It takes careful planning to keep a business successful. What many family business owners fail to realize is that a succession plan is a necessity, not an option. There are many ways to hand down the business to the next generation, but your main objective is to minimize the impact of estate taxes on your heirs. This will help them avoid having to dispose of the business.
One way to hand down the business is by transferring stock from the family business owner to the younger family members. Since stock transfers can take many forms and can be used either individually or in combination, a few methods are discussed below. Keep in mind that these methods assume that the family business has been legally incorporated.
1. Gifting stocks tax-free: By gifting some or all of the stock to the next generation during the owner’s lifetime, the owner is not subject to income tax on the gift. However, the younger family members may be subject to a large tax bite if and when the stock is sold. Since the gifted stock is acquired at the owner’s original cost and not at market value at the time of the gift, the significant difference (which is often the case) is fully taxable when the stock is sold. In addition, gift tax may be applicable if the stock value gifted by the owner exceeds the $14,000 (inflation adjusted amount for 2013 through 2016) annual gift tax exclusion allowed for each recipient and the owner has exceeded the life-time gifting exclusion ($5.45 million for 2016, up from $5.43 in 2015). Please contact this office for annual and lifetime gift tax exclusions for other years.
2. Bequeathing stock: This is considered as an economical method from an income tax standpoint and can be done by the controlling owner’s will. Since the younger family members obtain the stock at its fair market value, any potentially substantial gain is not subject to income tax. However, bequeathed stock is included in the decedent’s taxable estate and subject to estate tax at rates that can go as high as 40 percent years after 2013.
3. Selling the stock: Another option of the controlling owner is to sell his or her stock to the younger generation. The buyer may purchase the stock in exchange for cash or a note payable over time, but it must be paid for with after-tax dollars. It is most likely that the seller will recognize taxable gain on the sale, but if the sale is for a note, the gain can be deferred until the cash is received. Gift tax may also apply to the extent that the selling price is less than the fair market value of the stock.
4. Private annuity: If you are considering selling stocks, a private annuity may be a better alternative than setting a fixed price. With a private annuity, the seller receives a fixed amount on a yearly basis for life.
5. Buy/sell agreement: Another method that is used to transfer stock is through a buy/sell agreement. This is a legal document that specifies how stocks in the business are to be transferred in the future. Having this type of agreement ensures that the business transfer is carried out according to the agreed plan.
6. Redemption: This applies if the younger generation already owns stock in the family business. If that is the case, the corporation can redeem the controlling owner’s stock. The owner is faced with similar tax consequences to that of a sale. The only difference with redemption is that it eliminates the need for the next generation to come up with after-tax cash.
Before deciding on a course of action, please consult your tax advisor. Tax issues are complicated and professional advice is strongly suggested.