A taxing situation: Tax strategy and family business succession planning

The time for family business owners to act is now.

November 8, 2012
by Jim Fitts and John Weeks

Succession planning is one of the most challenging and complicated concerns family business owners face. Succession planning can be difficult for most companies, but it’s even more complex for family businesses because typical business concerns need to be balanced with the family’s needs.

Tax planning is an essential element of any family business succession plan because it affects the value of the company, the owner’s personal wealth, and the amount of wealth—either through financial assets or the business itself—that can be passed along to the next generation.

Changing landscape

Tax issues are even more important than usual because of changes to the tax code that may kick in on Jan. 1, 2013. Without additional legislation before Dec. 31, the estate applicable exclusion amount will drop from the current $5.12 million to $1 million as of Jan. 1, 2013, and the highest estate tax rate reverts to 55% from its current 35%. The current lifetime (noncharitable) individual gifting allowance of $5.12 million, unified with the estate tax exclusion, will also change without new legislation.

These changes would have significant repercussions for family business owners, and they illustrate the importance of early succession planning, rather than waiting until the owner’s retirement is imminent. Even if retirement is years—or decades—away, family business owners should consider gifting during 2012 to freeze their estate at its existing value, transferring future appreciation to the next generation.

Similarly, ordinary income tax rates are also scheduled to increase in 2013 when the extension of the Bush tax rates is set to expire. The same goes for capital gains tax rates, which are also set to rise. Likewise, qualifying dividends will be taxed as ordinary income on Jan. 1 barring legislative action. It is not clear if the two political parties will reach a compromise to extend the cuts. To the extent possible, family business owners may consider accelerating income and capital gains to 2012 to minimize their tax exposure.

The changes that may occur on Jan. 1 would have significant implications for family business owners, and the time to mitigate these changes is quickly running out. Owners should consider acting to minimize their tax burden in retirement and on their heirs when they finally pass the business along.

Tax planning and philanthropy

Another tax-related consideration of which business owners and their advisers must be aware is charitable giving. Successful families often turn to philanthropy to further the family legacy, particularly when liquid capital is going to be created through the sale of a company.

Strategic philanthropy requires careful planning. There are a number of different types of philanthropy, each of which brings unique tax advantages and challenges.

The first common approach to philanthropy is creating an annual gifting budget. Through an annual gifting approach, owners and their families are able to make charitable contributions from general family assets in a manner that permits them to maximize tax benefits. For business owners who face steep tax increases at the beginning of the year, this approach can be particularly attractive.

Another potential approach to charitable giving is to establish a donor-advised fund with an initial irrevocable gift. Donor-advised funds allow owners and their families to maintain a continuous stream of charitable giving that is directed by an experienced administrator though gifting decisions remain with the donor. Donor-advised funds are funds held within and set up by public charities. Because they are public charities, donations are subject to the higher limitations that apply to  Sec. 501(c)(3) organizations, i.e., a 50% of AGI limit for cash donations and 30% for property.

Additional capital can be added to the fund over time, as resources allow. The primary advantage of a donor-advised fund is that it handles the day-to-day administration while permitting donors to  recommend which charity will ultimately receive the funds. It also allows donors to maintain privacy because the donations do not have to be disclosed. In an increasing number of cases, donor-advised funds meet the charitable needs of even the wealthiest families.

Another option is to create a family foundation. This is a good way to create a family legacy while supporting good causes. In addition to the tax benefits that come with this type of charitable giving, creating a family foundation may provide more flexibility in what causes can be supported because the foundation controls those decisions. However, private foundations cost more to operate than donor-advised funds, have less generous treatment of tax deductions for donations (30% for cash/20% for property), and must make gifts of 5% of their assets each year. They also may be subject to greater IRS scrutiny.

Whichever option is selected, each may be pursued during life or upon death. Charitable giving is also an effective tool for managing estate taxes, putting much of what would otherwise go to the IRS in taxes under the control of the donor.


Tax planning and charitable planning are important issues for family business owners because they are useful tools in establishing the business owner’s legacy. Taking care of loved ones is the ultimate endgame for a successful entrepreneur. Transferring wealth to the next generation is a way to protect those who are most important to them.

Likewise, charitable giving is another way for owners to establish a legacy for themselves and their families. After all, do people remember Andrew Carnegie today more for his industrial successes or for his charitable endeavors? Likewise Alfred Nobel: Do people think of him more as the creator of the Nobel prize or the inventor of dynamite? Obviously, not every philanthropist can create a legacy on par with Andrew Carnegie or Alfred Nobel, but there are millions of charitable business owners who have made very real, important differences to society.

These dual goals of transferring a lifetime’s earned wealth to future generations and creating a philanthropic legacy are honorable—and an excellent reflection of a successful career owning and managing a family business. While they are typically always on the mind of successful family business owners, the impending changes to the gift and estate tax and the income tax rates give them more immediate urgency. All family business owners, no matter how old or close to retirement, should be working with their tax advisers to revise existing succession plans to assure that these changes do not negatively affect their personal retirement plans, their ability to transfer corporate and personal assets to future generations of the family, and their plans for future charitable endeavors.

Jim Fitts, CFP, is director of wealth counseling, and John Weeks is director of family wealth management at Concord, N.H.-based Harvest Capital. The firm’s recently published white paper, Family Business Transition Planning, is available at the firm’s website.