For family business owners, estate planning can be a challenge. Often, most if not all of their wealth is tied up in their companies, which creates a conflict between the desire to transfer ownership to the next generation and the desire to stay in control. One potential solution is to recapitalize the business into voting and nonvoting shares. It allows you to separate ownership succession from management succession.

Reaping the Benefits

From an estate planning perspective, the sooner you transfer ownership of your business to the next generation, the better. That way, future appreciation and income are removed from your estate and avoid gift and estate taxes.

Transferring ownership may be particularly tax-efficient this year, because the gift tax exemption is at an all-time high ($5.45 million).

Recapitalization can allow you to reap the tax benefits of gifting without ceding control of your business to your children.

For example, you might retain 10% of the company in the form of a voting interest and allocate the remaining 90% among your children in the form of nonvoting shares. You continue to manage the business while removing a large portion of its value from your taxable estate.

Plus, nonvoting shares typically are entitled to valuation discounts for lack of control and marketability. So for gift tax purposes, their value would likely be substantially less than 90% of the company's value.

Avoiding Conflict

When the time is right, you can begin the management succession process by transferring your voting shares to your children. But what if you have some children who are involved in the business and some who aren't?

Usually, the best option is to transfer your voting stock to children who are active in the business. But this can create tension between them and the nonparticipating children. The latter will likely be looking for cash distributions while the former may want to reinvest earnings to grow the company.

To avoid this sort of conflict, carefully design a buy-sell agreement that provides for a buyout — at a fair price — of the children who aren't involved in the business. To avoid placing a financial strain on the business, the agreement should call for the purchase price to be paid in installments over a reasonable period of time.

Not Just for Corporations

Recapitalization is an option for most types of businesses, including corporations, partnerships and limited liability companies. Even S corporations can have voting and nonvoting stock without running afoul of the rule that prohibits S corporations from having more than one class of stock.

If you're considering recapitalizing your business into voting and nonvoting shares, be sure to consult your legal and tax advisors. Generally, a properly structured recapitalization is not a taxable event for the company or its shareholders. But careful planning is required to ensure the desired tax treatment. This technique can generate substantial estate tax benefits. Those benefits may be lost on December 31st.

Proposed Regulations Just Issued: The Treasury (IRS) just issued Proposed Regulations that could have a dramatic impact on your estate planning by eliminating valuation discounts. For wealthy people looking to minimize their future estate tax, this is critical. Planning can also be essential for others as well. If you are concerned about protecting a family business from the risks of future divorce, or protecting your assets from lawsuits or malpractice claims, discounts can enable you to leverage the maximum amount of assets out of harm's way, without triggering a gift tax to do so.

Act Now: Time is of the essence. Once the Proposed Regulations are effective, which could be as early as year-end, the ability to claim discounts might be substantially reduced or eliminated, thus curtailing your tax and asset protection planning flexibility.

What are Discounts Anyway? Here's a simple illustration of discounts. Bernie has a $20M estate which includes a $10M family business. He gifts 40% of the business to a trust to grow the asset out of his estate. The gross value of the 40% business interest is $4M. Since a minority 40% trust/shareholder cannot force a sale or redemption of its interest, the non-controlling interest in the business transferred to the trust is worth less than the pro-rata value of the underlying business. Thus, the value should be reduced to reflect the difficulty of marketing the non-controlling interest. As a result, the value of the 40% business interest transferred to the trust might be appraised, net of discounts, at $2.4M. The discount has reduced the estate by $1.6M from this one simple transaction.

Election Impact: If the Democrats win the White House and the Democratic estate tax proposals are enacted, the results will be devastating to wealth transfer planning. Some experts project that a Democratic White House could affect down-ballot races and flip the Senate to the Democrats. The Democratic tax plan includes the reduction of the estate tax exemption to $3.5M, elimination of inflation adjustments to the exemption, a $1M gift exemption and a 45% rate. The Democratic plan will most likely include the array of proposals included in President Obama's Greenbook which seek to restrict or eliminate GRATs, note sale transactions to grantor trusts, and more. Wealthy taxpayers who don't seize what might be the last opportunity to capture discount planning, might lose much more than just the discounts. They might lose many of the most valuable planning options.

What You Should Do: Contact your planning team. A collaborative effort is essential to have your planning done well. As your estate planning and tax attorney we can review strategic wealth transfer options that will maximize your benefit from discounts while still meeting other planning objectives. Projections completed by your wealth manager could be essential to confirming how much planning should be done and how. Your CPA will have vital input on wealth transfer options, federal and state income tax implications, and more. Your insurance consultant can show you how to use life insurance to backstop some of the planning strategies, in coordination with the financial forecasting done by your wealth manager, to maximize both the tax benefits and your financial security.

Who Should Act: Married clients with estates that exceed $8 million or more and single clients with estates of $4 million or more should reevaluate the effectiveness of their plan.

Look for Upcoming Webinars: We are setting dates for webinars which detail the effect of these changes and describe some of the actions that may be appropriate to take. Please contact our office if you are interested in attending and let us know if a lunch, afternoon or evening time is best for you.


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