A Balancing Act: Transferring Shares in a Private Business to the Next Generation

  • Private Banking
Ali Hutchinson, a BBH senior wealth planner, and Ben Persofsky, the executive director of the BBH Center for Family Business, discuss the different methods for transferring shares in a private business to the next generation and cover the implications families need to consider from both a corporate and tax angle.

There are many reasons why and ways by which family business owners transfer shares to the next generation, and each method has its own implications, from tax burdens to impact on motivation. Those who are planning for this eventual transition must balance their end goals with any trade-offs. We recently spoke with Ali Hutchinson, a BBH senior wealth planner, and Ben Persofsky, the executive director of the BBH Center for Family Business, about the different methods for transferring shares in a private business to the next generation. During our conversation, they shared their perspectives on the implications families need to consider from both transition and tax planning perspectives. The end goal, as always, is to make well-balanced decisions that best align with the objectives of the family and of the business.

Let’s start with a straightforward method for transferring shares: Can business owners just give them all outright as a gift and hand over control?

Ali Hutchinson: This is certainly an option. An example that comes to mind is a family who owned an enterprise of two businesses that made up the majority of their holdings. In the 1990s, one business was thriving, the other less so. In case the weaker business collapsed, the senior family member (parent) planning for transition didn’t want any member of the next generation to be unequally disadvantaged, so he transferred equal shares of the overall enterprise to his four children as a gift at that point in time. He continued to run the enterprise, eventually the next generation joined, and it’s now a $1 billion enterprise owned completely by his children.

The tax benefit of this strategy was enormous. As our readers likely know, you pay a tax on the value of a gift, either when you make it or when you pass away and leave it to the next generation. If this owner had died with $1 billion in his estate, he would have paid a 40% tax on $1 billion. By instead handing over the companies many years ago, the family benefited from a substantial valuation discount as well as the growth in value of the companies over the past 30 years. Let’s say the business was worth $40,000 at the time of the gift. That gift of $40,000 – $10,000 for each child – would be the taxable transfer. This is an amount that would not draw a penny of transfer tax (defined as gift tax, estate tax or generation-skipping transfer tax) despite its growth to $1 billion of value today. While helpful for tax planning, it is important to note that he also no longer owned the business following the gift, and consequently his control went with it at that point too. He was comfortable with this because no one child could make a decision alone; it took a 3-to-1 vote to make significant business decisions. Perhaps most importantly, all four children worked in the business they owned, so had knowledge to back up their vested interests in growing the overall pie for the family.

Ben Persofsky: That last point is incredibly important. Not everyone is going to be comfortable parting with control, completely, right away and so soon, so this strategy isn’t for everyone. There are often trust issues (the relationship kind), which cause the senior generation to be uncomfortable about handing over control without the next generation meeting “qualifications.” This can include the embodiment of certain ownership values, or simply a desire for the next generation to have incentives to earn their share. That’s why ownership transitions often involve an intergenerational process to identify roles to be filled, qualifications to serve and agreement on both the terms and timeline of transferring both control and economic value.1

Is there a way to do something similar, where you give nearly all economic benefit but hold onto control?

BP: Some families choose to create more than one class of shares, voting and nonvoting, where the senior generation holds onto some or all of the control until they think the next generation is ready. Control of the enterprise can be moved to the next generation in increments that are aligned with perceived readiness. These power transfers can often occur at a different pace than the transfer of economic value because the timeline is driven by factors that differ from estate planning objectives.

AH: From a tax planning standpoint, you will want to transfer these shares to get them out of your estate, but you can’t just let go on paper and continue to control the business! If you retain too much control over the shares, the IRS is going to make the argument that you didn’t give anything away because you retained so much control that you never really let go. This usually plays out on an estate tax return. When someone passes away, the IRS asks for an estate tax return showing everything you owned at death. If you owned more than the current estate tax exemption (currently at an all-time high of $12.06 million), and your estate passes to your children, you will owe estate tax on every dollar over that exemption amount. In the case of a business owner who thinks she “gave” the business to her children many years ago, she would not include it on her estate tax return because she does not own it. However, if she still controls the business through “valueless” voting shares, or if she is still receiving significant compensation/benefits from the business, the IRS may audit and claim that she actually still owned it and that 40% in tax is due on the date of death value of the business she thought she gave away. So, there’s a real balance between retaining enough control that you feel comfortable making the transfer and retaining so much control that you didn’t actually transfer anything of value at all.

What are the implications of giving some shares to next generation but holding on to control?

BP: Holding back is tricky. Sometimes it happens when the presiding generation isn’t ready to let go. Other times, as we talked about earlier, it’s a view that the conditions aren’t right yet for the next generation to take control. This can give rise to tensions between generations on the how and when, and it’s why it’s very important to work together to define the transition roadmap as collaboratively and objectively as possible, as soon as possible.2

What do the parties involved need to consider before documenting that roadmap?

BP: Before you ever talk to someone about documentation, it’s important to have a solid understanding of how the process will work in the “real world.” What does the working relationship between the senior generation and the next generation look like during the transfer? Is the next generation sufficiently incentivized and rewarded via the proposed process for doing their part? Are financial objectives tied to passage? Are they thoughtfully integrated and realistic? Has the plan been discussed with the next generation? Does the next generation see things the same way as the senior generation? If the answer is no to any of these questions, a whole lot of time, money and conflict can be saved by addressing those disconnects before moving to documentation. Simply documenting it doesn’t make the issues go away – it just sweeps them under the rug until they surface again in a potentially more harmful way!

AH: It’s very important to think about these dynamics, but unfortunately, we often don’t see that being the case. Instead, we see transfers being made purely for tax reasons. Owners are being told by their peers to explore tax-efficient transfer methods, and for most, the primary tool is transferring a minority interest in the company to the next generation to get it out of an owner’s estate while it is worth less and the tax hasn’t been imposed yet. This works, but too often we see beneficiaries owning this business that they don’t have a connection to. It should be a shared plan and process across generations. As Ben would advise, don’t be afraid to spend the time on the planning rather than jumping right to execution.

BP: Another point to add here is that many owners write their operating agreements to thoroughly address ownership transfers when the senior generation dies. Death is an inevitable event, and contingency plans need to be made accordingly. But what about the equal or more exhaustive plans for transfers while the senior generation is still alive? Senior generations typically want both the next generation and the business to thrive. It’s only if time runs out or there is an unfortunate event that the death plan should be used. In most cases, continuity and success can both be achieved if both generations are able to see through the transfer together.

AH: I agree. Business owners need to have advisors and estate planners working together so the transfer is not only part of a long-term plan, but also includes how the business will function going forward, including how the presiding owner can be helpful to the next generation.

What happens if none of this happens, and the owner dies?

AH: That is a worst-case scenario from a tax perspective. If an owner-operator of a successful business passes away with no planning, and the business is very valuable, you are paying taxes on that peak valuation and transferring to unprepared heirs – under whose watch it will likely decline in value. It’s a bad outcome for the family and for the business.

BP: From an operating standpoint, it’s crisis management. What industry experts can you lean on in an advisory capacity to help pick up the pieces and fill the skills gap that has been left open by the deceased leader? Who internally is available to be appointed to assume any operational leadership on an interim basis? The interim talent should be assessed by someone independent as soon as possible. Family members can fill in roles as appropriate.

You mentioned earlier that giving shares outright may reduce incentives for the next generation. How have you seen economic incentives come into play during these kinds of transitions?

BP: Families vary widely on this matter. Some senior generations render demonstrations of “sweat equity” as sufficient. Others want the next generation to buy out the senior generation at market value. The latter approach has real limitations as the enterprise value gets into nine or 10 figures, so families get creative in how the next generation maintains “skin in the game.” One such strategy is using stock dividends – moving shares a bit at a time as an award to the next generation for participating in leadership. Another strategy is a forgivable loan that has an embedded repayment stream linked to the passage of time or performance milestones.

AH: In that second situation, the presiding generation loans money to the next generation, allowing them to purchase shares, sometimes at a discount. The IRS takes into account that family will lend to family at rates lower than commercial transactions, so the loan is at a lower rate – the applicable federal rate (AFR), which is around 2.9% right now. This is a true loan, not a gift, so the borrower must pay interest, which they need to be able to afford. This means the borrowing generation must have some cash, which is typically built up through compensation and dividend or other income – the ideal result being sufficient liquidity to pay interest on the loan and shares in the company that grow in value over time. This effectively accelerates the presiding generation’s estate plan in a very tax-efficient way. The shares are removed from the older generation’s estate (where they would otherwise be taxed if the normal order of death occurs with parents passing before children/grandchildren) and moves those assets to where they would have gone at the first generation’s death – into the hands of the next generation. This is tax efficient because the assets are transferred without incurring gift or estate tax.

BP: The question, then, is how would the loan be repaid?

AH: The key is that the next generation needs to have liquid assets to pay back the loan, so this typically works best in a company with cash flow and dividends, which they can use to pay back the loans. It also works where the next generation has a good salary (either in the family company or outside of it) so they have cash on hand to make those interest payments. The hope would be that one day, they own the shares outright – free of the loan.

The general message with this incentive is that the presiding generation isn’t just going to give the next generation the business. It’s not a gift; it’s a transaction.

Any closing thoughts?

AH: There’s obviously a lot to consider here, and it’s important not to take a siloed approach. There is a large spectrum between estate planning and corporate governance, and when thinking about succession of operating businesses, it’s important for those two groups to come together.

BP: Taxes are an important consideration, but there are other elements that are equally meaningful. In the end, the plan should align with the family’s values and accomplish what is best for them – all things considered.

Thank you both for this engaging conversation.

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1 For more information on the considerations during ownership transition, read “Thriving After Change: The Journey to Business Transition for a Presiding Owner.”
For more information on engaging the next generation in succession planning, read “Changing of the Guard: Collaborating with the Next Generation.”

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