Transfer stock to a spouse or children? In many privately owned companies, that is the last thing that you would want to let happen. However, with most family-owned businesses, a transfer to family members is not only permitted, but often an express objective.
Succession planning for a family-owned business raises a host of issues, and many of them have been previously addressed in this column. Planning must include both the transfer of management and ownership, and also must address the needs of the business and the family.
This discussion will focus on several topics and techniques for transferring ownership of interests to subsequent generations.
Shareholder agreements. Shareholder agreements are a good idea in any privately owned company. They are particularly important for a family-owned business. A shareholder agreement can prohibit some transfers while expressly permitting others. For example, an agreement might permit transfers to children but not to a spouse, or might permit transfers only to family members who are active in the business. A shareholder agreement might also require a sale or purchase on certain events, such as death, disability, or termination of employment with the business.
Voting/non-voting interests. It is relatively easy to divide shares of a corporation or interests in a limited liability company between interests that carry voting rights and interests with much more limited rights. This permits an owner to transfer equity of the business while still retaining control. It also permits a shareholder to transfer voting interests to some family and non-controlling interests to others. S corporations are generally permitted to have only one class of shares, but voting and non-voting stock is an exception to that rule. Retention or allocation of voting control can also be addressed in other means, such as a voting agreement, voting trust, or another form of entity, such as a limited partnership. Some vehicles for retaining control can cause a transferred asset to be included in the transferor’s estate for estate tax purposes, so caution is needed in this area.
Sale or gift? In some families, it has been a tradition for each generation to purchase their parents’ interests in the family business. This can be helpful in providing cash flow to the senior generation, but a lifetime purchase may trigger taxes — unnecessarily sharing the family’s cash flow with the government. Some families have a more compelling rationale: “My dad made me buy it from him, so you are going to do the same!” While there may be reasons in favor of a purchase, there are frequently more tax-efficient methods to move ownership between generations than a taxable purchase.
Will and trust provisions. Appropriate provisions in an owner’s will or trust can be an effective mechanism for a transfer of shares. Specific attention to the family business in your estate plan permits interests to be allocated selectively among different children or relatives, and also permits other post-death control. A trust may also use a different trustee or different holding periods for family business assets. However, provisions in a will and trust do not become effective until death, which may be too late. Lifetime transfers may be much more optimal for the family, for the business, and for reduction of estate taxes.
Tax-free gifts. Federal tax law permits each person to make a present gift of up to $13,000 to an unlimited number of individuals each year. As an example, a husband and wife with two kids and a total of four grandchildren can transfer $156,000 in value each year. Over a period of time, a remarkable amount of value can be transferred in this simple way. In addition to annual exclusion gifts, each person has a $1 million lifetime exclusion from gift taxes. Gifts such as these might be coupled with use of a trust and a shareholder agreement. But note that excessive limitations on a transferred interest might disqualify the gift for the annual ($13,000) exclusion, as that exemption requires a gift of a present interest.
GRATs. A Grantor Retained Annuity Trust can be an extremely effective tool in transferring ownership of a family business to the next generation. With a GRAT, the business interest is placed in a trust with an annuity being paid back to the grantor. The payments are designed to be nearly equal in value to the amount put into the trust so that there is little if any gift at the time of creation. The value of the annuity payments is based on a calculated interest rate, which is 2 percent for November 2010 (dropping to an all-time low of 1.8 percent in December). Basically, the income generated on the stock (as well as any appreciation) which exceeds the applicable rate, passes to the beneficiaries of the trust on a tax-free basis.
Sale to a grantor trust. Another alternative is to sell stock to an irrevocable “grantor” trust. Properly designed, this is treated as a sale for estate and gift tax purposes, but not for income tax purposes, so no current capital gain is triggered. The purchase can be for installment notes. With the current low interest rates, the rate of interest on the notes can be very low without any adverse tax consequences.
These are just a few of many issues and techniques. Because the values of many businesses are unusually low right now, it may be a good time to consider a transfer. With any of these alternatives, it is important to make sure that there is adequate retirement income for the senior generation. The transfer arrangements can sometimes provide that, or perhaps it has been taken care of in other ways. In any case, the senior generation is not likely to part with ownership and control of the company until their retirement needs are assured. But if the family business is going to remain a family business, the family needs to address how to best move it from one generation to the next, and the sooner the better. Help is available through local professionals and through the Family Business Alliance (www.fbagr.org).
Bruce Young is a partner with law firm Warner Norcross & Judd LLP specializing in corporate and transaction work with an emphasis on family-owned businesses. He is also a third-generation shareholder of the Behler-Young Co., where he serves as secretary and on the board of directors. He is also on the board of the Family Business Alliance.