Will Heirs Get What They Want From Their Business Inheritance?

Business Succession Planning During the Great Wealth Transfer

By DARREN T. CASE

The United States is presently in the midst of what is being described as the greatest wealth transfer in human history. Over $30 trillion is set to transfer from one generation to the next over the following few decades, with a large portion of this wealth being tied up in family businesses.

Many owners are now facing very difficult business transition decisions. The actions or inactions of the business owners can have significant tax consequences, favorably or unfavorably, and can also have a corresponding impact on the value of the business during one’s life and upon death. Thus, it is critical that tax and estate planning be contemplated and compared when implementing any business succession strategy, but it certainly cannot be the sole emphasis.

From a tax and estate planning standpoint, much of the focus on a potential sale of a family business involves the lifetime impact of capital gain taxes and post-mortem step-ups in basis. If a family business is sold by an owner during his or her life, many times the owner is subjected to capital gains taxes. In general, capital gains taxes are imposed on the difference between the adjusted basis of a family business and its sales price. If the asset is held for over a year, the “long-term” capital gains tax rate is anywhere from 15% to 23.8%.

While these capital gains tax rates are often more preferential than the progressive ordinary income tax rates, it is still a significant hit to an owner’s overall net worth. This is especially true considering that a successful family business ordinarily receives a step-up in basis upon the death of the owner. Business owners that have properly vetted the tax aspects of an exit strategy often learn that an incredibly effective tax strategy is one that the owner will never live to see.

Presently, the Internal Revenue Code generally provides that a family business will receive a step-up in basis upon the death of its owner. For example, if a business that is owned long-term, with an adjusted basis of $5 million and a value of $7 million, is sold during the owner’s life for $7 million, the $2 million in gain would be subjected to capital gains taxes at a rate of 23.8% (i.e., $476,000 in taxes). If, however, the owner died prior to the sale, the basis in the family business would receive a step-up to the date-of-death fair market value of $7 million; if the heirs sold the business following the owner’s death for $7 million, then zero dollars in income taxes would be imposed. When faced with the decision of paying $476,000 in taxes versus $0, it seems like waiting until death is the best option. Unfortunately, that is not always the case, and there are many more critical factors that business owners must consider prior to implementing a sound exit strategy.

While the step-up in basis is effective from a capital gains tax standpoint, there are other taxes of great concern. The better-known area of the Tax Code involving death is the estate tax. When this article was written in 2016, the estate tax rate was 40% on the date-of-death value of a decedent’s assets in excess of the $5.45 million exemption. Using the fact pattern above, assume that the owner did not sell the business during his or her lifetime. While it is true that the sale of the business at $7 million after the owner’s death would generate no capital gains taxes, the valuation amount of the business in excess of the estate tax exemption by $1.55 million would be subjected to the 40% estate tax rate. Thus, in attempting to avoid $476,000 in capital gains taxes, the owner was subjected to $620,000 in estate taxes, which is an overall net tax loss of $144,000. Of course, in order for the business owner to avoid the estate taxes, regardless of when the business was sold, other tax strategies would need to be explored.

While the tax aspects of business succession planning are important, there are other non-tax factors that are equally important. The examples above all assume that the family business can be sold post mortem at its date-of-death value. Often times, this is not the case.

The death of the owner, presumably one of the key persons involved in the business, can have a substantially negative impact on its value and, therefore, its sale price. It may take well over a year for the family business to go through a trust or probate administration process, causing fragmented ownership interests among beneficiaries and the business to be poorly run. This frequently leads to a “fire sale” of the business, with buyers swooping in to purchase it for anywhere from 40% to 80% of its date-of-death value.

It is doubtful that any tax strategy in place could offset the substantial decrease in value to the family’s wealth. This is just one of many non-tax factors to consider. Although tax analysis is necessary for any family business succession plan, all factors - tax or otherwise - need to be explored, because the business often makes up the majority of a family’s wealth. Even if a business owner is not quite ready to sell his or her business, an exit strategy needs to be implemented at some point, or the process can take much longer than anticipated when realizing the necessity of a multi-faceted analysis.

The examples and tax characteristics above showcase a few of the basic considerations to explore and their potential pitfalls, but it is highly recommended that a much more thorough analysis be conducted prior to proceeding with a succession plan. This will most likely facilitate a successful result, whether during life or upon death.

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