One of the most important decisions a business owner must face is when and how to step out of the business—in other words, business succession planning. Does the owner expect to retire from his business? Is there a plan in place? Does the owner have children to bring into the business? When the owner finally develops a succession plan for the business, there are two primary options: Sell it outright or give it away.
Selling the business outright
The business owner can sell the business outright and choose the right time to sell – now, at retirement, at death, or anytime in between. The sale proceeds can be used to maintain lifestyle or for practically any other financial reason. And as long as the price is at least equal to the full fair market value, the sale will be subject to gift taxes. But if the sale occurs before the owner’s death, there is the possibility of capital gains taxes.
An Employee Stock Ownership Plan (“ESOP”) is another option when selling a business. An ESOP can be a tool to transition businesses to employees through the use of a retirement plan. There can be tax benefits to the selling shareholder and/or the company, depending on structure.
Transferring the business with a buy-sell agreement
A buy-sell agreement is a legally binding contract that establishes when, to whom, and at what price the business is to be sold. The buy-sell can be structured to solve problems inherent in attempting to sell a closely-held business. It allows the price to be pre-determined, either through a formula or a flat price. It identifies a buyer for the business, which is beneficial when there is a limited market that would make a sale difficult. Once a buy-sell is in place, the owner cannot sell or gift the business to anyone other than the buyer named in the agreement.
Transferring the business with the use of a private annuity
With a private annuity, the owner can transfer the business to family members or another buyer. The buyer then makes a promise to make periodic payments to the seller for the rest of his life or for the rest of the seller’s life and the life of a second person (spouse, heir or survivor). Recently, the IRS has removed the previous advantage of spreading out the recognition any of the gain over the term of the payments.
Transferring the business with the use of a self-canceling installment note
A self-canceling installment note allows the owner to transfer the business to a buyer in exchange for a promissory note. The buyer must make a series of payments to the seller under the note and, through a provision in the note, states that the remaining payments will be canceled upon the seller’s death. Like private annuities, self-canceling installment notes can provide lifetime income and they avoid gift and estate taxes. But unlike private annuities, the notes give the owner a security interest in the transferred business.
Gifting the business
Many business owners choose to have their children inherit the result of all of their years of hard work and success. The owners can bequeath the business in their will, but transferring the business during their lifetime has many personal tax benefits.
Personal benefits of lifetime gifting of ownership of business
By gifting the business over time, the owner can hand over the reins gradually to offspring. This will allow the owner to evaluate the ability of the children to manage and grow the business. Adjustments to the ownership structure can be made as the children become better able to control the business operations.
Tax benefits to lifetime gifting of ownership of business
There are several tax benefits to lifetime gifting of business ownership interests. Gifting transfers the value of any future appreciation out of the owner’s estate to heirs. This is especially valuable in high-growth businesses. Gifts of the annual exclusion amount ($14,000 in 2013) per recipient are tax free. Aggregate gifts of $5,120,000 (2012 amount) are tax free under a lifetime exemption. Partial interest gifts, as with GRATS, GRUTS, and FLP, may be valued at a discount.
Gifting the business using trusts
The owner can make outright gifts or use a trust. The owner can even structure a trust so that control of the business can be maintained by the owner for any period of time. A revocable trust can be established, which will bypass probate and allow the owner to change strategy and end the trust, while an irrevocable trust that can provide income for a specified period of time and move the business out of the owner’s estate.
Gifting the business using a family limited partnership
The owner can transfer his business using another entity, such as a family limited partnership (FLP). An FLP is a limited partnership formed to manage and control a family business. The business owner and/or spouse can be the general partner, retaining control of the business itself, while children can be the limited partners. By using a FLP, the business owner can transfer value to children through the annual exclusion. These gifts may even be discounted and therefore allow more value to transfer out of the owner’s estate. The IRS has been looking at FLP and as long as there is an actual business interest, they have gone along with the strategy.
Choosing the right type of succession plan
Any of these various succession strategies can be used to reach the specific goals of the business owner. Depending on the owner’s particular situation, one or more of these tools may be appropriate. The tricky part is how does the owner decide? By consulting with the Horizon Bank Trust and Investment Department, the business owner can work through some decision tools that will help him decide on a strategy.
Bill Varanka is a Vice President and Trust Officer in the Horizon Trust & Investment Department. Mr. Varanka has over 27 years of advising clients on business succession and transition issues. Mr. Varanka is a Chartered Financial Consultant, Chartered Life Underwriter, and an Accredited Estate Planner.