Succession planning, as the term implies, involves the comprehensive planning of what will happen once you are no longer leading your business forward. This means not only thinking about how your personal financial situation will change but also thinking about how your departure will affect the business as a whole.
Naturally, business owners will want to minimize the tax costs associated with succession to the greatest extent they possibly can. In many other cases, business owners will also want to find ways to maintain some control or active participation in the business itself. After all, you’ve worked hard to get your business to where it is today, and letting go entirely can often be rather difficult.
Regardless, it will be crucial to have a firm plan in place. Below, we will discuss some of the most valuable business succession tools that are currently available. By taking the time to understand and explore your available options, it will be easier to find which one(s) makes the most sense for you and your business.
Grantor Retained Annuity Trust (GRAT)
If your intention is to transfer ownership (perhaps to the next generation in your family), not sell your business, then a grantor retained annuity trust (GRAT) could be your solution. This is an estate planning tool that can actually be used to pass on more than just your business to beneficiaries.
With a GRAT, an irrevocable trust is created, with shares of the business included. The trust lasts for a predetermined number of years (ideally, the business owner will outlive the trust). Once those years have passed, the assets in the trust pass to the beneficiaries. And, here’s the beauty of using a GRAT to pass on quickly appreciating assets like a thriving business: with the right maneuvering, it’s possible to transfer appreciation to your beneficiaries that will not be subject to the gift tax.
If you’re prone to cringing when you see the word “annuity” (we are too!), fear not. In this context, it simply means that regular installments of payments will be made (in this case, to you, the business owner) over the term of the GRAT. It is a self-created annuity – not something sold by a slick salesperson or insurance company. For many business owners, this creates the steady stream of retirement income that they need to supplement their savings (especially since they won’t be supplementing through the sale of their business).
Via a GRAT, a business founder can continue to enjoy future income streams and, at the same time, reduce their and their family’s tax liability.
Grantor Retained Unitrust (GRUT)
A grantor retained unitrust (GRUT) is structurally similar to a GRAT in many ways. However, there are still a few important differences that can directly affect both the grantor and the grantee (the person receiving the benefits or the buyer). Both GRUTs and GRATs are used to minimize taxes without totally surrendering a stake in the estate, but what makes GRUTs unique is the income stream that will be received.
With a GRUT, rather than receiving a predictable payment each year, cash flows will fluctuate. Payments will be calculated as a fixed percentage of assets as valued each year.
Family Limited Partnership (FLP)
A family limited partnership (FLP) is an excellent option for individuals that want to keep the business “in the family” and also avoid estate and transfer taxes that are commonly accessed by the federal and many state governments. Essentially, a family limited partnership allows multiple members to have direct ownership in the company and also buy (or sell within the family) shares of the business itself.
There are two distinct ownership classes for FLPs: general partners and limited partners. General partners typically own a larger portion of the business and will also be responsible for the management of the company. Limited partners play a more passive role but can still benefit from future cash flows. When an individual retires, they might transfer from a general partner to a limited partner—once again, this helps preserve generational wealth but also helps provide an additional tax shield.
An FLP can also be used to reduce gift taxes by the use of minority and lack of marketability discounts. If done properly, these discounts will pass IRS muster.
Installment Sale to an Intentionally Defective Grantor Trust (IDGT)
With an intentionally defective grantor trust (IDGT), it’s possible for a business owner to “sell” their business to the trust in exchange for a series of payments. The payments can either be used as a retirement income stream to the former business owner or as interest payments to the trust (for the later enjoyment of the beneficiaries).
An IDGT helps shield beneficiaries from estate tax and transfer tax liability, although the grantor is still responsible for income tax. Unlike most other irrevocable trusts, the grantor continues to be able to maintain some level of control over the trust throughout their lifetime.
As long as income is recognized appropriately, an IDGT is a great way to avoid taxes and reallocate wealth.
Exchange Common Shares for Preferred Shares
Many ownership shares (even among private companies) can be converted at a fixed rate. While common shares will typically produce returns for the owner depending on how the company performs, preferred shares are a bit more predictable and make it easier to plan for your financial future (in this case, retirement). A simple conversion will allow a business owner to enjoy the growth they’ve contributed to the company without the need for higher risks or active management.
The Actual Sale Transaction
Negotiating the tax structure of the deal with the buyer will dictate a portion of the sales price. I will touch on one of the major tax considerations to address in negotiations. However, you will want a tax-savvy financial advisor or CPA to discuss all of the tax issues before you start to negotiate with the buyer.
As the seller, you will prefer the sale of your stock or membership shares to have a larger portion of the proceeds taxed at the lower capital gains tax rate. However, most buyers want to purchase the assets of the corporation for faster tax write-offs and to avoid buying company liabilities. Don’t fret, you can still get a portion of the sale price treated as capital gains with an asset sale. The key is structuring the allocation of the sale price mostly to goodwill. There is a famous tax court case called Martin Ice Cream Co. v. Commissioner that addresses this issue.
Succession Planning with Bartley Financial
These are just a few of the tools that can potentially be used during the succession planning process. If you are interested in learning more about how any of these tools can help you better prepare for the future, consider speaking with a financial planner.
Robert Bartley, the founder and owner of Bartley Financial, grew up working many hours at his family’s restaurant. He saved the money he earned and started to invest.
The more time Robert spent managing his investments, the more convinced he became that there had to be a better way to manage his personal and family business’ finances. The CPAs and data silos headed by separate financial, insurance, and law professionals allowed too many chances for gaps in strategy and missed opportunities.
Robert craved comprehensive personal and business financial planning services that promoted a coordinated effort among the many professionals it takes to run a smooth business. Being the roll up your sleeves, detailed person he is, Robert went to school and pursued the professional designations of CPA (Certified Public Accountant) and CFP® (Certified Financial Planner®).
Now, Robert uses his business experience and financial acumen to guide other business owners in Massachusetts, New Hampshire, Florida and elsewhere toward their most successful futures. The Bartley Financial team coordinates your business and personal goals and, in the process, enhances your business’ attractiveness to employees when you need to hire and buyers when you want to sell.
If you’re looking for a fiduciary financial advisor who can guide you through the complicated process of small business succession planning, contact Bartley Financial today.