Handing Down the Business: Gift or Sale?
Two options for family business succession planning.

By John C. Davis

If you own a small business, at some point you will have to address the issue of management and ownership succession. In many cases, you will want to transfer ownership to a child or children whom you believe are qualified to manage the business.

Having a Plan
Having a plan is important, and the first part of the plan is determining your objectives. For example, do you want to retire? Do you need the value of the business to support you and your spouse? Can the child or other manager operate the business? Should assets of comparable value be given to other children if a gift of the business is made to one child?

The second part of the plan is knowing the current fair market value of the business. Valuating the business helps determine whether the child can afford to purchase the business or whether part ownership should be “gifted” from parent to child, and if so, the amount of the gift. Having a qualified appraiser is important in the valuation process.

The plan also should include a checklist and a timeframe for accomplishing the transition.

Outright Sale
One simple method of transferring ownership is a sale by the parent/owner to the child at fair market value. This leaves the value of the business (the sale proceeds) in the parents’ hands, where it would be available for their support in retirement. The seller will have a capital gain or capital loss on the sale, and the buyer’s basis for future capital gains or losses will be the purchase price.

The biggest business issue in this transaction may be the child’s ability to pay the purchase price. The funds may come from the child’s own resources or from borrowing from the seller or from an outside lender. Before borrowing, it’s important to determine whether the business can provide sufficient cash flow to make the payments.

An advantage to the seller of providing the financing is that the payments may be eligible for installment treatment. An advantage to the buyer may be that the interest rate charged by the owner might be lower than that charged by another lender. The seller’s risk is that the loan may never be repaid.

Gift
The transfer could also be by gift. Under the 2005 gift tax law, you don’t have to pay gift taxes on the first $1 million of taxable gifts, although gifts do effectively use a part of the donor’s estate tax equivalent exemption, which in 2005 is $1.5 million. A husband and wife each have a gift tax equivalent exemption, so they could give a total of $2 million without paying a gift tax.

A practical consequence of a gift is that the assets are no longer in the hands of the donor, where they would be available for the support of the donor. In addition, the donor may wish to make corresponding gifts to other children.

The child’s basis for future capital gains/losses in a gift scenario is equal to the basis of the donor.
    
Larger Transactions—Using a Trust
If the value of the business and the family’s net worth are large enough to justify a more complicated, and therefore more expensive, plan, the parent might consider creating a trust as a part of the transition. A trust in this situation would be irrevocable, and the beneficiaries of the trust would be the child and the child’s descendants.

The parent would make a relatively small gift of cash to the trust and would sell the parent’s stock or other equity interest in the business to the trust in exchange for a promissory with payments over time. This is a combination of the sale and gift methods described above.  However, the trust, rather than the child, becomes the owner of the stock.

As the business pays dividends on the stock to the trust, the trust can use those dividends to make the payments on the note.

The trust is controlled by the trustee, which could be the child.

There are some benefits to this arrangement. First, the trust can save estate taxes for the child. Second, the assets in the trust (company stock) would be exempt from the child’s creditors, and third, the child can vote the stock. The primary disadvantages are the complexity and the cost of setting up the trust, as well as the time and cost of the ongoing administration of the trust.

This is a complicated transaction, and you should give careful consideration to the various aspects of it. Seek the help of a qualified professional to learn more about this option. Having good advice is important, and a number of different professional disciplines (e.g., accounting, law) have experience and expertise that could be of assistance.

John C. Davis is a partner in Stinson Morrison Hecker LLP, and a member of the American College of Trust and Estate Counsel. He can be reached at (816) 842-8600.