Business Succession Planning Article
| Six Realities of Family Business Succession Copyright, 2006. John J. Scroggin, AEP, J.D., LL.M., All Rights Reserved. |
Many entrepreneurs intend to pass the family business to future generations. In considering that goal, there are six important realities that need to be understood:
The Estate Tax Is Not Going Away. Despite all of the political discussions to the contrary, there is not much chance that the federal estate tax will be permanently eliminated. Under the 2001 tax bill, the estate tax is only eliminated in the year 2010 and lifetime gifts over $1.0 million always remain taxable. Unless the elimination of the estate tax is re-enacted, on January 1, 2011, the pre-2001 tax laws are automatically reinstated, resulting in a reduction in the federal estate tax exemption to $1.0 million. The combination of a budget deficit, the cost of reforming the Alternative Minimum Tax, and the opposition of states, charities and most Democrats makes it extremely unlikely that Congress will vote to continue the elimination. Moreover, any re-enactment bill will probably be stopped by a filibuster in the Senate.
Currently less than 1% of all decedents are subject to a federal estate tax. It is likely that Congress will trade away the elimination of the tax for more broad-based tax changes. Instead, clients should anticipate a unified credit somewhere between $3 and $8.0 million per taxpayer (depending upon who wins the political arguments and how much the budget can fund).
Moreover, at least 38 states are considering or have enacted new laws to increase the state death taxes and gift taxes. Many of these new laws do not provide the significant tax exemptions that are provided against the federal estate tax. Therefore, even when a federal estate tax is not due, a state death tax may still be due. Clients need to discuss with their advisors the best methods to avoid or minimize these local taxes.
Given that the estate tax is probably not going to be eliminated, a family business owner who intends to pass the business to family members is forced to address the state and federal transfer tax cost of such a transfer.
There Is No Equity Value to A Family Business. When an entrepreneur wants to pass his or her business to family members, there is no true equity value to the business. Because the equity will not be reduced to cash (i.e., by a sale of the business), it provides no current benefit to the business owner. In fact, the equity value of the business is a liability waiting to happen because of the potential state and federal transfer tax liabilities on the passage of the business.
When the issue is properly addressed, the owner is interested in control of the business and the income and benefits which are derived from that control. Using readily available planning approaches (e.g., deferred compensation, voting rights, partnerships and trusts), the income and control of the business can be separated from equity, and the equity can be passed at a reduced tax cost to family members using various techniques (e.g., minority and lack of marketability adjustments).
The retention of the equity value of the business may create a transfer tax liability which could have been reduced or even eliminated. By retaining ownership, the entrepreneur loses the ability to not only discount the present value of the business, but also causes the family to pay estate taxes on the appreciation in the business. For example, assume in 2005 (when the gift tax unified credit is $1.0 million), a married taxpayer has a $10.0 million company and transfers 36% of the business to a family trust for his descendants. The client dies 15 years later. Such a gift has a number of benefits:
If the minority interest which was transferred was discounted at 45% and the donor's spouse agreed to gift splitting, the couple's gift tax unified credit would cover the entire gift (i.e., $3.6 million discounted at 45% is worth $2.0 million - the couple's combined gift unified tax credit). Because of valuation adjustments, even if the business did not grow, the immediate estate tax savings would be as much as $768,000 (i.e., the $1.6 million adjustment times the 48% top estate tax rate in 2004).
But what if the business grew at a 10% annual rate? At the end of 15 years, the prior transfer will have moved $13.7 million out of the donor's estate, saving the family an additional $4.5 million in estate taxes (i.e., $10.1 million in appreciation at a 45% estate tax rate in 15 years).
Because the entrepreneur still owns a majority of the business, he or she controls the business and determines how the income and benefits from the business are distributed. Trustees selected by the entrepreneur may control the gifted business interest and decide how trust distributions will be made to family members. With proper drafting, the business owner and/or heirs may retain the ability to remove the trustees, without the trust assets being included in his taxable estate.
With top estate tax brackets between 45% (starting in 2007) and 47% (in 2005) and the estate tax potentially due nine months after death, the tax burden may make it financially impossible for an entrepreneur to pass the business to family members. The tax payment of 45-47% of the value of the business (even when electing tax deferral under IRC section 6166) can result in such significant cash drains that the business cannot survive.
Essentially, federal transfer taxes are a voluntary confiscation tax. With proper planning the confiscation can be minimized or eliminated. The key is recognizing that equity is not the sameelement as control - and control allows the owner to benefit from the income of the business. The thoughtful business owner recognizes this difference and realizes that transferring current equity (and its future appreciation) can reduce the future tax burden on the business, without adversely impacting the owner's income or control. Contrary to the owner's intent, the emotional retention of all of the equity ownership can actually destroy the business.
The Inevitable Conflict. Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur's death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business.
During the owner's lifetime, the owner may have been able to maintain peace in the family and serve as the "benevolent dictator" of the family business. Unfortunately, this powerful role disappears with the entrepreneur's death or incapacity. Sibling rivalry, in-law problems and other issues begin to come forward, particularly between those who are operate the business and those who are outside the business.
Almost inevitably, the outsiders feel that the compensation and perks provided to the insiders are "excessive." Outsiders question the business decisions (e.g., capital expenditures, hiring and firing of employees, expansion plans) of the insiders even when they know little about the business's needs, operations or competition. Outsiders often believe that the income paid to them should match the compensation paid to the insiders.
Meanwhile, the insiders (who often feel they are working too hard) resent that their sweat is increasing the equity value of the outside family members who are continually asking for more and more income to which they are "not justly entitled." The insiders often fail to see that the outsiders have a right to a return on their "investment" in the business. Many family businesses have paid huge legal fees because of these conflicts and/or have been forced to sell the business to alleviate the problem.
This conflict is inevitable as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not a matter of "good" and "bad" family members. It is a matter of increasingly different life goals - a normal part of life.
The solution lies in setting up a structure in the estate plan which assures that those in the business own and control as much of the business as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this "equalization planning." This planning process is best done during the business owner's life so the entrepreneur can dictate the terms to family members. Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.
Heirs May Increase Their Own Burdens. A son works in the family business. Over 20-30 years the son helps grow the value of the father's business - only to share it with his siblings and a not-so-appreciative stepmother. Not only does the development of the parent's business increase the potential federal and state death taxes, but the son's participation in the growth of the business must be shared with siblings and other family members. By not addressing the issue before the father's death, the son will have increased his own burden. Even if a business owner is unwilling to address the value of the child's long term contribution, children in the business should address the issue.
Passing on The Problem. Many planners view the role of the estate planner as passing as much wealth to the next generation as tax-free as possible. Often a family business is included in the wealth passage. The problem with such an approach is it ignores the inter-generational tax confiscation of wealth that occurs as each generation grows the family's wealth and then attempts to pass it to the next generation.
Clients need to understand that it is possible to separate the control and income of the family business from its equity value and future appreciation. The equity and future appreciation can be passed across successive generations without incurring a transfer tax, while the control and the income benefits are passed to the appropriate family members who are involved in the business. Dynasty trusts can fulfill this purpose. Flexibility in inter-generational transfers can be maintained by using special powers of appointment and by the manner that successor Trustees are selected and/or removed.
Divorces Will Happen Almost 50 percent of all marriage end in divorce. If divorce is such a prevalent issue, why do we so often ignore the possibility in our planning? Planning should include reducing the divorce-driven exposure of a parent's and an heir's assets. Buy-sell agreements should be drafted to allow the family to purchase ownership interests which pass to non-family members by divorce. Trusts can be created which provide long term benefits to family members, but deny such benefits to divorcing spouses. Although they are not particularly romantic, clients and their heirs should be strongly encouraged to sign pre-nuptial agreements before marriage.
Clients who realize the existence of these seven truths will reduce future heartaches and avoid the potential loss of the family business to estate taxes and family conflicts.
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Author: John J. Scroggin, AEP, J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has written more than 300 published articles, outlines and books. To be added to his free blast email system on estate and income tax planning, contact Penny@scrogginlaw.com.
More planning information can be found at http://www.scrogginlaw.com/.
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