Timing is a critical element in the design of any transition plan, especially with family-owned businesses. The temperament and anxieties of the parent can impact all timing decisions. Some parents are anxious to move it full steam. Many need to take it slow, to walk before they run or transition out of the business slowly. Often the pace of implementing specific plan elements will accelerate as circumstances change and as the parents become more comfortable with the transition process and their new roles. The planning process usually is helped by focusing on 3 time frames:
So long as both Steve and Betty are living, their top priorities must include their financial needs and security, their willingness to let go and walk away from the business, and their appetite for living with any fall out that results from the transition of serious wealth and control to their children. From a tax perceptive, all transfers during this timeframe are going to trigger either a transfer of the parent’s existing stock bases, often very low – that’s a bad thing – or the recognition of taxable income predicated on such low tax bases. Neither of these is very attractive.
The death of the first parent often creates more flexibility. A double tax benefit is realized when the first parent dies. The income tax bases in all or major portion of the property including stock in the company may be stepped up to its fair market value and the marital deduction may be used to eliminate any estate taxes at that time. Now, any gift to other family members during this timeframe may transfer a high-basis stock. That’s good. Plus any sales of the stock to other family members or the corporation will likely be income tax-free because of the basis step-up. If the deceased parent has the strongest ties to the business, as is so often the case, officially surrendering total control may no longer be an issue.
In our case for example, Betty presumably would have no interest in being involved in the business following Steve’s death. Plus, if the life insurance planning correctly eye balls the parent most likely to die first, Steve in our case, the receipt of tax-free life insurance proceeds may substantially reduce or completely eliminate the surviving parent’s financial dependent on the business.
For these reasons, often a transition plan is designed as a targeted first step plan to shift into high gear the wealth transition process on the death of the first parent. Of course, the death of the surviving parent triggers the moment of truth for the two big consequences that have been the focus of the planning from the outset.
One, the ultimate transition of the business and the parent’s other assets, and two, the estate tax bill. As regard to the first, the transition, the goal is to ensure that the parent’s objectives for the family are satisfied without compromising the strength and survival prospects of the business. The objective of the second, that is taxes, is to keep the bill as small as possible while ensuring a mechanism for payment that won’t unduly strain the business. If substantial death taxes are expected on the death of the surviving parent, it may be very important to structure the timing of the various asset transitions to ensure that at least 35% of the surviving parent’s adjusted taxable estate consists of the company’s stock.
Two valuable benefits may be triggered if this threshold is met. First, a corporate redemption of the stock held by the estate likely will be tax-free to the extent the redemption proceeds do not exceed the estate’s liability for death taxes, both federal and state, and funeral and administrative expenses. If this 35% threshold is not met, all redemption proceeds likely will constitute taxable dividends to the estate of the surviving spouse. When corporate funds are needed to fund an estate tax burden, as is so often the case, this 35% threshold and the benefit it triggers becomes very important.
Second, if this 35% threshold is met, the estate may elect to fund the federal estate tax burden attributable to the stock over a period of up to 14 years at very favorable interest rates. In those situations where these two tax relief provisions are important, the timing of the parent’s stock transition program prior to death and the value of the parent’s non-stock assets must be carefully monitored to ensure that the 35% threshold will be met at the death of the surviving parent.