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Tax Strategies for Handing Down the Family Business

Taxes

In business, success is rarely an accident. So it's unfortunate that so many family business owners fail to plan for the transfer of their businesses to the next generation. Without planning, heirs often have to sell the business to pay hefty estate taxes.



Transferring stock from the owner of the family business to younger family members is one way to hand down the business. But stock transfers can take many forms, which can be used individually or in combination. Here are a few methods for transferring stock:

  • Bequeath stock. Stock can be bequeathed by the controlling owner's will. From an income tax perspective, this is an economical method. The younger generation obtains the stock at its fair market value, and no income tax is paid on any (potentially substantial) gain. However, bequeathed stock doesn't escape estate tax. The transferred stock is included in the decedent's taxable estate, and is subject to estate tax at rates that can reach 55 percent.


  • Tax-free gifts. During the owner's lifetime, some or all of the stock can be given to younger family members, which does not subject the owner to income tax on the gift. But this method packs a larger tax punch for the younger family members if and when they sell the stock. The gifted stock is acquired at the owner's original cost — not at market value at the time of the gift. The often-substantial difference is fully taxable. Note that the owner might also be subject to gift tax if the value of the stock exceeds the annual $12,000 gift tax exclusion allowed for each recipient.


  • Sell stock. The controlling owner can also sell his or her stock to the next generation. The sale can be either for cash or for a note payable over time. In either case, the buyer must pay for the stock with after-tax dollars. The seller will most likely recognize taxable gain on the sale. Although if the sale is for a note, the gain can usually be deferred until cash is actually received. The seller might also be subject to gift tax to the extent that the selling price is less than the fair-market value of the stock.


  • Private annuity. If a sale of stock is desired, consider a private annuity instead of a fixed price. A private annuity allows the seller to receive a fixed amount each year for life.


  • Redemption. If the next generation already owns stock in the family business, the corporation can redeem the controlling owner's stock. For the owner, the tax consequences of redemption are similar to those of a sale. But a redemption eliminates the need for the younger generation to come up with after-tax cash.


  • Buy/sell agreement. A buy/sell agreement is a legal document dictating the future sale of corporate stock. Using a buy/sell agreement ensures that the business transfer occurs according to an agreed-upon plan.
Each of these methods assumes that the family business has been legally incorporated. Remember that tax issues are complicated. Be sure to discuss them with you tax advisor before settling on a plan.



Mik Mikkelsen is president of Lautze & Lautze Accountancy Corporation. An expert in estate and income tax planning, he has more than 35 years of experience in income tax consulting, planning, and compliance. His practice areas include estate planning, corporate formations, liquidations, mergers and acquisitions, international aspects of U.S. taxation, and the taxation of S as well as C corporations, partnerships, trusts, and high net worth individuals.