It might be your dream to leave your business to your children, creating the opportunity to build something together over generations.
But your dream can sour in a hurry without smart business transition strategies – especially when it comes to taxes. Even if you’ve ironed out all the personal and professional issues that can arise, a well-considered plan could still fail if you don’t consider transition tax issues.
There are strict rules preventing family business succession from being used as a wealth-transfer vehicle exempt from taxation. As a result, what may have initially seemed like a simple family handoff can require a carefully crafted strategic business plan.
Start planning the transition early
It’s common for private business owners to envision selling their children the business or gifting them the company in exchange for a continued income or seat on the board. These transition strategies may sound appealing from a business-continuity standpoint, but the tax implications can be severe. Not only would the capital gains tax be very expensive, but a tax bill could also be large enough to force your heirs to sell parts of the business to cover it.
It’s best to start your transition plan early — and have an accurate assessment of the business’s value — to prevent value loss and ensure your family is well-positioned to assume leadership and ownership of the company.
The following are three transition strategies that may potentially help you avoid tax penalties.
1. Create a parallel business
One strategy to consider is to start a parallel business. Instead of handing over a fully functioning and highly profitable company whole — and the tax burden that comes with it — you can seed new businesses in your heirs’ names.
These startups can be linked to the core business and its clientele, without the overhead and assets of the original company. For example, instead of having your company develop and launch a new product, you could launch the product under a new name with a new owner — your children.
The new company has no initial value, but with the parents’ contacts, infrastructure and expert guidance, the startup could develop significant long-term value long before it’s ready to be handed off to the children.
2. Use a gifting strategy, one piece at a time
If forming a parallel entity doesn’t make sense for your company, another way to potentially avoid a big tax hit when transitioning your business to family is to gift the company in pieces.
Owners of smaller companies can take advantage of the annual $15,000 gift tax exemption to transfer ownership over time.
Owners of higher-value companies can plan to use the one-time estate tax exemption to gift interest in the business to heirs while the business value is still low enough to meet exemption limits. The Tax Cuts and Jobs Act of 2017 doubled those exemptions (with inflation adjustments, $11.4 million per million and $22.8 million per couple respectively in 2019), with these higher exemptions set to expire in 2026. The new tax law kept the estate tax at 40 percent.
3. The IDGT: A trust to avoid transfer taxes
Another transition strategy to consider is selling or gifting your business to an intentionally defective grantor trust (IDGT). The IDGT takes advantage of estate tax exemptions to avoid taxes on the transfer of the business; it removes future appreciation from the business owner’s estate and hands that value to the next generation.
An added benefit of the IDGT is that it also allows future generations to avoid generation-skipping transfer taxes — but only if ownership stays within the trust.
Even if you’ve ironed out all the personal and professional issues that can arise, a well-considered plan could still fail if you don’t consider transition tax issues.
Prioritize the family
With careful planning, these three strategies have the potential to mitigate the risk of taxes in the transfer of a family business. First and foremost, however, it’s important to focus on meeting the needs of your family regardless of any future tax bills.
In consultation with your family, determine who should ultimately take over your business, along with how and when you envision the transfer occurring. Then, work with a tax and financial professional to identify the best path forward.