A Smart Way To Pass Down Your Family Business

OCEAN CITY — Many family business owners balk at handing the reins of their companies to their children during their lifetime. Some fear having to pay significant gift taxes; others are simply not ready to cede control (or the children are not ready to receive it). Still others are concerned that passing down their company will mean losing access to the precious income stream they’ve worked so hard to build.

But not acting can have unwanted consequences, such as derailing well-deserved retirement plans and even causing rifts with children who may be perfectly suited to take control of the family business. In addition, by holding on to your business, you may be denying yourself the opportunity to take advantage of some important tax breaks for owners who pass down their companies. Some of those tax breaks are available only through the end of 2012, absent further changes in the relevant law.

The good news is that there are ways to transfer your business to your family without creating an undue tax burden or relinquishing either income or control. One such vehicle, an irrevocable grantor trust (IGT), can be particularly useful. Like any trust, an IGT is a separate legal entity into which you, as the owner, place your business’s assets. Appreciation in the business arising after the transfer is removed from your taxable estate for federal estate tax purposes. In addition, because you still have to pay taxes on the trust’s income, you increase the effective value of the gift. What’s more, you can maintain control over — and even draw income from — the business.

Recent actions by Congress and the President have made these types of trusts more attractive. The tax legislation passed by Congress and signed into law by the President in December 2010 raised the gift and estate tax exemptions to $5 million, which means you and your spouse can combine your exemptions to give away as much as $10 million of the value of your business without triggering gift or estate taxes. “But the clock is ticking,” says Kevin Hindman, director, Wealth Structuring Group at Merrill Lynch. “If Congress takes no further action, in 2013 the gift and estate tax exemptions will revert to just $1 million.”

The most straightforward way to pass down a business with an IGT is simply to give it directly to the trust. If the company’s value does not exceed your remaining gift tax exemption, there will be no gift tax due.

“By making the transfer during your life, you remove from your estate any future appreciation in the business, which otherwise would be taxed at your death,” says Hindman.

Because the trust is structured so that you continue to own the business for income tax purposes (but not estate tax purposes), you will be responsible for paying income tax on any income earned in the trust — a tax liability that otherwise would be borne by the trust or its beneficiaries. This can amount, in effect, to another tax-free gift for your heirs.

If you still need to draw income from the business, your attorney and Merrill Lynch Financial Advisor may recommend selling the company to the trust. With this option, you give only a portion of the company, as a kind of down payment, taking a note back for the remaining amount treated as sold to the trust. The trust will then make interest payments to you during the term of the note, with a balloon payment due at the end. Because you continue to be treated as the owner of the business for income tax purposes, no capital gain should be recognized from the sale.

Selling the company to the trust may also make sense if your company is worth more than your remaining available gift tax exemption (currently $5 million for individuals and $10 million for married couples). In this scenario, for example, if you gift $5 million worth of your company to the trust, you could sell an additional $45 million to the trust—for a total transfer of $50 million.

“The unpaid principal of the promissory note issued to you by the trust at the time of sale will be subject to estate tax at your death,” says Hindman, “but the company — which one hopes has appreciated — will not be in your taxable estate.

One important reason for placing a business in a trust is to keep it in your family for the next several generations. But your children’s ability to pass it along to their heirs may be hindered by rules in many states that require the trust to terminate and distribute assets after a maximum number of years, and by estate taxes when your children transfer the business to your grandchildren.

To make it easier to keep the company in the family, you may consider setting up your IGT as a dynasty trust in a state such as Delaware, which allows assets to stay in trust indefinitely. A properly drafted dynasty trust can give your beneficiaries access to the trust assets during their lifetime while protecting those assets from estate taxes and creditors.

IGTs can be valuable estate and gift planning tools, but there are important factors to consider before establishing one. Talk with your advisors about your goals for the transfer of your business.

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