Planning for your most valuable asset
Few people have more estate planning issues to deal with than the family business owner. For one thing, the business may be the most valuable asset in the owner’s estate. This means it can generate significant estate tax liability. Yet, because it’s a relatively illiquid asset, the business may not provide the cash needed to pay the estate tax bill. The transfer of ownership interests and leadership responsibilities can also be a major issue, often creating conflicts within the family. As a result, many family-owned businesses don’t survive beyond the first generation. Integrated estate and succession planning is critical if you want to beat those odds.
Address 3 key questions
If you’re a business owner, you should address the following concerns as you plan your estate:
1. Who will take over the business when you die? Owners often fail to develop a management succession plan. It’s vital to the survival of the business that successor management, in the family or otherwise, be ready to take over the reins.
2. Who should inherit your business? Splitting this asset equally among your children may not be a good idea. For those active in the business, inheriting the stock may be critical to their future motivation. To those not involved in the business, the stock may not seem as valuable. Or perhaps your entire family feels entitled to equal shares in the business. Resolve this issue now to avoid discord and possible disaster later.
3. How will the IRS value your company? Because family-owned businesses aren’t typically publicly traded, knowing the value of the business is difficult without a professional valuation. The value placed on the business for estate tax purposes is often determined only after a long battle with the IRS. So, plan ahead and ensure your estate has enough liquidity to pay estate taxes and support your heirs.
Take advantage of special estate tax breaks
Current tax law has provided two types of tax relief specifically for business owners:
Section 303 redemptions. Your company can buy back stock from your estate without the risk of the distribution being treated as a dividend for income tax purposes. Such a distribution must, in general, not exceed the estate taxes and funeral and administration expenses of the estate. One caveat: The value of your family-owned business must exceed 35% of the value of your adjusted gross estate. If the redemption qualifies under Sec. 303, this is an excellent way to pay estate taxes.
Estate tax deferral. Normally, estate taxes are due within nine months of your death. But if closely held business interests exceed 35% of your adjusted gross estate, the estate may qualify for a deferral of tax payments. No payment other than interest is due until five years after the normal due date for taxes owed on the value of the business. The tax related to the closely held business interest then can be paid over as many as 10 equal annual installments.
Thus, a portion of your tax can be deferred for as long as 14 years from the original due date. Interest will be charged on the deferred payments. (See the Case Study “Sometimes putting off until tomorrow makes sense.”)
Ensure a smooth transition with a buy-sell agreement
A powerful tool to help you control your — and your business’s — destiny is the buy-sell agreement. This is a contractual agreement between shareholders and their corporation or between a shareholder and the other shareholders of the corporation. (Partners and limited liability company members also can enter into buy-sell agreements.)
The agreement controls what happens to the company stock after a triggering event, such as the death of a shareholder. For example, the agreement might require that, at the death of a shareholder, the stock be bought back by the corporation or that the other shareholders buy the deceased’s stock.
A well-drafted buy-sell agreement can solve several estate planning problems for the owner of a closely held business and can help ensure the survival of the business. (See the Planning Tip “Protect your interests with a buy-sell agreement.”) It’s also critical to be sure that funding for the agreement is in place. Otherwise, you risk making all the planning ineffective.
Remove future appreciation by giving stock
One way to reduce estate taxes is to limit the amount of appreciation in your estate. Giving away assets today keeps the future appreciation on those assets outside of your taxable estate.
There may be no better gift than your company stock — this could be the most rapidly appreciating asset you own. For example, assume your business is worth $5 million today but is likely to be worth $15 million in several years. By giving away some of the stock today, you’ll keep a portion of future appreciation out of your taxable estate.
Warning: The gift’s value can have both gift and estate tax ramifications. The IRS may challenge the value you place on the gift and try to increase it substantially. The IRS is required to make any challenges to a gift tax return within the normal three-year statute of limitations, even when no tax is payable with the return. But the statute of limitations applies only if certain disclosures are made on the gift tax return. So seek professional assistance before transferring portions of your business to family members. •
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