In my last post about succession planning I talked about starting early and staying in control. In this post I want to provide some examples of how you can accomplish a successful succession plan.
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.
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.
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.
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 minimize future gift and estate taxes and hold on to your hard earned money.