To Heir Is Divine

There are a number of smart strategies you can use to help your small business clients pass their business assets on to heirs.

I buy books at a small family-run bookstore. I eat out most weekends at a multigenerational family eatery. I sent my mother flowers on Mothers Day from a small, family-run outlet. Of course, we hear an endless chorus bemoaning the “chaining” of America: a very true trend. And yet the small family-operated business remains a powerful force in the U.S. economy.

If you consider the estimated 26 million small businesses in the U.S. together with the demographics of the baby boomer generation, you'll quickly realize that a staggering number of individual investors need to begin looking at family-business succession planning. There are ways to pass along the family store, no matter how big or small, without taking a beating from the taxman.

“Oh boy, when you're dead you don't take nothing with you but your soul. Think!” John and Yoko probably weren't talking about succession planning when they wrote this line in The Ballad of John and Yoko, but it's relevant even here. While we have the sentimental ideal of a deathbed scene, where the departing family patriarch recites his last wishes, the most opportune time for small-business owners to begin thinking about what they will leave behind — whether to kids or business successors — is now. By bringing this up with clients, those currently holding the company keys stand a better chance of keeping the bulk of the wealth they have amassed and using it for retirement or handing it off to heirs.

“I can't stress enough the importance of suggesting to those thinking of handing businesses over to their children to begin the process sooner rather than later,” explains Patricia Phillip, a New Paltz, N.Y., CPA. “Businesses usually see their value increase over time, thus the tax burden will only grow as the entity's value does as well.”

There are several pre-liquidity strategies that can help lower federal transfer taxes, which include the gift tax, the estate tax and the generation-skipping transfer (GST) tax. They range from basic steps, such as taking advantage of the annual gift-tax exclusion — you can make annual gifts of up to $12,000 tax-free to any number of people, with a lifetime exclusion of $1 million per donor — to setting up a grantor retained annuity trust (GRAT) and making an installment sale to a grantor trust.

“The most basic idea here is to keep any gifts to one's children under the federal gift-tax limit,” says Phillip. (Note that the $12,000 figure remains unchanged from 2006 to 2007. That's up from $11,000 for 2002 to 2003). Gifts over that amount first eat into the $1 million lifetime gift-tax exemption amount ($2 million for a married couple); once that $1 million amount is used up, your client owes a gift tax. Some exceptions apply. Fortunately, one's spouse can also give $12,000 per child, per year. And the couple can each give the same amount to their child's spouse and each of their children. Bear in mind that once your client exhausts his or her lifetime gift-tax exemption, he, in turn, begins to eat into his estate-tax exclusion of $2 million.

There are a couple of ways to make sure that the small-business owner stays under gift- and estate-tax limits when passing the business on to heirs. For example, it makes more sense to give children a minority interest in the company, as opposed to physical goods, because minority interest shares can be sharply discounted. Later, when the children accumulate ownership in the company, those discounts will disappear. “Over time, you are really able to pass along accumulated wealth in a very tax friendly fashion,” explains Phillip. Another way to go might be to give away only the non-voting shares, allowing the owner to retain full control over the business while he's alive. An added bonus: Non-voting shares are worth less, allowing the client to give more of them each year tax-free.

Many advisors also suggest setting up a trust or a limited liability corporation (LLC) to shield proprietors from legal risk. Richard Stein, a financial advisor in San Francisco, agrees, saying, “The best vehicle for giving your kids the business is some kind of trust. These come in different flavors with differing pros and cons, but they share some advantages. For one, they give you the power to control at what age the children get access to the money. You can even mandate periodic distributions from the trust for their benefit. Another advantage is protection against lawsuits: A trust can shelter its assets from suits against you or your kids as well as from a divorcing spouse. Finally, a trust can prevent your kids from selling their minority interest, which you might not like even though their stake carries no control. Ownership, for example, could give a rival access to information you'd prefer not to disclose.”

In most cases, parents create an LLC naming themselves as members and managers. The parents then transfer assets to the LLC and, subsequently, transfer some or all of their membership interest to their children. By serving as the managers of the LLC, the parents retain control while transferring wealth to their descendants. When a membership interest in an LLC is transferred from a parent to a descendant during the parent's lifetime, that transfer is subject to gift taxes. However, significant valuation discounts may be available due to the nature of the interest transferred.

Of course, estate-tax planning is fraught with a certain amount of uncertainty. Today, the federal estate tax is scheduled to disappear in 2010, only to return a year later at a whopping 55 percent rate. But that could change. “What we do know, or at least feel comfortable with, is that there will be legislative changes to the estate tax before 2010,” Stein says. The House of Representatives has passed one bill repealing the estate tax in its entirety beginning in 2010, but proposals continue to float around Capitol Hill, including increased exemptions of $3.5 million to $5 million and, perhaps, marginal tax rates that are below the current 46 percent (for estates over $2 million). As in the past, there will likely be a number of bills introduced and voted upon before a final decision on the federal estate tax is reached. Democratic control of Congress until, at the very least, January 2009 suggests betting on the long-term repeal of the estate tax might be a losing wager.

Bob Scharin, RIA senior tax analyst from Thomson Tax & Accounting in New York , points out that calculating a family business' value can get awfully murky, and says there are upsides to setting up an LLC. The whole is greater than the sum of a business' parts, says Scharin — so it's a good idea to use a professional appraiser to estimate the fair value of a business. This goes beyond book value, discounted cash flow, sales multiple and liquidation value. “They take into account goodwill, relationships with suppliers, the assumed profit and so on. Also, using a professional here will help protect a client from the IRS.” Remember, the IRS is like the commissioner in a sports league. Its role includes having the power to reject trades or deals of any stripe. Scharin also points out that one has to update the value of stock given to children each year, since the value of a set share amount can fluctuate. If you're not paying attention, you can trip the gift-tax wire.

Families are often faced with the prospect of selling their parents' company to raise enough capital to pay the federal estate tax, which could amount to more than half of a company's value. Some families purchase enormous life insurance policies to offset the burden. Some of these policies are often placed in irrevocable trusts, not subject to tax. But watch out for state taxes. Under complicated rules that I won't get into here, state and federal inheritance taxes have, historically, been linked. But state governments do not share the Bush administration's conviction that a lower estate tax will increase growth. New York, Connecticut, New Jersey and many other state governments are either moving, or already have moved, to make sure they collect estate tax revenues whatever Washington decides.

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