Dallas Bar Association

Tax Issues in Succession Planning for a Family Business

by Andrew K. Jenkins

It’s an ordinary work week and your phone rings. Instead of your usual calls, it’s a well-respected small business owner referred by a financial planner you know. She is planning to bring her adult child into the family business and turn it over when the time comes. Succession planning not being your bailiwick, you attempt to find another attorney to whom you can refer the matter. To your dismay, you discover there is no one in your contacts that handles business estate planning matters within your client’s modest price range. Since you have a long-standing relationship with this referral source, you decide to handle the matter yourself.

Before entering this new legal territory, there are several tax matters that specifically apply to family business situations that you should know.

First and foremost, you must be aware that the IRS treats family businesses differentlythan other business organizations. The reasoning for the IRS’s heightened interest can best be summed up in the following fact pattern:

Wealthy Father starts up a business with Son. Father invests $3 million and Father and Son own equal shares. The business is a success, and Son buys out Father’s interest for a nominal amount.

Realistically, Father did not “invest” in Son’s business. Rather, he made a $3 million gift to Son.

While the above facts may be exaggerated, it is important to recognize that succession planning for family businesses can draw the attention of the IRS and be classified as a wealth transfer device.

Subchapter 14—Special Valuation Rules

The bulk of the rules governing the transfer of business interests between family members can be found in IRC §§ 2701-2704. The purpose of this subchapter is to ensure that when business interests are transferred between family members, the transfer is done for fair market value and on terms and conditions typically found in arms-length transactions.

These rules apply not only  when a family member buys the business interest of another, but also when a business redeems an owner’s interest. In the case of the latter, a transfer that violates Subchapter 14 will be treated by the IRS as a transfer of wealth from the withdrawing family member to all other family members in the business.

Additionally, discounts for conditions such as lack of control and lack of marketability, while proper and allowed, should not be aggressively applied. The IRS takes a dim view of unreasonable attempts to diminish the value of a withdrawing interest below that interest’s pro rata share of the business as a whole.

Other Tax Issues of Note

Another hurdle in succession planning for family businesses stems from the reluctance of founding family member(s) to cede control. Although §§ 302, 303 and 318 do not specifically provide for divergent treatment of family businesses, these rules can have a significant impact.

When a corporation redeems its stock and the withdrawing shareholder remains with the corporation as a director, officer or employee, the purchase price is treated as a dividend rather than a capital gain. This means the entire purchase price will be subject to tax, rather than the amount in excess of basis. Also, depending on the treatment of dividends at the time of the transaction, it may be taxed at a higher rate.

Further complications can be found in § 7872, which penalizes loans made at below-market interest rates. Because most small family-owned businesses do not have sufficient cash to fund the transaction, the purchase of the withdrawing interest will need to be financed. If family members are reluctant to charge each other interest on loans, the IRS may impose imputed interest income to both the holder and the maker of the note.

Failing to charge market rate interest can also violate § 2703(b) because a bona fide arms-length business arrangement would ordinarily contain at least market-rate interest in any financing arrangement. The note-holder’s failure to exercise remedies for default under the note would also endanger the scheme under § 2703(b).

Practice Tips and Considerations

While succession planning for family business is not excessively difficult, it does require additional attention and care. The standard set for transfers of interests in family businesses is the “bona fide business arrangement.” If the IRS challenges the purchase price for a withdrawing interest, formalities such as a comprehensive buy-sell agreement, valuation done by an expert, and documentation of the parties’ adherence to the agreement will be your evidence of a bona fide business arrangement. Absence of such formalities can be disastrous.


Andrew Jenkins is the President of the Law Offices of Andrew K. Jenkins, P.C. He has a transactional practice focused on the representation of family businesses. He can be reached at AndrewKJenkins@akj-law.com.

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