Article: Transferring Ownership of Your Family Business

Transferring ownership of your family business

It’s bad enough that estate planning is often relegated to the back burner. But for too many business owners, succession planning never makes it onto the stove. The following list of planning options, with some of their pluses and minuses, may help you get started.

Outright gifts. The simplest way to transfer a family business is to give it outright to your children, either during your life or upon your death.

Advantages. The outright gift is simple, and it avoids the involvement of third parties. The gift will probably trigger a gift tax, but the ultimate cost will be lower than the estate tax on the same asset, and the value of your taxable estate will be lowered by the amount of the gift tax.
Disadvantages. The transfer doesn’t provide liquid assets to pay the gift tax. If not all of your children are involved in the business, and if your company is your most valuable asset, you’ll probably find it unusually difficult to distribute your assets fairly. An outright gift of the entire business also leaves little opportunity to achieve savings through discounting or freeze techniques.

Intra-family sales. Another option is to sell the business to family members who are involved in it.

Advantages. The assets are frozen at fair market value at the date of sale, which removes future appreciation from your estate. Assuming the business has been properly valued, neither the transfer nor the post-sale appreciation will trigger any gift or estate tax. You pay income tax on the sale, but the total tax can be much lower because income tax rates are lower than estate tax rates. The tax savings will be even greater if the sale qualifies for long-term capital gain treatment.
Disadvantages. The involved family members may not have the cash to buy the company. If the sale is made on an installment basis and you die before all payments are made, you may create an undesirable situation in which some of your children owe money to their uninvolved siblings.

SCIN. With a SCIN – a self-canceling installment note – you sell the business for full and adequate consideration in exchange for a note paid on an installment basis, on the condition that the right to receive payments terminates upon the death of the buyer. The sale price, which is based on fair market value, must take into account a premium for the potential that you will not receive the entire expected payment stream.

Advantages. With careful planning, the transaction will have no gift tax consequences. It will exclude from your estate (a) the transferred property, (b) all post-transfer appreciation of the property, and (c) the unpaid principal balance due on the note if the buyer dies before the note is paid. The capital gains tax you pay will further reduce your taxable estate.
Disadvantages. The transaction won’t qualify if the buyer is facing imminent death. Also, a reverse freeze can occur if the buyer lives long enough to pay off the note and you get back the fair market value plus the premium mentioned above.

Sale to a grantor trust. In exchange for a note, you sell the business to an irrevocable trust that you establish.

Advantages. Even though the trust is a grantor trust for income tax purposes, it is not included in your estate for estate tax purposes. You recognize no gain or loss because the sale is disregarded for income tax purposes. The trust pays the note, with interest. While the payment goes back into your estate, the appreciation goes to the beneficiaries and is excluded from your estate.
Disadvantages. Improper valuation may result in unintended gifts. Under certain circumstances, the IRS may disallow the transaction as a sham and restore the property to remain in your taxable estate.

Start planning now. Selecting a transfer method can be complicated, but don’t allow the complexity to distract you from the importance of addressing the future of your business ownership. The right planning is essential to protect and transfer what is probably your most valuable asset: your business.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.