For most business owners, succession planning for their business involves preparing the company for transfer, determining its value, and identifying a buyer or recipient (third-party, internal, family), often to maximize value and ensure continuity. A smaller percentage of business owners may also focus on advanced tax planning, maximizing financial performance, and executing a structured transition of leadership to support long-term goals. Most business owners do not consider estate planning until after they have already transitioned their business and received a material amount of wealth, often in liquid funds. While estate planners can capably assist with the transition of wealth, if family business owners consider estate planning earlier, additional techniques and vehicles can be utilized to increase the wealth being transferred to future generations.
Maximizing wealth is typically a goal that runs contrary to estate planning, which is a good problem to have. Another way of viewing maximizing wealth is expanding the targets of such wealth to include not only you, but your family, heirs, and potentially charitable beneficiaries. If you approach this view of wealth holistically, then your succession planning can better focus on timing.
Business owners can transfer portions of their business to heirs prior to the sale of the business to a third party. These transfers can be set up to vary the portions and voting requirements to ensure that the business owner still retains effective voting control while transferring substantial value. An early transfer, potentially years before a sale to a third party, can result in a transfer for a value at the time of transfer that is a fraction of the value in an eventual sale, thereby reducing the tax impact. In addition, the transfers can take advantage of minority and lack of marketability discounts to lower the gifted value even further. For example, in year one, the business owner transfers 25% of their business valued at $10,000,000 at that time to their child (effectively $2,500,000 of value). With discounts for minority interest and lack of marketability of 35%, the business owner can lower that transferred gift tax value to $1,625,000. In year five, the business sells for $20,000,000 and their child receives $5,000,000 of the proceeds as a 25% owner. By taking advantage of this timing, the business owner effectively transferred $5,000,000 of value for the “price” of $1,625,000 for gift tax purposes. In addition, the child will pay the income tax on their portion of the sale.
If a business owner has charitable intent, then additional options are available. One option is to create a charitable remainder trust (CRT) to hold a percentage of the interest in the business. A CRT will pay the business owner an annuity over the life of the trust and give the remainder to charity after the term of the CRT ends. This technique provides a charitable income tax deduction upfront based on the value of the remainder, while effectively removing the entire value of the gift from your estate without estate and gift tax. As the business owner will be selling the business, presumably for a large profit, they will be able to utilize this charitable deduction in the near future. In addition, a CRT is a tax-exempt entity and the business owner will essentially “save” the income tax on the portion of interest sold by the CRT. In the example above, if the business owner transfers 25% of the business to the CRT, then when the business sells for $20,000,000, the owner will only pay income tax on 75% of the total gain (i.e., their retained 75% ownership of the business).
Of course, these are simplified examples of complex techniques designed to show the benefits to approaching succession planning wholistically. A business owner should retain a succession planner to coordinate with all of their professional advisors prior to selling their business to maximize their practical, tax, and financial return and not wait to do estate planning until after the sale.
Contact counsel today to start your succession planning journey and set your business up for long term success.
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