Two Estate Planning Tax-Wise Ways to Shift a Business

Many business owners scrambled to sell their businesses before the end of 2012 to avoid potential tax increases. If you didn’t sell, don’t worry. There are a couple of other Estate Planning tax-wise ways to transfer business ownership that don’t require you to rush.

In one recent case, a taxpayer owned 100% of a corporation. His adult children were directors of the corporation, and he wanted them to take over both ownership and operation of the business as part of his estate planning.

He gave some of his stock to the kids. The business redeemed the rest of his shares in exchange for an installment note. The children now owned 100% of the outstanding stock, and he received regular payments under the note.

A redemption like this qualifies for long-term capital gain treatment when the selling shareholder terminates all his interest in the corporation, other than any interest as a creditor. Also, the gift of stock to the children mustn’t be primarily tax motivated. This owner asked the IRS for an advance ruling, and it ruled in his favor.

But do this transaction wrong, and the redemption will be treated as a dividend to either the children or you.

The other estate planning strategy is to first create an employee stock ownership plan (ESOP). There are a lot of tax breaks for setting up the plan and selling your business to it.

In a typical ESOP, a small business owner creates the ESOP and a related trust. The company borrows money from a bank and in turn lends that money to the trust. The owner sells some or all of his stock to the trust. Over time, the company makes annual contributions to the trust, which are deductible. The trust uses the money to repay the loan from the company, which the company uses to repay the loan from the bank.

Special tax breaks allow the company to deduct both the interest and principal it pays on the loan. It also gets to deduct contributions made to the trust as well as dividends it pays on stock owned by the trust.

The owner also gets tax breaks. Any gain from the sale of the stock he sold is deferred if within a year the owner uses the proceeds to purchase securities issued by domestic companies and meets other restrictions. Taxes are due only as the owner sells those investments. The owner can sell whatever percentage of his stock he wants. In many ESOPs, the owner still retains a majority of the company.

An ESOP is best for an owner whose children do not want to run or own the company, but others can use it as well. The ESOP gives a share to each employee and must meet nondiscrimination rules; the owner can’t pick and choose which employees get greater shares. When an employee leaves the company, he receives cash equal to the value of his ESOP account. Employees generally are allowed to vote on major corporate changes, such as mergers and acquisitions.

RW January 2013.