An effective succession plan encourages a smooth management transition while minimizing transfer taxes.
By Mark E. Battersby
Sooner or later, everyone contemplates retirement. For those who own a closely-held or family specialty fabrics business, retirement is more than just a matter of deciding not to go to work any more. In addition to ensuring there will be enough money to retire, business owners, shareholders and partners must decide what will happen to the business when they are no longer in control.
An effective succession plan provides for a smooth transition in management and ownership with a minimum of transfer taxes. Additionally, a business succession plan can provide financial security and freedom to the retired business owner and his or her spouse.
At its most basic, a succession plan is a documented road map to be followed in the event of the owner, partner or shareholder’s death, disability or retirement. The tax component of succession planning addresses the minimization of taxes upon death.
U.S. tax law changes in 2001 contained a one-year elimination of the estate tax (the so-called “death tax”). The estate tax rose from the grave at the end of 2010, with a Bush-era top rate of 35 percent and an applicable exclusion amount of $5 million ($5.12 million in 2012). In 2013, the estate tax is set to revert to its pre-2001 form. The applicable exclusion amount will decrease to $1,000,000, and the top marginal rate will leap twenty points to 55 percent. A 5 percent surtax will also return, to be levied on estates between $10 million and $17 million. This raises the top effective rate of the estate tax to 60 percent.
Giving it away
Because a key method to reduce estate taxes is to lower the value of assets that are in the estate, “gifting” strategies can legitimately lower any owner, partner or shareholder’s tax liability. There are several ways in the U.S. to make gifts outright, all of which serve to reduce the amount of the overall estate.
- Annual gift tax exclusions: Currently, property valued at up to $13,000 per year per donee (the person receiving the gift) may be gifted without any gift tax consequence.
- Other gift tax exclusions: Gifts for the purposes of the donee’s health or education are excluded from gift tax calculations (this is why parents could seemingly pay unlimited amounts for their adult children’s doctor appointments and, for some lucky ones, educational expenses).
- Lifetime gift tax exemptions: In 2011 and 2012, giving lifetime gifts totaling up to $5 million before any estate, gift or generation-skipping taxes are imposed is possible.
Unfortunately, these gifting strategies don’t provide any direct benefit to the business. Other strategies for transferring businesses exist, strategies that frequently include retaining control.
Flipping for FLPs
By controlling the business through a family limited partnership (FLP) or a family limited liability company (FLLC), everyone can benefit from gifting shares at considerable discounts. An FLP or FLLC can also assist in transferring a business interest to family members.
First, a partnership with both general and limited partnership interests is created. Then, the business is transferred to this partnership. A general partnership interest is retained for the owner, allowing a continuation of control over the day-to-day operation of the business. Over time, the limited partnership interest is gifted to family members.
A buy-sell agreement, often called a “business prenup,” is a legal contract that prearranges the sale of a business interest between a seller and a willing buyer. A buy-sell agreement allows the seller to keep control of his or her interest until an event specified in the agreement occurs, such as the seller’s retirement, disability or death. Other events such as divorce can also be included as triggering events under a buy-sell agreement.
When the triggering event occurs, the buyer is obligated to buy the interest from the seller, or the seller’s estate, at its fair market value (FMV). The buyer can be a person, a group (such as co-owners) or the business itself. Price and sale terms are prearranged, which eliminates the need for a fire sale if the owner, partner or major shareholder becomes ill or dies.
An employee stock ownership plan (ESOP) allows the owner of an incorporated business to sell his or her stock to the ESOP and defer the capital gains tax. Ownership can be transferred to the operation’s employees over time, and the business can obtain income tax deductions for the plan contributions. It can provide a market for the shares of owners who leave the business, a strategy for rewarding and motivating employees, and a way to take advantage of incentives to borrow money for acquiring new assets using pretax dollars.
To keep income rolling in without having to show up for work every day, succession planning might look at selling the professional’s interest in the business outright. When the business interest is sold, the seller receives cash (or assets that can be converted to cash) that can be used to maintain the seller’s lifestyle or pay his or her estate taxes.
The time to sell is optional—now, at retirement, at death or anytime in between. As long as the sale is for the full fair market value of the business, it is not subject to gift tax or estate tax. Of course, a sale that occurs before the seller’s death may be subject to capital gains tax.
Succession planning 101
Developing a succession plan is a multi-phase process outlining, in detail, the who, what, when, why and how changes in ownership and management of the business are to be executed. At a minimum, a good plan should help accomplish the following:
- Transfer control according to the wishes of the operation’s owner, shareholder or partner;
- Carry out the succession of the business in an orderly fashion;
- Minimize the tax liability of the owner, shareholder or partner and his or her heirs; and
- Provide economic well-being after the owner steps aside.
Business owners seeking a smooth and equitable transition of their interests should seek competent, experienced advisors to assist them in this matter. No matter how talented and earnest those professional advisors are, their limited specialties should never dictate the choices for the business or the owner, shareholder or partner’s family.
Tax planning should never control business decisions. A tax lawyer can make compelling arguments for strategies that can minimize estate and gift taxes. A CPA can be very convincing when suggesting strategies for controlling income taxes. It’s a similar story with financial planning and insurance professionals.
Succession planning isn’t something that can done once and forgotten. To be complete and effective it must be continually revisited, reviewed and updated to reflect changes in the value of the business, market conditions, and the owner, shareholder or partner’s health as well as the abilities and passions of the people it will be passed on to.