1. Introduction
Businesses run by families are a prevalent norm in the country. For the continuous longevity of the family business, it is often fruitful to do succession planning, to avoid disputes and conflicts amongst various family members. Consequently, an effective succession planning process ensures that the allocation of assets and properties is in consonance with the wishes of the owner of the property.
1.1. What is Succession Planning?
Succession planning is the process of transferring the leadership of the family business to the potential successor. A succession plan ensures that the legacy of the family business remains for a long period of time and is not disrupted due to unforeseen events.
It further defines the duties of the members of the family, the profit distribution, the leadership roles, and future responsibilities in the family business. Additionally, a clear and defined succession plan minimizes conflicts and allows for informed decision-making.
1.2. Importance of Succession Planning
Succession Planning is significant as it helps to achieve a structured process for the family business. It helps:
- To ensure family harmony and avoid conflicts: A crucial aspect of succession planning is that it ensures family unity by establishing guidelines, and expectations and clarifying roles and responsibilities. Thus, this ensures family harmony.
- To ensure continuity of business: Further, identification of potential successors helps in ensuring that the succession remains operative for a longer period of time.
- Family legacy and control over business: Additionally, effective succession planning ensures that the business remains in control within the family and there is long-term sustainability without persistent legal disputes.
- To ensure proportionate distribution of assets: Succession planning is also essential to ensure that the assets are not distributed in a disproportionate manner to the successor or to unintended beneficiaries.
- Maximizing the value of a family business: Also, the value of the business can be maximized by ensuring the potential successor with requisite skills and experience is chosen.
2. Steps of Succession Planning
Stage I: Before moving with succession planning
- Identifying Assets: It is essential to list out the assets at the time of succession planning. This is because it helps in further allocation. In identifying assets, the following aspects need to be considered: –
- What is the nature of the assets?
- Whether the asset is self-acquired or ancestral?
- Who is the Legal owner of the asset?
- Whether there are Joint or co-owners of the asset?
- Where is the Place or location of the asset?
- Identifying and Evaluating Potential Successors: Successors are to be decided after evaluating the weaknesses and strengths of the person, along with experience and skill. Thus, it will ensure that the family business remains intact.
- Financial Planning: It is crucial to have a sound and healthy financial plan to ensure that the company complies with the regulatory and taxation framework, all the while ensuring liquidity.
Stage II: During the succession
- Estate Transfer: It is to be decided how the estate of the company is to be transferred, whether through:-
- Will ; or
- Trust ; or
- Gift ; or
- Family Arrangement, etc.
- Tackling Conflicts: During the making of a succession plan, there might be issues of conflicts, amongst members, either on the nature of assets to be distributed or the proportion of assets allocated. Such disputes can be easily resolved by effective communication.
- Help from Professionals: There might be times when help can be taken from professionals. A professional can act as a neutral person, who can be objective about the entire process. In particular, a professional can help with: –
- Estate evaluation,
- Tax implications, etc.
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Stage III: After Succession
- Documentation of the Succession Plan: – Lastly, after identifying the successors and the assets, it is pertinent to prepare and keep documentation of the succession plan to maintain authenticity and avoid future disputes.
3. Use of Will for Succession Planning – Testamentary Succession
3.1. What is Will?
Will is a commonly used method in succession planning. Further, through a deed of will, a person outlines the distribution of the properties and assets of the person after his/ her death, amongst various persons.
The important thing to note is that will of a person takes effect only after the death of the person and not before.
3.2. Importance of Will
The importance of will is as follows:
- Helps in Estate Planning ;
- Avoid future disputes ;
- Avoiding succession by way of intestate (through legal statutory method) ;
- Distribution of property and assets in a smooth manner ;
- Can be revoked or altered before the death of the person.
3.3. Essential Elements of Will
The essential elements of will are as follows:
- The capacity of the Testator: The capacity to be a testator means that the person has the ability to make a rational decision regarding the contents of the will.
- Description of Property and Assets: The will should clearly define the properties and assets with locations, specifications, etc. Additionally, to whom the property or asset will devolve after the death of the testator.
- Free from the influence, force, etc.: If a will is not made from free will but through the means of fraud, threat or undue influence, etc., then it will not be considered a valid will.
- Will can be revoked or altered before the death
- Signed by Testator and attested by witnesses: The will has to be signed by the testator himself so as to prove its veracity and genuineness and it has to be attested by 2 witnesses.
- Details of Executor: The executor is the person that will execute or implement the will after the death of the testator. It is generally the legal representative.
3.4. Tax Implications of Will
Taxing the income of the estate of the Testator of the Will Deed
As per Section 168 of the Income Tax Act, of 1961, the income of the estate will be taxed in the hands of the executor.
- Where there is one executor: – Income received is taxed as income of an individual
- Where there is more than one executor: Income received is taxed as income of ‘association of person’
- Residential Status of Executor of Will Deed: The residential status of the executor will be deemed as according to the testator, if he is a Resident or Non-Resident in the previous year of his death.
Capital Gains on Transfer of Assets under a Will
If capital assets are transferred or transmitted by way of a will, then capital gains arising on such a transfer would not be chargeable to tax under the Income Tax Act, of 1961.
Specific Exemption from Income Tax for assets received under a Will
If any money or property is received by the person by way of will or inheritance, then, it is exempt from being taxed as income from other sources under Section 56. Though, the condition is that it should be received from a relative.
Cost of Acquisition (COA) of assets acquired under a Will:
The cost of acquisition of assets acquired under a Will be the cost at which the testator got the property.
3.5. Probate of Will
Probate of Will establishes the authenticity and genuineness of the will by the authority of the court of law. After the will is proved in court in India, it becomes effective from the date of the death of the testator.
4. Concept of Family Arrangement or Family Settlement for Succession Planning
4.1. What is Family Arrangement?
Litigation over disputes of succession often takes a long time before reaching a conclusion. At times, the families feel that an arrangement can be made to keep the interests of the members intact along with the distribution of properties.
Thus, a contractual agreement is entered into between the members of the families which is ‘mutual’ in nature and may involve compromise on the parts of the members to reach an amicable resolution. So, this is called a family arrangement or family settlement under succession planning.
4.2. Importance of Family Arrangements
The importance of family arrangements is as follows :
- Avoiding long and delayed procedures of court through litigation
- Helps in succession planning in complex family relationships, where there are multiple sub-families involved
- The agreement is enforceable in the court of law and binding in nature
- Amicable resolution of disputes
- Preserving the relationship between members of the family
- Flexibility in approach for distribution of property
4.3. Essentials of Family Arrangement/ Family Settlement
The essential elements of the family arrangement are as follows:
- It can be oral or written in nature.
- It has to be between family members, and it cannot be between strangers
- There should be ‘free will’ of all the parties to enter into a family arrangement. But, a family arrangement cannot be undertaken through force, coercion, etc.
- There has to be a dispute which needs resolution. Though, family settlement cannot be a garb to avoid tax through cross transfers etc.
- It is different from partition between the members.
- There has to be a mutual agreement between all the parties.
4.4. Deed for Family Arrangement/ Memorandum of Family Arrangement
The family arrangement is not necessarily to be done between all the members of the family. Also, it can be related to one or more properties.
After a decision is reached for the distribution of assets, then, a family arrangement deed is to be made which will give it the legal force. It must contain the following:
- Information about the family members who are in conflict
- Information about the property
- Details about the distribution of property among members
- Details about the settlement regarding property
- Execution mechanism of the deed
4.5. Taxation of Family Arrangements
For Individual Members: A family arrangement between individual members will not be considered a ‘transfer’ under the Income Tax Act, 1961. Since it is not considered a transfer, so, the family arrangement will not be taxed as capital gains under Section 45. Case: Sujan Azad Parikh v. DCIT (2022)
For Limited Company: In the case of a limited company, the court held that the company is a separate legal entity and even if there is a family arrangement, the transfer of shares will be considered as per the definition of transfer under Section 2 (47) of the Income Tax Act, 1961. Thus, it will be taxable as capital gains for the corporate entity in case of family arrangement. Case: B.A. Mohota Textiles Traders (P.) Ltd. v. DCIT (2017).
However, there are conflicting judgments where in the case of ITO v. Narendra Kapadia, it was held that it would not be taxed as capital gains because it was out of natural love.
For Partnership: In the case of a partnership where the partners are family members, then, the transfer of shares in a partnership, through family arrangement or family settlement will not be taxed as capital gains under Income Tax Act, 1961. Case: CIT v. Kay Arr Enterprises (2018). However, in the present scenario, the provision of Section 45(4) may need to be considered which provides that where a partner receives any money or capital asset or both from a firm, in connection with the reconstitution of such firm, then any profits or gains arising from such receipt shall be chargeable under the head “Capital gains”.
5. Concept of Trust for Succession Planning
5.1. What is Trust?
A person (the settlor) entrusts his property to another person (trustee) for managing it for the benefit of a third person (beneficiary) by the formation of a trust.
5.2. Importance of Trust
The importance of trust is as follows:
- Protect the property or asset
- Helps in planning estate
- Smooth transition of ownership
- Protect beneficiary’s interest
- No need for probate as required under the will
5.3. Types of Trusts
There are different types of trusts and so, it is essential to understand their meaning:
- Revocable Trust: A revocable trust deed is one which can be canceled.
- Irrevocable Trust: A trust that cannot be canceled and has to be performed is called an irrevocable trust.
- Private Trust: A trust involving private members like family members, relatives, etc. is called a private trust.
- Discretionary Trust: The trustee has the power to ascertain the share which the beneficiary will derive from the trust
- Determinate Trust: The settlor will fix the benefit to be derived by the beneficiary. Also, it can be through a formula.
5.4. Taxation of Trust for Succession Planning
Capital Gains: There will be no capital gains arising to the settlor on the transfer of capital assets to an irrevocable trust.
But, these will be considered as transfers under an irrevocable trust :
- Shares,
- Debentures
- Warrants as per Employees Stock Option Plan
- Scheme offered to employees as per Central Government
Will the beneficiary be taxed?: Under Section 56(2)(x) of the Income Tax Act, 1961, an exemption is provided that where a trust is created for the benefit of the relative, it will not be taxed. It is pertinent to look at whether the beneficiary qualifies as a ‘relative’. Thus, if the beneficiary is a relative, then it will not be taxed under Section 56 for income from other sources.
Note: Section 56(2)(x) does not apply to trustees, since they do not own assets but are managing them for the beneficiary.
Taxing the Trust
Further, where the shares of the beneficiary in the trust are determinate. Then, the tax payable by the Trust will be on the aggregate tax liability of all the beneficiaries, on their individual share.
In the case where the income in the hands of the trustee is from business profits and gains, the tax will be applied at an MMR rate (Maximum Marginal Rate) on the whole of the income.
But where the income is not of business, it will be taxed as follows:
- In the hand of the assessee
- In the hands of the trustee (representative assessee)
Exemption: Though, the tax will not apply where the profits and gains from the trust are:
- For the relative, that is dependent and for his maintenance and support ;
- It is the only trust by the settlor.
Where Shares of Beneficiary are unknown: In this case, the tax will be charged at MMR for the portion of interest of the beneficiary, which is unknown under Section 164 of the Income Tax Act, 1961.
6. Conclusion
Thus, it can be concluded that succession planning is a crucial concept in relation to family and estate planning. Additionally, it ensures that the property is distributed as per the wishes of the person through a cost-effective and tax-efficient mechanism.
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FAQs
Q1. What is succession planning?
Ans. When the leadership of the family business is transferred to potential successors, it is called as succession planning.
Q2. Why is succession planning important for a family business?
Ans. Succession planning is essential to ensure the continuity of the family business, legacy, and control over the business. Additionally, it keeps harmony among family members.
Q3. What are the different ways by which I can transfer my estate?
Ans. You can transfer your estate by a will, gift, trust, or family arrangement through succession planning. Additionally, if there is no succession planning, the estate will devolve intestate as per established legislation.
Q4. Do I need to evaluate my taxes for succession planning?
Ans. It is generally preferable to get your taxes evaluated through a Tax Profession before moving with succession planning to ensure no future disputes and lengthy litigations.
Q5. Is it essential to prepare a succession plan for estate planning?
Ans. To ensure clear division and ownership of properties, assets, etc., it is preferred to prepare a succession plan. Further, it will help in avoiding future legal conflicts.
