Succession is still a taxing issue

How a family business is structured is often a key factor in whether it is passed on to the next generation or sold.

Succession planning can have brutal tax implications that can end family control of a business.

Capital gains tax is the biggest issue, because it makes a huge difference to the owner in regards to how much they will get out of the deal, not to mention the total costs for the party taking over the business.

Now, under current legislation, there is no capital gains tax payable on transferring shares or ownership if the shareholders acquired them nearly 30 years ago, before September 19, 1985. But that’s a long time ago, and it also means one thing: a lot of family businesses and “next genners” will be caught up in the CGT net. In many cases, it will discourage business owners from passing the business on to their children. When that happens, the business won’t remain with the family.

Indeed, a major survey completed by business advisory firm Pitcher Partners and the Swinburne University of Technology released this week, entitled Succession Reset: Family Business Succession in the 21st Century Report 2014, highlights how a high percentage of Australian business owners are aiming to sell rather than go through a succession process.

How does CGT work for most family businesses? In cases where the shares are post-CGT, and where they have been held for at least 12 months, individuals and trusts are allowed a 50 per cent reduction in the taxable capital gain on the transfer of the shares. For an individual on the top marginal tax rate of 48.5 per cent, this becomes an effective tax rate of 24.25 per cent on the capital gain.

Now, the most common way around the CGT is to transfer the assets to the children through a trust. A trust typically has a life of 80 years, which gives plenty of time to pass over control.

You would typically find that mums and dads set up the trust so they are primary beneficiaries. Children and family members are generally in the class of general beneficiaries. Ultimate control of the discretionary trust is held through the position of an appointor, and control of the trust rests with them.

And there’s the rub: mums and dads can  pass control of the trust on to children by nominating their children as appointors of the trust. When this is done, the CGT is avoided. There is an exemption from CGT, because the trust is not selling any asset. The trust doesn’t change, they’re not selling any asset, they’re just passing over control of the trust.

If a business is owned by a company, however, they don’t have the same luxury. They either need to sell the shares to their children or pass those shares on to their children. Either way, for capital gains tax purposes, that will be classed as a disposal of those shares. And if it was a company set up after the introduction of CGT in September 1985, then they would fall within the capital gains tax net.

That is why many family businesses are structured through trusts -- it’s simpler to deal with succession issues.

Pitcher Partners managing partner, John Brazzale, says capital gains tax is a complicating factor and might discourage owners from passing the business on to their children. Instead, they would have to sell it on the open market or pass it off through a management buyout.

“They can sell it in the open market or pass it on to the key executives that are already working in the business,” Mr Brazzale says.

“It’s pretty critical, because the tax is a cost and quite often the children don’t always have the funds to pay for the shares or the business up front. And the moment you enter a contract for the transfer of that business, you crystallise the capital gain.

“If the children don’t have the funds up front to pay for those shares, then you’ve got to find money out of elsewhere to pay for the tax liability. Then again, the children might fund the acquisition of those shares over a long period of time out of the earnings of the business. It becomes a stumbling block.”

Family businesses are facing a continuity crisis. Research by family business advisory firm MGI shows that younger generation family members are not as interested in actively managing the business as the older generation. The capital gains tax can add to the problem.

Also read The hard sell on succession.

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