Succession planning is much more than just the buy-sell agreement.  It is a process that takes time and involves the family in the process.  To neglect the family component of succession planning is to set the process up for a less than optimal outcome.

Giving away your business without giving away the store

If you own a family business, a smart succession plan is essential. If you’re like most business owners, a significant portion of your wealth is tied up in the business, so you’ll be relying on it to generate income for your retirement and to provide for your family.

Succession planning involves a variety of complex issues, such as identifying and grooming a successor, determining how to treat family members who aren’t involved in the business, and ensuring sufficient liquidity to pay taxes and other expenses. It’s also important that your succession plan include strategies to minimize the impact of gift and estate taxes.

Keep it in the family

It’s every business owner’s worst nightmare: The founder dies and the heirs are forced to sell the business to pay the estate taxes.  This scenario is becoming less common as the federal estate tax exemption increases.  And if the estate tax is repealed permanently, it should become a nonissue (although state death taxes are a growing concern).  But for now, it’s a very real problem for many family and closely held businesses.

The most effective way to avoid this predicament is to begin planning early in the life of the business and to take steps to mitigate the effects of estate taxes.  But there are some last-minute strategies that can be used to ease the pain.  These include special-use valuation, which allows an estate to discount the value of business real estate, and deferred estate tax payment, which doesn’t reduce the tax but gives heirs some breathing room to raise the necessary funds.

Reducing estate tax with a special-use valuation

If a significant portion of your estate consists of real property used in a family business or farm, your family may be able to reduce estate taxes with a special-use valuation.  The purpose of special-use valuation is to assist families struggling to hang on to a small business or a farm.

Ordinarily, real property’s fair market value is based on its “highest and best use.”  A piece of prime real estate in a downtown financial district, for example, would likely be valued based on its use for an office building, even if the owner operates a parking lot on the property. Highest-and-best-use valuation can lead to harsh tax consequences for successors who wish to continue the property’s current use.

So if certain requirements are met, the tax code allows an executor to elect to value real property based on its actual use, rather than its highest and best use. For example, let’s say you own a manufacturing plant on the outskirts of a growing suburb. The land’s value, based on its current use, is $1 million, but its fair market value is $1.5 million based on its highest and best use as a residential subdivision. If the property qualifies for special-use valuation, your loved ones can reduce the property’s value for estate tax purposes by $500,000. The special valuation cannot reduce the gross estate by more than $870,000, as indexed for 2005.

Qualifying for special-use valuation

The tax code imposes strict requirements designed to ensure special-use valuation is used only for its intended purpose. You must meet the following qualifications to be eligible for special-use valuation:

• You (the decedent) must be a U.S. citizen or resident.

• The property must be located in the United States and must be used for business or farming.

• You or a family member must have owned the land for at least five of the eight years immediately preceding your receipt of Social Security benefits, disability or death (the qualifying period).

• You or a family member must have materially participated in the business during the qualifying period.

• The property’s adjusted value must account for 25% or more of your gross estate’s adjusted value. Adjusted value is the highest-and-best-use value, reduced by certain debt.

• The adjusted value of all real and personal property used in the business must account for 50% or more of your gross estate’s adjusted value.

• The property must pass to a “qualified heir,” which includes your spouse, parents, grandparents, children and grandchildren.

• The qualified heir must materially participate in the business or farm operations for at least 10 years after the decedent’s death.

If the heir sells or otherwise disposes of the property or stops operating the business during the 10-year period, the IRS can collect some or all of the estate taxes that would have been owed absent the special-use election.

Deferring estate tax payments

Another tax code provision designed to ease the burden on closely held businesses allows your estate to defer estate tax payments for five years and then pay the tax liability in 10 annual installments. Your estate pays only interest for the first four years, including a special 2% rate on taxes attributable to a specified portion of the business’s taxable value ($1,170,000 in 2005).

To qualify for deferred payments, your interest in a closely held business must exceed 35% of your adjusted gross estate. A closely held business includes:

• A sole proprietorship,

• A partnership, if you own at least 20% of the capital interests or the partnership has 45 or fewer partners, or

• A corporation, if you own at least 20% of the capital interests or the corporation has 45 or fewer shareholders

The tax code contains special rules for determining whether a business passes the 35% test. For example:

• Certain passive assets — or assets not used in the business — are excluded,

• You can combine more than one business to meet the 35% test, as long as you own at least 20% of each, and

• An interest in a farm also includes any interest in farmhouses and certain other structures.

Keep in mind that your estate can’t defer all of its tax liability, only the portion attributable to the closely held business. Also, your estate must secure its payments either by furnishing a surety bond or consenting to a tax lien on the property.

Your estate will lose the right to defer tax payments, and the entire tax liability will become due immediately, if there’s a default in the payment of tax or interest, if your estate fails to distribute sufficient income or violates lien conditions, or if 50% or more of the value of your business interest is sold or withdrawn from the business.

Planning today for tomorrow

There are some moves you can make now to ensure that the benefits of special-use valuations and deferred estate tax payments will be available to your heirs. Both tax breaks require that business assets account for a certain percentage of your estate. You can help ensure those tests can be met by gifting nonqualifying assets or acquiring additional qualifying assets during your lifetime.

Start early

The earlier you begin transferring ownership of the business to your children or other family members, the easier it is to reduce the tax bite.  Currently, the annual gift tax exclusion allows you to make tax-free gifts up to $13,000 per recipient per year ($26,000 for gifts you “split” with your spouse).

Transferring the business gradually over time also allows you to take advantage of minority interest valuation discounts, which means you can transfer more of the business at a lower tax cost. Once you transfer a business interest, any future appreciation in value bypasses your estate, so there’s a big tax advantage to starting early.

 Lifetime estate planning strategies for business owners

Special-use valuations and deferred estate tax payments are valuable tools your heirs can take advantage of after your death to lower the cost of business succession.  But they’re no substitute for planning during your lifetime to soften the blow of estate taxes.

Many business owners are reluctant to relinquish ownership because they fear losing control of the business. But there are a variety of techniques you can use that allow you to start sharing the wealth without giving up control.

Strategies to consider include:

Nonvoting stock. Giving away stock without voting rights is a simple way to transfer business interests to your family while retaining complete control over the company. Plus, nonvoting stock generally is less valuable than voting stock, so you can discount the transfer for gift-tax purposes.

Family limited partnerships (FLPs). With an FLP, you form a limited partnership to own the business (or your interest in the business) and then transfer limited partnership interests to your children or other family members. By maintaining a small ownership interest and acting as general partner, you retain the right to manage the business indefinitely. And because limited partners have less control over partnership affairs, the values of their interests are deeply discounted for gift-tax purposes. Keep in mind that the IRS tends to scrutinize FLPs, so it’s critical to structure and operate them carefully to preserve the tax benefits.

Grantor-retained annuity trusts (GRATs)/grantor-retained unitrusts (GRUTs). Under the right circumstances, a GRAT or GRUT can be one of the most powerful tools available for transferring a business to family members at a low tax cost or even tax free, while you continue to control the business during the trust term. A GRAT pays you an annuity — based on the trust’s initial value — for a specified number of years. The payments from a GRUT, however, are determined based on the annual value of the trust.

At the end of the term, the business assets are transferred according to the trust’s terms. The assets may be distributed directly to your heirs, or the assets can be retained in the trust and held for the trust’s beneficiaries.

The gift tax value is equal to the present value of your beneficiaries’ remainder interest, calculated using a relatively conservative assumed rate of return published by the IRS (the Section 7520 rate). If you set the annuity payments high enough and the term long enough, you may be able to reduce the gift tax value to zero.

GRATs and GRUTs aren’t right for everyone. For the trust to be effective, several things must happen. First, you’ll have to outlive the trust term; otherwise, the tax benefits will be erased. Second, the business must generate sufficient cash flow to fund the annuity payments. And finally, for a GRAT or GRUT to successfully reduce transfer taxes, the business’s value must grow faster than the Sec. 7520 rate. Otherwise, the tax savings may be offset by the wealth returned to your estate in the form of annuity payments.

Employee stock ownership plans (ESOPs). An ESOP is a qualified retirement plan that invests in the company’s stock. By selling your stock to an ESOP, you can create liquidity and diversify your portfolio. And if the ESOP ends up with at least 30% of the company’s stock and you reinvest the proceeds in qualified U.S. stocks and bonds, you can defer your capital gains. Even if the ESOP acquires a majority ownership interest, participants have limited power over the company’s day-to-day operations, so you stay in control.

In addition to providing ownership benefits to family members and other employees, an ESOP generates a variety of tax benefits for the company, including tax deductions for ESOP contributions. If the ESOP is leveraged — that is, if it borrows money to buy company stock — the company can fully deduct contributions used to pay both interest and principal on the loan.

Looking ahead

If your business is young and your retirement is decades away, you may feel that you have plenty of time before you have to start worrying about succession planning. But the earlier you start to plan, the greater your ability to both groom an appropriate successor and minimize future gift and estate taxes.