What are the Tax Consequences of Your Business’s Succession Plan?

When it comes to succession planning, small business owners usually try to address everything from maintaining day-to-day operations to ensuring that their families retain whatever equity they have in the company. But the tax implications of the plan are often an afterthought, if the issue is considered at all.

While taxes should never be the primary driver of any succession plan, it is unlikely that you want to leave a large tax bill for your successors after you retire, become incapacitated, or pass on. Unfortunately, the tax issues raised by succession planning often cannot be addressed after you have moved on. That means you need to be aware of the tax implications of your plan at the time it is put into place.

In this article, we will lay out several basic succession planning strategies often used by small businesses and explain the tax consequences of each.

Buy-Sell Agreements

If you want to keep control of your closely-held business until you leave, one option is executing a buy-sell agreement with other stakeholders in the company or the business itself. A buy-sell agreement is a legal agreement that prearranges the sale and may be triggered by your retirement, death, or incapacity. After the triggering event occurs, the buyer is required to purchase your interest in the business at fair market value. These purchases are often financed by life insurance policies on the seller.

As a general rule, buy-sell agreements that confer the right or obligation to purchase your share of the company on other stakeholders are preferable for tax purposes. The remaining stakeholders receive what is known as a “stepped-up basis” in their share of the company, which means the cost basis for those shares will be calculated on the price they paid. The higher basis will likely reduce their capital gains tax bill if they decide to sell their interests down the road. Additionally, if the purchase was funded by a life insurance policy, the proceeds of that policy are usually tax-free.

When the business is a C corporation and has a buy-sell agreement with an owner that is funded by a life insurance policy it is generally less advantageous from a tax perspective. This is often because the life insurance payout is high enough to trigger the corporate alternative minimum tax. The arrangement is also likely to raise the value of the remaining shares in the company without increasing their basis. As a result, the owners of those shares will likely pay more capital gains tax when they are sold.

Treating Personal Goodwill as an Asset

When a business is operating as a C corporation, the owner may choose to sell his or her interest  in the corporation’s assets outright through a transaction that is not a stock sale.  These types of sale often lead to double taxation because it will be taxed as an asset sale at the company level and then the shareholders will pay the capital gains tax on their distributions from the sale. However, the concept of “personal goodwill” will help eliminate a large part of that double taxation.

If the stockholder can show personal goodwill, it is treated as an asset owned by the individual and not the business. Personal goodwill is generated by the expertise and business relationships of an individual shareholder or employee. In the right situation, a significant portion of the purchase price can be paid directly to the seller and treated as the sale of a capital asset, which is only taxed as a capital gain to the seller.

Transfers to Family Members

Most small business succession plans are structured to benefit the owner’s family members. These often focus on reducing the gift and estate taxes (transfer taxes) that must be paid by those family members. We will review some of the most common planning strategies here.

Family Trusts. Traditionally, transferring a business to a family trust was a way to minimize estate taxes when the owner died. But with the current federal estate tax threshold hovering north of $11.5 million for the 2020 tax year, most small business owners are not presently expecting to pay the estate tax when they pass on. That said, family trusts are still sometimes used to provide certainty as to how assets will be transferred to surviving family members.

Trusts are subject to the federal income tax and are taxed at 37% on all income above $12,950 for 2020. One way to counter the income tax bite for the trust is to empower trustees to make distributions to beneficiaries who are in lower income tax brackets.

Valuation Discounts. Often, inter-family transfers of interests in a business qualify for valuation discounts. This is because the transfer of the interest may not transfer full control of the company and the fact it is often difficult to sell a partial interest in a small business at full value. This transfer method is most effective when used to transfer an interest in a limited liability company (LLC) or family partnership.

In August 2016 the Treasury Department issued proposed regulations addressing what it viewed as the abuse of valuation discounts for transfers. But after receiving a large number of complaints the department announced in October 2017 that it was withdrawing the proposed regulations.

Lifetime Annuities. A company may be sold in exchange for a private lifetime annuity when older owners still want to pass a business on to younger relatives but still receive cash flow from a business. This method has the advantage of removing the business’s appreciation from the owner’s taxable estate. In some cases, it will also remove a portion of the business’s current value from the estate as well.

Self-Canceling Installment Note. When an older owner is seeking a future payment from a younger family member a self-canceling installment note (SCIN) may be used. These notes are utilized when a business is sold to a family member or family trust. In return for that sale, the owner receives an installment note which generates interest. The transaction will be treated as a sale for tax purposes and will not incur any gift tax liability.

The note is referred to as “self canceling” because if the owner dies during its term, then the buyers no longer need to continue making payments and will not incur transfer taxes. The term of the SCIN cannot be longer than the life expectancy of the seller at the time of the transaction.

Gifting the Business. If the business is simply gifted to a family member for nothing or less than its fair market value it may be subject to either the gift tax or the estate tax. If the gift is more than $15,000 ($30,000 if made by a couple) while the donor is still alive it will be subject to the federal gift tax. If the gift is made after the donor dies, then the federal estate tax may apply if it is for assets exceeding $11.58 million for 2020.

As you have likely observed, many of these succession planning strategies are complex and must be structured properly to ensure that you and your successors will see the full tax savings. We strongly recommend that you speak to a tax professional who can give you a better idea of which options are best for your personal situation before putting any succession plan into place.

Categorised in: Planning

This post was written by Sean Allaband