Strategies to Consider Now for A Tax-Efficient Business Exit Later

Whether you’re just starting out or thinking about retiring in the next few years, it’s not too soon to consider a strategy for exiting your business.

“The day you open your business is the day you have to plan for exiting it,” said Paul DeLauro, a manager in Wealth Planning at City National Bank.

“The later you start planning, the worse your chances of minimizing the tax hit when your business eventually changes hands,” he said. “Even if you expect to hold onto your company for the foreseeable future, the business represents value within your estate that needs to be properly handled.”

Options for Asset Protection and Tax Savings

Start by consulting your financial planner, lawyer and accountant, each of whom can help you evaluate your estate and plot financially sound moves.

DeLauro starts with a company’s governing documents, which may limit options for structuring the business to benefit owners and successors in a transaction. You can change these documents anytime, so ask your advisors to review them and suggest improvements. Potential exit scenarios include selling or giving the company to the family’s next generation, transferring the business through a sale-gift combination, redemption of shares to a partner and selling to employees or to a third party.

Planning for asset protection and tax savings should occur long before a third-party sale, said DeLauro, because once an offer is made your options become more limited.

The GRAT Option

Owners who want to move their business out of their estate may want to consider a grantor retained annuity trust or GRAT, which enables beneficiaries to eventually take possession of the business when the trust expires while saving significantly on estate taxes. Owners can place the company in a GRAT at a relatively low valuation, with growth occurring outside their personal estate, DeLauro explained.

If you wait until someone makes an offer on your business, it’s too late to benefit from transferring shares to a GRAT. This is because you can’t value an asset at less than its known worth, he said.

One City National Bank client planning to eventually sell a family business obtained a valuation of $10 million and placed his company shares into a GRAT. So did his brother and co-owner. The following year, they received an offer to sell the business for $65 million. “After the sale, because of the GRAT, they each have an annuity for many years from the sale’s returns,” said DeLauro.

The co-owners saved millions in estate tax by transferring the lower value shares into the GRAT during their lifetimes — prior to receiving a letter of intent to buy the business, DeLauro said.

A GRAT can be used for a business that might go public, allowing families to pass along assets while avoiding paying estate taxes on soaring post-IPO share prices, DeLauro added. However, if the business owner dies before the GRAT expires, all assets in the GRAT return to the estate and the heirs must pay taxes on the full value of the business.

It’s always important to consult with an attorney and a CPA for a comprehensive analysis of your unique situation.

Gift-Tax Exclusion

The annual gift-tax exclusion can be used to transfer ownership of a closely held business to the next generation. You may give anyone cash or other assets valued up to the annual gift-tax exclusion — $15,000 in 2021 or $30,000 from a married couple — tax free. One City National Bank client used this strategy to pass ownership interest in their business to three of their four children over several years. The fourth child, who won’t be participating in the family business, received annual gifts of equal value, DeLauro said. You should obtain a valuation before transferring shares in the business, explained DeLauro. The IRS allows closely held businesses to discount the value of shares for a valid purpose, such as minority share discounts or closely held business discounts.

Family Limited Partnership

A family limited partnership (FLP) also provides significant estate- and gift-tax savings when business ownership passes between family members, DeLauro noted.

For example, married business owners can transfer assets to a new limited partnership in exchange for a 1% general partnership interest and a 99% limited partnership interest. The couple maintains complete control through their general partnership interest, even though it represents only a small percentage of the family limited partnership’s value. The value of these limited partnership interests will be significantly discounted due to the partnership’s lack of operational control — third parties would pay less for a restricted interest in a company than they would for unrestricted control — which works to the family’s financial advantage.

Eventually, the couple may choose to transfer general partnership interests to their heirs. This way, when they die, the IRS doesn’t determine they retained too much control and shift the partnership’s full value to the estate, which would trigger a high tax bill for the heirs.

Before Accepting an Offer

While an unexpectedly high offer for a business is exciting, DeLauro urges owners to carefully evaluate the long-term implications of selling.

In one instance, a client with a tech business held off, believing the company would increase in value significantly in five years. That decision included planning for the sale in a few years by restructuring from a C corporation to an S corporation, transferring funds into an investment portfolio and placing the business in a GRAT.

Given the complexity and the number of options available, it’s important to consult with professionals to evaluate your situation before a sale.