By Robert “Bobby” Stover, Jr., Private Wealth Services national director of Client Development and Service
Download the Currency - December 2009 issue
The current economic environment has left many financial institutions questioning the future. Even in the best of times, creating a succession plan or planning for a business transition can be daunting. According to Family Business Review editor Dr. Joseph Astrachan, only 30 percent of businesses survive to the second generation, just 12 percent make it to the third generation, and a mere three percent reach the fourth generation. Of the institutions that do not make it to the next generation, many are sold, go public, or are simply liquidated. The family retains the wealth, but in another form. Without proper planning, privately owned and family-owned institutions risk not only their longevity, but also their bottom lines.
Poor planning adds a silent partner to the business: the federal government. For every dollar increase in value, the government is owed approximately fifty cents when the owner dies and the business is passed on. In a large, successful institution, this can be a big number. Although the estate tax may not be detrimental to the survival of a business, a surprisingly high percentage of family business owners have failed to gauge their potential tax exposure. They are also often unaware of the estate and/or inheritance tax liabilities accrued as a result of the increasing value of their businesses.
With proper planning, a significant amount of what is owed to the government could be retained for future growth and expansion of the business, or if the owner exits, as liquid wealth to provide for future generations. For a privately held or family-owned institution, property that is transferred — whether as part of a succession strategy or exit strategy — typically comprises the interests in the institution. Before engaging in any estate planning, it is important to assemble a team of advisers to help assess the future of the institution, determine your goals and objectives, and assess the value of and market for the institution. As part of this assessment, the business owner should consider different strategies for transferring the business, which could include one or more of the following:
- complete sale to unrelated parties;
- partial sale to an outside entity, a management team, or family members;
- implementing an employee stock ownership plan;
- lifetime or testamentary transfer to family;
- complete redemption of senior-generation ownership; and
- recapitalization.
It is important to note that even if the ultimate strategy for the institution is an exit through a sale, proper succession and estate planning before the sale can significantly increase the wealth left for the family by reducing taxes. A significant part of estate planning focuses on the lifetime transfer of property out of the taxable estates of senior family members and into the portfolios of junior family members, such as children and grandchildren. The current turmoil actually makes now one of the best times to conduct estate planning, based on three factors:
- The values of most businesses and assets are at historic lows.
- Interest rates are extraordinarily low.
- The uncertainty of estate tax reform in the future (the current favorable estate tax regime is set to expire Jan. 31, 2010, resulting in higher estate taxes unless there is congressional action).
Taking those three factors into account, the institution’s owner should keep in mind the following tax considerations when developing a business succession and estate plan:
- Gift tax is cheaper than estate tax.
Despite currently having the same 45 percent marginal tax rate, the estate tax, which is imposed on transfers of property at death, is almost twice as expensive as the gift tax, which is imposed on transfers of property during life. The reason is that estate tax is tax-inclusive, meaning that the tax is assessed on the property transferred, including the cash used to pay the tax. Conversely, gift tax is tax-exclusive, which means that the cash used to pay the tax is removed from your estate and is not subject to tax.
- Greater planning opportunities with valuation discounts.
Both the estate and gift tax are imposed on the value of the property transferred. However, valuation for estate tax purposes is different from valuation for gift tax purposes. Estate tax is imposed on the property owned by the individual at the time of death. Gift tax focuses on the property that is actually transferred. From a privately held institution’s perspective, this means that there is a greater opportunity to reduce taxes on lifetime transfers through transfers of partial interests in property. If an owner has control of the institution at death, the valuation of the stock for estate tax purposes will take into consideration that the interest held by the decedent is a controlling interest, resulting in a higher value and thus, a higher tax. However, for lifetime transfers, if the separate block of stock transferred does not represent control, this would be factored into the value for gift tax purposes, resulting in a lower value and thus, a lower tax.
- The value of the tax benefit related to the applicable tax rate.
There is a tax-basis step-up for property held at death, but the value of this tax benefit is realized at capital gains rates (currently 15 percent). Transferring property during life removes future appreciation from the estate, and the tax benefit is realized at the estate tax rate (currently 45 percent).
- Tax savings allow for the profitable growth of the business.
Since the institution may be the major source of liquidity for meeting estate tax obligations upon the death of the owner of a privately held business, each dollar of tax savings achieved through a lifetime transfer of interests in the business is a dollar that can be used to grow the business. Therefore, every dollar of tax savings enhances the prospects for a successful transition of ownership to the next generation.
- Lifetime freeze techniques.
Strategies commonly referred to as “freeze” techniques allow business owners to transfer the future growth of interests in their institutions to junior family members with minimal gift tax consequences. At the same time, the appreciation in these interests is removed from the business owner’s estate and is therefore not subject to estate tax.
The benefits of freeze techniques are achieved by transferring interests in an institution whose future appreciation is expected to exceed a certain “hurdle rate.” The hurdle rate is generally a rate based upon monthly rates published by the IRS, referred to as applicable federal rates or AFRs. These rates are tied to the interest paid on Treasury bills of varying durations. To the extent that the transferred interests in the institution appreciate in excess of the AFR, such excess appreciation passes to junior family members without additional gift or estate tax consequences. The higher the rate of return on the interest transferred, the greater the benefit of the freeze technique.
Although many are hesitant to sell their institutions in the current economic environment, it is perhaps the perfect time to review succession and estate planning. Determining the future course of a business requires time and focus and should include a team of qualified advisers. Whether the owner decides to keep or divest the business, proper planning will enhance the amount of wealth that is retained by the family. With the natural valuation discounts created by the current weakness in the economy and AFRs at historic lows, there has arguably never been a more favorable environment for the owner of a privately held business to begin planning for the future.
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