Small Business Owners: Estate Planning
Going on a trip? Do you have a plan? Someone to watch the house; take care of pets, etc.? Of course.
So what is your plan for your small business when you are no longer able to operate it?
Who will be left to pick up the pieces? Will they have the necessary skills, time and desire to take over?
You've spent a lifetime building your business. Take a moment to make sure that your hard work will survive your death or the death of one of your partners.
You need a plan and we can help.
Small Business estate planning looks at a number of issues:
- Everyone wants to Minimize Taxes.
Under current law, taxes due on a small business, upon the owner’s death, usually range from 35% to 50% of the business value and the tax is due within nine (9) months of your passing. Unless the business is uniquely liquid, that’s a lot of money to have to come out of the pocket of your heirs at a time when they have just lost you. In many cases paying the tax means selling the business or what’s left of it without you. Proper estate planning can minimize the amount and the timing of the tax bite and preserve the business. Two (2) IRS provisions, Section 303 and Section 6166, alleviate the tax burden on small businesses after the owner has passed.
- Section 303 permits your estate to redeem your stock in the business with very little tax cost. This is a one-time opportunity, and the stock value must be more than 35 percent of your estate.
- Section 6166 offers estate tax deferral for small business owners. To take advantage of Section 6166, more than 35% of your adjusted gross estate must be from your business interests. If eligible, your executor can pay the estate tax in 10 annual installments and the first installment isn't due for five years.
- Qualified family-owned business exclusion. If your business qualifies as "family owned," you may be able to exclude part of it (up to $675,000) from estate taxation. Your business qualifies as family owned if the business comprises more than fifty (50%) percent of your total estate and you pass the estate on to a "qualified heir." A qualified heir is generally defined as a spouse, child, grandchild or other descendent. Your heirs, however, should realize that they have to hang onto the business for at least ten (10) years following such an estate transfer. If they don't, they may have to pay the full estate taxes that were avoided. Life insurance can provide your heirs with the cash necessary to pay estate taxes whether or not you qualify for this exclusion.
Proper valuation of your business is an essential element for tax planning.
- Buy-Sell Agreements between or among partners.
If you have a partner(s) qualified to operate the business after you are gone, a buy-sell agreement structures the transition of the business to your partner(s) and generates value for your spouse and family. A Buy-Sell agreement is generally structured as a bi-lateral contract that establishes a plan for the business in case one of the owners dies or becomes incapacitated. The agreement establishes a sale price or a formula to determine a price for the business and your share of the business. Since the business price has been established, family members know they are receiving a fair price.
However, if the business assets are not liquid, where does your partner(s) get the capital to buy out your share? Very often, the capital comes from life insurance. Each partner takes out a life insurance policy which names the other owner(s) as beneficiary. This strategy gives the surviving owner(s) tax-free proceeds to purchase the deceased's portion of the business from his or her estate.
- Sole Proprietors.
If you're a sole proprietor (no partners), your business is your personal assets. Probably more than any other type of business, you need a clear plan of action for what should take place after you're gone. Your other assets can be used to cover business debts. Delegate and prepare your successor if you want to pass on the business. If you want to sell the business, do the research that will make selling it easier and less expensive for your heirs.
You want to communicate with your family about a wise path for the future. But you also want to document those wishes in an estate plan to prevent disagreements after you’re gone.
- Family-Run Businesses: Considering the Heirs.
You may have some heirs who are involved in the business and others who are not - how do you divide your business assets? Many people choose to distribute assets based on a relative's contribution level. Let's say two of your children are going to take over the family business. Do you want your third, uninvolved child to have an equal share? Perhaps you want the two involved siblings to buy out the third. Regardless of what you decide, controlling these types of choices is critical. Your heirs have lost you, but your estate plan memorializes your wishes. Proper estate planning allows your business to have a smooth transition.
- Lifetime Transfers of Business Interests.
The first step in making a lifetime transfer is to properly determine the value of the business. There are many options available, including:
- outright gifts equal to the annual gift exclusion (currently $12,000 to each person or $24,000 if the business owner has a consenting spouse) which amount is increased yearly based upon inflation);
- outright gifts greater than the annual gift tax exclusion which would reduce the Applicable Federal Estate Tax Exclusion Amount available to your estate at death;
- gifts in trust to family members which would reduce the Applicable Federal Estate Tax Exclusion Amount available at death (unless the beneficiaries had certain rights to withdraw property from the trust);
- Gifts of interests in a family limited partnership (FLP) or limited liability company (LLC);
- transfers of all or a portion of the business interest into a Grantor Retained Annuity Trust ("GRAT");
- transfers of all or a portion of the business interests into a common law Grantor Retained Income Trust ("GRIT") if the beneficiaries are not the owner's descendants or spouse.
There can be considerable flexibility with lifetime gifting programs. The interest in the business can be transferred outright or placed in trust for the benefit of a younger family member. The trust can be either an inter vivos trust (established during the owner's lifetime) or a testamentary trust (set up under the owner's Last Will and Testament). The inter vivos trust can either be revocable or irrevocable. In a revocable trust, the transfer is not considered a completed gift since the owner can amend or revoke the trust. If the trust is irrevocable, the transfer may be considered to be a completed gift, and the property may be subject to gift tax.
Your desire to continue to maintain control of the business may dictate whether the property is placed in an inter vivos or a testamentary trust. If you are willing to forfeit control of the property, then the property can be transferred into an irrevocable inter vivos trust with any post-transfer appreciation passing free of estate and gift tax (in most circumstances).
When a business owner gifts partial interests in the business to family members, the value of those interests may be reduced by lack of marketability and/or minority discounts. A lack of marketability discount is a reduction in the value of the property due to the difficulty or inability of the owner to sell the property to a third person. A minority discount is a reduction in the value of the property since the interest does not provide for control of the entity.
Attorneys David T. Bunker and Maria Menard Pitney, Gould & Ettenberg, P.C. © 2014