April 12, 2018
It might be your dream to leave your family business to your children, creating the opportunity to build something together over generations. But your dream can sour in a hurry without smart business transition strategies — especially when it comes to taxes.
Even if you’ve ironed out all of the personal and professional issues that can arise with business succession, a well-considered plan could still fail if you don’t consider transition tax issues.
There are strict rules preventing family business succession from being used as a wealth-transfer vehicle exempt from taxation. As a result, what may have initially seemed like a simple family handoff can actually require a carefully crafted strategic business plan.
Transition strategies: start planning early
It’s common for private business owners to envision selling their children the business or gifting them the company in exchange for a continued income or seat on the board. These transition strategies may sound appealing from a business-continuity standpoint, but the tax implications can be severe.
“The capital gains tax alone on such an exchange can be very expensive,” says John Reddersen, a CPA and principal with Withum, a tax advisory firm in Washington, D.C. In a worst-case scenario, Reddersen says, a tax bill could be large enough to force the heirs to sell parts of the business to cover it.
To prevent value loss and ensure the next generation is well positioned to assume leadership and ownership of the company, Reddersen recommends that business transition planning start early. “You want to start planning while you’re still in good health and have time to make decisions,” he says.
Create a parallel business
According to Reddersen, a favorite strategy to potentially avoid tax penalties in a business handoff is to start a parallel business. Instead of handing over a fully functioning and highly profitable company whole — and the tax burden that comes with it — business owners can seed new businesses in their heirs’ names.
These startups can be linked to the core business and its clientele, without the overhead and assets of the original company. For example, instead of having your company develop and launch a new product, you could launch the product under a new name with a new owner — your children.
The new company has no initial value, but with the parents’ contacts, infrastructure and expert guidance, the startup could develop significant long-term value long before it’s ready to be handed off to the children. “The kids have ownership with a small interest held by the senior generation, and you move beyond the tax issue,” Reddersen says.
Use a gifting strategy, one piece at a time
For enterprises in which forming a parallel entity doesn’t make sense, another way to potentially avoid a big tax hit in a business transition plan is to gift the company in pieces.
Owners of smaller companies can take advantage of the annual $15,000 gift tax exemption to transfer ownership over time. Owners of higher-value companies can plan to use the one-time estate tax exemption to gift interest in the business to heirs while the business value is still low enough to meet exemption limits. The Tax Cuts and Jobs Act of 2017 doubled those exemptions to $11.2 million per individual and $22.4 million per couple starting in 2018, with these higher exemptions set to expire in 2026. The new tax law kept the estate tax at 40 percent.
“The longer you wait, the higher the value of the business is likely to be,” Reddersen notes.
The IDGT: A trust to avoid transfer taxes
Another way to help you potentially avoid taxes in family business succession is selling or gifting your business to an intentionally defective grantor trust (IDGT). IDGTs take advantage of estate tax exemptions to potentially avoid taxes on the transfer of the business, remove future appreciation from the business owner’s estate and hand that value to the next generation.
An added benefit of the IDGT is that it also allows future generations to avoid generation-skipping transfer taxes — but only as long as ownership stays within the trust.
All of these strategies can mitigate the risk of taxes in the transfer of a family business, as long as you plan ahead. Starting your planning early and having an accurate assessment of the business’s value are all critical components of a successful transfer plan.
There’s one more thing you should remember when creating a transfer plan, according to Reddersen: make sure that it focuses on meeting the needs of the family first and foremost, regardless of any future tax bills.
In consultation with your family, determine who should ultimately take over your business, along with how and when you envision the transfer occurring. Then, work with your wealth advisor and tax advisor to identify the best path forward. “You never want taxes to control the outcome of your legacy,” Reddersen says.