By Jennifer Civitella Hilario, Esq.
Owning and operating a family business presents many
challenges, perhaps none more daunting than planning for succession to
the next generation. This challenge may become particularly complicated
when not every member of the succeeding generation is or wants to be
an active part of the business.
On one hand, you want to take care of your business by
creating a smooth transition in management and operations. On the
other hand, you want to provide for your children, whether they’re a
part of the business or not.
In both cases, you want to minimize the looming estate
tax liability which may hurt the business and the bottom dollar
received by the next generation.
Gifting is one strategy to mitigate the potential
pitfalls that may arise while passing the torch to succeeding
generations. The following example illustrates gifting and how it works
when the succeeding generation includes one child who is involved in
the family business and another child who is completely uninvolved.
Mary owns a successful real estate management and
development company valued at $6 million. Mary is divorced and has two
adult children. She would like to divide her estate equally between her
children. Only one child, however, her daughter, participates in the
business. Her son does not.
It is not always easy for the owner of a business to
give up control, especially when she is still actively leading the
company. Mary is no exception. Yet her advisors are encouraging her to
transfer some of the business to her children today.
Gifting provides a possible way for Mary to retain
control of her business while removing the value of some of the
business from her taxable estate at the same time.
Mary would like her daughter to take over control of the business,
but would like both children to benefit equally from its success.
By creating voting and non-voting interests in her
business, Mary accomplishes two things: She provides control of the
business by giving her daughter voting interests and she delivers
economic benefit to her son in the form of non-voting interests that
provide him equal rights to dividends, distributions and liquidation
Mary, however, may not be giving her son something
equally valuable if the business does not make any distributions or is
not sold. An alternative is for Mary to purchase life insurance and
designate her son (or an irrevocable trust for his benefit) as the
beneficiary of the policy.
If Mary’s business owns the real estate in which it
operates, she can convey the real estate into a separate entity (such
as an LLC) and charge the business rent. The entity will collect the
rent and make regular distributions to its owners.
As Mary makes gifts of the business to her children, she can also make gifts of the real estate entity to her son.
The next step is to transfer the business interests in
a tax-efficient manner. Mary may choose to spread out her gifting
strategy over a longer period of time and gift interests in the
business to her children in amounts equal to her “annual exclusion,”
currently $12,000 per recipient.
If Mary were married, she could “split” the gift with her husband and gift $24,000 to each child tax-free.
If Mary wants to speed up the process – e.g.
foreseeable IPO, declining health, early retirement, etc. – she can
gift a larger percentage of the business to her children. Typically,
gifted interests will have transferability restrictions.
Mary may want to limit the size of the gift so that
the gifted interest is too small to constitute majority control of the
business (more than 50 percent). Under these circumstances, with a
proper valuation by a qualified appraiser, a “discount” may be
available in valuing the gifted interest.
Assume an appraisal by an independent professional
confirmed that Mary’s business is worth $6 million. Mary decides to
gift 25 percent of her business to her daughter in 2008. Mary’s
advisors conclude that a one-third discount for “lack of marketability”
In other words, the gift is not really worth 25
percent of the business because Mary’s daughter couldn’t sell the
interest on the open market. Accordingly, the gift should be given a
discount to reflect that the interest cannot be sold to a third-party.
Even though Mary is transferring 25 percent of her
business’s value to her daughter ($1.5 million), for gift tax purposes,
she is making a $1 million gift ($1.5 million minus the one-third
In addition to the annual exclusion, Mary has a lifetime gift tax
exemption which allows her to gift $1 million during her lifetime
tax-free. Mary’s gift is completely gift tax free.
Mary turns her attention to her son. She has decided
to augment his inheritance with life insurance. Mary is concerned about
leaving the death benefit outright to him because he is having marital
problems and she doesn’t want the proceeds within his ex’s reach. Mary
can leave the life insurance proceeds to her son via an irrevocable
To add protection to her son’s inheritance, Mary may
name an independent third-party to serve with her son as co-trustee.
She can broaden the list of beneficiaries to include her son’s
children. Mary will make annual contributions to the trust to pay the
If Mary’s son and his two minor children are
beneficiaries of the trust, Mary may gift $36,000 a year to the trust
($12,000 multiplied by three beneficiaries) tax free because of her
annual exclusion. The trust will provide Mary limitless possibilities
to design how and when the trust will pay money to her son and his
While this is a hypothetical example of a fairly
common scenario, no two family business situations are identical. This
hypothetical demonstrates why working with a team of legal and
financial advisors (e.g., accountant, financial planner, estate
planning attorney) is critical, particularly well in advance of your
retirement from the business.
Jennifer Civitella Hilario, Esq. is an associate
attorney with Tarlow, Hart, Breed and Rodgers, Boston, and concentrates
her practice in the areas of tax and estate planning.