An important aspect of tax planning for any business owner is succession planning. Implementing the best strategy for your business, family, and tax savings can be a daunting process. To aid you in your succession plan, below are the top 10 succession planning strategies to provide you with tax advantages as you hand over your business to the next generation. The following overview will give you an idea of the benefits and disadvantages of each option, but you should consult with a qualified advisor before implementing any of these strategies, as there are procedures and qualifications, the details of which are beyond the scope of this article, that must be met in order for the strategy to reap the full tax benefits described.
Taxpayers can give a maximum of $15,000 per year to any number of recipients (married taxpayers can give up to $30,000) without incurring gift tax. A business owner can use the annual gift exclusion to start transferring business interest by planning stock gifts to family members, incurring little to no transfer tax.
- Stock gifts allow individual business owner to pass ownership to successors of their choosing during their lifetime
- May help avoid probate and other estate costs
- Reduces taxable estate
- Stock gifts could create income tax advantages by shifting income to taxpayers in lower income brackets
- Value of a gift of a minority block of stock in closely held corporations should be determined without regard to family relationship of the donee to other shareholders
- Donor cannot use the securities to alleviate unexpected future financial burdens
- Business owner may not be ready to give up control of the business
- Business owner might not want to give up dividend income (C Corporations)
- Transferring stock to trusts may result in unexpected and significant tax consequences if strict compliance is not followed
Buy/Sell agreements generally allow the company or remaining shareholders to acquire stock at a set value from the estate of a deceased shareholder. Usually, the purchase is made with insurance funds. The corporation would pay the premiums on the life insurance that will be used to fund the stock acquisition from the estate, and then the corporation deducts the premiums and they are reported as income by the stockholders-beneficiaries. If the corporation is the beneficiary, they do not take the deductions and do not report the income.
- Liquidity provided to estate and business
- Smooth transition reducing family disputes and minimizing likelihood of forced liquidations
- Increased ease of transition by adding a provision to the buy/sell agreement with the evaluation procedure or formula
- Flexibility in structure with hybrid or combination plans
- Generally not taxable if stock’s value exceeds 35% of the decedent’s adjusted gross estate and other requirements are met
- Difficulty of structuring when unrelated shareholders are involved
- Cost of insurance coverage
- Potential characterization of corporate funds used for purchase by shareholders as disguised dividends
- Must meet specific requirements to be treated as part of the GST tax value
Recapitalization – E Reorganization
E reorganizations are when a shareholder exchanges common stock for preferred stock in a tax-free transaction. This changes the corporations underlying capital structure, but the preferred stock can be voting stock so that the shareholder giving up common stock still has control.
- Assures future dividend income
- Starts transfer of business without giving up control
- Gives other shareholders motivation to grow the business
- Preferred stock may be given in the future as a tax-free gift
- No reportable gain
- Simplifies stock valuation for estate tax purposes
- Preferred stock sale could be subject to ordinary income tax rates due to potential for Code Sec. 306 taint
- Capital loss limitations against ordinary income
- May be subject to Chapter 14 “estate freeze” where the transfer restricts business interest’s growth and value by attributing growth to heirs
- Value of retained interest is zero for gift tax purposes if the owner relations an interest after transferring business to family members
- Can cause non-tax issues to arise, such as: company control, stock allocation, and future dividend policy
Stock redemptions are tax-advantaged treatments for qualified stock redemptions under Code Sec. 302. This is very similar to the buy/sell agreements, but can be made without an actual agreement.
- Provide immediate and long-term cash flow to retiring owner
- Redemption to terminate owner’s interest treated as capital gain sale or exchange
- Strict criteria regarding termination of a shareholder’s interest
- Retiring shareholder must agree not to acquire an equity interest or retain interest as an officer, director, or employee for 10 years, if any immediate family continues to own stock
- If the 10 year provision is violated, the redemption can be retroactively treated as a dividend
- Note used to finance the transaction must be carefully drawn in order to avoid violation of requirements
Selling stock can be completed either through lump sum or installment plans.
- Allows the owner to choose who receives the business
- Removes the stock from the seller’s estate
- Useful when seller’s gift tax exclusions are already fully used or if the owner prefers to receive a distribution
- Possible inability to locate family member to buy the stock
- Selling to outside investors can defeat succession planning purpose
- Strict rules for installment sales to related parties
- A second disposition of the stock within two years of the initial sale to a related party causes the gain on the sale to be fully recognized by the seller in the second year, if under an installment method
Private annuities are similar to stock sales, but the buyer agrees to make fixed periodic payments to the seller for the remainder of the seller’s life.
- Creates steady income during retirement
- Relatively uncomplicated
- Minimized estate tax
- Non-taxable transfer (unless not an arm’s length transaction)
- Gain spread out over time
- Difficulty locating a buyer
- Uncertain payment period because based on seller’s lifespan
- Potentially gives rise to gift tax
- Time-consuming negotiations and computations
An employee stock ownership plan (ESOP) help accumulate the cash necessary to acquire or redeem stock from a retiring owner.
- Deductions cash contributions and dividend payments to an ESOP
- Ready market for stock
- Useful financing vehicle because it can borrow money
- Cannot restrict investments to only stock of employer, so it can create a diversified portfolio
- Can be or own an S Corporation
- Deferral of gain if for seller to reinvest the proceeds of the sale to the ESOP 12 months into publically traded securities
- High administrative costs
- Control issues if employees acquire enough stock
- Market for stock can be greatly affected by external events and only marginally by company’s actual performance
A D reorganization allows a company to transfer one of its businesses to a newly created company in exchange for the new company’s stock. The new company’s stock is then distributed to the owners of the original company.
- Tax-free, if certain conditions are met
- Moves company out of owner’s estate
- Enables handing of family disputes without compromising the entity as a whole
- Determining the part of the company to move can be difficult
- Decrease the size of the original company can create problems
- Additional steps are needed to complete the succession plan
A B reorganization is essentially a stock for stock exchange wherein a business is acquired only for the purpose of acquiring the voting stock. The inclusion of some cash, not to exceed 20%, in the transaction might not affect the tax-free status of the reorganization if the transaction is properly structured.
- Ready market for stock
- No release from contingent liabilities
- Loss of control
There are a number of ways that a business owner can use charitable contributions to transfer property out of the estate and receive tax deductions. Tax vehicles such as a charitable remainder trust (CRUT) can potentially create future income flow.
- Reduces estate
- Creates deductions
- Bargain sale
- Unrelated use
- Family friction
By Amanda McBride
- This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.