When it comes time for a business owner to transition or sell their business, taxes tend to be one of the most important negotiating points. In many cases, recent tax legislation has increased the value of businesses through favorable credits and deductions and reduced tax rates.

Yet, with reports of abusive tax shelters constantly in the press, many taxpayers and their advisors are increasingly wary of even the most fundamental tax planning strategies. Despite this, solid tax planning remains an essential component of building personal wealth, and preserving multigenerational longevity. In fact, a recent study from Accenture estimates that over $30 trillion in financial and non-financial assets in North America will transfer from the hands of baby boomers to their heirs over the next 40 years. And according to the Joint Committee on Taxation, wealthy Americans are expected to turn over $269 billion to the U.S. government over the next decade alone in the form of inheritance taxes.1 Yet according to AARP, only 58% of boomers have estate planning documents completed.2

The Three Pillars

Throughout the cycle of building, operating and ultimately transitioning a business, there are a variety of strategies that can help protect the value you have created from state and federal income tax and lifetime gift and inheritance taxes.

These alternatives can be categorized in three groups:

  • Estate Freezing and Transfer Techniques
  • Rollovers, Exclusions and Tax Deferral Techniques
  • Deductions and State Income Tax Avoidance

Estate Freezing and Transfer Techniques

Perhaps the most thoughtful way to consider passing a highly appreciating asset like a business to your children, while minimizing the tax impact of the transaction, is to "freeze" the value of the business at its current valuation, transfer this asset to a child and then sell the asset in the future after it has appreciated in value, thus avoiding gift or inheritance taxes on the future appreciation.

Six of the most common strategies for accomplishing this tactic include:

  • Annual gifting. Individuals may transfer up to $15,000 ($30,000 for married couples) of stock in their company to each child, every year. While likely insufficient to fully transfer a business, this technique can be useful nonetheless.
  • An installment sale to an intentionally defective grantor trust. This strategy involves a sale of all or part of the business to an irrevocable trust for the benefit of the seller's children in exchange for a note, typically several years in advance of a sale. When the business is ultimately sold, the trust receives the proceeds from the transaction and repays the note to the seller. Any growth in the value of the business during the interim period between the transfer and the sale will remain in trust for the seller's children, having transferred out of the estate free of gift or estate taxes. During this interim period, profits from the business that are distributed to the trust can be used to cover the interest payments on the note due back to the seller.
  • Private annuities. Similar to the installment sale strategy described above, a private annuity can be structured whereby a business owner sells the business to his or her children in return for an unsecured promise to pay back an annuity to the business owner for life. This technique may be riskier if the business owner intends to rely on the annuity payments to cover ordinary living expenses and does not have complete confidence in his or her children's ability to manage the business.
  • Grantor retained annuity trusts (GRAT). A GRAT is a common wealth transfer strategy that involves transferring shares of a business to a trust in return for an annuity typically equal to the value of the shares transferred. Any subsequent appreciation in the value of the business after it is transferred to the GRAT passes to the trust beneficiaries free of gift and estate taxes. Earnings and appreciation on the business must exceed the aggregate annual annuity payments for this technique to succeed. This is a popular technique during low interest rate environments, as the payment requirements are low. In fact, according to Richard Covey, the attorney who is credited for pioneering this technique, U.S. taxpayers have saved more than $100 billion using GRATs since 2000, representing nearly one third of all estate taxes the U.S. has collected since that time.3
  • Charitable lead annuity trusts (CLAT). A CLAT is a charitable alternative to a GRAT where shares of a business are transferred to a trust that pays an annual annuity to a charitable organization. At the end of the annuity term, whatever value is left in the trust (the remainder interest) passes to the trust's non-charitable beneficiaries, such as the grantor's children. This technique can be structured to provide an immediate charitable income tax deduction, yet — if the shares are highly appreciable — also allows for the appreciation of the remainder interest to remain in the family free of gift and estate taxes.
  • Family limited partnership (FLP) and recapitalization. This technique involves recapitalizing shares of a business into voting stock held by the business owner and non-voting stock held by the business owner's children or trusts for their benefit. This strategy enables the business owner to retain voting control of the business while transferring almost all of the economic value of the business (i.e., the non-voting stock) and any future appreciation out of his or her estate free of gift and estate taxes. Furthermore, the value of the non-voting shares may be transferred at a discount to fair market value due to the shares' lack of marketability and lack of voting control.

Rollovers, Exclusions and Tax Deferral Techniques

Unlike estate-freezing techniques, which require business owners to enter into a transaction or create a special legal entity, rollovers and exclusions are sections of the tax code that may be utilized so long as you meet certain criteria. Three of the most relevant sections for business owners include:

  • Section 1042 "Tax-Free" rollover from the sale of a business to an employee stock ownership plan (ESOP). According to section 1042 of the tax code, a business owner can sell company stock to an employee stock ownership plan (ESOP) and defer federal (and often state) tax on the transaction by rolling over the proceeds into qualified replacement property (QRP), such as the stocks or bonds of domestic operating companies. If held through their lifetime, the deferred taxes are extinguished at death and the children will receive a stepped-up tax basis on these assets.
  • Section 1202 capital gains exclusion. Section 1202 allows small business owners to exclude at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held for five years or longer. This gain is limited to the greater of $10 million or 10 times their basis in the stock. For more on this, consult our paper, "The Tax Benefits of Investing in Small Businesses."
  • Section 1045 rollover. Section 1045 allows the seller of a business to rollover the taxable gain of QSBS into another QSBS within 60 days of the sale, thus deferring the recognition of the capital gain due until this newly acquired business is disposed of. This technique can be combined with section 1202 so that some of the proceeds of a qualified sale can be retained as cash, and the remainder can be reinvested in another venture. This technique may be particularly useful for "serial entrepreneurs."

Deductions and State Income Tax Avoidance

While there are many deductions available to owners of operating businesses, there are two particular tactics that are lesser known, yet have been gaining popularity among clients. These include:

  • An interest charge domestic international sales corporation (IC-DISC). An IC-DISC is an entity created in order to enable exporters to convert ordinary income from sales to foreign unrelated parties into qualified dividend income (up to 50% of combined domestic and international income). This strategy allows international companies to convert ordinary income tax into capital gains tax, reducing their federal tax obligation each year and increasing the value of the business that a buyer would be willing to pay.
  • An incomplete gift non-grantor trust (INGT). This trust structure allows a business owner to shift tax exposure from a high-tax state such as California or New Jersey to a state with no state income tax such as Delaware or Nevada. If created far enough in advance of a sale of the business, usually at least two years, an additional benefit is the elimination of state capital gains tax on the sale. Sophisticated planners have realized this type of jurisdictional planning can help wealthy families minimize or avoid home state tax, though some states have pre-empted this technique.

Thoughtful Planning Can Lead to Savings

Thoughtful tax, trust and estate planning, and business succession strategies provide the greatest opportunity to maximize legacy economic wealth for business owners. Familiarizing yourself with the three pillars is only the first step. It is imperative you have a collaborative team of advisors, including attorneys, accountants, wealth managers and planners who can incorporate your vision for your business, and your plans for succession, into a well-defined, tax-efficient structure.

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