Turn bad economic news into good business strategy

With the economic downturn of the past few years, many family-owned businesses have struggled to find positive news. However, the present economic situation affords owners a chance to turn bad economic news into good business strategy — the opportunity to recapitalize the company stock and take advantage while valuations are lower to begin the transfer of a portion of the business to their children.

Such a transfer does not mean the owner must relinquish control of the business. Now is simply the best possible opportunity for the business owner to take advantage of a significant tax-advantaged financial strategy.

Sooner or later, every family business owner needs to determine the future of his or her business. Relinquishing control and transferring the business to heirs is exceptionally difficult for most owners.

In fact, according to recent data, more than 70% of family-owned businesses do not survive the transition from founder to the second generation. In most cases, this is due either to tax/financial issues or family discord. However, the present economic situation affords family business owners an opportunity to address the tax and financial aspects of company transition in an extremely favorable way.

NEED TO ACT QUICKLY

If your client is one of the few proprietors of family-owned businesses enjoying large or growing profits year after year, it is advisable for this transfer to be completed as quickly as possible. By doing so, the value of the business can be “frozen” and the potential loss due to estate taxes on increasing wealth stopped.

Unfortunately, due to the economic slump, many family businesses have suffered reduced profits, or losses. The positive side to this is that these companies are at a lower valuation point, allowing business owners an opportunity to make a tax-advantaged transfer.

The business owner may wish to retain voting control until he or she is confident in the successors’ business acumen and his or her own financial security. However, retaining control does not mean only 49% of the stock can be transferred to the children. A recapitalization of the corporation will turn virtually all of the stock into nonvoting stock, maintaining just a few shares as voting stock. The business owner retains control by possessing all of the company’s voting stock, allowing the transfer of virtually all of the equity to the children.

The most significant financial advantage of making this move today is the huge discount your client’s company will receive for tax purposes. Nonvoting stock, because of various discounts, has a value of about 65% to 75% of the stock’s real value. This is a clear financial benefit for any family-owned business. In order to take advantage of these discounts, businesses need to move swiftly, as a tax law change could eliminate this tax-saving opportunity.

One way to transfer the nonvoting stock to the next generation is through a sale of the stock to an intentionally defective grantor trust.

The stock is purchased by the IDGT with payment made by a promissory note. The note can be paid, including interest, using the dividends or S distributions received from the company. Since this is a grantor trust, there will be no capital gains tax to the business owner/grantor upon receipt of payments. However, the income earned by the trust is income taxable to the business owner, and not to the trust or the trust’s beneficiaries (in effect, further leveraging the transfer).

When the note is paid off, the stock and all future appreciation will then be owned by the IDGT and continued to be held in trust for the benefit of the business owner’s family (children and, if desired, grandchildren).

Transferring stock in this manner also adds benefits for the owner’s children. The ultimate transfer of the stock to the children/successors is not considered a gift for gift or estate tax purposes. The current lifetime exemption of $5 million is reduced only slightly by a “seed gift” to fund the IDGT. This leaves the annual gift exclusion of $13,000 and most of the lifetime exemption ($5 million per person in 2011 and 2012) available so that the owner can take advantage of other estate-planning opportunities to pass along wealth to the children and grandchildren. Additionally, the stock transferred to the children in this way is protected from their creditors and from their spouses in the event of a divorce.

STARTING A DIALOGUE

Beyond the financial benefits that this strategy offers, the transfer of stock to the children is an opportunity to launch a real dialogue about the future of the business between you and your client. Which of the children really want to be involved in the day-to-day business? Which children actually are capable of leading the company? Children who will not be active in the company can be treated under the will with other assets.

A family meeting may be an opportune time to educate them and enhance your relationship with the next generation.

A succession plan’s top priority should be the provision by the company and successors for the financial security of the senior generation. Without that security in place, owners are unlikely to turn over responsibility, ownership and control to their successors. And let’s face it — if they spent their life and risked their fortune building a business, it seems only fair that they should enjoy the fruits of their labors. Once he or she is satisfied and comfortable with the plan, the owner can start to make decisions that begin to outline an exit strategy.

Fortunately, there has never been a better opportunity for business owners to offer ownership of their company to their children. The financial benefits are apparent. The time to act is now.

These asset-shifting practices may be more expensive and less attractive to the next generation at the time of your client’s death, so it is prudent to consider making plans for the recapitalization of the company and transfer to children of nonvoting stock today. This is an opportunity for you to demonstrate your value as their adviser, creating a strategy for their family legacy.

Jeff Morrison is a managing partner of Kistler Tiffany Advisors, which provides fee-only wealth management to high-net-worth individuals and their families.