Family business exit planning is a complex process. If you decide to exit your business and have a family member take over, you must essentially decide on whether to sell or gift the establishment. Having a family member buy the establishment often results in undesirable tax implications for both parties. The buyer may have to use after-tax dollars to buy the business and the seller may have to pay capital gains tax. This is why family business owners often choose to gift their business.

When to gift?

An owner can gift their business upon death, by passing on shares of the company in their will. From an income tax standpoint, there is a definite advantage to using this method. That's because the former generation can acquire the stock at its fair market value, without having to pay income tax on any (potentially large) profit. Unfortunately, inherited stocks are not free of estate taxes. The shares that are transferred are counted in the decedent's taxable income.

Another method is to pass on control of the company before you die. When gifting the business over a certain time frame, you can pass on ownership gradually. This may be a more effective way to have your heirs to learn the business. Also, you will be able to minimize your estate taxes.

Cumulative gifts beyond $5,120,000 (2012 figure) are tax-free under your lifetime exemption. Lifetime gifting transfers the value of any future growth in the company out of the estate to your heirs. This is especially beneficial if business growth is expected. Partial interest handouts may be valued at a discount due to lack of marketability or limits on transfers. Gifts of $13,000 per heir are free of taxes according to the annual gift tax exclusion.

Gifting your business by way of trusts

Your gift can be given outright in a will or in a trust. You can even develop a plan that allows you to retain ownership of the company as long as you want. You could have a revocable trust which will allow you to end it if desired. As another option, you could

Our current low interest rates and economic recovery make it a good time to consider establishing a GRAT or GRUT as part of your family business continuation plan. The irrevocable trusts have a fixed term that affords the business owner (the "grantor") an annual income. This "annuity" often includes a total annuity payout over the long term that is practically equal to the initial worth of the funds placed in the trust. In essence, as the trust term ends, the remaining increase in the assets above and beyond the annuity disbursements received by the heirs, are typically free of gift and estate taxes.

If the profits you receive is a predetermined amount without a yearly fluctuation, the trust is considered a GRAT. On the other hand, if the profits from the trust funds is based on a percentage and fluctuates, it is a GRUT. These funds can help you save estate taxes by transferring an asset (such as your company) and any future profits, to your beneficiaries at a discount, particularly if you want (or need) the funds.

Gifting your business with a family limited partnership

You can also consider establishing a family limited partnership (FLP) to pass on shares of your company. An FLP is a limited partnership used to manage and operate a family enterprise. Both you and your spouse can be general partners, maintaining control of the business and receiving income from the company. You can appoint your heirs as limited partners. By transferring the company to an FLP, you may be permitted to use valuation discounts to significantly minimize the value of the business for tax purposes by distributing yearly gifts to the limited partners.

It is important to realize that trusts, family limited partnerships, and bequests are only a few of the numerous methods for saving taxes when transitioning a business across generations. But it is still a good idea to explore other options with your advisors as well.