Pay Less in Taxes When Transferring Your Family-Owned Business to the Next Generation
There are many different ways a business owner can transfer a family-owned business to the next generation. Each method comes with its own set of risks and benefits, especially when it comes to tax implications associated with the transfer or sale.
As both a business owner and a parent, you likely have a few priorities when transferring your business, especially regarding the funding of your retirement. It’s important to start planning for the transfer of your business early. The earlier you start the exit planning process, the more time you have to plan and make adjustments that allow you to transfer your business at the lowest cost to both you and the next generation.
⚠️ IMPORTANT FOR 2021: The current estate tax laws provide great opportunities to transfer business value at a very low estate tax cost. However, the Biden administration is proposing significant reductions in the estate tax exclusions. As a result, analyzing the best approach for transferring a business is more important and timely than ever.
Tax Savvy Methods for Transferring a Family Business
- Grantor Retained Annuity Trust (GRAT)
- Give Your Children a Loan
- Self Cancelling Installation Note (SCIN)
1. Grantor Retained Annuity Trust (GRAT)
A GRAT allows a parent to transfer the family business (and other significant assets) to family members with very little transfer tax consequences. This allows the parent to keep almost all of the income from the transferred business for years. Essentially, a GRAT freezes the value of the business so the benefits of the business’s future appreciation in excess of the parents’ return of income and principal transfers to the next generation.
Under a GRAT, a parent transfers ownership of the business to an irrevocable trust and, in return, receives a fixed annuity for a term of years. The annuity structure allows the parent to receive the entire amount of the initial business value plus interest at the Applicable Federal Rate (AFR). At the end of the GRAT term, when all of the annuity payments are completed, any remaining value of the business passes to the children free of transfer taxes.
For this strategy to be successful, the total return on the business transferred to the GRAT must exceed the AFR. This is very likely to occur in a business that is valued at, say, five times earnings of a 20% return per year while the low AFR requires a payout of only 2 or 3%, an easy hurdle to substantially outperform.
When it comes to using this strategy to transfer the family business as part of your estate plan there are a slew of other considerations – such as the possibility of a premature death – that you should consider. Your CPA and attorney should discuss the pros and cons of GRATs with you.
2. Give Your Children a Loan
Another option for transferring your family-owned business is loaning your children the money to purchase the business at the lowest interest rate allowed under the Treasury Department’s safe harbor rates for loans. This rate is the Applicable Federal Rate (AFR).
Using a grantor trust will provide your family with supercharged family tax benefits, allowing the parents to pay the taxes on the earnings of the business. This provides an additional tax-free gift to the next generation. If you are confident that the future of the business is secure with your children at the helm, then funding your retirement out of the future profits of the business is a viable option. Your family will also benefit from a low tax cost transfer of the business. If the total return of the business sold to your children exceeds the interest rate charged on the loan (i.e. AFR), the excess will be the equivalent of a tax-free gift to the children.
You need to have a valuation of the business done by a properly certified professional, like a Certified Valuation Analyst, to ensure the value will withstand IRS scrutiny. It makes sense for both you and your children to have an objective, professional opinion about the value of the business before you discuss the size of the loan or loan terms.
“Discounting” lowers the value of partial interests in a gifted family business. Discounting is good to consider in situations where a family business is involved and estate assets are above the current exemption thresholds. In 2021, the current federal exemption is $11,700,000, and the top tax rate on estates of any amount over the exemption is 40%.
By applying discounts, you can transfer a greater percentage of the business, which can lower the potential estate tax burden upon a parent’s passing.
There are two types of discounts:
- Discounts for lack of marketability recognize that the value of closely-held shares (as compared to shares trading on an active market) are less valuable due to the difficulty of selling those shares and converting them to cash
- Discounts for lack of control recognize that a minority interest is less valuable than a controlling interest due to the inability generally of the minority holder to affect the cash return on their shares held
⚠️ IMPORTANT FOR 2021: The Biden administration has proposed eliminating discounts in family gifts. If your family is considering this strategy, time is of the essence.
In either case, the value of these discounts can vary depending on the facts and circumstance of each situation but can range from 10-35% for each. Important note: you’ll need a credible valuation of your business to use this method.
Although using discounts is a sound tax minimization strategy for estate planning, deploying this strategy depends on several considerations, from the size of the estate to methods used to value the family business to the determination of the appropriate (and defensible) levels of discounts for control and marketability.
Because courts and the IRS scrutinize the way discounts are developed and applied, it’s prudent to engage the assistance of a qualified and appropriately credentialed CPA firm that can do both the valuation and determinations of justifiable discounts.
4. Self Cancelling Installation Note (SCIN)
At its simplest level, a SCIN transfers value out of a business at no gift tax cost. This works by having the owner sell to a family member or trust in exchange for a promissory note, which has a self-cancellation feature. This self-cancellation feature terminates the note, canceling the outstanding balance if the owner dies during the term of the note.
SCINs will have a “risk premium” in case the owner survives. If the owner dies during the term of the note, the remaining balance deducts from the owner’s estate. The value then shifts (transferred tax free) to the next generation without any additional obligation on the note.
The IRS and courts allow SCIN transactions, but it is important to have the proper documentation for the transaction and properly adjust for a premium as required to account for the risk of an early death. At first glance, it might seem like SCINs are a good fit for any family-owned business owner. In reality, SCINs aren’t common and are most appropriate when there is a more than likely chance for death before normal life expectancy.
Here are some pros and cons of an SCIN:
- Freezes the estate tax value of the property for sale
- Removes a portion of value from the business owner’s estate in the event the owner dies before completion of payment on the note
- Takes advantage of a low-interest rate environment
- Often used as a wealth transfer technique by related parties when the transferor isn’t expected to live past his or her life expectancy
- In return for the self-cancelling feature of the note, the payor will pay a “mortality risk premium” so if the seller lives to life expectancy, a premium beyond what was needed is paid
- The SCIN carries a greater risk of challenge by the IRS
- The terms of the note should not exceed the owner’s life expectancy or else the parties are at risk of the IRS reclassifying the payments as annuity payments, and the interest component will not be deductible
- SCINs aren’t a good idea when the transferor is in poor health and death is imminent, as you’ll lose the IRS challenge
If you are planning to sell your business, put together the right team to help you. If you need help, contact us online or call 800.899.4623.
Published on June 22, 2021