By Bernard A. Krooks
Bequeathing your business to other family members can be a minefield. Misjudging their inclinations can lead to long-lasting conflict. Failure to assess tax implications can leave the business cash poor, threatening the viability of a life”™s work and the financial security of loved ones. Few family firms survive into the third generation, and unless business succession is addressed within the context of estate planning, the best intentions may be thwarted.
A Family Decision
Your plans for the business are likely to have a big effect on the lives of beneficiaries, so ask them how they envision their future role. Are some of your kids already working in the business? Suddenly involving someone new in daily operations risks missteps and confrontations. Does anyone possess the necessary skills to take your place? Would your spouse prefer to sell the company? Facilitating this difficult discussion now is a real gift to those you love, who will be ill-equipped to focus on such issues in the midst of mourning.
Business Structure
First-generation businesses are often sole proprietorships, functioning as extensions of the owner”™s personal assets, and it may be appropriate to consider alternative business structures as part of your succession planning. Possibilities include:
- General Partnership ”“ One or more family members are co-owners alongside the founder. They typically share equally in profits, losses and liability.
- Limited Partnership ”“ Owner retains management control as the “general” partner, while one or more limited partners contribute financially. The controlling partner has personal liability for the firm”™s obligations, while the liability of others is limited to their investment.
- Corporation ”“ Owners are shielded from personal liability. Corporations may issue stock, which facilitates the transfer of ownership through sale or gifting. The downside is that many federal and state regulations apply, and income is taxed at both the corporate and owner level. An exception is the S-corporation, where there is only a single layer of tax. .
- Limited Liability Company ”“ A partnership/corporation hybrid, with no personal liability, single-level taxation and easy transfer of ownership. A controlling interest empowers an individual to participate in operations, while a financial interest limits involvement to sharing of profits, losses and asset distributions.
Taxation and Liquidity
All too often, owners transfer the business to their heirs through a last will and testament, exposing hard-earned assets to steep estate taxes. Many a family business has consequently been liquidated at fire sale prices in order to cover taxes and other final expenses. In fact, it”™s wise to review the terms of existing bank loans to ensure that the business doesn”™t become starved for cash.
At present, estate taxes are scheduled to increase substantially on Jan. 1, 2013. Today, unprotected assets over $5.12 million are taxed at 35 percent, but next year that jumps to 55 percent on holdings over $1 million. In addition, New York state levies a progressive tax of up to 16 percent on estates of more than $1 million.
There are, however, options to limit your exposure. Topping the list are assorted trusts, legal instruments that discount the value of a business for tax purposes by granting varying levels of control to others. The more control assigned to others, the greater the tax benefit.
Annual gifting is another possibility. Each year, individuals can bestow–tax-free– gifts valued up to $13,000 each to as many people as they wish, in addition to a lifetime maximum of $5.12 million (dropping to $1 million in 2013). Once the lifetime maximum has been exceeded, gifts over $13,000 are subject to a 35 percent tax, rising to 55 percent in January 2013, unless Congress acts.
This means that during 2012, a business valued at $4 million could be given outright to someone else without being subject to gift taxes. On the other hand, such a step could expose them to significant capital gains taxes in the future. If they eventually choose to sell the company, they”™d be liable for any appreciation in value from the time you assumed ownership. If you founded the company, that would mean they owed taxes on every penny of accrued value from the time that the firm was established. If they were to inherit the company instead, they”™d only be taxed on appreciation from the date of your death.
Finally, the company can be sold to other family members. Selling the firm outright or through installments has the advantage of providing a source of retirement income. As an alternative, a buy/sell agreement can be written, stipulating that proceeds from the owner”™s life insurance be used to purchase shares in the company.
You”™ve spent years building the business, so invest the necessary time to safeguard its future. With thoughtful planning, it can be passed to the next generation in a manner that preserves both its value and the family peace.
Bernard A. Krooks, founding partner of Littman Krooks L.L.P., is former president of the Estate Planning Council of Westchester County. Visit the firm”™s website at www.littmankrooks.com .
