In estate planning this phrase refers to planning for the transfer of business ownership and control to the right persons while minimizing the tax cost. The concept usually applies to closely held family owned businesses.

In a typical situation a business is owned by a father whose wife will probably survive him or it is owned by both spouses. They have children who they wish to share equally in their wealth after their deaths. However, not all of the children are able to run the business nor are all of them interested in doing so. The business comprises most of the parents' assets.

The parents want to retain control of the business up to the date of their death or at least up to the date of their retirement. After they give up control they want to retain a right to income.

Since the children have to share equally and the business is the bulk of the estate, they will all get an interest in the business. However, maybe only one of them should be put in control. That one, however, may pay him or herself very well and not distribute any funds to the other children. If they are all in control they may fight over the business.

One way to solve all these problems is for the parents to sell the business while they are alive. If none of the children can run the business this may be necessary anyway unless plans can be made to hire a qualified manager. The cash from a sale is easier to divide. On the other hand it (or the securities it is invested in) will be valued at the market in the parents' estates. Transferring business interests to children allows for some estate tax savings because of using lower values for tax purposes.

If the children are going to wind up owning the business then consideration must be given to how it will be structured to allow one or more to run it while the rest are protected. Voting and non-voting interests can be used to allow equal ownership, but not equal control. Contractual arrangements can be instituted, such as a shareholder's agreement. This can set restrictions on transfer of the stock, provide for buyouts, call for income distribution and in general provide a framework for handling a variety of business issues.

Another technique is to give the business to one child and require him to pay the other children for it.

The assets of the business can also be divided and given to the children in different proportions - or with different control mechanisms. For instance, all the children may be given equal voting interests in the real estate used by the business while only one may have control over the business itself (while the other children have equal non-voting interests). Or one child may be given the real estate while another gets the business.

Provisions can be made so that on the death of both parents the voting stock goes to only one child. Other assets could go to the other children to equalize their inheritances.

Life insurance, for insurable parents, can sometimes be useful. It is an ideal asset to remove from a parent's estate because it can be given away to an irrevocable trust for the children at its cash value (or close to that) instead of its face value. When a policy is new that cash value is low.

The insurance proceeds can be used to pay estate taxes. They can be paid to children who didn't get the business. Or the proceeds can be used to purchase company stock from the parents' estate.

The transfers of the interests can be made by gift while the parents are alive or at death. Or they can be transferred by sale. Lifetime gifts and sales both result in post-transfer appreciation in value of the interest being removed from the parents' estates. The gifts require the gift tax to be dealt with. The sales do not.

There are two tax free categories of gifts. One is the annual exclusion gift. In 2006 $11,000 per year per donee is excluded. If a spouse joins this is doubled. This means parents can give $22,000 per year to each child with no gift tax consequence.

The other is the $1,000,000 tax free amount under the gift tax. This is a life time amount and any of it used is subtracted from the amount that passes tax free under the estate tax.

Using annual exclusion gifts and the one time tax free amount a substantial share of a business can be transferred to children tax free.

In addition to these two tax free opportunities, minority and non-voting interests in businesses or business assets can be given away at discounted values. For instance a 10% non-voting interest in an operating business may be valued at only 7% of the value of the whole business under the theory that the lack of control makes it worth less.

These features of the gift tax are ideal for some business owning parents. They make a large gift of non-voting stock in the business to their children to begin with. The appreciation in value after that is out of the parents' estates. Then they give $22,000 of non-voting stock to each child each year. They retain control with voting stock. For each gift they get an appraisal of the value of the stock which will usually show a discounted value for the stock.

Several other techniques are also used to transfer business interests while the owners are alive and to minimize taxes while still maintaining income for the parents. One is the GRAT or grantor retained annuity trust. The business or part of it is transferred to a trust which in return promises to pay a set yearly amount to the transferor for a set term. The set yearly amount is like an annuity. At the end of the term the children get the business interest. This involves no gift and, if the transferor survives the term of the trust, no estate tax. For this type of trust the transferor is treated as the owner of the trust for income tax purposes so there is no sale and no capital gains tax.

In a variant of this the trust does not pay an annuity. Instead the stock is sold to the trust for a promissory note and the trust makes payments on the note to the transferor. The grantor is still treated as the owner of the trust for income tax purposes so payments on the note are not taxable. However, all trust income is taxable to the grantor. For estate tax purposes the grantor no longer owns the stock. It is not in his or her taxable estate at death, although the note is. And the grantor does not have to survive the term of the trust to achieve this result.

One drawback of this device is that the grantor will have to give the trust 10-20% of the purchase price to use as a down payment in order for the IRS to agree that there is an actual sale. This will be a taxable gift and exemptions must be used.

Both of these trust devices allow parents to give away stock with a variety of tax benefits while still maintaining an income stream.

A similar device is a plain and ordinary sale to the children. Or a sale to one child. There is no gift and appreciation is renewed from the estate. The sale can be paid for with a promissory note so no down payment cash is needed. All that is left in the parent's taxable estate is the note. The note can be given to other children on the parents' death.

It is even possible for the note to be self-cancelling on the death of the parent. Then there is nothing in the parent's estate. However, the note will have to call for higher payments to give full value for the stock in this instance.

An ESOP can also be used in business succession planning. An ESOP is an employee stock ownership plan. This is an employee benefit plan designed to invest in employer securities. The owner of the company sells some or all of his or her stock to the ESOP. The ESOP gets the money to pay for the stock from a bank loan. Either the ESOP borrows the money and the company guarantees the loan or the company borrows the money and gives it to the ESOP. There are exemptions to the usual benefit plan rules to allow this.

The ESOP pays back the loan with dividends on the stock and contributions from the company. Contributions by the company to the plan are fully tax deductible (up to limits specified in the law). The result is that principal as well as interest payments on the loan are deductible.

The owner's sale proceeds can also be tax free. If the company is a non-public C corporation and the sale proceeds are invested in securities of publicly traded U.S. companies and the ESOP owns 30% of the company stock after the sale then there is no tax on the sale proceeds. The owner's basis in company stock carries over to the new securities. This means that when the securities are sold the gain gets taxed in full. Therefore the gain does not escape tax, the tax is merely deferred.

An exception to this exists if the replacement securities are held until death. The basis is then stepped up to the date of death value in the hands of the estate or heirs so when they sell all the pre-death gain escapes tax.

One way to use the ESOP is to sell only some of the stock to the ESOP. The owners can then give the stock he or she retains to the child who is going to run the business and the money to the other child.

If a majority interest or even all the stock is sold to the ESOP there are a variety of ways for the owner's family to retain control. The owner or family members can be the trustee of ESOP and a management contract can be used. Even if the ESOP has an independent trustee, that trustee is not likely to try to run the company or get another manager if a qualified child is available to run the business.

One benefit of selling a majority interest is that stock retained by the owner may qualify for a discounted value in his or her estate because it is a minority interest.

Use of the ESOP device allows a business interest to be sold tax free while a child can be placed in control. It also allows an owner to sell a minority interest, something that is usually not possible.

Why not just sell the company to the child who will operate it? That may be preferable for someone who doesn't want to deal with an ESOP and all its rules, but the sales proceeds are taxable and they are paid with after tax dollars (the company cannot deduct the principal.)

There are a variety of other more complicated techniques that are used, but usually only when complications in the fact pattern require them.

Donald M. Thompson * Illinois Business Lawyers - 55 W. Monroe #3950; Chicago, IL 60603
Ph: 312-782-0844 * Fax: 312-201-1436 * Email: donthompsonlaw@sbcglobal.net

© Copyright 2007  * Chicago Business Lawyer Donald M. Thompson