrle & Lombardo, P.C.
610-354-9700
www.powelltrachtman.com