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    Wednesday
    Dec082010

    Transferring your family business to your children

    Because transferring your business to your children can have income, gift, and estate tax consequences, it can take careful planning to prevent some (or all) of the business assets from having to be sold to pay those taxes. Your business succession planning should include ways to ensure the continuity of your business with the smallest possible tax consequence.

    Some common strategies for minimizing taxes are discussed briefly below, but none of these strategies are without drawbacks.

    Gifting or bequeathing your interest outright

    If you don't need continued income from the business and you don't want to retain some control, you can simply give the business to your children outright. To minimize the gift tax consequences, you can first use your $5 million lifetime exemption. Then, you can begin a systematic program of making annual gifts to your children in amounts that equal the annual gift tax exclusion (currently $14,000 per year per recipient). By transferring your interest in this manner, you may be able to transfer all or a significant portion of the business free from federal gift tax (although these transfers may still be subject to state gift tax depending on where you reside - be aware, however, that there is no Massachusetts gift tax in effect at this time). The disadvantage here is the amount of time that may be needed to transfer your entire interest.

    If you can wait and transfer your business at your death, Section 6166 of the Internal Revenue Code allows any estate taxes incurred because of the inclusion of your family business in your estate to be deferred for 5 years (with interest-only payments for the first 4 years and interest plus principal due in the fifth year), and then paid in annual installments over a period of up to 10 years. This will allow your beneficiaries more time to raise sufficient funds to pay the taxes or obtain more favorable interest rates if they need to borrow the money. Be aware that the business must exceed 35% of your gross estate and other requirements must be met.

    Selling your interest outright

    If you need income from your business, you can sell your business interest (for full fair market value) to your children. This will avoid gift and estate taxes, but you may owe capital gains taxes. However, currently, long-term capital gains tax rates are lower than gift and estate tax rates.

    Using a buy-sell agreement

    If you want to sell your business interest to your children but retain control over the business for a while, consider using a buy-sell agreement. This is a legal contract that prearranges the sale to happen when a specific event occurs, such as your retirement, disability, divorce, or death. When the triggering event occurs, the children will be obligated to buy your interest from you or your estate. The price and sale terms will have been predetermined. Remember, however, that you will be bound under a buy-sell agreement: you won't be able to sell or give your business to anyone except the buyers named in the agreement (unless they consent).

    Using a grantor retained annuity trust (GRAT)

    A GRAT is a trust into which you would transfer your business interest. The value of the gift is determined using the IRS's current interest rate (published monthly by the IRS). The trust must terminate at a specified time (e.g., 10 years). You receive annuity payments during the term of the trust, and at the end, your children will receive the business. Hopefully, the business will have appreciated beyond the IRS's interest rate, allowing the excess to pass tax free. Be aware however, that if you die during the GRAT term, your entire business interest will be included in your gross estate for federal estate tax purposes. You will have failed to transfer your business interest and lost the tax advantages of the GRAT, and you will have incurred the costs of creating and maintaining the GRAT for nothing, so structure your GRAT carefully.

    With a GRAT, you receive a fixed dollar amount that does not change even if the value of the trust property (corpus) increases or decreases. You may, alternatively, retain the right to receive a fixed percentage of the trust corpus, determined annually. That type of trust is called a grantor retained unitrust (GRUT).

    A rolling or cascading GRAT is a technique that involves creating a series of short-term GRATs (typically two or three years) with each successive GRAT being funded by the annuity payments from the previous ones. This technique can minimize the risk of the grantor dying during the GRAT term, and can also minimize interest rate risk.

    Creating a family limited partnership (FLP)

    An FLP is a type of business entity. First, you establish a partnership with both general and limited partnership interests. Then, you transfer the business to this partnership. You retain the general partnership interest for yourself, allowing you to maintain control over the day-to-day operation of the business. Over time, you gift the limited partnership interests to your children, leveraging your lifetime gift tax exemption and the annual gift tax exclusion. You also save taxes because the value of the gifts may be eligible for valuation discounts, such as the minority interest and lack of marketability discounts.  Be aware, however, that three recent tax cases (Hackl, Price and Fisher) have held that gifts of interests in family-owned businesses to family members do not qualify for the annual gift tax exclusion if the interests transferred are not “present interests,” with readily ascertainable income and an immediate economic benefit for the donee of the gift.