30 Ways to Structure a Transfer of a Business to a Successor Reviewed by Momizat on . Ways 16 through 30 (Part II of II) This is the second part of this two-part article where the author presents fifteen other structures owners may want to consid Ways 16 through 30 (Part II of II) This is the second part of this two-part article where the author presents fifteen other structures owners may want to consid Rating: 0
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30 Ways to Structure a Transfer of a Business to a Successor

Ways 16 through 30 (Part II of II)

This is the second part of this two-part article where the author presents fifteen other structures owners may want to consider as part of a succession plan. Click here to read part one.

businesstransferThe first of this two-part article presented fifteen of the thirty ways owners can pursue to establish a succession plan.  In this second part, Edward Mendlowitz presents the remaining fifteen structures.

[su_pullquote align=”right”]Resources:

Transition Planning: The Good, The Bad, and The Ugly

Exit Strategy=Business Strategy

Exit Planning—What Practitioners Need to Know

Certified Exit Planning Advisor (CEPA) Credentialing Program


16.  Stock redemption

This is a method where the designated successors acquire a small number of shares followed by a complete redemption by the majority shareholder.  The redemption price paid must be fair market value, and would be taxed as a capital gain.

If there is not enough cash for the redemption, or if a tax deferral is wanted, the sale can be set up as an installment sale thereby stretching out the time to pay the tax on the gain.  Keep in mind the age and estate tax picture of the seller.  If he or she is older, the loss of the step up in basis could become a factor and should be considered before the transaction is done.

This method would be best used where there is a cash rich company.  If there is not sufficient cash, and if the funds have to be borrowed, then the loan repayment would be with after tax dollars; possibly causing a tax and cash flow burden on the successors.

17.  Installment sale

Installment sales of business stock or other business interests will result in capital gain tax to be paid by the seller.

Now that capital gains rates have increased, the taxes on the transaction become more of a consideration.  Further, with lifetime sales, the capital gains tax payments would remove that cash from the eventual estate while the successor will get a step up in basis.

Businesses expected to increase in value rapidly should consider the advisability of either freezing the current value or a sale at current values.  Further, while current interest rates are quite low, and again depending on the circumstances and who the successor is—whether a family member of a long time employee—the interest rates on the unpaid balances can either be set at the lowest allowable AFR presenting an opportunity to reduce the estate tax value of the installment note if it is still held upon death; or at a high rate which will provide a reasonable cash flow to the seller while permitting the buyer to deduct the interest payments.  To keep rates low, a suggestion could be a long term note using the three year AFR and having it reset every three years at the then current rate.  However, the current long-term rates are pretty low by historic standards so perhaps locking in that rate would be better for the buyer while providing a higher current interest payment than the short-term rates would.

If the sale takes place after death, there will be a step up in basis, and the capital gain tax will be avoided by the seller’s estate.  The terms of the sale and the installment notes can be set in the will or living trust.

There are special rules for installment sales between related parties.  If the related party sells the stock within two years while there are still unpaid notes, there will be an acceleration of the tax on the installment gain to the extent the related party receives proceeds on the sale.

Unpaid installment notes are taxable as income in respect of decedent (IRD) by the decedent’s estate to the extent the obligation exceeded the decedent’s basis, and are also included in the gross estate at the present value of the remaining payments.  This means that the capital gains will be taxed on the sale; there is no step up for this capital gain asset.  Note that there will be an income tax deduction for the federal (but not state) estate tax attributable to the IRD taxed to the estate.

18.  Self-canceling installment note

The unpaid portion of a self-canceling installment note (SCIN) is not includible in the gross estate, but the gain attributable to the canceled installment notes is accelerated and is includible as income by the decedent’s estate.  This means that the untaxed capital gain will be taxed at death, but the unpaid notes will not be subject to estate tax.

For a SCIN to work, a higher interest payment amount is usual to offset the value of the self-cancellation feature, and the term must not exceed the life expectancy of the seller.

19.  Installment sale to a “defective” grantor trust

In this method, an intentionally defective irrevocable trust, also known as a grantor trust, is established.  Shares of the company are sold to the trust.  As long as the shares are non controlling interests, the valuation of the shares is adjusted to reflect their lessened value.

The stock is sold for installment notes payable at a minimum of the AFR interest rate.  Payments must be made at least annually.  It is advisable to have some additional assets (equivalent to a minimum of ten percent of the installment note principal) in the trust so the IRS cannot contend the note’s payment is tied solely to the success of the business.

For estate tax purposes, the trust is considered irrevocable and its assets are excluded from the grantor’s estate.

For income tax purposes, the person who sets up the trust—the grantor—is considered the owner of the company stock held in trust.  Therefore, the transaction is not recognized for income tax purposes.  There will be no capital gains tax and no income tax on the principal or interest paid on the installment note.  The trust pays no tax.  The trust’s income is taxed with the grantor’s other income on his/her individual tax return.  In effect, the sale is considered to be a sale by a person to him/herself and is not recognized for income tax purposes.

Using a trust takes the stock out of the grantor’s taxable estate and simultaneously provides cash flow, asset ownership, and appreciation benefits to the beneficiaries of the trust.  The grantor pays tax on the trust income, creating a “tax-free gift” from the grantor to the trust beneficiaries for the taxes paid.  This method also freezes the value of the business to the value of the notes.  If the grantor dies while there are still unpaid notes, the unpaid balance of the notes will be includible in the grantor’s estate.  A downside to this transaction is that the basis to the beneficiaries will be the grantor’s basis, not a stepped up basis, and that the unpaid installment notes deferred profit would be subject to capital gains taxes.

While it is advantageous in many instances to have the trust be a grantor trust, there is a simple triggering mechanism that can end that status and have the trust revert to a typical irrevocable non-grantor trust subject to trust taxation rules.

20.  Charity remainder trust

Instead of redemption (see #16 above), the majority stockholder might want to consider gifting the stock to a charity remainder trust (CRT) that will redeem the stock.  Here the capital gain will be avoided, and the annual cash flow to the original owner from the trust will be much higher since there is no diminution in the assets able to be invested because of the payment of the capital gains taxes.

Also, there will be a limited charitable deduction equivalent to the present value of the remainder interest reverting to the charity.  This charitable deduction is age related—the younger you are the lower the deduction.  The deduction might also be limited based on the donor’s adjusted gross income, but can be carried forward for five additional years.  The annual deduction usually cannot exceed twenty percent of adjusted gross income.

There are a number of variations of CRTs.  These include charity remainder annuity trusts (CRAT) and charity remainder uni trusts (CRUT).  CRATs provide a fixed annual distribution determined at the inception of the CRAT.  CRUTs provide a changing distribution based upon a fixed percentage of the current values of the investments within the trust.  Taxes are payable on the distributions from the CRT based upon the nature of the trust’s income.

If the business will be retained indefinitely in the trust, a CRAT might be better that a CRUT since there is no requirement to revalue the CRAT assets each year as there is with a CRUT.

The grantor can be the trustee.

Note that capital gain will not be avoided if the trust has a legal obligation to redeem the stock.  Therefore, the transfer to the CRT must be made before any arrangements are made to redeem shares.

When the beneficiaries eventually die, the remaining trust principal would be transferred to one or more named charities.  Note that this charity can be a private family foundation or a donor advised fund thereby extending family control over the distribution of assets to charities.

21.  Grantor retained interest trust

Stock can be transferred via a Grantor Retained Annuity Trust (GRAT) or a Grantor Retained Unitrust (GRUT).  These are used where the transferor and/or spouse want to retain an income interest in the assets transferred.

With a GRAT the grantor receives annually a specific dollar amount that is determined when the trust is established.  With a GRUT the annual income is refigured annually based on a fixed percentage of the current value of the trust’s assets.  The payments from the GRUT will vary from year to year and can increase (or decrease).

Gift tax is payable on the present value of the asset interest that will remain in the trust at the end of the term.  The longer the term and/or the higher the income reserved for the donee, the lower the gift value.

A period less than the donor’s life expectancy should be used, since, if the grantor dies before the trust term ends, the trust corpus will be included in his/her estate.  It could also be subject to estate tax if the beneficiary of the trust assets is other than the grantor’s spouse.  However, the value used might be less than the actual value of the stock at that time since a life interest was stripped away from the stock that was given to the trust.

Because of the inclusion in the estate if the grantor dies before the expiration of the GRAT or GRUT term, it might be advisable to form multiple GRATs/GRUTs with varying terms, so if the donor dies early, not all of the GRAT/GRUT assets would be includible in his/her estate.  For example, stock could be put into three GRATs with lengths four years apart, instead of one GRAT with a twelve-year life.  There would be a higher gift tax value, but a better guarantee that some of the GRAT stock would be kept out of the estate should there be a premature or untimely death.  A suggestion if the client wants to minimize the gift tax valuation is to use the longer term and set up a trust to purchase term life insurance to cover the added estate taxes resulting from the early death.

With a closely held business, a GRAT might be better that a GRUT since there is no requirement to revalue the GRAT assets each year as there is with a GRUT.

There are no limitations, with some minor exceptions, on the duration of the GRATs or GRUTs, or on the amount of income that can be reserved, but the grantor must outlive the term.

Further, the grantor may be the trustee.  Accordingly, a grantor/parent can transfer stock with a child as beneficiary and remove it from their estate, and still control the business.  While the grantor can be the trustee, many people have someone other than the grantor appointed as the trustee with the grantor reserving the right to remove the trustee and appoint a successor at any time.

In valuing the stock transferred to the GRAT or GRUT, a minority and lack of marketability discounts possibly can be applied to the value determined for the stock.  The basis of the stock to the beneficiary is the same as the donor’s basis.  There is no step up.

S corporation stock can be owned by a GRAT or GRUT since they are considered “grantor trusts” under the grantor trust rules.

22.  Employee stock ownership plan

Employee Stock Ownership Plans or ESOPs are a way a business can be passed to the next generation of business owners without the transferor being subjected to capital gains tax on the sale.

An ESOP is an employee benefit plan designed to invest primarily in employer stock or other securities.  ESOPs belong to the same family of qualified employee benefit plans as profit sharing plans and are subject to those rules and antidiscrimination requirements.

The ESOP can purchase part of the company’s shares, with the participants sharing in the ownership of the stock held by the plan.  If the acquisition is structured properly, the desired successors could control the company with shares they own outside the plan, along with the shares attributed to them from the ESOP.

The big advantage of selling to an ESOP is that the capital gain on the proceeds can be deferred to the extent the proceeds are invested in stock or other public marketable securities, provided at least thirty percent of the seller’s stock is sold to the ESOP.

One way the ESOP transaction can be structured is for a newly created ESOP to purchase forty-nine percent of the owner’s stock, with the balance being sold or gifted to his children.  This way the family still will have absolute control.

The ESOP could borrow the money to pay for the stock.  This creates a “leveraged ESOP.”  The company’s annual tax-deductible payments to the ESOP will correspond to what the ESOP needs in cash flow to make the annual interest and loan principal payments.  Also, any dividends paid by the company on stock owned by the ESOP are fully tax deductible!  Note that by doing it this way the company is able to deduct the loan principal payments since the bank is being repaid from the ESOP, and not the company.

ESOPs are a particularly effective way to transfer C corporation stock.  S corporations can also be owned by the ESOP.

23.  Sale-Leaseback

In this method, a stock redemption is paid for with equipment or real estate of the business.

Note that if the property has a fair market value greater that the book value, taxable income to the corporation will result.  This income could also be from depreciation recapture.  Note that no capital gain taxation is permitted when depreciable property is sold to a related party—all income is ordinary.

If the business is operated as a C corporation, the redeeming shareholder will get the asset at the fair market value, and will also be taxed as a dividend.  If the entity is a pass through entity such as an S corporation, partnership, or LLC, the income will pass through to the owner and will be taxed as ordinary income.  Basis will be established to the extent the amount is taxed.

The property could be leased back to the company and the income would be partially offset by depreciation deductions.  Even though the transaction is taxed twice (the gain by the corporation and the redemption by the stockholder), no cash has to be paid for the stock.  If the redemption takes place in a year the company has an operating loss, the tax on the gain will be reduced or eliminated.  Also, this is a method of providing a future cash flow to the seller with tax-deductible corporate dollars.

24.  Preferred stock recapitalization

The owner could transfer some common stock to his children or other successors and have the balance exchanged for newly issued preferred stock with a face value equivalent to the fair market value of the remaining shares.

As long as the preferred stock is entitled to a cumulative market rate dividend, is valued at fair market value, and the value assigned to the common stock is at least ten percent of the total value of the corporation, no gift, or income tax would result with regard to the recapitalization.  Be aware that provisions of IRC Sections 2701 and 2702 must be adhered to; and the limitations of Section 306 are considered.

This is sometimes referred to as a stock freeze since the value of the preferred is unable to grow (except with regard to market rate fluctuations).  The growth of the company’s value is attributed to the common stock the children or other successors hold.

25.  S election

A C corporation can make an S election and thereafter the current year’s profits can be distributed to the shareholders.  This would enable the current owners to “freeze” the book value of the company with respect to growth attributed to earnings.

If a small number of shares were transferred to eventual successors, and an agreement was made to sell them additional shares, the shares could be paid for with the after tax cash flow distributions of the current year’s income from the S corporation.

The S election has pitfalls if the company is sold within five years, but this treatment would be no different than if the S election was never made.  The IRS requires a “fair market value built-in gain” appraisal when the S election is made so that the “built-in gain” at the time the S election is made could be measured, and fixed.  If the company is sold within five years of making the election, any gains up to the built in gain amount would be taxed as if the company were still a C corporation.  An advantage in this process is that the appraisal may not represent the actual value of the company if it were to be sold based on strategic value, current or projected earnings, or for some special processes or formulas.  Also, the growth could be exponential making the built in gain taxation less significant.

S shares can be placed in a defective grantor trust, a qualified sub S trust, or an electing small business trust, creating other scenarios.

26.  AB stock recapitalization

A corporation or other entity can recapitalize by issuing A shares representing voting interests and B shares representing nonvoting interests.  After the recapitalization, each existing shareholder would end up with the same ownership percentage of both A shares and B shares.  This can also apply to S corporations, which can have two classes of stock only when the sole difference between the two classes is that one carries voting rights.

An example is where the corporation recapitalizes leaving the original owners with ten percent of the corporation with A shares—which allow voting rights—and ninety percent of the company with B shares—which have no voting rights.  The B non-control shares are then transferred to the successors at possibly discounted values.

27.  Private annuity

A private annuity is a transfer of the ownership interest in exchange for an obligation by the buyer to make fixed periodic payments for the rest of the transferor’s life.  It can only be done if neither party is an insurance company.

This is an effective strategy in succession transfers where the seller wants a future income stream they cannot outlive and with low down payments by the successor.  The downside to the buyer is that the seller can live way beyond their life expectancy greatly increasing the payout; no part of the payments can be deducted as interest; or that the business might not have future cash flow to support the payments.

If the business issues the private annuity, there will be GAAP reporting issues that could impact the company’s net worth as well as loan covenants.

IRS Life Expectancy Annuity tables need to be used to determine the annuity payments based on the fair market value of the business, the age of the seller, and possibly their spouse.  There are various types of private annuities with the payments for life the most common.  Like an installment sale and self-cancelling installment notes, the value of the business is frozen at the current value.  Private annuity payments are usually higher than with an installment sale.  The private annuity has its benefits and detriments and should be compared to those other methods.

The total gain realized is the excess of the annuity’s present value over the transferor’s basis.  If the property is a capital asset, the gain is capital gain.  Any excess fair market value (over the present value of the annuity) is taxed as a gift.

If the annuity is secured, the entire capital gain is immediately taxed.  If the annuity is unsecured, the gain is deferred and is taxed ratably as payments are received over the life expectancy of the annuitant.  The annual payments are partially considered as capital gain and possibly depreciation recapture capital gains, ordinary income, and return of basis.

If the annuitant outlives their life expectancy at the time the annuity was issued, then the entire payments thereafter are treated as ordinary income.  There is no tax deduction available to the payor, even though part of the annuity actually represents an interest payment factor.  Therefore, all payments are made with post tax dollars.

A private annuity cannot be done if the annuitant has an abbreviated life expectancy based on the IRS tables or a serious life threatening health condition.

Annuity payments can be delayed to a later date and the payments would be increased accordingly.

At the point the annuity is issued, the business interest will be out of the transferor’s estate.  If the transferor lives much longer than the initial life expectancy, this transaction could end up costing substantially more than if it were never done.  An appropriate place to use a private annuity is where children, jointly, will be supporting a parent who is not involved in the business; say a mother who inherited the stock from her husband, the stock is paying little or no dividends, and where the support will most likely have to continue for the rest of her life.

Some people use a private annuity trust for this transaction.  This provides an element of asset protection for the person receiving the payments.

28.  Stock Split-Up

Section 355 provides that where there are distinct businesses within a corporation, each line of business can be placed in a separate corporation and the stock distributed tax free to the shareholders.

There is a requirement that at least eighty percent of the transferred corporation be transferred to the shareholders of the transferor corporation and that the assets transferred must be that of an active business owned and operated by the transferor corporation for at least five years before the split up.

This could be done where a child or sibling does not want to be part of the business with the others that are presently involved, or where part of the business is being sold to outsiders and he does not want to be included in the package; and can clearly define the part of the business he is running and can carve it out of the company.

Examples are divisions in two states; a machine tool and manufacturing division; an electroplating and parts assembly operation; or an air conditioning contractor and a separate service division.

29.  Family Limited Partnership

A family limited partnership (FLP) can be a vehicle to transfer ownership in a business into so that there will be management control or centralization of family assets and where gift or eventual estate taxes can be reduced at the same time.

An FLP would be created with the corporate stock, or business interests, transferred into the partnership in exchange for the partnership interests.  The business owner could retain some general partnership interests with someone else receiving the remaining general partnership units and children would be given, over time, limited partnership units.  It is not recommended that the transferor keep control.  If the transferor does not want to give up control, then this method might not be the way to go.  After the transfers, the general partner(s) will have complete control over the partnership.  An FLP also removes any future appreciation of the shares transferred from the estate of the original owner.

The transfer of the limited partnership units can be as a gift to the intended successors; as a conventional sale; as a sale to a grantor trust; or using any of the other methods covered here.  In each situation, the limited partnership interests possibly can be valued at a discount from the value of the assets the FLP owns.  The discount recognizes that the limited partnership shares have no control or say in the management of the partnership, are not easily marketable, and possibly represent a minority interest in the business.

FLPs also can be used to keep the shares out of the grasp of creditors or estranged spouses of the limited partners, and can control the disposition of the units if a limited partner dies.

30.  Leveraged buy-out

This could be accomplished where arrangements are made by the original owner for a bank to lend money to the company on a leveraged basis so that he could be bought out with cash.  The loan will be repaid by the company that would now be under the new ownership.

Any additional notes received by the selling stockholder would then be subordinated to the leveraged buyout debt.  Alternatively, additional payments can be made to the seller using an earn-out provision, which provides for an additional purchase price based on attainment of predefined targets such as exceeding a base profit of cash flow or retaining a major customer or source of supply.

This method will enable the owner to strip out all existing cash and borrowing power of the company, and for him to still get more from a sale of the business if it continues to be successful through payments of the subordinated note.

Also, instead of additional notes payable to him, there could be a long-term consulting agreement so the company could at least pay this portion with tax-deductible money.  If the seller separately owns the real estate used by the business, a long-term lease can also be structured as part of the buy-out.  A variation of this, and perhaps a better tax transaction, is the leveraged ESOP that has previously been described.


Structuring a business transfer involves maximum skill of the advisor.  It has to take into account the source of the funds, income, estate and gift taxes, possible financial statement reporting consequences, valuation abilities and insights, the reasons and personalities, and the ultimate wishes of the client and the people who will be carrying on the business.

Many of the above methods are usually used in combination.  Additionally, many can be done pre or post death—it just needs the proper contractual agreements.  The accountant, as the advisor usually closest to the situation, should be a catalyst to have the client start the process and formulate a plan that could accomplish the multiple objectives.

A word of caution is that many of these methods are highly technical and provisions of the Internal Revenue Code and Regulations must be strictly adhered to.  Additionally, in some cases it might be desirable to secure an IRS ruling.

LEdward Mendlowitz, CPA, ABV, PFS is Partner with Edward with WithumSmith + Brown, PC’s New Brunswick, NJ, office. He is an accomplished professional and is one of Accounting Today’s 100 Most Influential People. Mr. Mendlowitz is also author of 24 professional books including The Adviser’s Guide to Family Business Succession Planning (AICPA 2006), over 1000 articles and blogs and developer and presenter of more than 250 continuing education courses, speeches and webinars. He has testified twice before House Ways and Means Committee on tax reduction, equity and reform; admitted to practice and argued cases before U.S. Tax Court; and was an adjunct MBA instructor for 11 years.
Mr. Mendlowitz can be reached at (732) 964-9329 or by e-mail to emendlowitz@withum.com.

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