[Tax Story] Fostering Century-Old Enterprises and Inheritance Tax System for Family Businesses

We often hear news of first-generation founders of small and medium-sized enterprises (SMEs) on the verge of business succession selling the companies they have built over their lifetimes. In the mergers and acquisitions (M&A) industry, the trend is that the pool of companies for sale is gradually expanding from SMEs to mid-sized enterprises. While changes in the legislative environment, such as minimum wage increases, play a role, the primary reason seems to be the heavy inheritance tax burden associated with business succession. Under the current tax system, companies are subject to income tax of up to 49.5% or corporate tax of 27.5% on their profits. Upon inheritance, up to 60% of the company's value is taxed as inheritance tax. In partnerships, if one partner dies first, it is common for management rights to be transferred to the other party due to the inheritance tax burden, and there are cases where companies are liquidated or effectively nationalized because there are no funds to pay the inheritance tax. The state, in effect, is a special major shareholder that forcibly receives a significant portion of the company's lifetime earnings value in the form of taxes and recovers more than half of the disposal value upon inheritance.

According to the 2018 statistics from the Korea Federation of SMEs, there are 6,638,694 SMEs, accounting for 99.9% of all companies, and they employ 17,103,938 workers, responsible for 83.1% of employment, forming the backbone of our industry. Because of this, the excessive tax burden on business succession is heavily criticized as it contradicts the constitutional spirit of respecting economic freedom and creativity of enterprises and protecting and fostering SMEs.

The current business succession tax system is mainly represented by the post-inheritance business succession deduction and the special gift tax taxation on lifetime transfers. While inheritance and gift tax reduction benefits are granted, the heir must assume the previous acquisition cost and bear capital gains tax upon future disposal. The business succession deduction applies to SMEs and mid-sized companies that have managed specific industries such as manufacturing and construction for more than 10 years, where the parent has continuously held at least 50% of shares (30% for listed companies) for over 10 years, and the successor has served as a representative for at least half of the total business period and 10 years. If a child aged 18 or older has worked in the business for more than 2 years, is appointed as an executive by the inheritance tax filing deadline, and assumes the CEO position within 2 years, inheritance tax is exempted up to a total inherited property value of 20 billion KRW (30 billion KRW if the management period is over 20 years, 50 billion KRW if over 30 years). However, if certain conditions such as asset disposal, share reduction, or employment reduction occur within 7 years from the inheritance commencement date, the exempted inheritance tax is reclaimed. The special gift tax taxation applies when a parent aged 60 or older, who is the largest shareholder holding at least 50% (30% for listed companies) of an SME and has managed the business for over 10 years, gifts shares to a child aged 18 or older who starts working in the business within 3 months of the gift and becomes CEO within 5 years. In this case, 500 million KRW is deducted from the gift tax base up to 10 billion KRW, with a low gift tax rate of 10% up to 3 billion KRW and 20% above 3 billion KRW.

The business succession deduction and special gift tax taxation were introduced in 1987 and 2008 respectively, but their utilization has been low. According to the 2020 National Tax Statistics Yearbook, the business succession deduction was used in only 88 cases (236.3 billion KRW), and the gift tax special cases in 172 cases (238.3 billion KRW). Compared to 169,911 gift tax taxpayers with a gift property value of about 29 trillion KRW and 8,357 inheritance tax taxpayers with an inherited property value of about 16 trillion KRW during the same period, these figures are very insignificant. The legislative intent expressed during the 2014 tax law revision?to encourage the succession of technology and management know-how of specialized mid-sized long-lived companies and job retention?has been rendered ineffective. Furthermore, the 2019 revision extended the exemption requirements for 30 billion KRW and 50 billion KRW based on the decedent's management period from 15 and 20 years to 20 and 30 years, respectively, and for mid-sized companies, completely excluded the application of the business succession deduction if there is a certain amount of inherited property outside the business succession.

In contrast, leading advanced countries actively support business succession under more relaxed conditions. In Germany, there are no restrictions on the size or industry of the target company, and the required shareholding by the decedent is only 25%. Moreover, heirs are not required to work in the business or assume the CEO position. Japan enacted the "Smooth Business Succession Law" in 2008, establishing comprehensive measures including business succession tax systems, financial support systems, and special provisions for statutory reserved portions. There are no restrictions on business operation periods or limits on inheritance and gift tax deductions, the post-management period is short at 5 years, and there are no obligations to maintain employment, assets, or industry. The UK's Business Asset Inheritance Relief system also has no company size restrictions, no post-succession management requirements, and France only requires simple post-management conditions of 3 years of business management and 4 years of shareholding after inheritance. For reference, the U.S. had a qualified business asset inheritance deduction, but under the Trump administration, with the increase of the inheritance tax exemption threshold to 10 million dollars and other tax cuts, there was no practical benefit to operating a separate business succession deduction system, so it was abolished.

Various improvement measures have been proposed for the current business succession tax system. First, the term "business succession" may be misunderstood narrowly as the succession of small business owners or self-employed businesses, so changing it to "enterprise succession" or "business succession" is worth considering. Also, the application requirements should be relaxed and benefits expanded. Instead of limiting the application to SMEs and some mid-sized companies, it is reasonable to expand the scope significantly by size and industry like the UK, and reduce the required shareholding ratio to around 25% as in Germany. The current 10 billion KRW limit for the special gift tax taxation is significantly lower than the maximum 50 billion KRW for the inheritance tax special case, so it is desirable to regulate it the same as inheritance tax, as in Germany or Japan. Comparatively, Korea's post-management requirements are excessively strict, so the period should be shortened to less than 5 years, and employment and wage maintenance obligations should be converted into additional incentives. Business succession of SMEs is not a simple transfer of personal wealth like general inheritance but contributes to employment of workers and development of local communities and the national economy through the company's survival efforts. It is a crucial time to design a system that actively supports the use of business succession tax systems to foster century-old companies.

Baek Jeheum, Lawyer at Kim & Chang