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Transferring The Family Business To Your Heirs

If it were easy to hand off a business to the next generation, more than just one in three would successfully complete the trip. As it is, many factors contribute to a high mortality rate for family companies. Estate and gift taxes take a toll, and so do family conflicts about who will take over, how to compensate heirs who don’t work in the business, and how to keep the company safe from divorcing spouses and creditors who want a piece of the action. A well-thought-out plan can head off many problems, but what works for one family may be wrong for another.

Gift and estate taxes kill many family firms. Though the first $3.5 million of an individual’s estate is currently shielded from estate taxes, inheritors of a company worth $5.5 million might owe almost $2 million in taxes, and coming up with the cash often means selling assets or the business itself. Meanwhile, giving away a business before death could trigger punishing gift taxes that kick in after you’ve used a $1 million lifetime gift-tax exclusion.

The simplest solution is to transfer ownership of a company gradually, or to fund a trust that helps reduce taxes. There’s an annual gift-tax exemption that permits tax-free gifts of as much as $13,000 to an unlimited number of recipients. Such relatively small gifts add up over many years, particularly if you take advantage of techniques the IRS allows for discounting a gift’s value. But a gradual transfer requires a sound succession plan and the right business structure.

You may want to begin plotting your exit from a business years before you leave. An early start lets you groom your successors and choose a business entity that serves your ends. It also gives you a chance to see who among your heirs is interested in working in the business and perhaps one day taking the helm. Meanwhile, you can consider how to structure your estate to provide fair compensation to heirs who choose a different career.

You won’t be able to transfer your business piecemeal if it’s organized as a sole proprietorship, which must change hands all at once. Shares in most other business entities—so-called C and S corporations, limited liability companies (LLCs), and limited partnerships (LPs)—can be broken out and given away a few at a time, and you may be able to retain management control even when you become a minority shareholder. Moreover, if children can’t sell their stakes, the IRS considers the shares to be worth less than their full market value—so that an $18,000 piece of your business that you give to your daughter might count as a gift-tax-exempt transfer of $13,000. But you’ll need an entity that passes muster with an increasingly-wary IRS. Owners who want to transfer value but keep management control must be particularly careful.

Various trusts can help reduce gift and estate taxes, deal with control issues, and shield personal assets from creditors. For example, you could sell the company to a grantor trust created for your heirs. You’d get an IOU, and the business would gradually pay for the shares transferred into it. Or you could set up a grantor retained annuity trust, or GRAT. If the company gains value at a rate exceeding an interest rate set by the IRS, you could end up with a major break on gift and estate taxes.

Regardless of how your business is constituted, and however you decide to hand it off to your heirs, you need a formal buy-sell agreement spelling out what happens if you die unexpectedly or simply choose to walk away from the company. Such an agreement obligates partners or heirs to purchase your share according to a specified formula, and it’s typically funded with life insurance on you and other owners—likely the heirs to whom you’ve begun to transfer ownership. If you die, they get the proceeds and can buy back your stake.

Almost all of these strategies require an accurate fix on what your business is worth, and that means periodic assessments by a professional business appraiser. We can help you find one and work with you on a succession plan that reflects the make-up and goals of your family and business.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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