You Can Gift Away Value And Still Keep Control

By: Randall A. Denha, J.D., LL.M

“So you want to give away the tree but keep the fruit?” This describes, in general terms, the way a donor of a gift wishes to make a transfer with strings attached. If you are not careful then all of the gifts previously made could be returned to your estate and subject to an estate tax. Individuals are currently permitted to make gifts of up to $5.25 million free from federal gift and/or generation-skipping transfer tax. The foregoing amount is set to increase in 2014 to $5.34 million, absent legislation to the contrary. From an estate planning perspective, the sooner you transfer ownership of your business to the next generation, the better. That way, future appreciation and income are removed from your estate and may also avoid the dreaded gift and estate tax.

In light of the foregoing, many business owners and their advisers have been inundated with countless articles outlining the potential tax savings associated with gifting techniques designed to take advantage of the expanded exclusions. While these recommendations are certainly worth exploring, small business owners often face two significant practical obstacles when making gifts: lack of liquidity and the desire to maintain control of the business.

Individuals with sufficient liquidity can use cash to make large gifts, either outright or in trust, without any concern regarding the impact on the small business. However, the vast majority of small business owners’ assets are typically tied up in their business, and selling these assets to produce liquidity for estate planning purposes is simply not an option. Even where individuals have considerable assets outside of the business, there are often both tax and non-tax factors preventing them from gifting such assets.

Individuals lacking liquidity are typically left with few alternatives and often consider gifting a portion of the ownership interest in their business in order to take advantage of estate planning opportunities. While the tax reasons for such gifts make sense, few small business owners are willing to give up control of the business to the next generation, especially if the next generation is “unproven” or not involved in the business whatsoever.

Thankfully, a few options exist that permit the owner of the business to transfer the business to the next generation. The following are a few of the options available:

Recapitalization. One option to consider involves recapitalizing the business into both voting and nonvoting stock. The nonvoting stock has identical rights as the voting stock except that its owners have no ability to control the business. For S Corporations, such recapitalizations do not run afoul of Internal Revenue Service regulations allowing only one class of stock. The value of both the voting and the nonvoting stock is typically comparable, and is subject to discounts for lack of marketability and minority interest.

Once the recapitalization occurs, the small business owner can use nonvoting stock to transfer a significant portion of the value of the business to the next generation. However, the business owner retains as much of the voting stock as he or she desires in order to maintain absolute control over the business. This creates an ideal way for a small business owner to “fund” his or her estate plan without concerns regarding disruptions in the operations of the business. Moreover, the value of the nonvoting stock that is transferred is “frozen” for estate and gift tax purposes, and all future appreciation escapes transfer tax entirely. The existence of nonvoting stock also allows the small business owner to equalize distributions among all of his or her children regardless of whether they are involved in the business. For children involved in the business, the business owner can then incorporate additional gifts transfers of voting stock in order to slowly cede control as such children prove their aptitude.

Any recapitalization also involves review or implementation of a shareholder agreement in order to guard against disruptions in the operations of the business. The shareholder agreement typically contains provisions prohibiting or limiting transfers of stock to outsiders, and sometimes requires shareholders to actually work in the business. For permitted transfers, the shareholder agreement provides procedures for determining the value of and paying the purchase price for any stock transferred.

The shareholder agreement may contain different provisions for each of the shareholders, and the shares retained by the small business owner need not be subject to the same restrictions as other shares. Moreover, the small business owner can retain the ability to require non-controlling shareholders to participate in any decision to sell the business. Therefore, the shareholder agreement affords small business owners additional control over the ultimate disposition of the business.

Basic Estate Freeze. What happens in a basic estate freeze is that the owner exchanges some of his common stock in the business for preferred stock, and then transfers all or some of his remaining common stock to his child or children. Keeping the preferred stock gives the owner some level of control, usually being able to have a shareholder’s vote. The “freeze” occurs because the preferred stock is essentially “frozen,” meaning that shareholders of preferred stock are entitled only to a fixed amount for their shares upon sale of the company. Any sort of appreciation in the value of the company after an owner has exchanged his common stock for preferred stock is shielded from estate tax when the preferred shareholder dies. Because the value of the preferred shareholder’s interest is fixed (meaning it excludes appreciation in the value of the business, which is what the common stock would be worth), any appreciation of the company is excluded from the calculation of the preferred shareholder’s taxable estate on his death.

Installment Sale. This is considered one of the simplest methods of transferring over the family business to a child or children. In this situation, the owner parent can sell all or part of the shares or partnership units to a family member. The benefit of this method is that installments on the sale can be done over time, which would provide an income for the owner after his or her retirement.

Gift. Depending on the value of the company, giving any part or all of the company as a gift is restrained by gift taxes, because an owner can only gift a certain amount before incurring a tax on the gift. There are ways, however, to gift a business without having to deal with gift taxes. Under federal tax law, there is a maximum amount that can be gifted per year before that gift is subject to the gift tax. This is known as the Annual Gift Tax exclusion which amounts to $14,000 per spouse per year per beneficiary. In the case of gifting a business, a parent may gift stock or membership interests in the company to a child each year, eventually gifting the entire ownership interest in the company. However, using the annual exclusion gifts in this way will take quite a bit of time but a gift tax is usually avoided and the owner’s estate tax will decrease.

Place Business Assets in Trust. The business owner may choose to transfer property into a trust. There are several types of trusts applicable, the Grantor Retained Annuity Trust (GRAT), Grantor Retained Unitrust (GRUT) or Intentionally Defective Irrevocable Trust (IDIT). In general, these are irrevocable trusts that an owner may transfer his assets into and choose to receive income payments for a specified amount of time. At the end of this established time, or death of the owner, the assets in the trust are passed on to the other trust beneficiaries. With regards to the GRAT and GRUT, the value of the retained income is subtracted from the value of the property that was transferred (meaning the shares of the business). What happens then is if the owner lives past the specified amount of time in which he received income payments, it is possible that the business may be transferred to the next generation at a reduced value for estate or gift tax purposes. It is important to note that the transfer of property into an irrevocable trust is subject to gift tax. With regards to the IDIT, a part sale and part gift transaction is entered into which permits both a gift to be made as well as a sale. The gift is subject to gift taxes (which may or may not have to be paid depending on remaining gift exemption) and the sale portion allows a note payment back to the Grantor for a stated term. Upon expiration of the term, the note is returned plus a nominal interest rate and all appreciation on the sold asset is removed from the estate.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.