An Ideal Succession Plan

OCEAN CITY – It is perhaps the entrepreneur’s fondest wish: to pass a business on to a daughter or son. Yet actually making the transfer can be complicated and often includes undesirable compromises for parents, children or both.

Taxes will vary depending on whether you give or sell the business to your offspring, and whether it changes hands before or after your death. An unforeseen tax liability could take a huge bite out of the value of the family company, weakening it or even forcing a sale.

With foresight and the help of tax and legal professionals, however, solutions can be designed to address each of those challenges: Tax considerations can often be addressed through a well-thought-out plan of making gifts and using legal vehicles, such as a grantor trust. Dividing business assets fairly among children can be achieved through a judicious allocation of controlling shares, or the use of life insurance policies to spread wealth more equitably. And a measure of breathing room can be found through bringing in outside investors for additional liquidity.

If a business is small, parents may want to consider simply handing over ownership to a child, because gift taxes don’t kick in until they’ve received the equivalent of $1 million (or $2 million, if the gift is from both parents). But with larger businesses, there may be better alternatives that owners can explore with tax and legal professionals.

For instance, simply gifting a business in 2010 when the federal tax rate on gifts equals the rate for ordinary income could result in an insurmountable tax bill. Selling the business to your child may help to avoid a gift tax liability, but could pose other problems. For example, if your business has appreciated while you’ve owned it, a sale could trigger a substantial capital gains tax. The current rate for long-term gains is 15%, and that’s scheduled to rise to 20% in 2011 unless Congress and the President intervene.

To avoid this double-edged sword, Scott Cooper, managing director of wealth structuring for Bank of America Merrill Lynch, suggests a strategy that combines a gift with a sale and uses a special kind of trust. This approach can help you minimize taxes. The transfer can take place over time, while the parents are still working in the business or as they retire. With this strategy, you and your spouse begin by setting up a grantor trust and giving it shares of the business worth $2 million, which will be fully sheltered by exemptions and thus won’t trigger gift taxes. To help maximize the value of that initial gift, you can transfer nonvoting shares to your relative. The value of these shares is typically discounted 25% to 40% because they generally don’t allow owners to have a legal say in corporate issues and would therefore be difficult to sell.

After making a gift of shares whose discounted value equals $2 million, selling the remainder of the business to the trust may be an option. Because a grantor trust is generally treated as owned by you, the parents who created it, you are technically making a sale to yourself. Therefore, although you will owe income tax on the earnings of the trust, you will not owe a capital gains tax on the company’s sale to the trust. You can finance the sale with a note that uses a published IRS interest rate. In October 2010, the rate for long-term sales of more than nine years was 3.32%. The trust could repay you with profits from the business during the term of the note, and at the term’s end, the beneficiary of the trust – your son or daughter — would receive the business fully paid for without subjecting you or your estate to gift or estate taxes.

Although using a trust to transfer your business can reduce taxes that you or your company would otherwise have to pay, this strategy will work only if the business is profitable enough to make the interest and principal payments and have enough left over to be viable. There’s also the question of whether the payments you receive will be sufficient to support your lifestyle. "A family’s wealth is often tied up in an operating company," says Ann Dugan, executive director of the University of Pittsburgh’s Institute for Entrepreneurial Excellence. "The senior generation has spent a lifetime building a business, and they need the asset to provide them with retirement income." If you need an immediate or more substantial payout, or if your children can’t afford to finance the entire cost of the business, you may have to look for outside investors. Doing so can complicate matters, but ideally you’ll be able to structure the deal in a way that allows your family to maintain majority control and won’t leave the business saddled with excessive debt.

Beyond the question of how to structure the business’ transfer, there’s also the matter of how to divide assets among multiple children. To avoid hard feelings, you will probably want each child to receive an equal inheritance — but you’ll need to make sure that control of the business stays with family members who work there. Parents with sizable investment portfolios may elect to transfer the entire business to the children who will take over the company and provide cash or nonbusiness assets to those who have chosen other careers.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)