Perhaps you have been considering giving your children a piece of the family business. Maybe you would like them to be more involved or invested in its future. Maybe your financial advisor has been urging you to do some estate or income tax planning. Or maybe you are just looking to retire.
Whatever the reason, it may be time for you to decide exactly how you are going to transfer some of the business to your children. This article may help alert you to some planning ideas, as well as some traps to avoid.
Transfers of Voting vs. Nonvoting Interests.
Rather than giving away voting power in the company, consider recapitalizing the company to create non-voting shares. Such a recapitalization can be accomplished without any adverse income tax consequences.
Transfers to UTMA Accounts vs. Trusts.
Perhaps your children are not yet financially responsible. It is easy to transfer ownership to minors under the Uniform Transfers to Minors Act (UTMA). Keep in mind, however, that under the UTMA the child must obtain absolute ownership of the stock no later than age 25.
A trust is a more flexible alternative to the UTMA. A typical trust instrument appoints a trustee who will manage and vote the stock for the beneficiary. If desired, the beneficiary may later, at a responsible age, become a trustee or co-trustee.
Typical Trust Terms.
If a trust is used to hold a business interest, the trust should be structured in a tax-efficient manner. For example, if your business is an S corporation, care should be taken to ensure the trust is a qualifying shareholder.
If the trust is intended to be excluded from your estate for estate tax purposes, the grantor of the trust generally should not serve as the trustee, and should not retain the right in any capacity to vote the transferred interests or amend or revoke the trust. As grantor, you may, however, retain the right to remove and replace the trustee with an “independent” trustee (e.g., someone other than a parent, spouse, sibling, descendant, or employee).
Tax Treatment of Gifts.
A gift of an interest in a business is exempt from income taxes, but may potentially be subject to gift taxes. Under current law, an annual exclusion of $14,000 per person applies for gift tax purposes. Any transfer exceeding that amount will use up a portion of your lifetime gift tax exemption, an inflation-adjusted amount currently set at $5.43 million. Transfers exceeding your lifetime exemption are subject to federal gift tax.
Potential Risks With Profits Interests.
If interests in the family business do not have proportionate rights to distributions, you should tread carefully before making any gifts. Many people are aware that a profits interest generally is treated as having a value of zero for income tax purposes. However, for gift tax purposes the IRS has taken the position that a profits interest can have significant value. For example, if you make a gift of a profits interest to a trust for your children, it is possible that, under the complex valuation rules of section 2701 of the Code, the IRS could argue the taxable gift is significantly larger than its actual fair market value.
Ways to Sell or Transfer the Growth of Your Business to Your Family.
Perhaps you’re not interested in making a gift of your entire business, but wouldn’t mind having any future increase in value pass to your children. In that case, you may consider selling portions of the business either to your children or to a trust for their benefit.
If you sell directly to your children, the transaction will be a taxable event, and you may recognize gain for income tax purposes. More complex techniques, such as grantor retained annuity trusts or sales to a grantor trust, may permit more tax-efficient transfers of the growth of your business to your children.
This article is only a brief introduction to some of the ways in which you can give your children a piece of your business. Whichever method you choose for your situation will depend on a combination of tax and non-tax considerations.
By Steven E. Hollingworth, partner, Solomon Dwiggins & Freer