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As a Houston estate planning attorney, I often represent small business owners who want to give shares of their company’s stock or other ownership interests in the business to their children but do not want to lose control of the business while they continue to operate it. There are several ways of accomplishing this depending on the goals and objectives of the business owner, but one way is to recapitalize the business into voting and non-voting stock (or membership interests for LLCs), giving the non-voting stock to the children and retaining the voting stock. This works for most Texas entity types, including corporations that are taxed as S corporations. S corporations are only allowed one class of stock, but having voting vs. non-voting shares does not violate the rule. By disposing of the stock in this manner, the business owner gets the stock out of his estate for estate tax purposes. It also shifts any future appreciation in the value of the stock from the owner’s estate to the children’s estates. If this is done by gift, the owner will have to use some or all of his federal gift and estate tax exemption amount ($5,430,000 per individual in 2015). Additionally, the gifted shares will have the same basis in the children’s hands as it did in the owner’s hands (which is often very close to $0). This could result in significant capital gains tax if the stock is later sold.
There is also a more advanced strategy that works well in some cases. Rather than giving the stock to the children, the business owner can form an irrevocable trust the income of which is taxed to the grantor for federal income tax purposes, but not for federal gift and estate tax purposes (this type of trust is often referred to as an “intentionally defective grantor trust”, or “IDGT”). The owner can then sell the stock to the trust and take back a promissory note. Since the trust is a grantor trust, the sale transaction is disregarded and there is no capital gains tax due on the sale. Moreover, the trust gets a cost basis in the stock. Although the business owner will be taxed on the income that the trust is allocated with respect to the business interest, the idea is that the income can be used to pay the note as payments become due each year. The sale to an IDGT is an advanced strategy that should be carefully considered with your financial advisors, estate planning attorney, and CPA to ensure that it is executed properly. Among other things, you will need a qualified appraisal to prove that the trust paid fair market value for the ownership interest.
Regardless of what method is used to transfer ownership of the business interests to the children, it is generally preferable to transfer the interests to trusts for the children rather than to them outright. By transferring the interests in trust, they will be protected from the children’s creditors. You should speak with your Houston estate planning attorney to determine the best way to handle the succession of your family-owned business.
