Bloomberg Tax
Free Newsletter Sign Up
Login
BROWSE
Bloomberg Tax
Welcome
Login
Advanced Search Go
Free Newsletter Sign Up

All in the Family—Transition Strategies for Family Businesses

Nov. 9, 2022, 9:45 AM

Television’s Archie Bunker created estate planning poetry when he exclaimed: “Somebody’s gotta be dead. That’s life!” While the reality of death is uncomfortable to think about, all business owners must plan for it lest they leave their families a mess rather than a blessing. In the context of a family-owned business, the failure to properly plan for disability, death, or the ultimate transition of the business can lead to disastrous financial consequences for the business and the family as a whole.

What Happens if the Business Owner Does Nothing?

A family business often is the family’s main financial asset, and the business owner often doesn’t have significant or sufficient liquidity outside of the business itself. In such circumstances, the business owner must consider federal estate taxes upon death. Every individual has an estate, gift, and generation-skipping transfer tax exemption of $12.06 million ($24.12 million per married couple), though these historically high exemption amounts are set to revert to prior lower levels in 2026. The amount exceeding the exemption may be taxed at 40%.

Assuming an estate tax liability is incurred upon the death of a business owner, how would the family pay the tax? If a spouse survives the business owner, Section 2056 of the tax code allows them to use the unlimited marital deduction to defer federal estate tax liabilities until the survivor’s death. Of course, the estate tax will be assessed on any appreciation of those assets during that time.

Additionally, certain provisions in the tax code may mitigate or prevent the need to sell the business to achieve liquidity for paying estate taxes. For instance, Section 6166 allows the executor to pay part or all of the estate tax due over 15 years, provided the value of an interest in a closely held business exceeds 35% of a decedent’s adjusted gross estate. The payment can be divided into five years of interest-only payments and 10 equal installments at a low interest rate.

While this election may be appropriate in certain circumstances, more advantageous options also should be considered. Business owners can mitigate or entirely avoid federal estate tax liabilities upon death with proper business succession planning during their lifetimes.

Use of Charitable Vehicles

Charitably minded business owners might consider including charitable trusts or entities as part of a tax-efficient business transition plan. A charitable remainder trust, or CRT, offers significant benefits and may fund a business owner’s retirement in a tax-efficient manner.

If a business owner transferred equity interests in the business to a CRT prior to a liquidity event, no capital gains would be generated upon the sale of the business, because the CRT generally is exempt from federal income tax. Income from the sale would be deferred and recognized as the CRT made distributions to the business owner in accordance with its terms. At the end of the term, the CRT’s remaining assets would inure to the benefit of the selected charitable remainderman, which could be a family-established and managed private foundation. This tool also may be paired with other strategies.

Consider Patagonia Inc. founder Yvon Chouinard, who recently transferred all of his voting stock to the Patagonia Purpose Trust, which was created to allow the Chouinard family to protect Patagonia’s core values. Chouinard then transferred all his nonvoting stock in Patagonia to the Holdfast Collective, a 501(c)(4) social welfare organization dedicated to fighting the environmental crisis.

Such strategies were intended to advance the Chouinard family’s philanthropic desires, but this business succession model accomplished other financial and tax-saving goals as well. As reported by Bloomberg, the transfer to the Patagonia Purpose Trust resulted in a $17.5 million gift tax for Chouinard, which is significantly less than the $700 million capital gains tax resulting from the proposed $3 billion sale of Patagonia.

Use of Intentionally Defective Grantor Trusts

Family businesses generally appreciate over time; owners should consider shifting equity out of the taxable estate through a combination of gifting and selling business interests to a properly structured intentionally defective grantor trust for the benefit of the owners’ beneficiaries. Any appreciation after the date of transfer should be excluded from the taxable estate upon death for purposes of determining federal estate tax liabilities.

This strategy allows business owners to retain the voting control of the business and shifts nonvoting equity interests in the business to other family members while obtaining significant estate tax benefits. However, Section 2036 and other estate tax inclusion provisions must be considered in any lifetime business succession plan, and business owners should consult with a competent attorney to implement any such strategy.

Use of Recapitalization and Valuation Discounts

Some business owners establish their business as a family limited partnership or limited liability company and, over time, decide to sell or gift a percentage of the interest to the next generation, subject to the discounts available for the transfer. Business owners also should consider hiring a qualified appraiser to issue a valuation report on the transferred interests and claim any possible discounts available after recapitalizing the ownership interests.

Such discounts may account for lack of control and lack of marketability. For example, business owners can retain the voting stock and gift or sell the nonvoting stock to trusts for the benefit of the remaining family members, with voting interests to be transitioned to the next generation when appropriate. This strategy allows business owners to use valuation discounts for lack of marketability and control. Of course, estate tax concerns must be considered to ensure the voting interests retained by the business owner are not pulled back in the gross estate.

Conclusion

The ultimate disposition of a family business is one of the most important decisions a business owner will face, often with only one “bite at the apple.” We recommend that a business owner remember Archie Bunker’s admonition, consult with competent tax and estate planning counsel, and get to planning.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

J. Scot Kirkpatrick is a shareholder in the Atlanta office of Chamberlain Hrdlicka and head of the office’s Trusts and Estates Practice Group. He primarily represents high-net-worth individuals and their families in a wide variety of estate and tax law matters.

Stephen C. Heymann, senior counsel in Chamberlain Hrdlicka’s Atlanta office, focuses his practice on helping business owners and high-net-worth families preserve wealth through sophisticated income and wealth transfer tax planning strategies.

Jasmin N. Severino is an associate in the Atlanta office of Chamberlain Hrdlicka, where she helps clients establish estate and business succession plans and assists them with wealth preservation plans.

We’d love to hear your smart, original take: Write for Us.