Every day the IRS is inventing new ways to increase tax collections. Coupled with the upcoming presidential election, small to mid-sized business owners are faced with a slew of financial decisions that could impact the wealth of their business and the legacy they leave to their successors. For business owners, what’s at stake ahead of election uncertainty?
Unrealized tax breaks
The current estate tax threshold of $11.58 million per individual is set to sunset at the end of 2025, when it could revert to the pre-2018 exemption level of $5 million for an individual taxpayer. Depending on the 2020 election outcome, the estate tax exemption could be phased out before the increase is eliminated in 2026.
Increased tax liability
This presents a use it or lose it situation for business owners. Current gifts can use the full exemption of $11.58 million whereas future transfers may be subject to a much lower exemption amount. In turn, this causes some of the transfer to be subject to gift tax at 40%.
Missed opportunity at lower valuations
With properly structured current gifts to family members, which take advantage of lower valuations (i.e., before value appreciation due to capital gains) and current allowable valuation discounts, families can pass a greater share of their business to their heirs tax free.
For example, under the current tax law, say the owner of a family business gifted $1 million of the business to one of their heirs, but at the time of the owner’s death, those shares appreciated in value to $10 million. By making a gift early, the business owner only used up $1 million of the estate tax exemption. The other $9 million escaped estate taxation of 40% for a tax savings of $3.6 million.
If the laws change before gifts are made to take advantage of the current favorable rules, family business owners could be missing out on substantial savings.
In order to protect your business enterprise from the dismal D’s – death, disability, divorce or health setback, it’s imperative to be prepared. It’s important to have the right documented plan with the appropriate estate protection in place.
1. Restructure your business. If you’re the owner of an S corporation, you are no stranger to the complexities that come along with estate planning. One tax strategy to consider is reorganizing your business so you have both voting and non-voting shares. Gifting non-voting shares may provide some relief to business owners not willing to relinquish control of their business.
2. Prepare future ownership alternatives. Business owners should explore planning alternatives that will provide them with the greatest flexibility in terms of receiving future cash flow and being able to use principal from time to time. Sales, entity freezes, Grantor Retained Annuity Trusts are all methods a business owner can use to retain access to some cash flow and transfer future appreciation of the assets out of their estate and save the aforementioned $3.6 million.
3. Use exemptions from estate planning now. Most owners of family businesses are concerned that they cannot use this increased exemption because of their desire to retain the cash flow from the gifted assets. However, if the use of the increased tax exemption is delayed, it may not be available later, depending on the 2020 election outcome. Today’s favorable estate tax environment is unlikely to come around again.
4. Determine current lower valuations and allowable valuation discounts. Current lower valuations and allowable discounts provide added leverage in using this valuable estate tax exemption amount. An individual willing to use $11.58 million of their exemption, and assuming a 25% discount, can gift $15 million of assets at no current gift tax cost. Look for the lowest valuation of businesses and business interests deemed supportable for tax regulatory purposes.
5. Know your gifting options. Gifting does not need to be done by outright gifts. For example, some business owners establish an irrevocable trust, which provides asset protection for the family and allows the trust to have control on the distributions, thus saving them on any future estate tax.
It takes an experienced advisor to understand the challenges and nuances of estate taxes and compliance with regulatory authorities.
This article was originally published in Kansas City Business Journal.