Keeping it in the Family An Overview of Selling or Transferring a Business to Family Members

written on August 24, 2009 by Chris Cooper

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Many family business owners want to continue family ownership of the business.  Unfortunately, 70% of family businesses do not survive to the second generation.  A good succession plan can allow a business owner to pass the business on to family members while minimizing taxation.  A variety of strategies can be used to pass on the business.  The tools available should be used to form a cohesive overall strategy for ownership and management succession.

Gifting stock is an alternative that is widely used and can completely avoid taxation on much of the value of the business.  Often, gifts are used along with other tools for an overall strategy to pass on the business. 

Trusts are another tool which can help to reduce taxation, provide continued income to the former owner and his or her spouse, then pass the business on to the next generation. 

Selling to a family member should be explored carefully.  IRS attribution rules can make this simple alternative much more complex.  The parties should arrive at a realistic, legally defensible value for the business.  A valuation performed by an independent, qualified valuation advisor may be very worthwhile.  Remember, the IRS is not obligated to respect valuations it does not consider reasonable.  A low valuation may cause the IRS to claim that there is, in fact, a gift being given, on top of the sale of the business.  A high valuation may saddle the business, or family member with excessive debt.  Further, IRS attribution rules complicate the process.  The process should be treated very carefully, as the proceeds could be considered by the IRS to be a dividend payment, or a gift to the family member.

Selling a business to a family member may, in effect, maximize taxation.

• The purchase of the business, whether directly by the family member or through the business, will be done in after tax dollars.  This means that the business may pay as much as $1.52 per dollar of capital purchased.  (This assumes a 34% business tax bracket.  The business must make $1.52, pay $0.52 in taxes and have $1 left to pay for stock or assets).  Further, if the business or family member has to borrow funds to acquire the assets or stock, there will be interest on that money as well.

• The owner will pay capital gains taxes on the gain realized at the sale of the business, reducing the after-tax value of the business to the owner.

• When the unused portion of the proceeds from the sale of the business pass into the estate of the original owner, they will be counted in the overall estate.  Therefore, estate taxes will be taken out before the estate is passed on to the heirs and beneficiaries.

Grantor Retained Annuity Trusts (GRAT) can move assets into a trust.  After the trust termination, it will be outside the estate and thus reduce taxes.  A business owner can establish a GRAT that will provide continuing income to the business owner and his or her spouse.  When the fixed length or lifetime annuity expires, the assets of the trust are passed to the beneficiary – the next generation or a second generation – further avoiding taxes.

Supplemental Executive Retirement Plans (SERP) can provide income to a retired owner, and reduce taxation.  A SERP is an unfunded liability of the business.  The firm pledges to pay a certain amount of income to the retired executive for a number of years.  Since this retirement plan pledges future income of the business, it will reduce the fair market value of the business.  The business can then be sold for a reduced price to the successor generation, gifted directly, or passed into a trust.  It is important to establish the SERP before the sale of the business, as the IRS can rule that the SERP is a payment for purchase of the business, hence disallowing the corporate deduction.

Family Limited Partnerships may be used to split the value of the business into income, equity and control functions.  Once split, the owner can sell or gift the equity assets to the next generation.  In this way, the business owner can retain control.  The limited partnership units receive a greater discount in these transactions than the company stock by itself.  The Family Limited Partnership is especially useful in a long-term strategy for transferring ownership.  The ability to use it is one of the many advantages to timely succession planning.

Selling or gifting rapidly appreciating assets is a technique that can be used to achieve the same goals as the Family Limited Partnership.  By shifting ownership of assets that are likely to increase in value, the owner of a business can transfer the assets at a low value, through gifting or sale, and the appreciation in value will be in the ownership of the next generation, avoiding taxation on the first generation.  This approach, too, can be of tremendous value over many years.  These alternatives are some of the many tools which can be used to keep the business in the family, while reducing taxation.  All of the alternatives have complex tax implications and should not be established without proper legal and financial advice.

This article is excerpted from An Owner's Guide to Business Succession Planning, 2nd Edition, by Stephen Clifford and the Staff of the Ohio Employee Ownership Center's Business Succession Planning Program at Kent State University, and was edited for COSE Mindspring by Chris Cooper.  The book can be ordered from the OEOC at http://www.oeockent.org/index.php/home/publications-a-research, or you can contact Jay Simecek, Roy Messing, or Chris Cooper of the OEOC at 330-672-3028 or oeoc@kent.edu. The book and dvd were made possible with the support of the Ohio Department of Job and Family Services (ODJFS).