If you’re considering handing over the reins of your family business to your children, it’s important to understand the income, gift, and estate tax consequences. Naturally, you’ll want to be able to sell your business to your children at its full value. There are a number of estate planning tools available today that can help you successfully transfer your business. Careful planning can help prevent the need to sell some (or all) of your business assets to pay taxes.
Business succession planning should include ways to not only ensure the continuity of your business, but to do so with the smallest tax consequences possible. Here are some common tax-minimizing strategies:
Gifting your interest outright
If you don’t need continued income from the business and you don’t want to retain control, you can simply give the business to your children outright. By transferring your interest in this manner, you may be able to transfer all or a significant portion of the business free from federal gift tax. The disadvantage here is the amount of time that may be needed to transfer your entire interest.
If you wish to transfer your business at your death, Section 6166 of the Internal Revenue Code allows any estate taxes incurred due to the inclusion of your family business in your estate to be deferred for 5 years and then paid in annual installments of interest and principal over a period of up to 10 years. Specific requirements must be met.
Selling your interest outright
When you sell your business interest to a family member or someone else, you receive cash (or assets you can convert to cash) that can be used to maintain your lifestyle or pay your estate taxes. If you need income from your business, you can sell your business interest (for full fair market value) to your children. This will avoid gift and estate taxes, but you may owe capital gains tax.
Self-canceling installment notes
A self-canceling installment note (SCIN) allows you to transfer the business to the buyer in exchange for a promissory note. The buyer must make a series of payments to you under that note. A provision in the note states that at your death, the remaining payments will be canceled.
Using a buy-sell agreement
If you want to sell your business to your children but retain control, consider a buy-sell agreement. This is a legal contract with predetermined price and sale terms that states, the sale will happen when a specific event occurs (such as your retirement, disability, or death). Once the triggering event occurs, your children are obligated to buy your interest from you or your estate.
Keep in mind, you won’t be able to sell or give your business to anyone except the buyers named in the agreement (unless they consent). This could restrict your ability to reduce the size of your estate through lifetime gifts of your business interest, unless you carefully coordinate your estate planning goals with the terms of your buy-sell agreement.
Using a Grantor Annuity Trust (GRAT)
A GRAT is a trust into which you transfer your business interest, and from which you receive income for a period of time. This is a more sophisticated business succession tool than a buy-sell agreement. In a GRAT, the value of the gift is determined using the IRS’s current interest rate. You receive annuity payments during the term of the trust, and at the end, your children will receive the business. If the business appreciates beyond the IRS’s interest rate, the excess can pass tax-free. Be aware that if you die during the GRAT term, your entire business interest will be included in your gross estate for federal estate tax purposes.
Creating a Family Limited Partnership (FLP)
In a FLP, you establish a partnership with both general and limited partnership interests, then transfer your business to this partnership. You retain the general partnership interest for yourself, and over time, gift the limited partnership interests to your children. This leverages your lifetime gift tax exemption, the annual gift tax inclusion and saves taxes through valuation discounts.