There are over 5.5 million family businesses in the US with an average life span of 24 years (familybusinesscenter.com, 2010). About 40% of family-owned businesses turn into second-generation businesses; approximately 13% are passed down successfully to a third generation, and 3% to a fourth generation or beyond (Businessweek.com, 2010). Much of business owners’ net worth lies within the family-owned businesses.
Research shows that business succession risks are greater than ever because nearly a third of owners have not invested in estate planning beyond a simple will. Further complications can occur when only one or two heirs are active in the business, and other nonworking beneficiaries inherit a proportion of ownership. Passing the family business from one generation to the next is a significant estate planning challenge. Assuring a seamless transition to the next generation with minimum taxes, costs and interruptions in the flow of business can be daunting. However, creating the right estate plan and a well-drafted will and trust establishes a reasonable and practical structure for accomplishing dispositive goals that are properly aligned with the business owner’s intentions.
Passing the family business to the next generation with minimum taxes and other estate settlement costs requires planning and the assistance of an experienced estate planning attorney. One option is to place the family business into a revocable trust designating the business owner as grantor and trustee. As trustee, the business owner retains control and management of the business. In the event of death or disability of the owner, the trust contains explicit instructions as to how the business should be managed and by whom (often a management committee is designated) as well as how the business interests are ultimately distributed to heirs. The trust can also contain instructions based on a ‘triggering’ event such as an heir reaching a certain age or the business obtaining certain goals. The business owner can also name a ‘trust protector’ with certain powers to change successor trustees in managing the trust business and other trust assets.
As is true of all revocable living trusts, a business trust avoids the cost of probate and maintains management continuity so that interruptions are minimized by circumventing the typical delays and ‘red tape’ of estate administration. Another advantage of a trust is that if members of the next generation are too young or inexperienced to take on the responsibility of running the business, the power to manage and control the business can be assigned to a special management committee with trustee oversight until the heirs are a certain age or sufficiently experienced to take control.
Placing a family business into a trust can secure significant estate and inheritance tax savings by employing certain planning techniques. Irrevocable trusts are often used in an asset value ‘freeze’ that shelters business value appreciation from estate taxes.
For example, if an owner of a privately held business places his or her shares in an irrevocable trust (let’s say valued at $5.6 million – the 2018 estate/gift lifetime tax exemption), that value is frozen for estate tax valuation purposes. Over time, if the share value grows to $6.6 million, the $1 million appreciation is estate tax-free, along with the initial $5.6 million (sheltered by virtue of the lifetime exempted gift). This technique is especially effective when future growth of a business or eventual sale of the business is expected. A gift of shares up to $5.6 million into an irrevocable trust now can keep future appreciation out of the taxable estate.
Another tool to consider is the Family Limited Partnership (FLP). The business owner, known as the General Partner (GP) makes a gift of his or her business interests to the newly created FLP. The GP status enables the owner to retain control and management of the business. Other members of the FLP are limited partners (LP’s), obtaining various proportional interests in the business. The GP can direct whether income and gains are distributed to the LP’s or retained by the business. This form of partnership can have significant estate tax benefits by assigning larger proportional interests to the LP’s, significantly reducing the business owner’s (GP’s) taxable estate, but without giving up control. It can also be a solution for differentiating working vs. nonworking family members. For instance, the GP can assign a larger equity share to working members and income to non-working members.
A competent, experienced estate planning attorney should always be retained in order to determine what tools are necessary for ensuring an efficient transition of a family owned business.