[This article was originally published in the Oakland Business Review in the May / June 2019 issue.]

Passing interests in a family business to the next generation in a tax-sensitive way is an issue that confronts many family business owners.  Several techniques allow senior generation owners to minimize the transfer-tax consequences of passing ownership to the next generation.

The federal transfer tax system consists of three separate taxes: the gift tax, the estate tax, and the generation-skipping transfer (“GST”) tax.  Currently, the amount that is excluded from estate tax is $11.4 million per person.  The gift tax and GST tax exclusions are also $11.4 million.  The exclusions are adjusted annually for inflation.  The tax rate on transfers of assets that exceed the exclusions is 40%.  Under current law, the $11.4 million exclusion will be reduced to about $6 million on January 1, 2026.

Business owners wanting to keep a business in the family often must minimize the impact of these taxes.  An outright gift of an interest in the business is the simplest approach.  However, business owners may want to consider additional techniques to transfer business interests to the next generation in a tax-sensitive way.

A grantor retained annuity trust (“GRAT”) allows transfers of business interests that will appreciate while retaining a right to payments for a stated term.  The payments can consist of cash earned by the business interests or even the interests themselves.  At the end of the term, any remaining business interests (the appreciation in the business during the term) are distributed to the trust’s beneficiaries, who can be the next generation of owners.

Another technique involves the sale of interests to a trust established by the business owner (“grantor”) in exchange for a promissory note.  The trust’s beneficiaries can be members of the grantor’s family.  The trust is treated as being owned by the grantor for income tax purposes but is excluded from the grantor’s estate for estate and gift tax purposes.  Typically, the grantor contributes cash to the trust, which uses some of the grantor’s gift tax exclusion.  The trust then purchases business interests from the grantor for fair market value (determined by appraisal) using cash funded with the grantor’s contribution to the trust and a promissory note.  If the business interests appreciate at a rate faster than the interest rate on the note, the “excess” appreciation is removed from the grantor’s estate with no gift tax consequences.

Family businesses that include ownership of income-producing real estate can be transferred to the next generation by direct gift, GRAT, or sale to a grantor trust.  Upon transfer to the next generation, the family owners should consider entering into a tenancy-in-common agreement to manage the property and its finances and restrict transfers to non-family members.

These various techniques often involve the transfer of a partial interest in the business.  For valuation purposes, this can result in discounting the value of the transferred interest based on lack of marketability and control of the interests.  Discounts reduce the amount of gift tax exclusion used on the transfer.  They also reduce the overall purchase price of the interest.

Family business owners may miss an important opportunity if they do not utilize one of these techniques while the transfer-tax exclusions are over $11 million.  It is worth considering one of these methods to transfer business interests before the exclusions go down in 2026.