Handing Over the Family Business

Many entrepreneurs intend to pass the family business on to future generations of the family. In considering this goal, they must understand two important realities.

THE ESTATE TAX IS NOT GOING AWAY
Despite all the political discussions to the contrary, there is not much chance that the estate tax will be permanently eliminated. Under the 2001 tax bill, the estate tax will be eliminated only in the year 2010. Unless the elimination of the estate tax is re-enacted before 2011, on Jan. 1, 2011, the current law will be automatically reinstated. A dwindling surplus, the cost of the war on terrorism and the opposition of States, charities as well as many Democrats, make it extremely unlikely that Congress will vote to continue the elimination.

Instead, clients should anticipate a unified credit somewhere between 1 million to 3 million per tax-payer, depending on who wins the political arguments and how much the surplus can fund. Congress may also provide for a reduction of estate taxes on Family Farms and Businesses, which is more workable than the present day estate-tax business deduction which expires in 2004.

THERE IS NO “EQUITY” VALUE IN A FAMILY BUSINESS
When an entrepreneur wants to pass his or her business to family members, there is no true equity value in the business because the equity provides no current benefit to the business owner. The equity creates a current benefit only if the business is sold, (i.e., as would occur in a third-party buy-out). In fact, the equity value of the business is a liability waiting to happen because of the potential transfer tax liability on the passage of that wealth.

When the issue is properly addressed, the owner is interested in control of the business and the income and benefits that control generates. Using readily available planning approaches, such as deferred compensation, Family Limited Partnerships, and Trusts, the income and control of the business can be separated from its equity. The equity can be passed on at a reduced tax cost to family members by using various valuation-adjustment techniques.

The retention of the equity value of the business may create transfer-tax liability that could have been reduced or even eliminated. By retaining ownership, the owner not only loses the ability to discount the present value of the business, he also causes the family to pay estate taxes on the appreciation of the business.

Essentially, the federal transfer tax is a voluntary confiscation tax. With proper planning, however, this confiscation can be minimized or eliminated The key is recognizing that “equity” is not the same thing as “control”—and “control” allows the owner to benefit from the income that the business generates.

For more information on how all of this might work, please see the next article on the publications section of this website entitled; “Succession Planning: Seven Steps to Continuing Success”.