Succession and Tax Planning: An overview to accomplish your goals before the end of 2014

As we approach the middle of the third quarter, the end of the year likely seems like an eternity away. However, the end of 2014 is quickly approaching and the window to implement proper succession and tax planning will be over sooner than you may think.  Therefore, this is the first in a three-part series that will focus on succession and tax planning techniques, particularly for owners of closely held businesses.

Many clients wish to eventually transfer their ownership in the family business to either their children or grandchildren. From a succession, income tax, and estate tax planning perspective, there is tremendous benefit in transferring a portion of a closely held business to the next generation during the owner's lifetime.  Ownership is transferred to the eventual successors, giving them a greater connection to the business, and appreciation in the value of the business is removed from the client's estate.

The most straightforward method of transferring ownership would be to make small gifts of the business over an extended period of time to the younger family members.  If the amount of the gift is less than the annual gift tax exclusion, there will not be any gift tax due.  Spouses may make tax-free gifts of $28,000 per donee per year.  Thus, over a period of time, a portion of the equity may be transferred to family members in a younger generation.

If the business will potentially appreciate rapidly within a short amount of time, then making small gifts every year is not a viable option because the majority of the appreciation would remain in the client's estate.  However, it is possible to transfer significant portions of the business and thereby the appreciation on a relatively efficient gift tax basis through the use of a grantor retained annuity trust ("GRAT") or through a sale to a trust for the benefit of the business owner's children and grandchildren.  If structured properly, the appreciation will be removed at marginal gift-tax cost.

In some situations, the successor will not be a member of the owner's family—say for instance the business is owned equally by two unrelated parties.  In these cases, it is vital that there be either a redemption agreement or cross-purchase agreement in place if the desire is for ownership to remain in the hands of those that are active in the business, as opposed to the deceased owner's heirs. Depending on the classification of the entity (i.e. a C corporation, S Corporation, or LLC taxed as a partnership), then different tax considerations will affect the form of the agreement.

Regardless of whether the goal is to transfer a business to family members in a younger generation or to unrelated persons, proper planning is essential to accomplish either of these goals in the most tax efficient manner.  In the next installment, we will discuss specific income tax issues and viable solutions for closely held businesses.