The Hidden Tax Trap in Your Family Business—and How to Avoid It.

By Omar Vasquez on April 4th, 2016Posted in Governance & Business Operations

You have a business.  You have a family.  You have a family business.  And frequently, the family makes decisions about the business.  Sometimes, those decisions are not formalized.

And that’s where a hidden tax might lie.

Here’s a common scenario:

A family business is owned by a handful of family members.  Then some significant transaction happens—maybe a shareholder (or LLC member) withdraws, or maybe a shareholder pays in additional capital.  After the transaction, the owners agree to restructure shareholdings, (“I’ll have 45%, you’ll have 35%, and our cousin will have the remaining 20%”).  But they never come around to telling their business and tax lawyer, and so the share transfers are never recorded.  Maybe they think they can do this later.  Time marches on.

Here’s where the trap kicks in:

What happens if you then bring in a new shareholder? Or sell the company altogether?  Or one of the shareholders decides to have his or her shares redeemed?

You’ll need to paper the earlier restructuring at that point.  But wait!  What valuation of the shares should you use?  You’d like to value the shares as they were at the time of the verbal agreement (which happened years ago by this point).  But now you are on the verge of a new, even bigger transaction, and the valuation of your company has (hopefully) increased!

You’d like to use the (lower) valuation then-existing at the time of the verbal agreement.  But you will have a hard time justifying that lower valuation on the eve of a transaction which gives a higher valuation.

So what can you do? 

You can’t just issue new shares to effect the shareholdings you verbally agreed to—that would probably result in a taxable transaction.  Same issue with redeeming shares to back into those ownership percentages—now you have taxable gain or distributions.  You could possibly gift shares among the family members, but there are tax implications associated with this too, e.g., annual and lifetime gift exemption limitations.

The tax trap has sprung.

And here’s another problem: even if the business never enters into a subsequent transaction, how will your accountant know how to prepare the individual shareholder/member/partnership tax returns?  Based on the recorded shareholdings or based on the verbal arrangement?  And what if the accountant’s approach varies from year to year?

Don’t get trapped.  Call your family business and tax lawyer if you plan to make or have already made verbal arrangements within the family.

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