The first hurdle has been cleared. The business owner has decided to transfer the company to the next generation. Ideally, this should be done free of charge so as not to place an immediate financial burden on the successors—often the children—such as through an obligation to pay a purchase price. But is the business owner adequately provided for in retirement?
A common arrangement to ensure that the entrepreneur continues to receive income from the company even after the transfer of the shares is for the entrepreneur to reserve a usufruct right as part of the transfer of the shares.
A usufruct grants the entrepreneur the right to continue to derive all—or, depending on the contractual terms, only certain—benefits from the company shares even after they have been transferred to the successors. A full usufruct grants the entrepreneur, in addition to the income, voting and management rights, for example, even after the transfer of the company shares.
Income Usufruct: Retaining the Right to Income from the Company Shares
In contrast, as is often the case in business succession, the usufruct can also be structured in such a way that it is limited to the right to receive profits (so-called “usufruct of income”). In this case, the entrepreneur retains the income from the company shares, whereas the voting and management rights are transferred to the successor upon the transfer of the company shares.
The reserved usufruct thus enables the entrepreneur to transfer the corporate interest as intended to the successors, who can henceforth determine the company’s future and directly participate in any appreciation in the value of the interest.
Meanwhile, the profits continue to accrue to the entrepreneur—either in full or on a pro-rata basis, depending on the terms of the usufruct—for the agreed-upon duration of the usufruct right. The structuring options are diverse and offer the entrepreneur the opportunity to implement their plans on an individual basis.
From a tax perspective as well, the transfer subject to a usufruct right is a standard practice, particularly since a legislative change in 2009 allowed the capital value of the usufruct to be deducted in full from the tax value of the transferred assets.
Unsettling Ruling by the Federal Fiscal Court
In business succession, the goal is to avoid the taxable realization of hidden reserves as part of the succession process while at the same time not jeopardizing the exemption of business assets from inheritance and gift taxes. Particular tax challenges arise in this regard with regard to business succession in partnerships—a practice widespread among small and medium-sized enterprises—when the transferor reserves the right to continue exercising shareholder rights.
A ruling by the Federal Fiscal Court (BFH) dated January 25, 2017 (X R 59/14), which held that an income tax-neutral transfer of a business to a successor is not possible if the transferor reserves the right of usufruct. The BFH ruling of November 6, 2019 (II R 34/16, BStBl II 2020, 465) and a letter from the Federal Ministry of Finance (BMF) dated November 20, 2019, previously unresolved legal issues have been clarified, so that, fortunately, there is now legal certainty in this regard for structuring transactions.
In its letter, the Federal Ministry of Finance clarified that—unlike in the case of sole proprietorships—at least for partnerships, the reservation of a right of usufruct does not preclude a tax-neutral transfer at book value if the successor is granted partner status. This is also a prerequisite for exemption from inheritance and gift taxes.
Granting a Proxy for Voting Rights in Favor of the Transferor
In addition to sharing in the economic risks and opportunities, it is necessary that the successor, in principle, also be able to exercise the voting and management rights associated with the interest, at least with regard to so-called core transactions. This is not the case in the event of an abuse of full rights. However, according to the Federal Fiscal Court (BFH) ruling of November 6, 2019, the mere granting of a proxy for voting rights in favor of the transferor (usufructuary) does not preclude an income tax-neutral transfer or exemption from inheritance and gift taxes.
This case law has since been published by the tax authorities and is therefore applied by them. The reservation of a usufruct right is comparatively unproblematic when transferring shares in corporations, since exemption in this case does not depend on the transfer of co-owner status.
The reservation of a (income) usufruct is therefore often a useful structuring option in the context of business succession from an economic, legal, and tax perspective. Careful drafting of the contract in each individual case remains crucial.
