November 29, 2023

5 Wealth Transfer Strategies for Family Businesses

Comerica Wealth Management

Secure your business legacy by exploring essential wealth transfer strategies for family businesses, weighing the pros and cons, to help you make informed decisions. 

Watch as Comerica’s National Wealth Planning Manager, Noah Harden, discusses five common wealth transfer strategies that many business owners use to transfer their business to their family members.

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Key Takeaways:

  • Without proper wealth planning, the transfer of your business can lead to problematic disputes and unforeseen tax burdens.
  • There are several methods to transfer your business assets to future generations, each with its benefits and drawbacks.
  • Given the complexities and potential IRS attention, especially with methods like Intentionally Defective Grantor Trusts (IDGT), consult with tax, legal and financial advisors to ensure a smooth, efficient and tax-optimized transfer.

Your family business isn’t just about the bottom line, its about the legacy you have created. In fact, for many family business owners the business itself often feels like part of the family. When the time comes to leave the family business, keeping it in the family is often a key focus for these business owners.

As you plan for the future, consider these five wealth transfer strategies for family businesses:

Strategy 1: Transfer the Business through Your Estate Plan

One approach for transferring a family business is to include the business as a part of the owner’s estate. Essentially, this means that the business will be distributed based on the terms of the owner’s estate planning documents (typically a will or trust).

With this strategy, your estate planning documents serve as the definitive guide on how the business will be distributed after your passing. You can bequeath the business as a whole or break it up into separate interests. You can also set guidelines for its operation or potential sale. Ultimately, the level of detail you choose to include in your estate plan is flexible and depends on your specific objectives for the business.

Pros:

  •  Simplicity: This strategy is straightforward. By including the business in your estate planning documents, you can clearly indicate who will inherit the business after your death.
  • Intention: This strategy ensures the business transitions to the intended beneficiaries, honoring your wishes.
  • Stepped Up Basis: The basis of assets in a decedent’s estate at the time of death is adjusted to the fair market value at the time of death. This could reduce the capital gains tax that the beneficiary would pay if they sold the asset later.

Cons:

  • Illiquid Estates and Estate Tax: For illiquid estates that are subject to estate tax, there is a risk that the business would need to be sold to pay the tax liability.
  • Unanticipated Events: A will or trust may not cover all potential changes in circumstances that could effect the business owner’s wishes. For example, the death, disability or divorce of a beneficiary might cause the business owner to change their plans for the business. However, unless the owner takes proactive steps to revise the estate planning documents, those changes may not take place, which could lead to unintended results.
  • Family Disputes: Transferring a business through a will or trust can lead to disputes among beneficiaries, especially if the distribution isn't explicit or if some family members feel they've been treated unfairly. This could result in additional expense and time delays.

Strategy 2: Direct Gift of the Business During Life

Transferring ownership of a family business during life can be done in a number of ways. Possibly the most straightforward is by gifting the business directly to your family. This type of transfer allows a great deal of flexibility. The owner could transfer the entire business at once or gift smaller parts of the business over time. Transferring the business by gift will use the owner’s federal estate and gift tax exemption ($12.92 million per person in 2023). When the gift is complete, however, the business will no longer be the owner’s taxable estate (for estate tax) and the future growth of the business will also remain out of the taxable estate.

The owner could also structure the business in a way that allows them to gift away most of the value, while still retaining control. This provides the ability to continue receiving income from the business, while removing much of the business value from her/his taxable estate.

Gifting business interests will generally require an appraisal to determine the reportable value of the gift, which is reported on a gift tax return. Please discuss with your tax, legal and financial advisors.

An alternative to giving directly to family members is to gift portions of the business to an irrevocable trust for the benefit of your family. There are a variety of irrevocable trusts which all have their set of unique benefits and drawbacks. Two common trusts used to transfer business interests are Intentionally Defective Grantor Trusts (IDGT) and Grantor Retained Annuity Trusts (GRAT), as discussed below:

Pros:

  • Reduce the Taxable Estate: By gifting portions of your business, you can shrink the size of the taxable estate, potentially reducing estate tax at the time of death.
  • Instant Ownership Transfer: Once the gift is complete, your beneficiaries own that part of the business. There is not anticipation or waiting until after death.
  • Simplicity: Although transferring a business always carries complexity, a direct gift during life is as straightforward and understandable as it gets.

Cons:

  • Gift Taxes: Gifting business interests can trigger gift tax when the value of the gift is larger than the taxpayer’s available federal estate and gift tax exemption. Although, compared to the alternatives, paying gift tax on a lower value is not always a bad thing, the potential for tax liability and its implications must be understood and planned for in advance of the gift. Please discuss with your tax, legal and financial advisors.
  • Carryover Basis: When an asset is gifted, the basis of that assets remains the same before and after the gift. If the new owner sells the business, the potential for capital gains tax may be increased if the basis is low. In contrast, if the business is transferred pursuant to a will or trust, at the time of death, the basis will generally step up to the date of death value, potentially decreasing the gain upon sale.
  • Control Shift: Once you gift away control of your business (by giving away a majority or giving away enough voting interests), your authority is gone. This can be a difficult emotional hurdle for some business owners and should be considered prior to making the gift.

Gifting your business directly to your family is a simple approach to wealth transfer that can help reduce the owner’s taxable estate. However, be mindful of the gift tax and capital gains tax implications to avoid surprises.

Strategy 3: Sell Your Business to Family In Exchange for a Note

Although gifting may efficiently transfer a business interest, it is not an option for everyone. Business owners who need the value of their equity to retire or accomplish other goals, may need to sell the business. Depending on the value of the business and the ability/inability of the purchaser to obtain financing, the selling owner may choose to finance the sale by accepting a promissory note in exchange.

This provides the selling owner with a stream of income, in the form of note payments, which can be structured to meet the selling owner’s needs. Keep in mind, however, that this comes with the risk that the purchaser will not be able to afford repayment at some point in the future. Nevertheless, this is a good option for business owners who want to transfer the business to family and also get value in return.

Pros:

  • Transfers the business to family while providing a stream of income to the selling owner.
  • Freezes the value of the asset in the selling owner’s estate by swapping a high-growth asset (the business) for a low growth asset (promissory note).
  • It's rather simple to accomplish the transaction.

Cons:

  • There is risk that the purchaser will not repay the note, which is generally caused by the business revenue decreasing.
  • The seller must be aware of and plan for the potential income tax liability.

Strategy 4: Lifetime Transfers to Intentionally Defective Grantor Trusts (IDGT)

The IDGT has become a staple for those wishing to transfer business interests to future generations and also reduce the size of their taxable estate (for estate tax). Once the trust is created, the business owner can gift assets to the trust and also sell assets to the trust in exchange for a promissory note. The gifted assets (and the future growth of those assets) are then, presumably, out of the taxable estate.

When assets are sold to the IDGT, the value of the promissory note is in the seller’s taxable estate. However, the value of that note will hopefully grow at a slower rate than the business interest that is now owned by the IDGT. This is referred to as “freezing” the value of assets in the estate (swapping a high growth asset for a flat or slow growing asset). The promissory note payments can also be structured to create personal cash flow from the IDGT to the seller/business owner.

An IDGT is often created as a grantor trust, which means the grantor of the trust can pay the income tax generated inside the trust. In effect, this allows the trust assets (often business interests) to grow unencumbered by tax liability, which can lead to significant growth over time.

Pros:

  • Estate Tax: The key benefit of an IDGT is reducing estate tax liability, which can be especially effective when transferring high-growth assets like a business.
  • Income Tax: With the ability for the grantor to pay the income tax for the trust, the potential for growth of the assets in the trust is compounded.
  • Personal Cash Flow: By selling business interests in exchange for a promissory note, the selling business owner can create personal cash flow.

Cons:

  • Complexity: There are complexities to creating and transferring assets to an IDGT. Obtaining advice from tax, legal and financial advisors is important.
  • IRS Attention: Given its potential to transfer significant wealth while reducing tax, IDGT transactions can attract scrutiny from the IRS, especially when discounted valuations are used for the transferred assets. It is important to make sure the IDGT is created, funded and reported correctly.

An IDGT is a powerful estate planning tool that can help reduce estate tax and transfer large amounts of wealth to future generations.. High-growth assets, like business interests, may be ideal for transferring to an IDGT.

Strategy 5: Use a Grantor Retained Annuity Trust (GRAT)

A Grantor Retained Annuity Trust (GRAT) is a special format of irrevocable trust. You start by moving your business into the trust and naming the family members you want to receive the business as beneficiaries. From there, you receive a regular payout for a set number of years. This payout essentially treats the assets as returned to the grantor. Once the designated period wraps up, what remains in the trust (including appreciated value) goes to your beneficiaries. This reduces the size of your estate– and thus estate taxes.

Pros:

  • Future Appreciation: A strong feature of GRATs is they let you transfer any increase in the value of the business assets while keeping the increase out of your main estate.
  • Tax Perks: If handled correctly, using a GRAT can significantly reduce the amount of your estate taxes.

Cons:

  • Timing Matters: If life throws a curveball and you pass away before the GRAT term is done, those assets may transfer back into your estate.
  • Interest Rate Rollercoaster: GRATs aren't immune to the whims of the financial world. Their performance can be influenced by interest rate changes.

A GRAT can help reduce your estate taxes and set your heirs up for financial success. However, it can be complex to set up and manage. Work with attorneys and financial advisors to make sure your GRAT is expertly designed.

Whether a gift, sale or combination of both is right for you, transitioning your business to future generations of family can be both personally and financially rewarding. Considering the options and their implications in advance will help ensure you accomplish the objectives that are important to you and help cement the legacy you have created.

Planning for Your Businesses’ Future?

When considering this (or any other) strategy, it's important to consult with tax and legal advisors familiar with estate planning and business transition planning to ensure the best outcome for both the business and your beneficiaries.

Work with the experienced professionals at Comerica. Our wealth advisors can help you review your estate and find the right strategy for your financial goals. Contact your Comerica Relationship Manager or contact Comerica today.

NOTE: IMPORTANT INFORMATION

Comerica Wealth Management consists of various divisions and affiliates of Comerica Bank, including Comerica Bank & Trust, N.A. and Comerica Insurance Services, Inc. and its affiliated insurance agencies. Non-deposit Investment products offered by Comerica and its affiliates are not insured by the FDIC, are not deposits or other obligations of or guaranteed by Comerica Bank or any of its affiliates, and are subject to investment risks, including possible loss of the principal invested. Comerica Bank and its affiliates do not provide tax or legal advice. Please consult with your tax and legal advisors regarding your specific situation.

This is not a complete analysis of every material fact regarding any company, industry or security. The information and materials herein have been obtained from sources we consider to be reliable, but Comerica Wealth Management does not warrant, or guarantee, its completeness or accuracy. Materials prepared by Comerica Wealth Management personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect information known to, professionals in other business areas of Comerica Wealth Management, including investment banking personnel.

The views expressed are those of the author at the time of writing and are subject to change without notice. We do not assume any liability for losses that may result from the reliance by any person upon any such information or opinions. This material has been distributed for general educational/informational purposes only and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product, or as personalized investment advice.

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