We the Family: The Benefits of Creating a Family Constitution

For our first two editions of Owner to Owner,  we thought it appropriate to explore the foundation upon which most successful estate planning for a business owner is built.  Giving away an interest in a privately-held business to loved ones (this quarter’s topic) or charity (next quarter’s topic) during life can dramatically reduce the substantial taxes that may be due when the business owner passes away and the ownership of the business or the wealth generated from the sale of the business is distributed to the business owner’s intended beneficiaries. While it may seem counterintuitive to contemplate giving away part of the ownership in a business at the precise moment when that business is realizing incredible growth and success, the tax savings produced by a properly timed gift can be compelling.   In order to take advantage of these gift and estate tax savings, the business owner must part with a portion of his business interest, though it is unnecessary to surrender control of the business in the process.  There are many ways to structure a gift such that control of the business is not prematurely surrendered to those who may not be ready or willing to take part in running it.    

Motivation for Strategic Gifting: a 40% (Or More) Transfer Tax 

Successful business owners are likely not strangers to the inevitable experience of paying taxes.  In addition to the income taxes the business owner pays on annual business profits, the business owner’s estate may be liable for a hefty estate tax on the value of the business upon his death.  While the estate tax rules allow anyone to leave an unlimited amount of wealth to his or her spouse or charity without incurring estate tax, leaving property to other beneficiaries (including to children and grandchildren) can be expensive.  

An estate tax will be imposed when property passes upon death to anyone other than a spouse or charity in excess of the “applicable exclusion” amount, which is currently $5.43 million and is increased each year for inflation.  The federal estate tax on assets exceeding the applicable exclusion amount is 40%.  Many states also impose an estate tax, which can bring the total estate tax rate above 50%.  To add to the sting, if property is distributed to a grandchild, more remote descendant or any unrelated person who is more than 37 ½ years younger than the deceased person or the person making the gift, there may also be a generation-skipping transfer (“GST”) tax of an additional 40% of the value of the property distributed. Fortunately, there is also an exclusion from the GST tax, which is an identical $5.43 million under current law. 

Estate and GST taxes can be so crippling that it is often difficult for a business owner’s estate to come up with sufficient cash to pay these taxes without either selling the business or saddling the business or the owner’s beneficiaries with debt.  For example, if a Vermont business owner dies in 2015 leaving a business and other property worth $50 million to his daughter, his estate will incur around $22.3 million in Vermont and federal estate taxes (assuming he made no prior gifts).  If that same business owner instead leaves his $50 million to his grandchildren, his estate will incur around $30 million in Vermont estate and federal estate and GST taxes.  If the Vermont business owner’s primary source of wealth was his interest in the business, it might be difficult for his estate to pay the estate taxes due without threatening the future success of the business.


Figure 1:  Effect of Estate and GST Taxes after Two Generations

With estate taxes so high, it might seem advisable for a business owner to give away his business shortly before his death, thereby avoiding the estate tax.  Although giving away property during life is a winning strategy for reasons we’ll discuss shortly, it is crucial to note that federal law currently taxes all wealth transfers equally, whether in the form of lifetime gifts or transfers at death.  The system is “unified” in the sense that transfers during life and transfers at death are aggregated and subjected to taxation on a cumulative basis.  In other words, the $5.43 million (for 2015) applicable exclusion amount allows each person to either give away during life, or transfer at death, or a combination of the two, property worth up to $5.43 million without paying gift or estate tax.  Aggregate gifts and transfers at death beyond $5.43 million in value are subject to federal taxation at the same rate of 40%.  

Avoiding Estate/Gift Tax Due to the Upswing in the Business’ Value

If giving away an interest in the business during life triggers the same 40% federal transfer tax that would be imposed on the business interest in the business owner’s estate at death, why bother considering lifetime gifts?  If the value of the business is likely to increase substantially in the future, then gifts of business interests during life are well advised.  If the business owner properly gifts an interest in the business while the value of the business is still low, or relatively low compared to what it could be in the future, all of the growth in the value of the business interest following the date of the gift will pass to family or other intended beneficiaries free of gift or estate tax.    

To illustrate the dramatic tax savings that could be realized by giving away an interest in the business before the business has greatly increased in value, consider two hypothetical entrepreneurs, Sam and John.  Sam and John each plan to contribute $2 million to their newly formed business, Startup Co.  Sam and John will each receive 50% of the shares of Startup.  Sam decides to immediately gift 20% of his shares (a 10% interest in the company) to a trust for his children.  Since Startup is new and its earnings are unknown, the value of the gift of Startup shares to the trust is likely $400,000 or less (10% of the $4 million total initial capital). Sam does not need to pay any gift tax for this gift because it is within his lifetime applicable exclusion  from the gift/estate tax.  John, on the other hand, does not engage in any lifetime gifting and instead keeps his entire 50% interest in Startup.  Ten years later, Startup is sold for $40 million, and the trust for Sam’s children receives 10% of the proceeds, or $4 million, free of gift or other transfer taxes.  The $4 million is not included in Sam’s estate upon his death, and Sam has successfully removed 10% of the proceeds of the sale of Startup from his estate while using only $400,000 of his applicable exclusion from the gift/estate tax.  Depending on the overall estate value, John’s estate would owe approximately $1.4 million more in federal estate tax on his death than Sam’s estate since John did not make any gifts and instead retained all of his interest in the business.

An Interest in a Privately-Held Business Can Be Discounted for Gift Tax Purposes

We note above that the value of the 10% interest that Sam gives to the trust for his children is likely worth $400,000 or less.  Naturally, Sam would prefer for the business to be worth less for gift tax purposes, so he does not need to use as much of his applicable exclusion from the gift/estate tax.  How is it that Sam could potentially report less than $400,000 on his gift tax return?  A valuation discount often applies to gifts of privately-held business interests.  The reason for the discount is that a non-controlling interest in a privately-held business cannot easily be sold for full value.  There are few available markets to sell an interest in a privately-held company compared to publicly-traded securities, therefore such an interest is highly illiquid.  This lack of marketability reduces the value of the business interest for gift tax purposes since the recipient of the gift does not have a marketplace in which to quickly sell the interest for full value.  The recipient of the gift may also receive non-voting shares, or simply not enough shares to control voting decisions.  Lack of voting control further reduces the value of the business interest for gift tax purposes since the recipient of the gift cannot vote to change any of the operations of the business and cannot force the business to liquidate and distribute its funds to the owners of the business.

Let’s illustrate the discount for lack of marketability and lack of control with the Startup example, and how that discount helps Sam to save gift and estate taxes.  Assuming that Sam’s appraiser finds that the 10% interest in Startup should receive a combined 30% discount for lack of marketability and lack of control, then Sam would report a value on his gift tax return of $280,000, calculated as 10% of the $4 million initial capital ($400,000) reduced by 30%.  After the discount, Sam only needs to use $280,000 of his applicable exclusion from the gift/estate tax to gift 10% of the shares of Startup to a trust for his children.  When Startup is later sold for $40 million, the trust for Sam’s children would still receive $4 million free of gift or other transfer taxes, which also would not be subject to estate taxes upon Sam’s death. 

Impediments to Gifting

Of course, life is not always as simple as the utopian example of Sam and John.  Family, business or personal dynamics often make it difficult to successfully gift an interest in a private business to family members or other loved ones. Fortunately, there are a number of gifting strategies that enable a business owner to overcome impediments to gifting business interests while reducing overall transfer taxes.

1. Voting Control

Many business owners may be reluctant to gift an interest in their business if their intended beneficiaries have neither the maturity nor the experience necessary to successfully operate it.  To make a gift without putting the control of the company in untested hands, one could simply gift a minority, non-controlling interest in the business.  If the recipient of the gift does not have a significant or controlling interest, his ability to misalign the business is limited.  Although gifting a non-controlling interest in the business can provide some protections against inexperienced or immature beneficiaries, this strategy may prove limiting.  As a business’ value increases, the owner may desire to transfer the majority of the business to certain structures that will not be taxed in his estate.  In these situations, the business owner could gift non-voting interests in the business, and such interests could carry the same financial rights to the business as the voting shares.  Businesses that do not yet have voting and non-voting interests may, subject to certain limitations, be recapitalized to produce these separate classes of interests. 

2. Protecting the Business and the Beneficiary

Restricting a beneficiary’s ability to vote and control the operations of the business is sometimes not enough to protect the business and the beneficiary from misfortune or the unexpected.  Gifting an interest in the business to a trust provides added protection for both the business and the business owner’s beneficiaries.  When an interest in a privately-held business is gifted to a trust, the business interest is managed by the trustee of the trust for the benefit of the trust beneficiaries.  The trustee can exercise any voting rights conveyed by the gifted business interest or, if desired, a special business advisor can be appointed to vote and manage the interest in the business gifted to the trust.  The trustee would also manage, invest and distribute to the beneficiaries (pursuant to the terms of the trust) any distributions from the business or the proceeds from the sale of the business, which may help to ensure that an improvident beneficiary does not squander or misuse the funds received from the business.  

Making gifts into a trust is not only appropriate for immature or imprudent beneficiaries.  Trusts provide added protection against claims of the beneficiary’s creditors (i.e., those who are suing the beneficiary), including some claims from the beneficiary’s former spouse for alimony or property division.  If the trust is structured correctly, the trust property should not be distributed to the beneficiary’s creditor (or the beneficiary’s former spouse) even if the creditor has a legal judgment against the beneficiary. 

Making a gift to a trust may also provide better protection against the estate tax.  If the business owner allocates his GST exemption (discussed in the first part of this article) to the trust, and the business interest remains in the trust for the lifetime of his children or other beneficiaries, then upon the death of the children or beneficiaries, the business interest in the trust should not be subject to estate tax.  In fact, for as long as the business interest or the proceeds of its sale are held in the trust, no gift, estate or GST tax should be imposed.  Accordingly, the business interest gifted to the trust can be transferred from generation to generation gift, estate and GST tax free.

3. When the Business Owner Needs Available Cash

Many business owners pay themselves modest salaries and instead use distributions from the company (which often carry fewer or no payroll taxes) to fund their lifestyle needs.  A business owner may wonder how he can gift business interests if he is accustomed to retaining 100% of the distributions from the business.  Those who are happily married could gift an interest in their business to a trust for the benefit of their spouse and intended beneficiaries (e.g. children).  Cash distributions from the business could, at the discretion of the trustee, be distributed to the business owner’s spouse to pay for a portion of shared living expenses.  The business interest gifted to the trust should still not be subject to estate tax upon  death if the trust is structured correctly.

4. Restrictive Shareholders Agreements

For businesses with multiple owners, or those partially owned by a private equity investor, a shareholders or partnership agreement, which restricts the ability to transfer an interest in the business, might be in effect.  Frequently, certain “permitted transfers” are carved out from the restriction.  For example, transfers to children or trusts, to an entity controlled by the transferring shareholder or to an existing shareholder are generally permitted. Even if such transfers are not permitted, many business owners desirous of making gifts to family members have had success negotiating an amendment to these restrictions to allow gifts to family members if the gift does not convey voting rights or control of the business.  If it becomes impossible or impractical to amend the shareholders agreement to relax the restriction on transfer, and if a sale of the business appears to be on the horizon, one might consider gifting a derivative tied to the performance of the business to his intended beneficiaries.  This strategy is not for the faint of heart, and should be pursued only with the assistance of a qualified attorney and in certain circumstances.   


If the value of your business is about to multiply, congratulations.  But don’t bask in your success for too long.  Engage your team of advisors including your Brown Brothers Harriman Wealth Planner to assist you with a program of giving to transfer an interest in your business to your loved ones while the tax savings opportunities are still abundant. 

This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries ("BBH") to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area ("EEA"), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2019. All rights reserved. December 2019. PB_03077_2019_09_06