Business Succession Planning Article

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 2013, a married taxpayer has a $10.0 million company and transfers all of the business to a three separate family trusts for his three children and their descendants. The client dies 15 years later. Such a gift has a number of benefits:

• If the minority interest which was transferred to each trust was discounted at 45% and the donor’s spouse agreed to gift splitting, the couple’s combined gift tax unified credit would cover the entire gift (i.e., $10.0 million discounted at 45% is worth $5.5 million – less than the couple’s combined gift exemptions).
• Because of valuation adjustments, even if the business did not grow, the immediate estate tax savings would be as much as $1.8 million (i.e., the $4.5 million valuation adjustment times a 40% estate tax rate after 2012).
• But what if the business grew at a 10% annual rate under the parents died 15 years later? At the end of 15 years, the prior transfer will have moved $42 million out of the donor’s estate, saving the family an additional $12.8 million in estate taxes (i.e., $32 million in appreciation at a 40% estate tax rate in 15 years).
• 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 a 40% 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 40% of the value of the business (even when electing estate 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 same element 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.

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 same element 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.

It is my impression that most small businesses split because either they do too poorly or they are too successful. Small business owners need to draft pre-nuptial (i.e., buy-sell agreements) at the beginning of their business marriages which definitively deal with how the business marriage will be terminated with the least amount of damage to the business. For example, if remaining owner is buying out the interest of the departing owner based upon a “going-concern-value” of the business, the remaining owner needs to make sure the agreement limits the ability of the departing owner to compete with the business or solicit its customers from an building across the street.

HEIRS MAY INCREASE THEIR OWN BURDENS. A son works in the family business. Over 20-30 years the 4 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 helping to foster 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 marriages end in divorce. Baby boomer divorce rates have doubled in the last two decades. 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-blood family members at divorce or death. Trusts can be created which provide long term benefits to family members, but deny such benefits to divorcing spouses or non-blood heirs. Although they are not particularly romantic, clients and their heirs should be strongly encouraged to sign pre-nuptial agreements before marriage.

Conclusion: Clients who realize the existence of these eight 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 three time 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.