Success in your business should be a reason to celebrate and take pride in your accomplishments. Yet as a savvy business owner, you also need to consider what this success will mean for the next generation.
Without careful planning, your beneficiaries could find themselves with a hefty tax bill. A tax expert can help you a) minimize estate taxes and b) generate sufficient liquidity to satisfy estate expenses.
In 2021, the federal estate tax does not apply to individual estates worth less than $11.7 million[1], but after 2025, this exception is expected to reverse to $5 million for an individual.[2] Many more business owners need to be thinking ahead about estate planning! This article outlines a number of estate planning tax strategies…
LIFETIME GIFTING, LIQUIDITY RELIEF, LIFE INSURANCE
Lifetime Giving. Every year, taxpayers can gift up to a certain amount per beneficiary without having to report it on a gift tax return (Form 709).[3] Currently, the cap is $15,000 per year.[4] You may also be able to take advantage of the lifetime gift tax exemption, which has the same threshold as the federal estate tax exemption[5] ($11.7 million through the end of 2025).
If your business is closely held (five or fewer shareholders own the majority of the company), gifts of shares may be entitled to a discount for lack of marketability or a minority ownership interest. [6]
Liquidity Relief. A business can be the most valuable piece of your estate and yet offer the least amount of liquidity for estate expenses, including estate tax. The Internal Revenue Code does provide some relief, such as allowing stock redemption for cash[7] and deferring federal estate tax payments[8] (when the business represents at least 35% of your gross estate). Unfortunately, there is no real planning that can be done to guarantee that the business will meet that threshold.
Life Insurance. Life insurance is another simple planning strategy to generate liquidity for estate expenses. The proceeds are promptly available to the beneficiaries, and the insurance may also provide equitable treatment to those beneficiaries who are not inheriting the business.
THREE TYPES OF IRREVOCABLE TRUSTS
GRATs (Grantor Retained Annuity Trust): The owner gifts assets with growth potential to the trust. During the grantor term, the owner receives an annuity payment for a term of years, either a fixed amount or a percentage of the value of the trust assets.[9] Two stipulations…
- The owner must survive the grantor term[10]
- The assets in the trust must “beat” the IRS §7520 rate (the annual rate of return that is expected on the investment) [11]
One way to mitigate survival risk is to use multiple short-term GRATs. As of January 2021, the §7520 rate is very low (0.6%)[12], so well-performing assets should have a good chance to beat that rate. If successful, the assets are transferred to the beneficiaries with no gift or estate tax in the remainder term.
IDGTs (Intentionally Defective Grantor Trusts): The trust removes assets from the owner’s estate for gift and estate tax purposes but not income tax purposes. The income tax payments count as transfers to the trust, which are exempt from gift tax.[13] This further reduces taxable estate. Again, there is a survival risk. If the owner dies before the note is repaid, the value of the note as of the date of death will be included in the estate.
ILITs (Irrevocable Life Insurance Trust): Create this trust to either accept ownership of an existing life insurance policy or purchase a new policy on your life. If the insured owns life insurance policies at the time of his or her death, the value of the policy will be included in the estate[14]; however, if the ILIT owns the policy, the value is generally not included in the estate. By gifting enough money to the ILIT to cover the premiums, the insured further reduces the taxable estate.
Note: The insured cannot have any ownership rights or “incidents of ownership” in the insurance policies, such as the right to change a beneficiary, or the value of the policy will likely be included in the estate, even if the right is never exercised.[15]
AN EXAMPLE
Elizabeth owns a family business worth about $20 million. Her oldest son, Charles, is planning to take over after Elizabeth’s retirement within the next five years. Her other three children are not involved in the business.
Elizabeth has three goals: 1) gradually transfer ownership of the business to Charles, 2) have a stream of income, and 3) provide for her other three children. To accomplish these goals, she can:
- Gift 20% of her shares to Charles. In her case, these shares were discounted due to lack of marketability and minority ownership interest.
- Create a short-term GRAT with 20% of her shares (valued at $2 million). She’ll receive $400,000 per year for two years with Charles as her beneficiary.
- At the end of two years, create another short-term GRAT with similar terms, assuming interest rates are still low.
- Create an IDGT and sell 40% of her shares (valued at $8 million) and receive installment payments for the loan term with Charles named as the beneficiary.
- Create an ILIT, which owns a life insurance policy on her life, and names her other three children as beneficiaries in equal shares.
As a result…
- Charles becomes the sole owner of the business
- Elizabeth has a steady income stream
- At her death, Elizabeth’s other children receive the life insurance proceeds to allow for equitable treatment and to pay for any needed estate expenses
SUMMARY
Your business success should be nothing but a cause for celebration for you and your beneficiaries. Let us help you plan for the future and eliminate the stress factor with an estate tax planning consultation.
[1] Rev. Proc. 2020-45, Sec. .41. [2] IRC § 2010(c)(3)(C). [3] IRC § 2503(b). [4] Rev. Proc. 2020-45, Sec. .43. [5] IRC § 2505(a)(1). [6] Rev. Rul. 59-60; Rakow v. Commissioner, T.C. Memo 1999-177. [7] IRC § 303. [8] IRC § 6106. [9] IRC §§ 2702(b)(1), (2). [10] IRC § 2036(a). [11] IRC §§ 2702(a)(2)(B); 7520. [12] Rev. Rul. 2021-1. [13] Rev. Rul. 2004-64. [14] IRC § 2042(2). [15] IRC § 2042(2).
