Family Business Article for Skit Week 5

8/12/2019 Family Business Article for Skit Week 5

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The Family Business: Preservingand Maximizing an Investment inthe Past, Present, and FutureJohn R. Wiktor*

A family business, often the primary source of family s wealthandthefamily s largestinvestment can consume itsowner. Thisis only natural, but sometimes the day-to-day management issuesblind an ow ner to the need for careful succession and estate plan-ning. Advisors to owners of family businesses should m ake surethat the succession plan and tax consequences associated withthe transfer ofthe businesswhetherthrough sale, retirement, orupon deathare not overlooked. Careful attention to planningdetails will enhance value for future generations.IntroductionIn today s world, a family business often is the primary source of a family swealth and the fam ily s largest investment. The m anagement and growth ofthe family business are also often the primary focus of the family businessowner. Because ofthat however, sometimes the succession plan and tax con-sequences associated with the transfer of the businesseither through sale,retirement, or upon deathare overlooked.The transfer of a family business to future familial generations not onlyraises many complex financial, tax, and legal considerations, but also canraise many critical intrafamily issues. For example, to which family memberswill the client transfer the business? Are there certain family members whoare more involved in the business than others? How can the client provideassets of equivalent value to those family members who have not receivedany part of the business? And how can a client who is transferring ownershipof the family business upon death to the children assure that the survivingspouse receives income from it?

All too often, the transfer of the family business among generations isunsuccessful. But the odds can be improved.

* John R. Wiktor is a partner with the global law firm of Reed Smith LLP. He may bereached by email atjwiktor@reedsm ith.com or by phone at (312) 207 -645 1.

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Because of the complex issues associated with a transfer of a familybusiness , advisers should consider the many options available to successfullytransfer the business to future generations. Dynasty trusts, grantor retainedannuity trusts (GRATs), and installment sales are commonly used vehiclesfor transfer of a business to future generations. In addition, advisers oftencomb ine these transfer techniques with gifting strategies, to make the transfermore efficient from a tax perspective. Finally, in addition to the actual trans-fer technique used, it is of primary importance for the adviser to review withthe family all of the nontax and family issues associated with the transfer ofthe family business in order to make that transfer as successful as possible.

This article reviews from the family perspective some of the issuesinvolved with transferring a business. In addition, it provides examples ofestate planning techniques that can be used to ensure that the transfer or saleis most effective from a tax perspective.IFamily Succession Issues Generally

For business owners, devising the appropriate exit strategy from ownershipand management of their company can be the most important planning theyever do. Good succession planning and implementation of the right strate-gies are vital for success in the transition of leadership and management, andto provide a sense of security and peace of mind to the current owner andthe rest of the company. Failure to adequately plan could be the differencebetween maximizing the value an owner has spent a lifetime building, andseeing that value dissipate due to estate taxes, poor management, and intra-family disagreements. Thus, whether a business owner wants the businesspassed on to family members during lifetime or at death, or sold to someoneoutside the family during lifetime or at death, the owner needs to have aworkable plan.Need for Focus on the Three Ts The three Ts of business successionplanning timing, transition, and taxesare all important in this regard. Forbusiness owners, the life cycle of decisions related to their company willdepend on their own personal timing, long-term goals and objectives, and thetransition of management and control in a tax efficient manner. Oftentimes,conversations regarding these decisions take place from the onset of the plan-ning proce ss, and most successful plans have their origin in clear and consis-tent comm unications between the owner and his or her trusted adv isers.1

iming Proper timing of the preparation and execution of the ow ner'sexit strategy is perhaps the single most important factort consider. Most situ-ations will require significant planning well ahead of the day when the ownerdecides to sell or retires from day-to-day activities of the business or when


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the ow ner s health starts to fail. Generally, private business owners shouldbegin discussing their exit strategy at least five years before they intend toactually sell or phase out of the com pany s day-to-day affairs. This will allowfor ample time to properly devise a strategy as to (1) how the business owner-ship will change (if at all); (2) who will be groomed to take over managementresponsibilities; (3) when and how the management transition will occur;(4) how the owner will be able to access the equity built in the companyor otherwise provide adequate liquidity, post-departure, to satisfy lifestyleneeds; (5) what planning techniques can be implemented, in regard to boththe owner and the entire family unit, to minimize or reduce income, gift,and estate taxes in the event of a sale; and (6) how the divestiture of owner-ship can m atch up with the owne r s long-term personal goals and objectives.Almost every plan will require the future coordination of many parties.

ransition Selecting the appropriate management succession plan is alsocritically important. number ofstepsshould be implemented as part ofatran-sition plan. Some require substantial lead time. For example, training for indi-viduals, whether family membersornot who will take over day-to-day affairs ofthe business needs to be in placeand tested for a substantial period of timebefore the business ow ner s actualexit.Also, incentives to keep management inplace after death or departure of the owner (assuming the management team isa good one) will be required to ensure that the management team rem ains com-mitted to the ongoing success ofthecompany. Likewise, it is important that theowner s estate planning documents be consistent with the preservation of themanagement structure created, and that this is transparent to all parties.

axes From an income tax perspective, the ability of the owner to sellor transfer the business in a tax-efficient manner will depend on how far alongthe owner is in the process. Ifasale is contemplated, to avoid having some orall oftheincome from the sa le attributed to the owner, planning should be putin place well before a sale agreemen t, binding letter of intent, or sales price isfinalized. In many instances, the use of certain types of irrevocable trusts canallow the owner to minimize the income taxes that result from the sale of thebusinessand thus preserve more wealth for the family.Additionally, proper planning techniques implemented before a sale orthe own er s death may allow for the transfer of wealth to the owne r s familyat little or no gift tax cost. If gift and estate tax laws are important factors inthe plan, it will be critical to evaluate and select planning techniques earlyin the process. Certain techniques will help reduce both gift taxes during thebusiness o wn er s lifetime and estate taxes at death. Keeping in m ind thatsome planning alternatives may reduce estate taxes payable by the owner sestate at death, but not eliminate them, careful planning also is required toanticipate the estate taxes that will be due and then to provide sufficient


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68 JOURN L OF T X TION OF INVESTMENTSliquidity for such paym ents. If this is not done, the company could be put injeopardy as a result. In many instances, the use of stock redemptions by thecompany and the purchase of life insurance to provide liquidity to pay estatetaxes can ease the burden on the company and the owne r s family, and ensurethat the transition plan put in place maintains its course.Importance of the Family Meeting Today we live in an increasinglyglobal world. Family members live ever further away from each other andoften grow apart. When considering the succession of a family business, thefamily meeting is not only an important step for wealth transfer planningbut also has the additional benefit of bringing together generations of familymembers who do not live near each other. Not surprisingly, therefore, familymeetings have become very popular. The meeting can be held at the homeof a family member or an easily accessible vacation spot. Generally, it isimportant for the family to have a mod erator for the meeting. Frequently, thefamily s trusted advisers attend the meeting to act as moderators.

The family meeting is a great way to review the family s successionplan and wealth transfer goals. The family s advisers should suggest at themeeting that the parents discuss with their adult children the parents plansfor wealth transfer. This will allow the children to understand the parentsestate plan, and should reduce the likelihood of anguish, family fighting,or, worse, litigation after the parents death. The advisers can also discussthe asset portfolio that will be used to implement the plan. By doing this,the parents will be able to better review their transfer p lanning goa ls, and thechildren will gain a better understanding ofth portfolio of assets that w ill betransferred over time.

Also, the advisers should specifically review the transfer vehicles thatwill be used to complete the wealth transfer. For example, if the family hasestablished a foundation or a donor advised fund as part of the successionplan, these entities should be explained to the family members. The familymeeting is an opportunity for the family to discuss which charitable initia-tives the family will support each year. An adviser may suggest that eachyear one or two family members research a charitable cause to support, andpresent a report at the family meeting as to why that cause should be sup-ported. The result will be that the family will learn about different charitableinitiatives, and the reporting family mem ber w ill have a personal stake in thefamily s philanthropic goals.In addition to the other benefits, the family meeting can be a time toassess the accountability and effectiveness of the wealth transfer plan thathas been put into place. Accountability can be measured by the extent thatall members of the family participate in the wealth transfer initiatives.Effectiveness can be measured through the growth of the assets, the goalsthat have been achieved, and the purposes that have been furthered.


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Tax Issues and Prim ary Considerations in SuccessionPlanningA number of estate and income tax planning strategies can be used in con-junction with succession planning for a family that is planning for a familybusiness. Some of the most common strategies include the basis step-up,annual exclusion gifts, grantor trusts, and charitable plann ing.Basis Step Up. Many estate planning transfer vehicles for dealing withfamily wealth transfers are detailed and complex. The client's basis in thefamily business must be strongly considered at the outset of any planningprior to sale or transfer.The basis step-up concept is very simple. When a person purchases oris gifted an asset, that person receives a basis in the property. The client whosells an asset prior to death will recognize gain on the difference between thefair market value (FMV) at the time of sale and the client's basis. If, on theother hand, the client retains the asset until death, the successors in interestwill generally receive a basis in the asset equal to the FMV as of the date ofthe client's death.' Because of this basis step-up, the client's heirs can sellthe asset immediately, benefitting from the increased value, and no capitalgain will be recognized.The basis step-up is therefore a very important consideration for thefamily business owner who is considering sale prior to death. For exam ple, aclient who currently has an interest in a now successful family business with avery low basis m ay be better served by holding on to the business until death.This way, the basis in the asset will be stepped up to the date-of-death value;the client will avoid paying capital gains taxes and thus will have a largerestate to be transferred to the next generations. But this may not always be thebest option. The client must consider and evaluate the difference between thecapital gain that will be generated during the client's lifetime and the estatetaxes that may due upon his or her death. Critical thinking and evaluationare imperative in order to ensure that the family is able to transfer as muchwealth from the family business as possible to the next generations.Annual Exclus ion Gifts .When a business owner desires to transfer por-tions of the family business during lifetime to other family members, anannual gifting program is a commonly used estate technique to transfer suchinterests. Currently, an individual taxpayer can make an unlimited number of 14,000 gifts of cash or other property on an annual basis tax free. oensure

' IRC 1014.^ IRC 2503.


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7 j JOURNAL OF TAXATION OF INVESTMENTSthe tax savings, the client must only remember that no one individual mayreceive more than 14,000 in a given calendar year. (Note that spouses maycombine their annual exclusion gifts to together make an unlimited numberof 28,000 gifts.) The annual gifting exclusion applies not only to cash gifts,but to other assets as well, so the taxpayer may also gift interests in the fam-ily b usiness.

When gifting noncash assets such as interests in a family business, onemust keep in mind the basis step-up rules. Even with the annual gift exclu-sion, it may be more appropriate for a given client not to currently gift thoseassets; that is, it may be more tax-savvy to hold them until death and thusbenefit from the basis step-up. In addition to the basis step-up rules, a familybusiness owner should consider whether outright gifts or transfers to familymem bers in trust provide greater bang for the buck.

Dynasty Trusts A dynasty trust is designed to hold assets in trust withoutdirect ownership being transferred to any beneficiary. Successor generationsmay benefit by receiving distributions of income or principal, and assets thatremain in the trust will provide future growth. In addition, with proper plan-ning, dynasty trusts can provide income, transfer, and generation skippingtax benefits.Dynasty trusts can be an important part of a family's business transferplanning. For example, if your clients are parents who are concerned that achild may receive too much money too early, they can set limits as to whenthe children may actually withdraw assets from the trustsay, one-half atage 25 and the balance at age 30. Or the parents may decide that the assetswill be distributed only at the discretion of the trustee, and the children willnever be able to fully take the money from the trust. This type of trust thuscreates the perfect opportunity for the family business to remain in trust, becontrolled by the trustee, and not allow for distributions to the children. Careshould be taken, of course, to appoint an appropriate trustee, as this personultimately will have control over the trust's interest in the business.Dynasty trusts have also become a popular tool for parents who want totransfer their assets but are concerned about their child's vices, such as drugsor alcohol, and/or creditors. In this instance, the trust can be drafted so thatthe family business assets of the trust are protected from the child's creditors.Further, with proper generation skipping planning, the trust assets can passdown to future generations, thus keeping the family business interests thatare in the trust within the family.Dynasty trusts may be implemented either during a parent's lifetimeor as part of testamentary transfers. When combined with other techniques,such as installment sales or gifting programs, dynasty trusts are a greattool to allow parents to transfer assets to their children, obtain some taxbenefits, provide creditor protection, allow the appointed trustee to control


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the business interest, and provide a mechanism to dictate when, if ever, thebusiness interest may be removed from the trust.Potential Discount Options Discounts may be available when there arerestrictions in the goveming documents for the business or when a minorityinterest is being transferred. Before making a transfer of a family businessinterest, the owner should therefore review the operating agreement, bylaws,partnership agreement, or other goveming documents of the business. Withthe appropriate goveming documents, restrictions can be placed on trans-fers,withdrawals, and distributions of the business interest. Because of theserestrictions, the interests in the family business can then be transferred todynasty trusts or other beneficiaries at discounted values. For example, dis-counts can be taken for such items as lack of marketability where transferrestrictions are in place, or minority interest discounts where minority inter-ests are transferred. As a result, family wealth can be transferred at lowervalues than would otherwise be the case.Succession Strategies SimplifiedGRATs GRAT is an estate freezing technique that is authorized by statuteand can be an important planning consideration for the transfer of the fam-ily business.-^ The person who contributes assets to the GRAT is called thegrantor. The grantor of a GRAT transfers property to the trust and retainsan annuity payable by the trust. The period for which the grantor retains theannuity is referred to as the term. The term oftheGRAT can be for a set num-ber of years or for the grantor's lifetime. *

The grantor's initial transfer of the asset to the GRAT is a taxable gift.The amount of the gift is ordinarily determined by actuarial tables, and canbe reduced to zero if desirable. During the term, the trust will be a grantortrust. Accordingly, the grantor will report the income on the assets that havebeen in the trust. At the end of the term, the trust property passes directly tothe beneficiaries either outright or in trust for the beneficiaries. Although thegeneration skipping tax exemption cannot be designated to the GRAT, withproper planning equivalent results can still be achieved. If the assets gifted tothe trust essentially beat the appropriate rate of interest (the 7520 rate ^),thebalance will pass to the beneficiaries income tax free.

xample Bobby Business currently establishes a GRAT with aterm of 10 years. Bobby contributes to the GRAT a 20 percent' IRC 2702. Id.5 IRC 7520.


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membership interest in his family business. That interest increasesin value at a rate of 6 percent per year. The face value of the assetcontribu ted is 1 million but, due to discounts for lack of mar-ketability and minority interest, the gift tax value of the trans-ferred interest is only 700 ,000. Bobby reserves an annuity of 4percent.

If Bobby dies within the term, the remainder beneficiarieswill receive the remainder of the GRAT, and all or a part of theGRAT's value will be included in Bobby's estate. If Bobby sur-vives the term of the GRAT, at the end of the term, the trust assetswill pass to the remainder beneficiaries free of gift tax, and theassets transferred will be removed from Bobby's estate.Given the factors above, Bobby will have made a gift forgift tax purposes of approximately 450 ,000, but at the end of the10-year term nearly 1.3 million will be transferred to Bobby 'sbeneficiaries.In an alternative scenario, using the same values, Bobbycould zero out the GRAT so that there is no gift and, at the endof the tenn , approximately 300,000 will pass to the remainderbeneficiaries without any gift tax being paid on the transferredatrtount.

Sales to Intentionally Defective Grantor Trusts An intentionallydefective grantor trust is an irrevocable trust designed to secure certain taxbenefits by taking advantage of the fact that the grantor can be treated asthe owner of the trust's assets for income tax purposes. When the grantor istreated as the owner of the trust for income tax purposes, the grantor reportsall of the trust's taxable income on the grantor's income tax retum and paysany resulting income tax.* By personally paying the income tax that wouldotherwise be payable by the trust, the grantor allows the trust to retain moreof its assets (rather than using its assets to pay income taxes). Payments ofincome tax that the grantor makes on the trust's income do not count as tax-able gifts to the trust.'A defective grantor trust can be problematic from a cash flow stand-point. The inclusion ofthe trust income in the grantor's taxable income willobviously increase the amount of income tax that the grantor has to pay.The grantor must have adequate liquidity in order to pay this additional tax.To address possible liquidity issues, provisions can be included in the trustterms that would allow an independent trustee to reimburse the grantor for

IRC 671 .Rev. Rul. 2004-64, 2004-2 CB 7.


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the amount of tax the grantor pays that is attributable to the trust s income.Such provisions must be carefully drafted, however, to avoid the possibil-ity that the assets of the trust will be included in the gran tor s estate at thegrantor s death.*

Intentionally defective grantor trusts are excellent estate planning toolswhen closely held family business interests reinvolved Transactions betweenthe grantor and the trust are ignored for income tax purposes. Therefore, ifa family business is sold in an installment sale to an intentionally defectivegrantor trust in exchange for a note, no gain is realized on the sale nor is anyincome recognized by the grantor from interest payments on the note madeby the trust to the grantor. This type of sale is an estate freezing technique.Once in the trust, the family business is outside the grantor s gross estate forfederal estate tax purposes. To the extent the assets of the trust appreciate inexcess of the interest rate on the note, the sale of the family business to thetrust can be an extremely effective estate tax avoidance technique.ConclusionA family business is often the family s largest and primary investmentonethat got to be so valuable because the owner(s) invested time, money, andsweat equity. Owners want to be sure both the business and the family willsurvive and thrive over the long haul. Thus, for clients who are family busi-ness owners, succession planning, in regard to both tax and non-tax concerns,is of primary importance.

' *

Id. Rev. RuL 85-13,198 5-1 CB 184.


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Family Business Article for Skit Week 5

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