Entrepreneurs work tirelessly to build their companies, many with the intent to transfer their business to the next generation. But without proper estate tax planning, business owners at certain levels of wealth run the risk of missing out on significant savings opportunities.
Using tools like tax exemptions, trusts, valuation discounts and leveraging business structures for tax purposes can protect family wealth and ensure business continuity. These tools can also minimize estate tax burdens and help transfer wealth to heirs.
Comprehensive Approach for Business Owners
Incorporating one or more estate tax planning strategies into family business plans fortifies long-term business operations and helps minimize potential issues arising with beneficiaries.
Lifetime Gift Tax Exemption
The lifetime gift tax exemption is beneficial to business owners because it allows them to gift a certain amount of money or assets during their lifetime without having to pay federal gift tax. Currently, the combined federal estate and gift tax exemption amount is $13.61 million per person, or $27.22 million for married couples. It’s important to note the gift tax exemption limit is adjusted for inflation each year and, absent future action by Congress, these exemption amounts are scheduled to be halved after 2025.
Trusts
Trusts allow business owners to help protect their legacy and optimize wealth through tax-efficient planning strategies. Depending on a business owner’s goals, some trusts may be more beneficial than others:
- Spousal Lifetime Access Trust: From a tax perspective, establishing a SLAT may be an attractive strategy to make a large gift and take full advantage of the gift tax exemption amount. Here, business interests can be transferred to a SLAT with a spouse as beneficiary without resulting in later estate tax inclusion. Gifts to the SLAT can be made up to the lifetime gift exemption without being subject to federal gift taxes.
- Intentionally Defective Grantor Trust: Business interests transferred to a properly drafted IDGT by the grantor/business owner are considered a completed gift for estate tax purposes, which removes future appreciation from the business owner’s estate. Although the grantor pays income tax on the trust’s earnings, the payments are effectively tax-free gifts to the trust beneficiaries allowing a greater amount of wealth to be transferred to the next generation.
- Irrevocable Life Insurance Trust: When a life insurance policy is owned by an ILIT versus owned by an individual, the life insurance proceeds are not included in the value of the deceased’s estate.
- Grantor Retained Annuity Trust or Grantor Retained Unitrust: These trusts are designed to reduce gift and estate taxes by enabling business owners to transfer assets into a trust and receive payments from the trust for a designated period. Ultimately, any remaining assets are distributed to designated beneficiaries. GRATs and GRUTs are oftentimes considered when the transferred asset into the trust is expected to significantly increase in value.
Charitable trusts, Dynasty Trust, Family Limited Partnership (FLP) and Credit Shelter Trusts are other options business owners may consider in their efforts to minimize estate taxes, formalize business succession plans and facilitate transferring wealth. Consulting with wealth management advisors, accountants and attorneys can help align appropriate trusts to estate planning objectives.
Valuation Discounts
When considering transferring business interests to family members during a business owner’s lifetime, minority interest and lack of marketability discounts may substantially reduce the gift tax value for such transfers. These discounts allow business owners to use up a smaller amount of their lifetime gift exemption when transferring business interests. To take advantage of valuation discounts, transfers must occur well before any sale of the business.
Leverage Business Tax Structure for Unique Goals
Business designations, such as a Sole Proprietorship, Limited Liability Company (LLC), C Corporation (C-Corp) and S Corporation (S-Corp) have different tax structures. It’s crucial for business owners to align their choice of entity with their estate tax plan and business plan.
Why It’s Important to Plan Ahead
Succession planning is a dynamic process that addresses questions about ownership and management transitions. Failing to plan is planning to fail. Business owners who wish to pass their enterprise to a family member must incorporate estate planning into their strategic business plan to ensure a smooth business transition and tax efficiencies.
Engaging professionals who specialize in working with owners of privately held middle market companies can help ensure appropriate vehicles are implemented to protect and preserve a business owner’s hard-earned wealth — maintaining continuity for the business they spent a lifetime building.
Michael Blanton is the managing director for BMO Wealth Management Arizona. His team specializes in working with business owners and high-net-worth families, helping them navigate everything from business exit strategies to investment management.
Did You Know: Fewer than 50% of small business owners have an estate plan in place, and a survey of baby boomers reflected those who didn’t work with experts to secure tax-efficient estate plans didn’t feel prepared to transfer their wealth upon their passing.
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