When children are involved in the family business

Life Insurance Trust

For small businesses, life insurance policies must be held outside of the owner's estate in order to avoid estate taxes. Generally, policies are purchased and held by the trustee of an irrevocable trust, with the proceeds used to pay the estate taxes.

Some business owners buy what is called "key man insurance." The policy is paid for by the business and the proceeds are used specifically to keep the business going upon the death of the business owner or partner. Policies are typically written for $100,000 to $250,000.

Or family members who are active in the business may take out an insurance policy on the owner and use the proceeds to buy out the interests of the non-active family members after the owner dies. For example, when Joe Robbins of Robbins & Sons Furniture Mart died, he left his $4 million business to his two sons, who worked for the company, and his two daughters, who did not. His sons had purchased a $2 million life insurance policy on Joe. Upon his death, they used the $2 million cash value to buy out their sisters. The sons immediately gained control of the business while the daughters received their share of the inheritance in cash compensation.

Seek assistance from an insurance agent or an attorney.

Buy-Sell Agreement

Generally used with business partners, this is a contract that specifies what will happen to the business shares of an owner upon her death. In most cases, the surviving partner will buy the shares at a predetermined price, often using life insurance proceeds or launching a payment plan for a specified number of years. By predetermining the shares' value with the help of a certified public accountant, a partner can insure that her family will be compensated for her share of the business upon her death.

A buy-sell agreement can also be used when one partner decides to leave the business. Jan Olin and her partner owned an interior design firm. Jan did the marketing and kept the books, while her partner oversaw the interior design work. They created a buy-sell agreement that would become active should one of them die (paid for with life insurance), become disabled (paid for with disability insurance) or simply decide to leave the firm (paid a predetermined price). In this scenario, the buy-sell agreement ensures that Jan's partner cannot sell her half of the business to just anyone -- Jan has first purchase rights.

Seek assistance from an attorney, CPA or insurance agent.

Private Annuity

With this arrangement, the business is sold to the children in exchange for a fixed annuity income based on IRS interest rates (which change monthly, but are generally 6 percent to 7 percent) for the rest of the owner's life and, if elected, that of his spouse. If the owner outlives his life expectancy, the children may end up paying him more than the business is worth. However, if the owner dies sooner, they may pay less than the business is worth.

For example, say 69-year-old Antonio of Antonio's Pizzeria Restaurants is ready to retire. He transfers his business's interests to a trust for the benefit of his children in exchange for a private annuity totaling $750,000. His children immediately assume control of the business. Unfortunately, Antonio dies two years later, having only received $100,000 from his annuity. However, the annuity is dissolved, the children now own the business free and clear and they don't even have to pay estate taxes since the business had been previously transferred from Antonio's estate into a trust.

Seek assistance from a CPA or estate planner.

When children are not involved in the family business

Family Limited Partnership

One way to avoid estate taxes on a portion of business interests -- or altogether -- is to create a family limited partnership. In this type of agreement, the owner transfers some or all of his business to individual family members while he is alive. When he dies, the portion of the business that has been transferred is not subject to estate taxes as it is no longer considered a part of the owner's estate. However, care must be taken to minimize the gift taxes that result from transferring the business interests.

The family limited partnership is an ideal mechanism to ensure that the business will stay within the family. With this type of agreement Bob Sage, owner of Sage Dry Cleaning, transferred 50 percent of his business to each of his daughters, Katie and Sarah. Bob retains management rights as a general partner, with his daughters as limited partners. When he dies, Katie and Sarah will assume full ownership of the business without having to pay estate taxes.

Seek assistance from an attorney.

Minority Interest Discount

Similar to the family limited partnership, the owner may transfer portions of his business to family members in order to achieve a minority interest discount. For example, say the owner had a business worth $1 million, which he transfers in equal $250,000 increments to his wife and three children. Because the company is being split up, it is assumed to be worth less than it was worth when it was whole. The transfers are valued at the reduced price -- a discount of between 30 percent and 50 percent less. Therefore a 40 percent discount on $250,000 yields a $150,000 gift, for tax purposes, to each family member. The greatest benefit of this discount is that the family avoids estate taxes on any appreciation the business earns before the owner's death.

Seek assistance from an attorney.

Grantor Retained Annuity Trust (GRAT)

The GRAT is another type of transfer: The business stock is placed in a trust for the benefit of the owner's children for a specified number of years. (Note: Only irrevocable trusts receive tax benefits.) The owner receives a fixed income annuity determined by IRS interest rates (again, that varies but generally falls between 6 percent and 7 percent). At the end of the term, the stock is distributed to the children and removed from the owner's taxable estate. Should the owner die before the end of the term, the stock is taxed as part of his estate.

For example, Ed's Auto Parts -- valued at $250,000 -- is placed in an irrevocable GRAT for 10 years. Ed receives a fixed income annuity from the trust during that time. If Ed dies after only eight years, the stock would be subject to both estate and income taxes. However, if he lives 10 years, the business stock at its current appreciated value is transferred to Ed's children and he stops receiving an income check.

Seek assistance from an attorney.