Preparing a Family Business for a Generational Change

The handoff from one generation to the next is often the most complicated period in a family business’s history. The changes brought by a new set of leaders taking over can disrupt company culture and customer relationships—not to mention the personal dynamics within the family. Planning for a smooth transition is vital, and taxes should be part of that planning process.

What tax considerations go into a family business succession plan?

Succession planning is usually a balancing process between the sometimes-competing interests of the outgoing owners, their incoming successors, and the business itself. The structure of a succession can have important tax consequences that affect not just the value of the business, but also how much value the outgoing generation takes with it, and how much wealth the next generation will see from the family’s assets over time.

  • Business considerations may not have direct tax consequences, but can dictate the scope of options available to a tax planner. Does the outgoing generation want to retain control of the business? Does it need income from the business as part of its retirement plan? Is the business organized to allow for transfers of ownership?
  • Estate planning becomes more important as the outgoing generation retains ownership, control, and rights to income. Structuring these assets to optimize tax treatment is essential for protecting the family business as a long-term legacy.
  • Personal wealth management for everyone involved is one of the unique complicating factors in a family business. An optimal strategy for one generation may lead to undesirable tax liability for the other. Tradeoffs are sometimes necessary, which can create tension if not handled well.

Each of these categories is uniquely complex. But each also offers opportunities for finding efficient tax structures for a business succession. 

Transfer taxes and succession planning

A key tax question that family businesses must grapple with is how to structure the passing of ownership from one generation to the next. Always bear in mind that control and ownership need not be linked. In some cases, the outgoing generation wants to stay in charge of major decisions, typically as a board member, even as their kids take over day-to-day operations. 

  • Ownership structure

Any analysis of transfer taxes must closely consider the way a business is owned. This analysis has at least two layers. The first is the form of the business entity itself. Shares of corporate stock, membership interests in a limited liability company, and partnership interests in a limited or general partnership, each may be subject to distinct rules. 

The second layer concerns how those ownership interests are held. In many cases, direct ownership of a business entity is suboptimal from a tax planning perspective. Many families opt to place ownership into a family limited partnership, family limited liability company, or trust. 

  • Sale of ownership to the next generation

Some business owners prefer to simply give their ownership away to their kids, but simple gifts are often a mistake. In 2021, only $15,000 annually per gift, per recipient is sheltered from federal gift taxes. If the business is worth more than that, a direct gift can be one of the worst transfer options from a tax standpoint.

Instead, many professional succession advisors recommend structuring an intergenerational transfer as a sale. Numerous options are available to structure a sale of a business in such a way that it does not create adverse tax consequences. Oftentimes the preferred approach depends on considerations other than tax, including questions of control, income allocation, and the long-term goals of the business.

Many of these decisions come down to family dynamics, legal considerations, and corporate obligations. A tax advisor should be consulted to ensure the tax consequences of each option on the table is understood before a course is set.

  • Transfer by bequest

When the outgoing generation will retain significant ownership of the business, estate planning comes to the fore. Estate planning attorneys can guide business owners in developing strategies using trusts and other solutions to provide for professional oversight following the prior owner’s passing. 

In 2021 the estate tax exemption shields $11,700,000, after reductions for lifetime gifts, in an estate transfer from federal taxation. All amounts after that are taxed at 40%.

Ferguson Timar is here to advise your family business

At Ferguson Timar we are proud to work with family-run companies and their owners to explore tax-effective strategies at every stage of their businesses. Are you ready to begin? Give us a call at (714) 204-0100 or reach out through our contact page.