Generational succession in family businesses: taxation of gifts vs. inheritance

Generational succession in family businesses occurs in two areas: ownership and management. Apart from other less common possibilities (such as sale), succession in ownership usually occurs through lucrative transfers, either inter vivos or mortis causa (hereinafter, for simplicity's sake, we will refer to these as donations and inheritances).

But be careful with donations.

There is a perception that donations and inheritance are equivalent alternatives, the only difference being the moment at which the entrepreneur wishes to transfer ownership to the next generation. Therefore, when opting for donation, the decision is usually based on criteria such as ensuring compliance with current tax regulations, in anticipation of possible changes and tightening; yielding to the insistence of the next generation to access the property; the entrepreneur's desire to completely disassociate themselves from the business, etc.

It is well known that the legislator has put in place mechanisms to prevent the tax costs associated with both donation and inheritance from making the transfer unfeasible.

However, there are some aspects of the mechanisms associated with donations that are not so well known, and which should be taken into account to avoid unexpected adverse effects that are difficult or impossible to resolve. These aspects can be summarised as follows:

• The requirements for accessing the tax benefits of Inheritance and Gift Tax (IGT) in the case of a donation of a family business are more demanding than those for accessing them in the case of inheritance.
• The tax benefits granted for transfers by donation are less advantageous than those granted for inheritances.
• Although the donees may be taxed in accordance with the regulations of the corresponding Autonomous Community, which will normally require compliance with fewer requirements than the state regulations, the donor will be taxed in accordance with the state regulations on Personal Income Tax (PIT), which in practice will oblige the donees to comply fully with the requirements of the state regulations for donations.

Let's take a closer look at each of the above points.

(i) Requirements for accessing tax benefits for family businesses in the case of donations vs. inheritance

While in the case of inheritances, it is obviously not necessary to prove that the deceased has severed ties with the management of the business, if they had been involved up to that point, in the case of donations it is necessary to prove this.

In other words, the legislator only grants the benefits of the family business to donations made as a result of the donor's disassociation from the management or after such disassociation has taken place, but in no case while the donor is ‘active’.

To this end, it is required that the donor (a) be sixty-five years of age or older or be permanently incapacitated and (b) that, if they had been performing management functions and receiving remuneration for them, they cease to do so.

In addition, the donee is required to retain what they have received as a donation for at least 10 years, keeping it exempt from Wealth Tax (WT) during that period. 

In contrast, in the case of inheritances, the heir is only required to retain the value of the inheritance for ten years (i.e., they can transfer the inherited business and invest the proceeds of the sale in other assets), without the need to keep it exempt from WT.

In summary, the requirements for accessing the tax benefits of a family business are more stringent in the case of donations than in the case of inheritances.

(ii) Tax benefits of donating a family business vs. inheritance

As for the tax benefits that the law grants to donations, they are also significantly less generous than those associated with inheritance.

Thus, in the case of inheritance, the assets received will enter the heir's estate at their current market value for tax purposes, while in the case of donations, the assets will enter at the tax cost they had for the donor.

What is the practical difference that arises from the above? We will see with an example that it can be very significant.

Example: taxation of donations vs. taxation of inheritance

Let's imagine a businessman who owns 50% of a company that he acquired at the time of incorporation for €10,000.

When he turns 65, he decides to retire and donate it to his son, at which point the shares are worth €2,000,000. 

If the requirements for the donation to qualify for the tax benefits of a family business are met, the son will receive the shares valued at £10,000 for tax purposes, so that if, after the mandatory holding period, he sells them for £3,000,000, he will make a profit of £2,990,000. In other words, the father's capital gain has only been deferred, so that, in a subsequent sale, the son will be taxed on his personal income tax for both his own capital gain and his father's.

However, if the transfer occurs through inheritance, the father will not be taxed in his last income tax return for the capital gains accumulated on his shares (€1,990,000), as there is no such thing as ‘capital gains of the deceased’ in Spanish income tax law; nevertheless, his son will inherit the shares already valued at €2,000,000. Thus, if, after the mandatory holding period has elapsed, he sells them for €3,000,000, he will only recognise a gain of €1,000,000. In other words, the father's capital gains will not have been deferred in this case, but will be definitively exempt; those capital gains will never be taxed in the income tax of any taxpayer.

In summary, the tax benefit of succession in a family business is much greater in the case of inheritances than in the case of gifts.

(iii) Income tax liability of the donor in the case of a gift

As we have anticipated, the Personal Income Tax Law provides for the possibility that the donor of the family business will not be taxed on any gains obtained as a result of the donation, provided that the requirements set out in the previous sections are met by both the donor and the donee.

This already gives us a glimpse of the first serious problem: from the moment of the donation, and for no less than ten years, the donor's income tax liability depends on the donee's wishes, since if the donee decides to transfer the shares received or ceases to meet the requirements for the inheritance tax exemption, the donor will have to make an additional income tax payment on the deferred gain. The degree of uncertainty this entails makes this option much less attractive.

The second problem, mentioned above, stems from the asymmetry between the regulatory powers transferred to the autonomous communities in the areas of inheritance tax, gift tax and income tax.

In effect, while the autonomous communities have the power to regulate, within certain limits, tax benefits in the areas of inheritance tax and property transfer tax, they do not have the same power in relation to personal income tax regulations. And on this point, the state personal income tax law is difficult to interpret: in order for the donor not to be subject to personal income tax, the requirements of the state inheritance tax law must be met. It is not envisaged, as easy as it would have been, that the donor would not be subject to personal income tax when the requirements of the state inheritance tax law ‘or the applicable regional regulations’ are met. 

It follows from the above that any improvements that the autonomous communities may introduce to the requirements for enjoying the benefits of family business donations are, in practice, rendered ineffective for the donor to be exempt from income tax, since if all the requirements of the autonomous community are met but not those of the state law, the donee's taxation will be protected in the IGT, but not that of the donor in the PIT.

To sum up, in the generational handover of a family business:

• a) The requirements for accessing tax benefits for family businesses are more stringent for donations than for inheritances.
• b) The tax benefits of donations are less attractive than those of inheritances.
• c) The donor's taxation will depend for ten years on the wishes of the donee, who must comply with the requirements of state inheritance tax legislation even if they are applying less stringent regional tax benefits.

In conclusion: before donating the business to the next generation, it is important to assess whether, taking all of the above into account, it is still an attractive option, as in many cases it will not be. And if this is detected once the donation has been made, it will not be possible to remedy the situation by revoking the donation, as this will only result in a second donation (this time from children to parents), which will only make the situation worse.

Contact our specialist lawyers to resolve any queries. You can do so here.

• More information about Family Business

 Javier Lucas – Family Business Group

Partner in the Tax Area