The Family Cache

By forming new corporations or partnerships with younger relatives, owners of closely held companies can save on income and estate taxes without affecting the original business

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For most of closely held companies, tax questions usually fall under two headings: how to minimize personal tax liability on business earnings and how to limit estate taxes. Several strategies can help solve these problems, including corporate recapitalizations gift-giving, and filing tax returns as a Subchapter S corporation (see INC., January, page 94). But one solution often overlooked is the formation of a joint venture between the company and either younger family members, key company employees, or corporations it controls.

If younger family members are in low tax brackets, the income tax advantages of forming partnerships with them may be substantial, since the overall family tax burden will be cut. In principle, such partnerships are like a gift or an interest-free loan from the company or higher-income family members: Income from the asset is taxed to the individual in the lower bracket. In a partnership, income that flows to the lower-income partners is taxed at their lower individual tax rates.

A basic benefit of such a plan is that corporate earnings that might be subject to "double taxation" may be avoided. Earnings are passed through to the younger partners whose marginal tax rates may be significantly lower than the maximum individual rate of 50%. Furthermore, the value of the partnership interest can be accumulated in the estates of these younger family members who usually won't incur estate taxes for years.

Structurally, co-venturing with family members is the same as other types of joint ventures. As joint-venture partners, family members can share the profit-and-loss potential of a new business. Such joint ventures can provide the mechanism through which families can retain control of their wealth while subjecting income from business expansions or entirely new ventures to more favorable tax rates. They also can offer closely held businesses another legal means of protecting the existing corporation from the risks associated with a new venture.

However promising a family joint venture strategy may be, choosing the approach, and the best form, will depend on specific business risks and specific goals But three common techniques are corporate joint ventures, family partnerships, and family joint ventures using trusts.

Corporate joint venture. Owners can arrange for a joint venture between the existing corporation they control and a new corporation, which elects to file tax returns as a Sub S corporation, controlled either by younger family members or by key employees. The business of the joint venture might revolve around a new product line or a business unrelated to that of the original company. With this format, the source of the venture's capital would be cash contributions from the new corporation. It would receive its capital from owners of the old business in exchange for stock in the new corporation. Their stock could then be given as a gift to their children, or included in a compensation package for unrelated employees. A variation would be to give the younger family members enough capital to fund the new corporation. The new corporation's income would be taxed to the lower-bracket shareholders since the company had elected Sub S status.

Such a transaction may lower estate taxes and income taxes of the older family members, since part of the appreciation and income from the venture would flow to others. But older family members may also incur a gift-tax liability under either method. As with any other commonly controlled group of businesses, care must be used to allot income and expenses properly among the businesses.

Family partnership. Another option is for family members to create a partnership that includes parents as individuals -- not the family company -- as partners. Younger family members could participate as limited partners. This would permit earnings from the new venture to flow to the partners without passing through the existing company and perhaps being subjected to double taxation. To ensure control of the business, an agreement can be drafted to vest management of the new partnership in the parents or designated others.

This form of partnership has its pitfalls, too. As in the corporate joint venture, the parents face a possible gift-tax liability. But an even greater risk to the general partner is the exposure to personal liability from claims against the business. That potential isn't present in a corporate joint venture.

Joint venture with trusts. Sometimes, as when children are minors or inexperienced in business, legal barriers to their participation in the new venture may be desirable. If trusts are set up, the trusts -- not the children themselves -- are the partners. For example, if one or more children are active in the business and others aren't, the active or older children can be partners, while trusts are created through which the others can participate, perhaps as limited partners.

The first advantage of a trust is that a trustee the parents select makes the decisions on the business and cash distributions to the children. Also, each trust can be treated as a separate taxpayer. Thus, income from the new venture can be split among the children and their trusts, to minimize income-tax liability each year

Certain trusts may likewise own stock in a new company set up to form a corporate joint venture, thereby curbing corporate control to the appointed trustees. Despite these benefits, though, using trusts as partners won't erase pitfalls that exist in other types of family ventures.

By utilizing joint ventures, it is possible for families to accomplish their personal income-tax and estate-planning objectives without tampering with the success of an existing business. But since such vcntures can take several legal configurations, those considering family corporations, partnerships, or trusts should seek professional advice.