The next generation Featured

3:00am EDT November 1, 2005
Many closely held businesses share a common issue: transition.

As the founder of your business, you've spent many years building a successful enterprise and you are ready to transition ownership and perhaps slow down to enjoy the fruits of your labor. You want to keep the business in the family while maintaining some control.

What are your options? You could sell your interest to your adult children, but if you want to be fully paid immediately, they'll have to borrow money and it may be difficult to find a lender.

If you're willing to be paid over several years, consider an installment sale, but borrowing may still be needed. Or you could have the next generation buy a small share of the business and have the company redeem your remaining shares. The company, however, will probably incur debt. These options are likely to create a burden on the company and/or the next generation because of the requisite debt service. And, you may be faced with substantial taxable income and a significant estate-tax liability looming in the future.

Gifting ownership
As an alternative, with proper planning, gifting of ownership in the business can be an effective tool.

The federal gift tax is imposed upon lifetime transfers of property by an individual for less than full and adequate consideration. It should be noted that Ohio does not impose a gift tax. The tax is triggered by the transfer of property from you rather than the receipt by your children, and is based upon the value of the gifted property at the time of transfer.

A unified rate schedule is provided wherein lifetime gifts and transfers at death are taxed on a cumulative basis. In 2005, the top rate is 47 percent and it drops to 46 percent in 2006, 45 percent in 2007 and then 35 percent in 2010. A unified credit allows for $1 million of taxable gifts to be made during a taxpayer's lifetime without paying gift tax; the credit amount upon transfers at death is $1.5 million. Current law provides for the repeal of the estate tax in 2010 and its reinstatement in 2011. However, the gift tax is scheduled to continue without interruption.

In addition, you are permitted to gift a present interest in property of $11,000 per child on an annual basis without utilizing any of the $1 million exclusion. As a married business owner, you can also use your spouse's $1 million lifetime exclusion, as well as the annual $11,000 per child ($22,000 total) donee exclusion to transfer ownership.

Valuing a business
Upon gifting an interest in a business, valuing the interest is a critical factor. Stock in a publicly traded business can be readily valued by reference to the prices indicated daily on the appropriate stock exchange. However, valuing closely held businesses provides both challenges and opportunities for the business owner.

Because closely-held businesses have relatively few sales and a restricted market, the circumstances of specific cases are weighed heavily. Recognizing this situation, the courts allow various discounts for factors such as lack of marketability and transfers of minority interest.

Accordingly, using discounts may allow you to transfer more of an interest without incurring any gift tax.

For example, a $5 million dollar closely held business where a 20 percent interest would otherwise be worth $1 million may be valued at $600,000 after taking into account various discounts, which reduce the value by 40 percent. A transfer of an additional 13.33 percent of the business could be completed to utilize the full $1 million lifetime exclusion without having to pay gift tax. It is advisable to obtain an appraisal or business valuation to support the value reported, particularly where a discount is utilized.

A further advantage of gifting is that any future appreciation in the transferred interest will be outside of your estate estate. Although various legislative proposals leave the future of the estate tax uncertain, this may be an important consideration.

Terry L. Silver, CPA, JD (tsilver@skodaminotti.com), is a partner in Skoda, Minotti & Co.'s tax planning and preparation department.