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Michael A. Tedone
Four ways to transfer a family business

Determining the proper transfer technique requires a comprehensive analysis of the business’s balance sheet, cash flow, and the current estate plan.

September 30, 2013
by Michael A. Tedone, CPA/PFS

Owners of small businesses have a unique set of estate-planning needs and circumstances. Much has been written over the years about small family businesses being forced to sell or close as the result of the death of the majority owner of the business. Purportedly, the estate taxes due at the time of death are so substantial that the business is forced to liquidate in order to pay them. 

The reality is that, in my 30-plus years of advising small business owners, I have never seen this circumstance occur. There are cases, I am sure, where this happens, but the more important issue in my experience is the need for an efficient transfer of the business to the next generation and the minimization of estate taxes. 

Determining the financial ability of one generation to transfer a family business to the next generation requires a comprehensive analysis of the transfer’s balance sheet, cash flow, and current estate plan. (It’s important to note that I define a small family business as one with sales of less than $100 million; typically that figure is more in the range of $5 million to $50 million.)

Here are some things to consider when analyzing the various alternatives available for the transfer of a family business:

  • The annual exclusion for gifts for 2013 is $14,000 per person;
  • The federal exemption available during life or at death for 2013 is $5,250,000; and
  • Estate and inheritance tax laws are inconsistent among the various states. For example, as of January 2013, Connecticut is the only state that imposes a stand-alone gift tax on lifetime transfers. Certainly this factor is important for Connecticut business owners.

Ways to transfer businesses
Now let’s look at some techniques used to transfer family businesses. Techniques 1 and 2 below are appropriate when the client prefers to keep it simple and/or the value of the business is more modest.

  • Annual exclusion gifting. For businesses that have modest values, this can be an effective plan. Where there are two parents and multiple children, the $14,000 annual exclusion can become a significant amount.
  • Use of the lifetime federal exemption. This can be used when a family business has a somewhat larger value. Also, if a business is expecting a quick or steady increase in value, the use of the lifetime exclusion can be especially effective to remove the future growth from the donor’s estate.

More complex techniques
Techniques 3 and 4 are more appropriate when the client is not concerned with complexity, the value of the business is more significant, and estate tax savings are of great concern to the client. Because these two methods will require more sophisticated planning involving tax professionals (CPA and estate attorney), the cost benefit must be analyzed.

  • Intentionally defective grantor trust (IDGT). Numbers 1 and 2 above are sometimes combined with a sale to an IDGT. With the current low interest rate environment, this is a very attractive estate freeze strategy. If assets associated with the installment sale appreciate more than the interest rate, the increase in value will benefit the IDGT. A sale to an IDGT freezes the value of the property sold for the value of the note received. Future appreciation in the value of the family business is transferred to the next generation. The value of the note is included in the grantor’s estate if the grantor fails to survive the term of the note. No sale is recognized; therefore, there is no capital gain tax, because the grantor and the trust are considered to be the same taxpayer. There are many technicalities to follow when implementing this technique, but when used properly it can be an effective estate-planning tool for small business owners.
  • Grantor retained annuity trust (GRAT). The use of a GRAT is another estate-planning technique sometimes combined with numbers 1 and 2 above. Similar to the IDGT, this technique freezes the value of the business so that future appreciation is transferred to the next generation. Low interest rates, again, are beneficial to the establishment of a GRAT. Because the grantor retains the right to receive a fixed annuity equal to the value of the property gifted to the GRAT, at the applicable federal rate under Sec. 7520, the GRAT needs to appreciate at a higher percentage than the applicable federal rate. The risk of the GRAT techniques is minimal. The main risk is that the grantor does not survive the term of the GRAT and some or all of the trust assets are included in the grantor’s estate. To hedge this risk, rolling GRATs are sometimes used.

As you can see, there are several ways the small business owner can solve his or her family business transfer concerns. The key is to assemble the proper advisory team and develop a plan that ensures the most efficient transfer possible. 

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Michael A. Tedone CPA/PFS, is a partner with Connecticut Wealth Management LLC. He has more than 30 years of professional experience in the areas of wealth management and estate planning.

The AICPA’s PFP Section provides information, tools, advocacy, and guidance to CPAs who specialize in providing tax, retirement, estate, risk management, and investment advice to individuals and their closely held entities. All AICPA members are eligible to join the PFP Section. CPAs who want to demonstrate their expertise in this subject matter can apply to become a CPA/PFS credential holder.