Family businesses are more than work. They are a part of a tradition. For some, leading a family business can mean a rite of passage to an heir. When talking about family businesses, people look up to the first-generation business founders with respect. Yet, it is inevitable that they will somehow pass the baton to their younger generation. While there are stories that the second generation of family businesses should not live according to the shadow of those who paved the way, there are advantages to maintaining an established name.
To make sure that taxes do not take up much of the wealth you have worked hard for, it is important to plan. One should not wait for them to be on their deathbed before deciding what to do with their company. Estate planning is a must to ensure the continued success of the venture. A starting point would be to get in touch with estate attorneys who can help draft a plan that includes business succession. It is a big step to consider, and there are many options on how to legally and efficiently transfer a family business to its rightful heir.
1. Turn the company into an LLC
When doing estate planning, the result of these transfers will mean that income splitting will lower the family’s income taxes. Forming a limited liability company (LLC) is divided into the relative balance of the shared owners’ accounts.
The share of income of the new owners will be set as passive income. The initial $2000 of this passive income will be taxed as the heir’s tax rate, and the remainder will be under the original owner’s account. Yet, if the children are to provide services to the company and are paid for such, these payments will be taxed, but at lower rates.
When the heirs work for the company, their retirement plan contributions can be made for them. It will also allow them to qualify for the Employee Retirement Income Security Act (ERISA) to protect their exempt assets in a state court or bankruptcy proceeding. Moreover, this scheme will mean that the heirs’ earnings will not be charged under estate tax.
These transfers also offer flexibility when it comes to income taxes. As parents retain control, the heirs’ earnings can be recognized as the parents’ salary. This provides parents control over company cash flow. When these are turned into a trust under a spendthrift clause, the interests are protected from the heirs’ creditors.
2. Sell the business to your rightful heir.
Many owners would want to transfer the company’s ownership while they are still alive as they continuously receive income. A good option would be to sell the business to the children. This has to be done with proper documentation to avoid problems. While the heirs may not have assets to buy the business, there are alternatives for doing this.
A good way would be to sell the business with interest and with a promissory note. The heirs will have to pay off the principal and interest in due time. A “self-canceling installment note” or a variation of a promissory note could state that if the company owner passes away before the company is paid in full, all obligations to the estate will be canceled. These self-canceling notes can help avoid gift tax issues, too.
3. Turn the business to a trust.
Another way to transfer the ownership of a family business that will benefit the heirs would be by transferring the company to a trust. The trust helps protect the assets from creditors and ex-spouses. The business is then protected should an heir be involved in a lawsuit like a complicated divorce.
Some businesses sell their interests to a grantor trust. With this, owners can pay for income tax through trust assets. An advantage of pursuing this would be to avoid capital gains tax. It can also avoid income tax from interest payments. Many business owners rely on this strategy to retain wealth as they transfer the company to their successors.
It is important to recognize that not all heirs will be interested in owning the business. Some children are enthusiastic about the company, while others would rather choose a different path.
The three mentioned techniques can be combined. You can arrange for a transfer of business interest, partly as a gift and as a sale. If you are not yet ready to give up control of the company, you can split the ownership, too.
Transferring a family business is tedious work. Yet, with careful planning, these options can make sense for your family’s current setup. These will benefit not just you and your heirs but your long-term plans for your company as well.