Charitable Planning Can Enhance Business Succession Plans

A major challenge facing all business owners is planning for the ultimate succession of ownership and management in a way that will assure the businesss continuity, perpetuation and prosperity. In the case of a family business, adding to the challenge is the complex relationship between business objectives, family dynamics and personal financial goalsas well as the fact that the business interest often represents a substantial majority of the owners estate.

Additionally, in many cases, successful business owners are active and visible members of their communities, so philanthropy may be an important component of their financial plans and objectives.

In recent years, there has been a growing awareness and utilization of charitable remainder trusts and charitable lead trusts to accomplish clients goals in the context of personal financial planning, estate planning and philanthropy. But charitable trusts also can be an effective and tax-advantaged planning technique in a succession strategy for a family-owned business.

A charitable “bail-out” of a business interest may be used to get cash out of a C-corporation while minimizing corporate and individual taxes. It can also result in the transfer of business ownership to the next generation without adverse gift and estate tax consequences.

If the owner of a highly appreciated business interest sells it, substantial capital gains tax will be paid, and any lifetime gift of the business interest to successors will result in low carryover cost basis to the donees and potential gift tax. For the business owner who is charitably inclined, a charitable “bail-out” may provide an attractive alternative planning technique.

Consider the following examples:

A client and his children own shares in a C-corporation that has retained earnings. The client can transfer some of his shares to a charitable organization or charitable trust, and the corporation can then use the retained earnings to redeem the shares transferred. The client will receive an income tax deduction and thus increase after-tax income, the corporations retained earnings will be reduced, and the client will make a significant charitable gift while transferring equity in the corporation to his children without any gift tax.

Likewise, assume a business owner anticipates the eventual sale of his business interest to someone (e.g., children or other co-owners), but rather than selling the business interest directly, the owner transfers the interest to a charitable remainder trust, retains lifetime income from the CRT and the trustee sells the business interest to the successor owner(s).

As with a direct sale, the desired successors will own the business interest, but with the CRT “bailout” the owner receives a current income tax deduction, eliminates federal gift and estate taxes on the value of the business interest, achieves greater diversification, and creates a stream of income that will not depend upon the future financial success of the business.

A charitable lead trust also can be utilized to implement a creative and tax-advantaged succession plan for a family-owned business.

Suppose you have a client who is the patriarch of a family business who will “die with his boots on”i.e., he will maintain ownership and control of the business until his death. His children could purchase a life insurance policy on their father, and he could create a testamentary charitable lead trust to which his business interest would be transferred at death. The children would purchase the business interest from the CLT with the insurance proceeds, and after the income period, the remainder of the trust assets (insurance proceeds) would be paid back to the children. With this arrangement, the estate receives a charitable deduction for the income interest, the organization receives a stream of income, and the children end up with both the business interest and the insurance proceeds.

As with most planning techniques, charitable “bail-outs” have some potential “tax traps” that must be avoided. In particular, there must not be a pre-existing understanding or legally enforceable obligation respecting the sale of the business interest by the charitable organization or trust. Also, if the business is an “S” corporation, in most cases, a “bail-out” strategy will result in the termination of the “S” election and loss of “pass-through” status for federal tax purposes.

But for the business owner who has included philanthropy among his planning goals, a succession strategy utilizing a charitable gift can create a tax-advantaged “bypass” to arrive at the desired planning destination.

David A. Scott, J.D., CLU, is assistant vice president, advanced sales with Penn Mutual Life Insurance Company, Philadelphia, Pa. He can be reached at Scott.David@pennmutual.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 20, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.