by: Mike Rosenberg, CPA, Retired Partner
Business owners confront the same succession and estate planning issues faced by other entrepreneurs. These issues focus on how family businesses, their founders, successors, employees and heirs achieve their personal and financial objectives. These enterprises can either survive and thrive or falter and fail – depending upon their ability to meet the various challenges
encountered in the transition process.
A well designed succession plan encompasses not only the transfer of ownership rights and management responsibilities, but also considers the preservation of the family’s wealth and its financial security.
The goals of such a plan are:
- To determine the successor(s) to the owner(s) of the business, as well as key, non-family employees who are critical to the continued success of the business.
- To provide a method for transferring control of the business.
- To establish the means to balance personal, family and business priorities.
- To develop a plan and mechanism to ensure that succession decisions are viewed as unbiased and equitable based upon a family consensus.
- To achieve family harmony while maintaining family values and life styles.
- To clarify career paths for family and non-family members through proper goal setting and training.
- To integrate the succession plan with estate, retirement and financial planning and ensure the ongoing viability of the business by minimizing estate liquidity demands.
- To provide a flexible structure which can accommodate unforeseen contingencies and/or revision of the plan, if necessary.
The key elements that must work together to balance the goals set forth above include:
- Business and organizational considerations that address the company’s position in the marketplace, its cash flow and capital requirements and management infrastructure.
- Senior owner’s financial needs, addressed through salary continuation and deferred compensation plans, intra-family installment sales of business interests, and retention of business and investment assets (including use of trusts to provide owner and surviving spouse with financial security).
- Family dynamics and relationship issues which consider junior family members’ ability to succeed as the new leaders of the business, and the management role non-family members will have.
- Setting compensation for family members based on level of participation and responsibility in the company, creating niches within the business for family members, and resolving conflicts between active and non-active family members.
- Liquidity considerations for payment of estate taxes and planning funding mechanisms for buy/sell agreements between multiple owners.
While business succession planning implicates a host of non-tax considerations, it also requires a comprehensive integration of estate and gift tax planning. This includes minimizing income taxation on intra-family sales of business and investment assets, gift and estate planning to minimize transfer tax costs when shifting ownership to the next generation and freezing the size of the estate.
This is particularly important in the whole new world of 2011-2012, during which added tax advantages are available as a result of major changes to the transfer tax system enacted by the Job Creation Act of 2010.
Under these new rules the estate and gift tax exemption has been reunified to $5,000,000, a major increase from prior law. This means that up to $5,000,000 of lifetime taxable gifts are exempt from gift tax. Any portion of the exemption not used during life is available as exemption from estate tax at death. Under these new rules, the top estate and gift tax rate is 35%.
A basis step-up in the assets of a decedent takes place as such assets pass to heirs. This means that for income tax purposes the assets obtain a tax basis equal to fair market value at date of death. By contrast, the recipient of a lifetime gift receives the gifted assets with the donor’s basis. For highly appreciated assets, and particularly for assets subject to liabilities in excess of bases (a common occurrence with real estate assets), a basis step-up could be worth more than the estate savings of excluding such asset from the donor’s estate. This adds to the importance of careful and attentive planning for investment and business assets.
One should be mindful that beginning January 1, 2013, absent further legislative action, the generous rules enacted by the 2010 legislation revert to a transfer tax regime that limits the estate and gift tax exemption to $1,000,000 and raises the top gift and estate tax rate to 55%. As a result, careful integration of estate and gift planning with family business succession planning is particularly important during this window of opportunity.
Some of the planning techniques available to accomplish tax-efficient wealth transfers include:
- Shifting appreciating asset to a younger generation using favorable valuation of the gifted asset by taking into account marketability and minority interest discounts on business and investment assets.
- Establishing family investment entities (using a limited liability company, or “LLC”) as a vehicle to pool family assets, broadening the availability of different types of investment opportunities and provide for successive management. An interest in such a LLC may have features which give rise to discounted valuations, and may be an ideal asset for a gift.
- Gifting income assets with potential value appreciation to a defective grantor trust which insures that the assets of the trust are out of the donor’s estate but continue to be treated, for income tax purposes, as being owed by the donor. The donor’s payment of tax on the income of the trust will not constitute a gift to the trust’s beneficiaries for gift tax purposes. The assets of the trust will grow free of income tax and the donor’s estate will be depleted by payment of income tax.
- Employing structuring techniques which enhance leveraging of gifts, such as part gift/part sales to a grantor trust, which permits the transfer of assets to younger generations in exchange for low interest rate installments notes.
- Using freeze transactions whereby senior family members contribute low value LLC interests to a freeze partnership in exchange for a preferred interest entitling senior members to a cumulative preferred interest-like return and a liquidation preference. Junior family members contribute assets to the freeze partnership, in exchange for a “common” or “residual” interest, which entitle them to cash flow above the preferred return and appreciation above the preferred interest’s liquidation preference. Such freeze transactions may be particularly suitable for low tax basis/high value real estate where a basis step-up at death is desirable.
Close-Up on MWE’s Family Business Experience
In 1946, MWE was founded. Among its earliest clients were family businesses. Since its earliest years, MWE has served family businesses in industries including real estate, construction, manufacturing, distribution, professional services, retail, technology, entertainment and leisure and diverse service firms. MWE has assisted these family businesses and their owners with a wide array of succession and estate planning techniques incorporating fully-integrated plans that effectively address the financial and personal goals of senior members, successors, other family members and key employees, as well as the overall needs of the business entity.
MWE’s family business specialists have gained the confidence, trust and respect of their family business clients and are recognized by leading professional and civic associations as premier family business experts.
At MWE, family business succession planning encompasses a disciplined and focused process that implements a strategic plan that integrates the personal and financial needs of the owners, family members and key employees with the needs of the business as a viable ongoing enterprise.
This process extends beyond traditional estate planning and includes the creation of the right business structure while accommodating family dynamics and relationship issues, as well as addressing current and long-range requirements of the business operation.