Transferring family-business ownership to the next generation

There comes a time in almost every family-owned business to pass the torch to the next generation. But there are many aspects that must be carefully worked out long before the transfer actually happens. Here are just a few for you to consider.

Now or later?

To transfer the greatest wealth to your family, first decide whether to give shares immediately or at your death. In addition to $14,000 annual exclusion amounts, you can bestow up to $5,340,000 — the 2014 lifetime gift tax exemption amount — during your life without having to pay gift tax.

But the amount you give under your lifetime exemption reduces the amount you can transfer estate-tax-free at death. Plus, certain taxable gifts you’ve made within three years of your death are effectively brought back into your estate.

How to decide when to give? Consider not only the potential future estate tax savings, but also family income tax savings. And, remember the possible cash flow issues of having some of the company ownership, and attendant income and distributions, attributable to others.

Basis basics

Consider this scenario: Robert has heard about gifting but isn’t sure it makes sense for him. In theory, he likes the idea of transferring a portion of the business to his children, but he doesn’t want to relinquish control of the company. He also has heard of “step-up” in basis, or the loss of step-up, though he isn’t really sure how it should affect his decision.

Here’s how step-up works: If Robert owns certain property — such as his company shares and other securities — when he dies, its basis for income tax purposes steps up to the fair market value on that date (or, in certain circumstances, an alternate valuation date). But if he gifts the asset during his life, his basis carries over to the recipient, which can mean more income tax liability when the recipient sells the asset.

So, if Robert has a $1 basis in an asset and gives it to his children, they get his basis. If they sell when the asset is worth $1 million, they have a $999,999 gain. On the other hand, if Robert dies owning the asset when it is worth $1 million, and his children then sell it for the same amount, they’ll have no taxable capital gain.

Of course, the $1 million would be included in John’s estate and, at the highest current federal estate tax rate of 40%, be subject to a $400,000 tax (if he has no remaining estate tax exemption available). It also might be subject to state estate tax.

Giving and keeping

Because his children have consistently expressed the desire to continue running the company, Robert likes the idea of gifting shares in the business even though he realizes they won’t get a step-up in basis on those shares.

Besides, his other assets include long-held securities that have appreciated significantly. It’s more likely the children would sell those assets after his passing — and benefit from a step-up in basis on them — particularly if they needed liquidity for estate tax purposes. So it seems more prudent to Robert to focus on giving company shares and keeping the other assets.

He therefore decides to give each child a 10% interest in his company. Not only does this meet his objective of keeping control, but he learns that, as a bonus, the shares are probably eligible to be discounted for gift tax valuation purposes.

Let’s say a formal valuation determines that a 30% discount is appropriate for his company’s shares. Using the gifted shares’ $4.5 million discounted value, Robert is able to make the gifts without fully expending his lifetime gift tax exemption.

Think it through

If you’re wrestling with the thought of giving your heir(s) the reins to your business, don’t fret. Your tax, business and estate planning advisors can help you work through the multiple decisions that must be made when turning over a family business to a successor.  •