From the May 2006 issue of Wealth Manager Web • Subscribe!

Down the Rabbit Hole

The statistics are staggering: 90 percent of some 21 million U.S. businesses are family-owned, according to the U.S. Small Business Association. In all, they employ 62 percent of the nation's workforce, contributing 64 percent of the gross domestic product. Yet only a third of family businesses are successfully transferred from parents to the next generation--and fewer still make it beyond that.

Why do so few family businesses transition to the founder's heirs? It's not for want of trying. So what goes wrong? What can be done to help ensure a smooth change of hands--without getting ensnared in a web of estate and gift taxes? What are the best (and worst) ways of constructing a sensible, orderly family-business succession plan?

Death Taxes

For many, if it weren't for estate taxes, the family business could simply transfer through inheritance. Estate taxes have become a political football, and it's increasingly hard to keep score. Briefly, between 2006 and 2008 only estates valued at more than $2 million are subject to the federal estate tax. The current estate tax rate is 46 percent; it drops to 45 percent next year. In 2009 estates can be worth up to $3.5 million before they're taxed. In 2010, the estate tax disappears; inheritances will be taxed as part of regular income. In 2011, however--unless Congress amends or overrules the Economic Growth and Tax Relief Reconciliation Act of 2001 before then--the estate-tax reappears and the exemption reverts back to $1 million!.

In any case, if a family business is worth less than $2 million today, there's no federal-tax-based reason not to let it pass through a parent's estate. Yet there may be plenty of other reasons not to. "Transferring a family business via the will is normally the worst form of business succession planning," asserts Mike Noland of The Greenbrier Group, a financial planning firm in Marietta, Ga. "Wills can be challenged. Outside creditors can also cause problems because the business becomes just another asset that has to go through the probate process."

Another potential problem: If an attorney or bank is named executor of the estate, who's going to run the business until the heirs take the reins? "Most institutional executors won't take on the fiduciary liability," says Thomas E. Murphy, a financial advisor at TEMAA Financial, in Dallas. "More likely, they'll put it up for sale, even if that wasn't the parent-owner's intent."

While that might sound extreme, there's no question that it's better to build a succession plan that begins in the business owner's lifetime. "Begin planning when the business owners are in their 40s, with the actual documentation occurring in their early 50s," suggests J. Richard Emens, a partner at Chester, Wilicox & Saxbe, a family-business law firm in Columbus, Ohio. "If the transfer has not occurred prior to the time the owner is 60 years old, then with each passing year the chance for successful succession is reduced."


There are numerous ways to gift a family business to the next generation during the parents' lifetime. Beware, however, of the two sets of gift-transfer taxes: the Unified Credit and the Annual Exclusion.

Under the Unified Credit, anyone can gift up to $1 million tax-free in his or her lifetime. That's a cumulative number; you cannot gift $1 million to each child, or $1 million every year. (For each year in which a gift is made, a gift tax return, IRS Form 709, must be filed.) The IRS presumes a total tax credit of $345,800, which is equivalent to $1 million in gifts; i.e., no tax is due until the $345,800 credit is used up. Unlike the estate tax, that cutoff is not expected to change in the future.

The Annual Exclusion allows another $12,000 in gifts per year per recipient tax-free. That figure is not cumulative, but it is inflation-adjusted. Next year, the exclusion might be higher. (Again, IRS Form 709 must be filed.)

This means a person can gift up to $1,012,000 this year, tax-free. If the business owner is married, the spouse can do the same, even if the spouse is not a co-owner. That's called "gift splitting." In all, then, a married couple can gift a combined $2,024,000 in 2006 without incurring transfer taxes, and continue gifting as much as $24,000 per year thereafter to any number of recipients--or more when the Annual Exclusion is raised for inflation.

If your client gifts more than the allowed amounts, the tax due depends on the size of the gift. Gift taxes range from 20 percent to 47 percent; the more the gift, the higher the tax rate. Still, a great deal of value can be gifted incrementally over the years, without owing one-cent in federal taxes. Needless to say, it's important to start early so there's plenty of time to transfer as much as possible.

Structuring the Business

How the business owner actually makes the transfer depends on how the business is structured. If it's a sole proprietorship, the transfer has to be made all at once--lock, stock and barrel. If it's a big business, valued higher than the tax cutoffs, nearly half the value could be turned over to the government. A sole proprietorship also affords virtually no liability protection; if anything goes wrong, the single owner is fully responsible. So if your client is a sole proprietor, it may be time to recommend a change.

Better options are a Subchapter S Corporation (or S-Corporation), a Limited Liability Company (LLC), a Family Limited Liability Partnership (FLLP) and Family Limited Partnership (FLP). All of these allow a large asset such as a family business to be divided into easily transferred pieces. They are also "pass through" entities, meaning they don't pay separate federal income taxes. Instead, individual participants add their share of profits or dividends to their own personal income tax returns.

Differences between these types of business structure are subtle. S-corporations function much like their larger corporate counterparts. In most states, they have to file annual reports and hold formal, documented meetings of their shareholders and boards of directors. Typically, S-corporations can only have a certain number of shareholders; how many depends on the state, but it's usually more than enough for a family. Parents can hold the only voting shares while sons and daughters own non-voting shares. All shares must be held by actual people or trusts; they cannot be held by partnerships or other companies.

LLCs, on the other hand, are generally free of such requirements, except for annual report filing. But again, that depends on state regulations. Another advantage of the LLC is that any creditors of the business cannot go after individual members' assets. A FLLP is like a LLC for members of the same family, says Noland. All members can be managers of the business, or just one or two of them---usually the parents. The children can be designated a "limited interest," meaning no management control. FLPs are similar in that parents retain the general partnership interest and thus, control of the business, while the children get only limited partnership interests. But unlike a FLLP, the general partnership interest does not retain the degree of liability protection the limited partners do--unless it's a limited liability entity itself, embedded within the FLP.

Make sure the FLP or FLLP is actually active in a family business, and not just an umbrella for other family assets. "The IRS is watching these closely because people have been abusing them," cautions small-business expert Douglas Neal, of the Neal Financial Group, in Houston.

In all of these types of businesses, parents can retain control of the company even while reducing their estate by transferring pieces of it to their children. Parents can even run the company although their kids own most of it. "Papa owns, say, 5 percent of the FLP, so his estate isn't as big as it was, but he has 100 percent control," says Neal. "Even if he decides later to sell the business, the cash comes to the partnership and the kids get their share of the money, paying capital gains taxes but no inheritance or gift taxes."

Another significant advantage of transferring business ownership this way: The IRS discounts the value of the non-voting or non-controlling pieces. The bits carved out for the kids can't be sold or traded, and have little use on their own, so the value is diminished by 50 percent to 70 percent. Parents can then gift away more without triggering federal taxes.

Suppose your client's business is assessed at $10 million. The client and spouse both own the controlling shares of the FLP. Their two kids each receive a non-controlling apportionment. The FLP could be divided into any number of shares, but for simplicity's sake, let's say there are only four shares--two for the parents and two for the kids. Each share would seem to represent $2.5 million, a quarter of the whole. But because the kids' shares signify no power or marketable value, the IRS discounts them by 70 percent to $750,000 apiece. That's well below the $1 million Unified Credit exclusion.


Clearly, it's crucial to get an objective appraisal of the business. Business owners should hire a Certified Value Analyst, usually a CPA who has additional certification as a professional business appraiser. "You can use annual sales volumes, book value, other variables such as number of employees, and normally accepted industry ratios to provide a ball-park approximation of business value," says Greenbrier's Noland. But for transfer purposes, he stresses, "an independent valuation should be done."

In fact, it should be done every time a gift is made, or at least every three or four years. "It's not that expensive," says Murphy, of TEMAA Financial, who estimates a professional appraisal costs between $2,500 and $10,000.

Special Circumstances

Though family-business owners can gift away the lion's share of their estate well before death, what happens if mom or dad wants to retire and relinquish control--or worse, perishes prematurely in a horrible accident? Whatever the structure of the business, it needs a buy-sell agreement to lay out what happens in such circumstances. Usually drawn up by a lawyer, this is a document signed by all parties involved that covers death, disability, disenchantment, divorce and disinterest. "The five Ds," says Marty Palumbos, of Lincoln Financial Advisors in Rochester, New York. If someone drops out of the organization for just about any reason, the others can or must purchase the vacated share. "The agreement doesn't quote a specific price, but it tells the initial value of each person's portion and provides a formula for determining the buyout price over time," Palumbos explains.

Usually the buy-sell agreement is funded with insurance. Each participant is insured with the other members as beneficiaries. So if one partner dies suddenly or chooses to leave, the others receive sufficient funds to buy back his or her share. "If Mom and Dad get hit by a bus and the kids have to buy their controlling interest, they're not actually inheriting it, so there's no estate tax to worry about," adds Palumbos.

If the children are small, the agreement could assign a trust fund to take over the parents' shares if they're no longer able to run the business. The trustee would have to be someone who can maintain the business until the children are old enough to do so. The agreement can also restrict transfer of ownership without the parents' permission, even when the children are of legal age.


As good as these pass-through options may sound, they have one key drawback. The controlling members (or shareholders) have a fiduciary responsibility to the other participants. Usually, that's no problem, but there are exceptions. Murphy tells of a FLP in which the father began using his share of profits to buy a condo and jewelry for "his new young wife," he relates. "The kids took their dad to court and accused him of violating his fiduciary obligations to the partnership. The judge agreed, and at the age of 70-something, the man ended up destitute."

The lesson: As soon as your clients form a family partnership, LLC or S-corporation, the business is no longer entirely theirs. They might retain control over operations, but they have an obligation to the other shareholders or partnership members. Some entrepreneurs may balk at this, leaving you to come up with another plan.

One option: Have your client's heirs start their own, competing business, which in turn hires your client as CEO or in some other key advisory position. Your client's reputation and client list will help the new company get off to a good start. This can effectively transfer the business to the heir, without provoking gift taxes. If your client sets up a trust to own the new business, the business' assets will be protected from the son or daughter's creditors. In other words, if your client's child is in a car accident and gets sued, the litigants won't be able to get any of the assets of the new business.

Another spin on the trust idea: The parent can in effect sell the family business to a Grantor Trust set up for the benefit of the kids. The business can be moved in pieces or all at once. The trust gives the parent an I.O.U. for the price of the business plus interest, so there are no income tax ramifications. Once the trust owns enough of the business, it can gradually pay the parent back from dividends and other distributions. "At the end of the note period, when it's paid off, the only asset from the business that's left in the parent's estate is whatever cash is left over," says John D. Schuman of the wealth management firm Budros Ruhlin & Roe, in Columbus, Ohio. "The business is completely in the trust for the kids."

Other business owners might take a tip from the Walton family, of the Wal-Mart Stores chain. They're known to have used Grantor Retained Annuity Trusts (GRATs) to great effect. Here's how GRATs work: The parent puts a share of the business in trust for the children. If the parent is repaid the cash value plus interest at the end of the year, there's no tax due. Here's the trick: The interest, at a rate set by the IRS, is based on the initial value of the assets put in the trust--not their value at year-end. So if the assets appreciate in value, the trust ends the year with a profit. "It works best with something that has a clear valuation, such as Wal-Mart stock," says William J. Supper, director of financial planning at Massey, Quick & Co., a Morristown, N.J. firm. "Suppose Sam Walton puts $100 worth of Wal-Mart stock into the trust for his children," Supper hypothesizes. "He promises to pay himself back from the trust and charge the trust interest at a rate defined by the IRS, which currently is about 5 percent, so there won't be any gift tax. The stock explodes, and a year later those shares are worth $200. The trust has to repay Sam $105, and keeps $95 that's escaped gift and estate taxes. A lot of wealthy families use this kind of strategy."


Veteran advisors to family business owners point out that there's more to transferring a business than avoiding excessive taxation. All sorts of family dynamics come into play. "The accounting and legal issues can't be addressed if the [business] owners don't make personal decisions about fairness, equality, competency of heirs, governance of the business, and management succession," says Dean Fowler, president of Dean Fowler Associates, an estate and financial planner in Brookfield, Wisc.. "These soft issues drive the decisions about the accounting and legal issues. I see too many excellent estate plans fail because they were inconsistent with the extended family's needs and goals."

To try to address those needs and goals, it's a good idea to have your client introduce his or her children to the business early on and listen to their suggestions and ideas. Some advisors recommend that the offspring go to work for a competitor for a few years, to get a feel for the business without being in the shadow of mom or dad. Of course, whether the child wants to be in the business and whether he or she is actually capable of running it might be two different things. In some cases, it's necessary for the business owner to hire outside management, keeping the kids involved only as silent partners or nonvoting shareholders. "We're talking about two independent steps in any successful transition--ownership and management," stresses Schuman, at Budros Ruhlin & Roe. "More businesses fail to survive a transition due to poor management succession than problems with ownership or taxation issues."

Still, there's a solution for every problem. For instance, if one child can take over the business while the other doesn't want it, your client can give control to the one who stays in the business and buy life insurance for the other, so he or she can receive an equivalent amount of cash. If none of the children wants to be involved in the business, however, one option is to sell it. Big businesses are usually easier to sell than small ones; a small family business relies more heavily on the unique skills, vision and drive of its founder. Keep in mind that the seller will have to pay a capital gains tax, based on the sale price minus the value when the business was launched (assuming the seller was the founder), which is probably close to zero.

On the other hand, if the children inherit the business and then sell it, their capital gain will be less since they benefit from a step-up in basis. That is, they subtract the value of the business at the time they received it from its sale price to determine their capital gain.

But if the parents gift the business to the children, instead of allowing them to inherit it, there is no step-up in basis. If and when the second generation sells the business, they will have to pay the full capital gains tax going back to when the parents started or otherwise came into the business.

If the business has been hugely successful but there's a need for cash, it might be wise to advise your client not to sell, but to take a loan against the value of the business. The heirs can sell it later, after they've inherited the business, and take advantage of the step-up in basis. They can distribute the assets with less of a capital gains tax burden.

Retirement Needs

In planning a business succession strategy, it's important not to forget about funding the parents' retirement. If their entire income depends on the business they're transferring, what will they live on after their kids take over?

For this reason, family business owners should begin saving money outside the business as early as possible. It might not be easy to convince them. "All entrepreneurs want to reinvest in their business," observes Grant Robinson, of Robinson & Company, a family business advisory concern in Guelph, Ont., Canada. Remind them, he says, that "they have to save money to be able to step away from the business eventually and allow the kids to come in. It's essential to their building a legacy." He suggests the separate assets primarily be in low-risk investments, especially if the business itself is risky.

Yet if the business owner isn't able to put aside sufficient assets, other provisions can be implemented to guarantee an income stream after retirement. One example is a salary continuation plan, which is a contractual agreement that all owners of the company or partnership must sign on. The plan makes it the business' obligation to keep paying the founder or founders a certain amount after they leave the business. "Think of it as a severance package," says TEMAA Financial's Murphy. "The plan basically says the parents were undercompensated early in their career, which is almost always easy to document, and to make them whole again the company will continue to make payments in the event of retirement or disability and to the surviving spouse in the event of death." Furthermore, because the payments are part of a contractual obligation, they are deductible as business expenses. In case the IRS questions the expense, Murphy recommends writing the provision into the company minutes as early as possible, even at the business' first official meeting. At the very least, the document should be drawn up five years before a planned retirement.

Real Estate

Another idea is to separate the business from the real estate where it operates. It's best if your client owns the real estate, rather than rents from a third party. The real estate can then be owned outright or by a company or partnership entity that's distinct from the one that owns the business itself. "The business needs to be in a pass-through company for the liability protection, but the physical facility doesn't," notes Palumbos, of Lincoln Financial. "A company-owned piece of real estate doesn't get the tax benefits of depreciation that an individual gets."

If the parents own the plant or retail space where the business operates, the business can continue to pay them rent for the use of the property after they retire. "It's very common in closely held family businesses to have the parents own the real estate where the business operates," says Palumbos.

Additional considerations may arise if the family business is real estate. First, there are title issues. Even if the business is successfully transferred to the next generation, title to the real estate must be transferred separately. This process can be simplified, however, if the real estate is owned not by your client outright, but by an LLC. An LLC rather than an S-corporation or FLP, protects the owners from liability if, for example, someone slips and falls on the property. The LLC remains the owner of the property no matter who its member/shareholders are. "To transfer ownership of the real estate, you transfer interest in the LLC," says Supper, at Massey, Quick & Co. "Often people create a separate LLC for a piece of property just to shield the liability of the investors."

Combined Approach

In fact, in many cases, the best solution to the problem of how to pass a family business down to the kids is a combination of techniques and financial structures. "It's not at all unusual for family businesses to have two or three or more companies, partnerships, and/or trusts in place," observes Palumbos.

This is especially true with larger businesses. "We might use a FLLP to protect and control the transfer of a family business to the heirs. If any of the children are minors, we might put their portion of the FLLP in a GRAT. If the business interests include real estate, we might put each property inside a single-member LLC under the control of the FLLP. Then we might use an LLC for the general-partner interest in the FLLP to further insulate the family from lawsuits, creditors and ex-spouses of the children," says Noland, of The Greenbrier Group.

Because setting it all up can take years and might involve accountants, attorneys, trust officers, and more, it never hurts to start early. "It takes a team approach," says Palumbos, "but the financial advisor plays the crucial role of the quarterback."

Ben Mattlin, a Los Angeles-based writer, covers financial topics for a wide variety of publications

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