The Family Business: Preserving and Maximizing an Investment in the Past, Present, and Future

John R. Wiktor*
A family business, often the primary source of a family's wealth and the family's largest investment, can consume its owner. This is only natural, but sometimes the day-to-day management issues blind an owner to the need for careful succession and estate planning. Advisors to owners of family businesses should make sure that the succession plan and tax consequences associated with the transfer of the businesswhether through sale, retirement, or upon deathare not overlooked. Careful attention to planning details will enhance value for future generations.

Introduction
In today's world, a family business often is the primary source of a family's wealth and the family's largest investment. The management and growth of the family business are also often the primary focus of the family business owner. Because of that, however, sometimes the succession plan and tax consequences associated with the transfer of the businesseither through sale, retirement, or upon deathare overlooked. The transfer of a family business to future familial generations not only raises many complex financial, tax, and legal considerations, but also can raise many critical intrafamily issues. For example, to which family members will the client transfer the business? Are there certain family members who are more involved in the business than others? How can the client provide assets of equivalent value to those family members who have not received any part of the business? And how can a client who is transferring ownership of the family business upon death to the children assure that the surviving spouse receives income from it? All too often, the transfer of the family business among generations is unsuccessful. But the odds can be improved.

* John R. Wiktor is a partner with the global law firm of Reed Smith LLP. He may be reached by email atjwiktor@reedsmith.com or by phone at (312) 207-6451. 65

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Because of the complex issues associated with a transfer of a family business, advisers should consider the many options available to successfully transfer the business to future generations. Dynasty trusts, grantor retained annuity trusts (GRATs), and installment sales are commonly used vehicles for transfer of a business to future generations. In addition, advisers often combine these transfer techniques with gifting strategies, to make the transfer more efficient from a tax perspective. Finally, in addition to the actual transfer technique used, it is of primary importance for the adviser to review with the family all of the nontax and family issues associated with the transfer of the family business in order to make that transfer as successful as possible. This article reviews from the family perspective some of the issues involved with transferring a business. In addition, it provides examples of estate planning techniques that can be used to ensure that the transfer or sale is most effective from a tax perspective.

I Family Succession Issues Generally

For business owners, devising the appropriate exit strategy from ownership and management of their company can be the most important planning they ever do. Good succession planning and implementation of the right strategies are vital for success in the transition of leadership and management, and to provide a sense of security and peace of mind to the current owner and the rest of the company. Failure to adequately plan could be the difference between maximizing the value an owner has spent a lifetime building, and seeing that value dissipate due to estate taxes, poor management, and intrafamily disagreements. Thus, whether a business owner wants the business passed on to family members during lifetime or at death, or sold to someone outside the family during lifetime or at death, the owner needs to have a workable plan. Need for Focus on the Three Ts. The "three Ts" of business succession planningtiming, transition, and taxesare all important in this regard. For business owners, the life cycle of decisions related to their company will depend on their own personal timing, long-term goals and objectives, and the transition of management and control in a tax efficient manner. Oftentimes, conversations regarding these decisions take place from the onset of the planning process, and most successful plans have their origin in clear and consistent communications between the owner and his or her trusted advisers.

1
Timing. Proper timing of the preparation and execution of the owner's exit strategy is perhaps the single most important factor to consider. Most situations will require significant planning well ahead of the day when the owner decides to sell or retires from day-to-day activities of the business or when

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the owner's health starts to fail. Generally, private business owners should begin discussing their exit strategy at least five years before they intend to actually sell or phase out of the company's day-to-day affairs. This will allow for ample time to properly devise a strategy as to (1) how the business ownership will change (if at all); (2) who will be groomed to take over management responsibilities; (3) when and how the management transition will occur; (4) how the owner will be able to access the equity built in the company or otherwise provide adequate liquidity, post-departure, to satisfy lifestyle needs; (5) what planning techniques can be implemented, in regard to both the owner and the entire family unit, to minimize or reduce income, gift, and estate taxes in the event of a sale; and (6) how the divestiture of ownership can match up with the owner's long-term personal goals and objectives. Almost every plan will require the future coordination of many parties. Transition. Selecting the appropriate management succession plan is also critically important. A number of steps should be implemented as part of a transition plan. Some require substantial lead time. For example, training for individuals, whether family members or not, who will take over day-to-day affairs of the business needs to be in placeand tested for a substantial period of time before the business owner's actual exit. Also, incentives to keep management in place after death or departure of the owner (assuming the management team is a good one) will be required to ensure that the management team remains committed to the ongoing success of the company. Likewise, it is important that the owner's estate planning documents be consistent with the preservation of the management structure created, and that this is transparent to all parties. Taxes. From an income tax perspective, the ability of the owner to sell or transfer the business in a tax-efficient manner will depend on how far along the owner is in the process. If a sale is contemplated, to avoid having some or all of the income from the sale attributed to the owner, planning should be put in place well before a sale agreement, binding letter of intent, or sales price is finalized. In many instances, the use of certain types of irrevocable trusts can allow the owner to minimize the income taxes that result from the sale of the businessand thus preserve more wealth for the family. Additionally, proper planning techniques implemented before a sale or the owner's death may allow for the transfer of wealth to the owner's family at little or no gift tax cost. If gift and estate tax laws are important factors in the plan, it will be critical to evaluate and select planning techniques early in the process. Certain techniques will help reduce both gift taxes during the business owner's lifetime and estate taxes at death. Keeping in mind that some planning alternatives may reduce estate taxes payable by the owner's estate at death, but not eliminate them, careful planning also is required to anticipate the estate taxes that will be due and then to provide sufficient

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liquidity for such payments. If this is not done, the company could be put in jeopardy as a result. In many instances, the use of stock redemptions by the company and the purchase of life insurance to provide liquidity to pay estate taxes can ease the burden on the company and the owner's family, and ensure that the transition plan put in place maintains its course. Importance of the Family Meeting. Today we live in an increasingly global world. Family members live ever further away from each other and often grow apart. When considering the succession of a family business, the family meeting is not only an important step for wealth transfer planning but also has the additional benefit of bringing together generations of family members who do not live near each other. Not surprisingly, therefore, family meetings have become very popular. The meeting can be held at the home of a family member or an easily accessible vacation spot. Generally, it is important for the family to have a moderator for the meeting. Frequently, the family's trusted advisers attend the meeting to act as moderators. The family meeting is a great way to review the family's succession plan and wealth transfer goals. The family's advisers should suggest at the meeting that the parents discuss with their adult children the parents' plans for wealth transfer. This will allow the children to understand the parents' estate plan, and should reduce the likelihood of anguish, family fighting, or, worse, litigation after the parents' death. The advisers can also discuss the asset portfolio that will be used to implement the plan. By doing this, the parents will be able to better review their transfer planning goals, and the children will gain a better understanding of the portfolio of assets that will be transferred over time. Also, the advisers should specifically review the transfer vehicles that will be used to complete the wealth transfer. For example, if the family has established a foundation or a donor advised fund as part of the succession plan, these entities should be explained to the family members. The family meeting is an opportunity for the family to discuss which charitable initiatives the family will support each year. An adviser may suggest that each year one or two family members research a charitable cause to support, and present a report at the family meeting as to why that cause should be supported. The result will be that the family will learn about different charitable initiatives, and the reporting family member will have a personal stake in the family's philanthropic goals. In addition to the other benefits, the family meeting can be a time to assess the accountability and effectiveness of the wealth transfer plan that has been put into place. Accountability can be measured by the extent that all members of the family participate in the wealth transfer initiatives. Effectiveness can be measured through the growth of the assets, the goals that have been achieved, and the purposes that have been furthered.

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Tax Issues and Primary Considerations in Succession Planning

A number of estate and income tax planning strategies can be used in conjunction with succession planning for a family that is planning for a family business. Some of the most common strategies include the basis step-up, annual exclusion gifts, grantor trusts, and charitable planning. Basis Step-Up. Many estate planning transfer vehicles for dealing with family wealth transfers are detailed and complex. The client's basis in the family business must be strongly considered at the outset of any planning prior to sale or transfer. The basis step-up concept is very simple. When a person purchases or is gifted an asset, that person receives a basis in the property. The client who sells an asset prior to death will recognize gain on the difference between the fair market value (FMV) at the time of sale and the client's basis. If, on the other hand, the client retains the asset until death, the successors in interest will generally receive a basis in the asset equal to the FMV as of the date of the client's death.' Because of this basis step-up, the client's heirs can sell the asset immediately, benefitting from the increased value, and no capital gain will be recognized. The basis step-up is therefore a very important consideration for the family business owner who is considering sale prior to death. For example, a client who currently has an interest in a now successful family business with a very low basis may be better served by holding on to the business until death. This way, the basis in the asset will be stepped up to the date-of-death value; the client will avoid paying capital gains taxes and thus will have a larger estate to be transferred to the next generations. But this may not always be the best option. The client must consider and evaluate the difference between the capital gain that will be generated during the client's lifetime and the estate taxes that may due upon his or her death. Critical thinking and evaluation are imperative in order to ensure that the family is able to transfer as much wealth from the family business as possible to the next generations. Annual Exclusion Gifts. When a business owner desires to transfer portions of the family business during lifetime to other family members, an annual gifting program is a commonly used estate technique to transfer such interests. Currently, an individual taxpayer can make an unlimited number of $14,000 gifts of cash or other property on an annual basis tax free.^ To ensure

' IRC 1014. ^ IRC 2503.

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the tax savings, the client must only remember that no one individual may receive more than $14,000 in a given calendar year. (Note that spouses may combine their annual exclusion gifts to together make an unlimited number of $28,000 gifts.) The annual gifting exclusion applies not only to cash gifts, but to other assets as well, so the taxpayer may also gift interests in the family business. When gifting noncash assets such as interests in a family business, one must keep in mind the basis step-up rules. Even with the annual gift exclusion, it may be more appropriate for a given client not to currently gift those assets; that is, it may be more tax-savvy to hold them until death and thus benefit from the basis step-up. In addition to the basis step-up rules, a family business owner should consider whether outright gifts or transfers to family members in trust provide greater bang for the buck.

I
Dynasty Trusts. A dynasty trust is designed to hold assets in trust without direct ownership being transferred to any beneficiary. Successor generations may benefit by receiving distributions of income or principal, and assets that remain in the trust will provide future growth. In addition, with proper planning, dynasty trusts can provide income, transfer, and generation skipping tax benefits. Dynasty trusts can be an important part of a family's business transfer planning. For example, if your clients are parents who are concerned that a child may receive too much money too early, they can set limits as to when the children may actually withdraw assets from the trustsay, one-half at age 25 and the balance at age 30. Or the parents may decide that the assets will be distributed only at the discretion of the trustee, and the children will never be able to fully take the money from the trust. This type of trust thus creates the perfect opportunity for the family business to remain in trust, be controlled by the trustee, and not allow for distributions to the children. Care should be taken, of course, to appoint an appropriate trustee, as this person ultimately will have control over the trust's interest in the business. Dynasty trusts have also become a popular tool for parents who want to transfer their assets but are concerned about their child's vices, such as drugs or alcohol, and/or creditors. In this instance, the trust can be drafted so that the family business assets of the trust are protected from the child's creditors. Further, with proper generation skipping planning, the trust assets can pass down to future generations, thus keeping the family business interests that are in the trust within the family. Dynasty trusts may be implemented either during a parent's lifetime or as part of testamentary transfers. When combined with other techniques, such as installment sales or gifting programs, dynasty trusts are a great tool to allow parents to transfer assets to their children, obtain some tax benefits, provide creditor protection, allow the appointed trustee to control

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the business interest, and provide a mechanism to dictate when, if ever, the business interest may be removed from the trust. Potential Discount Options. Discounts may be available when there are restrictions in the goveming documents for the business or when a minority interest is being transferred. Before making a transfer of a family business interest, the owner should therefore review the operating agreement, bylaws, partnership agreement, or other goveming documents of the business. With the appropriate goveming documents, restrictions can be placed on transfers, withdrawals, and distributions of the business interest. Because of these restrictions, the interests in the family business can then be transferred to dynasty trusts or other beneficiaries at discounted values. For example, discounts can be taken for such items as lack of marketability where transfer restrictions are in place, or minority interest discounts where minority interests are transferred. As a result, family wealth can be transferred at lower values than would otherwise be the case.

Succession Strategies Simplified

GRATs. A GRAT is an estate freezing technique that is authorized by statute and can be an important planning consideration for the transfer of the family business.-^ The person who contributes assets to the GRAT is called the grantor. The grantor of a GRAT transfers property to the trust and retains an annuity payable by the trust. The period for which the grantor retains the annuity is referred to as the term. The term of the GRAT can be for a set number of years or for the grantor's lifetime."* The grantor's initial transfer of the asset to the GRAT is a taxable gift. The amount of the gift is ordinarily determined by actuarial tables, and can be reduced to zero if desirable. During the term, the trust will be a grantor trust. Accordingly, the grantor will report the income on the assets that have been in the trust. At the end of the term, the trust property passes directly to the beneficiaries either outright or in trust for the beneficiaries. Although the generation skipping tax exemption cannot be designated to the GRAT, with proper planning equivalent results can still be achieved. If the assets gifted to the trust essentially beat the appropriate rate of interest (the "7520 rate"^), the balance will pass to the beneficiaries income tax free. Example: Bobby Business currently establishes a GRAT with a term of 10 years. Bobby contributes to the GRAT a 20 percent
' IRC 2702. " Id. 5 IRC 7520.

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membership interest in his family business. That interest increases in value at a rate of 6 percent per year. The face value of the asset contributed is $1 million but, due to discounts for lack of marketability and minority interest, the gift tax value of the transferred interest is only $700,000. Bobby reserves an annuity of 4 percent. If Bobby dies within the term, the remainder beneficiaries will receive the remainder of the GRAT, and all or a part of the GRAT's value will be included in Bobby's estate. If Bobby survives the term of the GRAT, at the end of the term, the trust assets will pass to the remainder beneficiaries free of gift tax, and the assets transferred will be removed from Bobby's estate. Given the factors above, Bobby will have made a gift for gift tax purposes of approximately $450,000, but at the end of the 10-year term nearly $1.3 million will be transferred to Bobby's beneficiaries. In an alternative scenario, using the same values, Bobby could zero out the GRAT so that there is no gift and, at the end of the tenn, approximately $300,000 will pass to the remainder beneficiaries without any gift tax being paid on the transferred atrtount.

Sales to Intentionally Defective Grantor Trusts. An intentionally

defective grantor trust is an irrevocable trust designed to secure certain tax benefits by taking advantage of the fact that the grantor can be treated as the owner of the trust's assets for income tax purposes. When the grantor is treated as the owner of the trust for income tax purposes, the grantor reports all of the trust's taxable income on the grantor's income tax retum and pays any resulting income tax.* By personally paying the income tax that would otherwise be payable by the trust, the grantor allows the trust to retain more of its assets (rather than using its assets to pay income taxes). Payments of income tax that the grantor makes on the trust's income do not count as taxable gifts to the trust.' A defective grantor trust can be problematic from a cash flow standpoint. The inclusion ofthe trust income in the grantor's taxable income will obviously increase the amount of income tax that the grantor has to pay. The grantor must have adequate liquidity in order to pay this additional tax. To address possible liquidity issues, provisions can be included in the trust terms that would allow an independent trustee to reimburse the grantor for

IRC 671. Rev. Rul. 2004-64, 2004-2 CB 7.

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the amount of tax the grantor pays that is attributable to the trust's income. Such provisions must be carefully drafted, however, to avoid the possibility that the assets of the trust will be included in the grantor's estate at the grantor's death.* Intentionally defective grantor trusts are excellent estate planning tools when closely held family business interests are involved. Transactions between the grantor and the trust are ignored for income tax purposes.' Therefore, if a family business is sold in an installment sale to an intentionally defective grantor trust in exchange for a note, no gain is realized on the sale nor is any income recognized by the grantor from interest payments on the note made by the trust to the grantor. This type of sale is an estate freezing technique. Once in the trust, the family business is outside the grantor's gross estate for federal estate tax purposes. To the extent the assets of the trust appreciate in excess of the interest rate on the note, the sale of the family business to the trust can be an extremely effective estate tax avoidance technique.

Conclusion
A family business is often the family's largest and primary investmentone that got to be so valuable because the owner(s) invested time, money, and sweat equity. Owners want to be sure both the business and the family will survive and thrive over the long haul. Thus, for clients who are family business owners, succession planning, in regard to both tax and non-tax concerns, is of primary importance.

" '

Id. ' Rev. RuL 85-13,1985-1 CB 184.

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