Owning and operating a family business presents many challenges, perhaps none more daunting than planning for succession to the next generation. This challenge may become particularly complicated when not every member of the succeeding generation is or wants to be an active part of the business.
On one hand, you want to take care of your business by creating a smooth transition in management and operations. On the other hand, you want to provide for your children, whether they’re a part of the business or not.
In both cases, you want to minimize the looming estate tax liability which may hurt the business and the bottom dollar received by the next generation.
Gifting is one strategy to mitigate the potential pitfalls that may arise while passing the torch to succeeding generations. The following example illustrates gifting and how it works when the succeeding generation includes one child who is involved in the family business and another child who is completely uninvolved.
Mary owns a successful real estate management and development company valued at $6 million. Mary is divorced and has two adult children. She would like to divide her estate equally between her children. Only one child, however, her daughter, participates in the business. Her son does not.
It is not always easy for the owner of a business to give up control, especially when she is still actively leading the company. Mary is no exception. Yet her advisors are encouraging her to transfer some of the business to her children today.
Gifting provides a possible way for Mary to retain control of her business while removing the value of some of the business from her taxable estate at the same time.
Mary would like her daughter to take over control of the business, but would like both children to benefit equally from its success.
By creating voting and non-voting interests in her business, Mary accomplishes two things: She provides control of the business by giving her daughter voting interests and she delivers economic benefit to her son in the form of non-voting interests that provide him equal rights to dividends, distributions and liquidation proceeds.
Mary, however, may not be giving her son something equally valuable if the business does not make any distributions or is not sold. An alternative is for Mary to purchase life insurance and designate her son (or an irrevocable trust for his benefit) as the beneficiary of the policy.
If Mary’s business owns the real estate in which it operates, she can convey the real estate into a separate entity (such as an LLC) and charge the business rent. The entity will collect the rent and make regular distributions to its owners.
As Mary makes gifts of the business to her children, she can also make gifts of the real estate entity to her son.
The next step is to transfer the business interests in a tax-efficient manner. Mary may choose to spread out her gifting strategy over a longer period of time and gift interests in the business to her children in amounts equal to her “annual exclusion,” currently $12,000 per recipient.
If Mary were married, she could “split” the gift with her husband and gift $24,000 to each child tax-free.
If Mary wants to speed up the process – e.g. foreseeable IPO, declining health, early retirement, etc. – she can gift a larger percentage of the business to her children. Typically, gifted interests will have transferability restrictions.
Mary may want to limit the size of the gift so that the gifted interest is too small to constitute majority control of the business (more than 50 percent). Under these circumstances, with a proper valuation by a qualified appraiser, a “discount” may be available in valuing the gifted interest.
Assume an appraisal by an independent professional confirmed that Mary’s business is worth $6 million. Mary decides to gift 25 percent of her business to her daughter in 2008. Mary’s advisors conclude that a one-third discount for “lack of marketability” is appropriate.
In other words, the gift is not really worth 25 percent of the business because Mary’s daughter couldn’t sell the interest on the open market. Accordingly, the gift should be given a discount to reflect that the interest cannot be sold to a third-party.
Even though Mary is transferring 25 percent of her business’s value to her daughter ($1.5 million), for gift tax purposes, she is making a $1 million gift ($1.5 million minus the one-third discount). In addition to the annual exclusion, Mary has a lifetime gift tax exemption which allows her to gift $1 million during her lifetime tax-free. Mary’s gift is completely gift tax free.
Mary turns her attention to her son. She has decided to augment his inheritance with life insurance. Mary is concerned about leaving the death benefit outright to him because he is having marital problems and she doesn’t want the proceeds within his ex’s reach. Mary can leave the life insurance proceeds to her son via an irrevocable trust.
To add protection to her son’s inheritance, Mary may name an independent third-party to serve with her son as co-trustee. She can broaden the list of beneficiaries to include her son’s children. Mary will make annual contributions to the trust to pay the insurance premiums.
If Mary’s son and his two minor children are beneficiaries of the trust, Mary may gift $36,000 a year to the trust ($12,000 multiplied by three beneficiaries) tax free because of her annual exclusion. The trust will provide Mary limitless possibilities to design how and when the trust will pay money to her son and his family.
While this is a hypothetical example of a fairly common scenario, no two family business situations are identical. This hypothetical demonstrates why working with a team of legal and financial advisors (e.g., accountant, financial planner, estate planning attorney) is critical, particularly well in advance of your retirement from the business.
Jennifer Civitella Hilario, Esq. is an associate attorney with Tarlow, Hart, Breed and Rodgers, Boston, and concentrates her practice in the areas of tax and estate planning.