Tax-efficient Transition Planning for Family-owned Businesses

Zachary Meissner

By Zachary Meissner | November 20, 2018

Far too often, family-owned businesses fail to create a proper transition plan. A Price Waterhouse Coopers study found that only 23 percent of family companies had a robust documented succession plan in place, with 46 percent saying they were reluctant to pass on leadership to the next generation. But even if a family-owned business has a strategic transition plan in place, there are a variety of ways that unforeseen tax implications can disrupt a successful transition.

When creating a plan to pass down business ownership to the next generation, the focus is often on the avoidance of estate taxes, while failing to fully account for income tax and capital gains tax considerations. However, there are strategies business owners can implement to help decrease the impact these taxes have when transitioning the business.

It Can Get Complicated

One of my clients owns a business worth around $20 million. He is divorced, with two adult children who work in the business. I asked my client, “If something happened to you today, what do you think would happen to the kids?” With most of his personal wealth tied up in the business, he hadn’t considered that his children would probably need to sell all or part of the business to pay the approximately $8 million in estate taxes.

In order to avoid a forced sale of the business, he can gift portions of the business into a trust or purchase a life insurance to help to cover the estate tax. The life insurance policy can also be put into a trust so it would be free of both income and estate tax.

Beware Capital Gains Taxes

When business owners try to avoid estate taxes, they often gift all or a portion of the business over to the next generation. Unfortunately, this may unwittingly set up the next generation for significant capital gains tax exposure should they decide to sell some or all of their interests. Gifted assets do not enjoy a step up in basis that comes naturally when they are passed as part of an estate.

Alternatively, current owners could consider selling the business to their children. Of course, this generates a capital gains tax problem for the parents, which could be avoided by handling the transaction as an installment sale, where portions of it are sold over time. That spreads out the tax liability for the parents and the payments for the kids. Either way, the positive side of selling is that it creates a step up in cost basis for the kids. It also puts money in the parent’s pocket for retirement, if they need those funds.

Don’t Let Income Tax Drive Your Larger Strategy

No one likes paying taxes. However, when it comes to business transition planning, sometimes it makes more sense to pay the income taxes now rather than estate taxes later. Many business owners do everything they can to leave money in the company so they don’t have to realize income that is subject to income tax. However, that might not be the best strategy.

If we look at the big picture, we see that as the business grows larger, it will create more estate tax issues. It might make better sense to remove money from the business over time so it isn’t as big of an asset when it is passed or gifted to the next generation. Of course, reducing estate taxes should really be a secondary consideration here. Diversification and the creation of liquidity are the main reasons not to leave money in the company. Most owners become unhealthily concentrated in their business. Removing that cash provides an income stream that can create a more robust retirement plan for the business owner, independent from the business itself.

Putting It All Together

The best thing any business owner can do is to start the conversation early, perhaps 10 to 20 years before they plan on exiting the company. First and foremost, the conversation needs to start with whether or not a family business transition is even possible. Is the next generation interested in taking over the business? Are they being properly groomed for it? Are there valuable employees who might want to take it over instead? No matter what, start these conversations early, then you can start thinking about structuring the transition for tax efficiency.

There are many ways to dispose of the business if you’re going to sell it to your children. And all of them have different types of tax considerations that need to be taken into account, which is why it makes sense to be working with an adviser or an agent who specializes in family business transition planning.

For educational purposes only. Penn Mutual and its affiliates do not provide tax or legal advice. This information is based upon our understanding of current laws, which is subject to change. Life insurance policies are subject to eligibility requirements and restrictions, and may not be right for everyone. Please talk to a financial professional regarding your specific situation.

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