Tax & Business Insights

Business Succession – Part II

Volume 15 Issue 1 --  January/February 2003

In Part I of this series, we discussed one way that a business owner (“NEB”) can bring his son (“STUD”) into his stucco business (“Studco”) by making gifts of stock to him.  This time, we will look at some other ways NEB can transfer ownership and control of Studco to STUD.

Stock Sales

Instead of making stock gifts, NEB can sell some of his stock to STUD. If the younger generation is not immediate family, such as employees or nephews and nieces, then stock sales are more common than gifts. 

If NEB sells some of his stock to STUD, NEB will have a taxable event. If NEB started the business, his tax basis in his stock may be very low, so that NEB could have significant capital gains tax liability.  If NEB sells the stock at less than fair market value, the transaction might be part gift and part taxable sale.

Any sale by NEB (or other transaction requiring him to recognize gain) can have a doubly adverse tax result. In addition to possibly having a large amount of gain subject to income tax, the proceeds from the sale might also be in NEB’s estate when he dies and be subject to estate tax.

Instead of NEB selling his stock, Studco could issue additional interests which STUD would buy directly from Studco. This would result in a capital infusion to Studco and a dilution of NEB’s ownership in Studco. For example, if NEB owned 100% of Studco before additional stock was issued to STUD but 80% afterward, NEB would still have control over Studco.

If NEB makes gifts of his stock, NEB effectively finances STUD’s investment, but if STUD buys the stock, directly from NEB or from Studco, then STUD must finance his investment.

Stock Bonuses

Another, but less common, approach is to have Studco give STUD newly issued stock as bonus compensation. STUD may be surprised to find that his stock bonuses are taxable compensation to him.  They could also be subject to payroll taxes. On the other hand, the stock bonus would be deductible by Studco as compensation to an employee, STUD.  Stock bonuses provide one way for the corporation itself to finance STUD’s eventual takeover.

If STUD receives a stock bonus and no additional cash to pay the additional income tax, then he will be forced to pay the additional income tax from his regular compensation. Parents often provide additional funds to children-employees, like STUD, so they do not have to dip into their regular earnings in order to pay the income tax on the stock received. 

Of course, the additional compensation to pay the tax on the stock bonus would itself be taxable income, unless it is paid through a gift from the parents, outside of the corporation. 

Sweetheart Redemptions

NEB might also give or sell a portion of his interest to STUD, followed by Studco’s redemption (purchase) of NEB’s remaining interest. For example, suppose NEB owns all 100 shares of stock. NEB makes a gift of one share to STUD, and Studco then redeems all 99 shares of NEB’s stock. This is sometimes called a “Bootstrap Redemption.”

NEB will have capital gain on the redemption of his stock, and Studco cannot deduct the payments to NEB.  In this approach, NEB also must give up control immediately, unlike in the earlier approaches, but it does permit the corporation to be the source of funding, although Studco may be saddled with the liability to pay NEB.  It is also possible that NEB’s proceeds could be hit with both income and estate tax.

Form a New Business

If  NEB’s family wanted to diminish the growth in NEB’s estate, thereby reducing the possible estate tax burden, one novel approach would be to have STUD form a new business to compete with NEB, gradually shifting the growth in NEB’s business to STUD.  That way, NEB does not have to be concerned about gifts of stock or recognizing gain on the sale or redemption of the stock. 

In some situations this will not work.  Either STUD may not be able to “cut it” on his own with his new business or the business itself may require certain assets, such as a license or expensive equipment, that the old business owns.

If it is feasible, this allows NEB to phase out Studco over time. Of course, STUD’s new business might grow faster than expected and terminate NEB’s business sooner than planned.

Next time, we will conclude this series.

Copyright 2003
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