Should Your Clients Have Children Pay for Stock in the Family Business?

Three strategies ensure how they can learn to earn and appreciate stock gifts.

Many parents who are business owners struggle not only with whether they want their children to take on ownership of the family business, but also with how to best transfer their ownership. The two obvious options are to gift or sell stock to the next generation.

This decision can be complicated further due to the circumstances leading up to the point when the next generation is ready to take on ownership. For instance, if the parents have been required to pay for their interest in the business, they may feel it should work the same way for their children. Another factor is the children themselves, who may be more or less interested in or capable of assuming ownership. Child A may have demonstrated strong potential and been even more successful than their parents in terms of operating the family business profitably, while Children B and C are less than fully engaged in the family business and thus have a lower probability of success.

I have even seen parents with multiple children who have started or bought additional businesses that are more in line with their children’s individual interests. In other cases, parents have established separate but equal leadership roles for their children within the family business to try to keep their children engaged in the parents’ dream of making them second-generation entrepreneurs. All of these variables can have an impact on whether parents decide to sell or gift ownership to children.

Some thoughts or emotions that may enter into having a daughter or son pay for interest in the family business include:

•They will value it more if they pay for it;

•We need our children to pay for the stock in order to fund our retirement needs;

•Siblings and co-workers may more fairly view the ownership transition if those receiving ownership have to pay for it.
In terms of gifting ownership, the overriding emotion is the pleasure that gift-giving provides to both the giver and the receiver. However, considering that many successful entrepreneurs provide a higher standard of living for their children than they personally experienced, gifting stock may exacerbate parental concerns about providing excessively for their children. Typical concerns along these lines include worries about creating a generation that is too materialistic; that continually expects bigger and better things; that has lost a sense of gratitude and may even have developed a sense of entitlement and boastfulness that is offensive to others and damaging to personal and business relationships.

What’re the Best Tax and Economic Approach to Stock Transition?

The short answer is that gifting is hands down the best approach to transferring ownership to the next generation. In fact, this option became even more attractive for gifts in 2011 and 2012, as a result of changes made by the 2010 Tax Relief Act. For these particular years, individuals with substantial wealth can take advantage of the $5 million gift-tax exclusion and the generation-skipping tax exemption in passing stock along to children. With the value of many companies depressed as a result of the economic recession we have experienced, the $5 million exclusion goes a long way.

A quick example may help demonstrate why selling stock to family members is not a good economic decision. Suppose you decide to sell your business to a child for $2 million. The selling price is subject to a federal capital gains tax of 15 percent plus state-income tax (let’s assume that the state income tax at five percent and that you have little or no stock basis). Your child has to earn approximately $3.3 million (assuming they are in a 40 percent tax bracket) to have $2 million to pay for the stock. Additionally, at your death, your estate will need to pay approximately $0.934 million in estate tax. The math on this transaction is reflected below to clarify what your client, the parent, really gets from the sale:

Gross sales proceeds $2,000,000
Less: Capital gains tax (1) (400,000)
Less: Estate tax (2) (700,000)
Net Proceeds $900,000

1.Note that the top marginal federal rate on stock sales is scheduled to increase to 20 percent beginning January 1, 2013, which will increase this amount in the future

2.Note that the above example uses a marginal federal estate tax rate of 35 percent that applies for 2011 and 2012, however the rate is scheduled to revert to 55 percent in 2013
When coupled with the $1.2 million dollars of tax the child will pay to get the $2 million of gross proceeds paid to the parent(s), it’s clear that this is an all-around losing proposition. Not only are your client and their children out the dollars paid in taxes, but they will both have lost the time value of money on the tax dollars.

How to Ensure Children Appreciate Stock Gifts?

A key ingredient seems to be developing successor leaders that have a solid understanding of what it takes to be successful in business as well as having them bring some valuable experience to the business. Possible ways to have them “earn” their equity and not officially pay for it include:

•Requiring them to work outside the family business before they can officially enter (after completing their college degree in a field relevant to the family business.)

•Setting milestones of commitment and achievement through an individual development plan designed to guide their career and growth as leaders in the business over an extended period of time.

•Easing children into greater ownership over time, such as awarding them non-voting shares so they can learn how to handle the privileges and responsibilities of ownership.
Conclusion

Having a well-conceived succession plan will address both the financial and leadership development aspects of the business for all generations of the family. With solid planning, the shares the parent gifts will feel a lot more like shares that their children have “earned”.

Since not all family businesses are interested or able to pass on ownership to children, in an upcoming issue I will divulge how an employee stock ownership plan can be used as an
employee- and tax- favored vehicle to facilitate succession.