Most businesses have some type of informal or written business plan outlining operations, budget, and goals. But a surprising number do not have a written plan for the inevitability of business succession by death, retirement, or disability. It's difficult enough these days to run a business. The last problems any business entity needs are possible ownership disputes or reduced cash flow due to lack of tax planning for business succession.
Who Needs a Business Succession Plan?
Organizations where succession problems are a possible scenario, which includes almost all family businesses, small businesses, and many larger organizations, should have a concrete written plan which covers all possible succession problems.
What Should the Business Succession Plan Include?
The plan should include a clear outline for choosing and training successors. It should also clearly delegate authority and responsibilities of these successors. It is absolutely essential for a business plan to ensure that the business continues in a profitable and organized manner, even when a principal exits or passes on. There are a number of ways that businesses can be transferred to family or others prior to these events, with different tax scenarios and effects.
If co-owners are involved in the business, it's likely that it would be beneficial to the business for the business interest to pass on to the remaining owner or owners if one dies. Many businesses purchase life insurance for the owners to prepare for this type of contingency. This allows funds for the purchase to be readily available when needed. An irrevocable life insurance trust is often set up to avoid the probate process and ensure liquidity for these agreements.
One possibility is to arrange for the sale of the company in advance of the principal's exit. No transfer taxes apply if the business is sold at fair market value and using the criteria of a typical arm's length transaction. Any loans made to the purchasers must also charge market rate interest, as the IRS will examine these transactions. Installment sales are also possible, and may permit the purchaser to pay off some of the note with future funds from the organization.
Stock Share Gifting
Another way to pass a family business on is through the gifting of stock shares to the applicable family members. Individual gifts are tax free up to shares worth $15,000 annually to a child or grandchild. Gifts to married couples have a gift tax exclusion limit of $30,000. If you transfer amounts above these limits, they will count against the estate tax threshold, which is $11.7 million for individuals or $23.4 million for couples in 2021. Gifting of shares is especially advantageous when there is a longer time period with which to work. It pays to plan as far ahead as realistically possible so that family or heirs can gain the maximum possible benefit from these tax-free gifts.
Employee Stock Ownership Plans
Selling shares of the business to employees can be a good succession strategy when there is not a known family member successor or other interested party to purchase the company. Shares are held by a trust, are valued prior to sale and every year thereafter. This can be beneficial taxwise to the seller and also provide a benefit to the employees.
Private Annuities or Grantor Trusts
Private annuities are another way to transfer ownership. Again, the true market value of the business must be paid or recognized for the transaction to be classified as a sale. Grantor retained annuity trusts (GRAT) or grantor retained unitrusts (GRUT) are often utilized because they offer a source of income to the seller and certain possible gift tax advantages, especially when transferring high-appreciating assets.
Family Limited Partnerships
The formation of a family limited partnership can allow you to keep control of the business while still transferring business assets under favorable conditions. As with the GRAT or GRUT mentioned above, complex rules apply.
Corporations have a number of different ways to transfer business assets to family members. Recapitalization is one method that involves the issuance of two types of corporate stock, one for active management and the other for non-active participation. Non Voting shares permit equity for family members who are not presently active in corporate management.
Tax planning for the transfer of business interests in business succession is complex. Each option involves different tax ramifications. A number of states also currently levy state estate taxes. These should be included in your planning. A business organization structure change should only be undertaken with complete understanding of the full range of effects and ramifications it will bring.
Chandler & Knowles CPAs
Which business succession option is best for you? It is highly recommended that you seek the advice of a professional team when planning for business succession. Chandler & Knowles CPAs are experienced in all aspects of business structure and tax law. Contact the Chandler & Knowles team today for expert guidance with your business succession plan!