How to Transfer Business to the Next Generation

The reality and finality of death is uncomfortable to think about. However, people need to plan for death, unless they want to leave their families a mess instead of a blessing. In a family-owned business, this is especially vital, according to a recent article, “All in the Family—Transition Strategies for Family Businesses” from Bloomberg Law.

The family business is often the family’s largest financial asset. The business owner typically doesn’t have much liquidity outside of the business itself. Federal estate taxes upon death need special consideration. Every person has an estate, gift, and generation-skipping transfer tax exemption of $12.06 million, although these historically high levels may revert to prior levels in 2026. The amount exceeding the exemption may be taxed at 40%, making planning critical.

Assuming an estate tax liability is created upon the death of the business owner, how will the family pay the tax? If the spouse survives the business owner, they can use the unlimited marital deduction to defer federal estate tax liabilities, until the survivor dies. If no advance planning has been done prior to the death of the first spouse to die, it would be wise to address it while the surviving spouse is still living.

Certain provisions in the tax code may mitigate or prevent the need to sell the business to raise funds to pay the estate tax. One law allows the executor to pay part or all of the estate tax due over 15 years (Section 6166), provided certain conditions are met. This may be appropriate. However, it is a weighty burden for an extended period of time. Planning in advance would be better.

Business owners with a charitable inclination could use charitable trusts or entities as part of a tax-efficient business transition plan. This includes the Charitable Remainder Trust, or CRT. If the business owner transfers equity interest in the business to a CRT before a liquidity event, no capital gains would be generated on the sale of the business, since the CRT is generally exempt from federal income tax. Income from the sale would be deferred and recognized, since the CRT made distributions to the business owner according to the terms of the trust.

At the end of the term, the CRT’s remaining assets would pass to the selected charitable remainderman, which might be a family-established and managed private foundation.

Family businesses usually appreciate over time, so owners need to plan to shift equity out of the taxable estate. One option is to use a combination of gifting and selling business interests to an intentionally defective grantor trust. Any appreciation after the date of transfer may be excluded from the taxable estate upon death for purposes of determining federal estate tax liabilities.

For some business owners, establishing their business as a family limited partnership or limited liability company makes the most sense. Over time, they may sell or gift part of the interest to the next generation, subject to the discounts available for a transfer. An appraiser will need to be hired to issue a valuation report on the transferred interests in order to claim any possible discounts after recapitalizing the ownership interest.

The ultimate disposition of the family business is one of the biggest decisions a business owner must make, and there’s only one chance to get it right. Consult with an experienced estate planning attorney and don’t procrastinate. Succession planning takes time, so the sooner the process begins, the better.

Reference: Bloomberg Law (Nov. 9, 2022) “All in the Family—Transition Strategies for Family Businesses”

Can You Inherit a House with a Mortgage?

Inheriting a home with a mortgage adds another layer of complexity to settling the estate, as explained in a recent article from Investopedia titled “Inheriting a House With a Mortgage.” The lender needs to be notified right away of the owner’s passing and the estate must continue to make regular payments on the existing mortgage. Depending on how the estate was set up, it may be a struggle to make monthly payments, especially if the estate must first go through probate.

Probate is the process where the court reviews the will to ensure that it is valid and establish the executor as the person empowered to manage the estate. The executor will need to provide the mortgage holder with a copy of the death certificate and a document affirming their role as executor to be able to speak with the lending company on behalf of the estate.

If multiple people have inherited a portion of the house, some tough decisions will need to be made. The simplest solution is often to sell the home, pay off the mortgage and split the proceeds evenly.

If some of the heirs wish to keep the home as a residence or a rental property, those who wish to keep the home need to buy out the interest of those who don’t want the house. When the house has a mortgage, the math can get complicated. An estate planning attorney will be able to map out a way forward to keep the sale of the shares from getting tangled up in the emotions of grieving family members.

If one heir has invested time and resources into the property and others have not, it gets even more complex. Family members may take the position that the person who invested so much in the property was also living there rent free, and things can get ugly. The involvement of an estate planning attorney can keep the transfer focused as a business transaction.

What if the house has a reverse mortgage? In this case, the reverse mortgage company needs to be notified. You’ll need to find out the existing balance due on the reverse mortgage. If the estate does not have the funds to pay the balance, there is the option of refinancing the property to pay off the balance due, if the wish is to keep the house. If there’s not enough equity or the heirs can’t refinance, they typically sell the house to pay off the reverse mortgage.

Can heirs take over the existing loan? Your estate planning attorney will be able to advise the family of their rights, which are different than rights of homeowners. Lenders in some circumstances may allow heirs to be added to the existing mortgage without going through a full loan application and verifying credit history, income, etc. However, if you chose to refinance or take out a home equity loan, you’ll have to go through the usual process.

Inheriting a house with a mortgage or a reverse mortgage can be a stressful process during an already difficult time. An experienced estate planning attorney will be able to guide the family through their options and help with the rest of the estate.

Reference: Investopedia (April 12, 2022) “Inheriting a House With a Mortgage”

How Do You Pass Down a Vacation Home?

If your family enjoys a treasured vacation home, have you planned for what will happen to the property when you die? There are many different ways to keep a vacation home in the family. However, they all require planning to avoid stressful and expensive issues, says a recent article “Your Vacation Home Needs and Estate Plan!” from Kiplinger.

First, establish how your spouse and family members feel about the property. Do they all want to keep it in the family, or have they been attending family gatherings only to please you? Be realistic about whether the next generation can afford the upkeep, since vacation homes need the same care and maintenance as primary residences. If all agree to keep the home and are committed to doing so, consider these three ways to make it happen.

Leave the vacation home to children outright, pre or post-mortem. The simplest way to transfer any property is transferring via a deed. This can lead to some complications down the road. If all children own the property equally, they all have equal weight in making decisions about the use and management of the property. Do your children usually agree on things, and do they have the ability to work well together? Do their spouses get along? Sometimes the simplest solution at the start becomes complicated as time goes on.

If the property is transferred by deed, the children could have a Use and Maintenance Agreement created to set terms and rules for the home’s use. If everyone agrees, this could work. When the children have their own individual interest in the property, they also have the right to leave their share to their own children—they could even give away or sell their shares while they are living. If one child is enmeshed in an ugly divorce, the ex-spouse could end up owning a share of the house.

Create a Limited Liability Company, or LLC. This is a more formalized agreement used to exert more control over the property. An LLC operating agreement contains detailed rules on the use and management of the vacation home. The owner of the property puts the home in the LLC, then can give away interests in the LLC all at once or over a period of years. Your estate planning attorney may advise using the annual exclusion amount, currently at $16,000 per recipient, to make this an estate tax benefit as well.

Consider who you want to have shares in the home. Depending on the laws of your state, the LLC can be used to restrict ownership by bloodline, that is, letting only descendants be eligible for ownership. This could help keep ex-spouses or non-family members from ownership shares.

An LLC is a good option, if the home may be used as a rental property. Correctly created, the LLC can limit liability. Profits can be used to offset expenses, which would likely help maintain the property over many more years than if the children solely funded it.

What about a trust? The house can be placed into an Irrevocable Trust, with the children as beneficiaries. The terms of the trust would govern the management and use of the home. An irrevocable trust would be helpful in shielding the family from any creditor liens.

A Revocable Trust can be used to give the property to family members at the time of your death. A sub-trust, a section of the trust, is used for specific terms of how the property is to be managed, rules about when to sell the property and who is permitted to make the decision to sell it.

A Qualified Personal Residence Trust allows parents to gift the vacation home at a reduced value, while allowing them to use the property for a set term of years. When the term ends, the vacation home is either left outright to the children or it is held in trust for the next generation.

Reference: Kiplinger (Feb. 1, 2022) “Your Vacation Home Needs and Estate Plan!”