Jun. 29th, 2015

Spotlight: Part 3-Transferring the Business: Closely-Held or Family-Owned

Jerry Nichols, CPA

Jerry Nichols, CPA

In transferring the business to the family, there are different strategies which can be used to minimize either income tax and/or estate and gift taxes. The tax burden can create a significant tax cost which may limit the options available to transfer to the family. The difficult part may be implementing tax saving techniques and allowing the family objectives to continue to be met. These two items may be in conflict with each other. We attempt to leave the back door open for future changes to the plan. With some techniques, starting very early allows for the most effective tax savings. The election of a Corporation to be taxed as an S-Corporation or the establishments of family LLCs will allow the potential to be very tax efficient over time.

The valuation of the business becomes a key part of the planning process. We are attempting to determine the current value and what the projected value may be in the future. Transferring the business among family members must be documented and defended for transfer purposes. Are we making a gift of value to other family members? If we are transferring at a bargain purchase amount, we will be making a gift which may be subject to gift tax. We may choose to make a current gift to transfer all future value from the senior members. Are we selling to them at fair market value? What will be the income tax cost for the sale at fair market value? Is there enough cash flow to make all payments, along with sufficient cash flow for the business and the new family members? We are attempting to minimize the tax cost of the transfer, whether that is with income or gift taxes.

You will also need to answer the question whether you have set aside enough funds outside of the Company to transfer the business. Are you dependent on the current level of income from the Company to maintain your future life-style? How much can you expect from your retirement plans and other assets? An overall financial plan of income and future living costs will help to define the need to supplement your resources. This helps to understand the cash flow required by you. With this cost to the business, can it be transferred or will it require the business to be sold? Are the next family members prepared for the financial commitments needed to take over the business? They may have long-term cash requirements needed to buy-out the senior family members. How much risk are they willing to take on?

Will a transfer be made to all or a select few family members? How will governance be handled by the family members? Is there a natural leader in the family? If some family is in along with others outside of the business, how will this be handled? These become the non-financial decisions to be made. They will be emotional in nature. At times, outside consultants may be used to assess the capabilities and personal traits of the succeeding family members. The consultant may be better able to work through the family dynamics to this transfer. You will need to make decisions for the long-term future of the business and determine how Thanksgiving Day family gatherings will be held, if at all.

In discussing a transfer of the business among the family, I will sometimes suggest the following picture: Your family business is similar to a fruit tree. You have started the tree from a sapling. Now that the tree has grown, what is your next step?

The analogy has different options and outcomes:

  • The only real thing that I want from the tree is to be able to enjoy the fruit from the tree. As long as there are family members to care for the tree, I can transfer my responsibilities to the next generation.
  • With the tree, I may want to have others care for the tree instead of my family.
  • I will continue to own the tree but have the family enjoy the fruit from the tree.
  • I will decide that the next generation does not have the interest or the skills to maintain or continue to grow the tree. I will work to sell the tree to others outside of the family.
  • I will not be able to decide any course of action. The tree over time will lose its value and not have any value or fruit for the family. This would be a disappointing result for the family.

The point I am attempting to make is that the tree itself represents value and the fruit represents income. The two can be separated from each other. The owner needs to reach the conclusion over which aspect he wishes to have. Do you want to maintain the control of the business or enjoy the income from the business? With either aspect, the senior members of the family need to continue to grow the business and take steps to strengthen the business.

Jerry Nichols, CPA is a Shareholder of Hungerford Nichols CPAs + Advisors. Jerry has been with the firm since 1972 and has developed deep, long-term relationships with clients and has become an essential advisor to them over his many years of service. He provides key ideas and assists with implementing strategies to improve business operations and minimize current and future tax dollars.

Hungerford Nichols is a Tax, Auditing and Business Advisory firm with offices in Grand Rapids and Greenville, MI. The firm is celebrating 74 years of helping closely-held and family-owned businesses in West Michigan.