Case Studies and Articles

Freeze and Squeeze

Freeze and Squeeze

Why planning works to preserve family businesses


Despite all the press coverage about the death tax, in reality, few people worry about confiscatory estate taxes.  However, those owning family businesses and farms seem to provide a disproportionate share of federal and state revenues at death.  Although there is some temporary federal relief offered if you accept the moving goal post formula for estate taxes, the operative word is “temporary”.  A significant and new problem for many is the increasing percentage of estates subject to higher income taxes and the recently enacted estate and inheritance taxes imposed by revenue-starved states. 


The solution?

Consider making charitable gifts of those assets that trigger both income and estate tax at death (income in respect of a decedent or IRD), and keep the estate from ballooning in value.   With a little prior planning, there is no need to pay unnecessary taxes if owners freeze the value of their growing business and transfer it before tax liabilities mount up.  How does that work?  Easily, but few taxpayers take advantage of their right to make tax-free gifts to heirs on a regular basis.  It is a shame, because over time, significant value can be compressed and given via lifetime and annual exclusion gifts, especially if husband and wife join to make full use of gifts to children, in-laws, and grandchildren.  For many families with four married children, and grandchildren, it is common for half a million dollars in estate value to be transferred free of tax.  By making those gifts repeatedly over the years, most estates would see significant tax savings.  Yet few families take advantage of this right. Why?  Most family business owners resist making gifts fearing loss of control, and are unwilling to take a proactive long-range view of the planning process.


Plan now, notlater

Sam Walton, founder of the Wal-Mart empire, is a great example of successful transition tax planning.  He passed the bulk of his business interests to his heirs with little tax erosion by preparing the plan early in his career.  Sam and Helen started their retail business after World War II with $5,000 in savings and $20,000 borrowed from Helen’s father; then built that stake into a multi-billion dollar marketing behemoth.  Along the way, they learned lessons in business succession planning and resolved to create a family owned business, Walton Enterprises, in which they transferred 20% of their business interests to each of their four children (Rob, John, Jim, and Alice) and kept their remaining 20% portion as separate shares.  When Sam passed away in 1992, owning only his 10% ownership interest in the $26 billion Walton business, the taxable value of his estate was much smaller because of his prior gifts.  Although specific details are not available for the entire Walton zero estate tax plan, Sam’s 10% ownership of Walton Enterprises passed tax-free through a marital trust for his wife.  As reported by Forbes magazine’s best estimates of family wealth in the annual “Forbes 400” (September 2002), his planning meant that each of the five principal Walton heirs is now worth $18.8 billion.  When Mrs. Walton passes on, her interests divide when the non-voting shares flow to the Walton charities, while the voting shares transfer to their younger heirs who will continue to control the retail, banking and real estate business.  


The planning concept is simple.  The best way to reduce or eliminate estate taxes is to freeze the value and give it away before assets appreciate, so worth grows in the heirs’ hands.  This transfers the tax value.  Maintaining control is a different issue; keep the managing interest separate and retain command of the family business.  The advantage of passing non-voting ownership interests to heirs is that discounting and compression may result in a lower tax value when heirs do not have significant management influence.  Typically, the IRS allows independent appraisers to lessen the taxable value of a business if there are minority interests, limited marketability, and lack of control.  That is the “squeeze” in the planning, and it means that it becomes easier to pass a business at a discount.  This is not “do it yourself brain surgery”; proper planning and legal procedures must be used, so seek competent counsel and do it right.


Had that unplanned growth and value stayed in Sam and Helen Walton’s hands, and been subject to tax under current rates, the tax bill would exceed $47 billion today.  It would be hard to imagine any family business being unaffected by a need for that kind of liquidity in just nine months after the death of a principal owner.


What Sam Walton achieved through effective planning –

  • Reduced his gift and estate taxes
  • Improved his planning options
  • Protected some of his assets from creditors
  • Transferred assets to heirs without losing control
  • Kept his children tied to the family business by shifting an equity interest to heirs
  • Achieved flexibility of structure and design through the partnership
  • Avoided probate by using methods that operate by contract
  • Ensured privacy for his dealings
  • Leveraged use of his tax-free transfers, like the annual exclusion gifts that are now $11,000 and the new $1,000,000 applicable exclusion or $1,100,000 generation skipping exemptions.