Ideal time for business succession planning

One of the chief concerns of family business owners is how to pass the business to the next generation and/or key employees. Although various provisions of the federal estate tax laws are intended to ease the tax burden on the transition of small businesses upon an owner's death, these provisions are very limited in their scope and benefit. However, the recently enacted Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provides business owners with some meaningful tax-free opportunities to move their businesses to the next generation.

As widely publicized, the act extends the Bush-era individual income, capital-gains and dividend tax cuts for all taxpayers for two years (2011 and 2012). Most people also know that the act temporarily increased the federal estate tax exclusion (i.e., the amount that may be passed to heirs free of federal estate tax) from $1 million to $5 million and reduces the federal estate tax rate to a single tax bracket of 35 percent.

Obviously, a business owner who dies in the next two years will be able to pass substantially more of his or her business to his or her heirs than would have been possible without the act. However, unless the business owner dies in the next two years (which is hopefully not the case) the act's changes to the estate tax laws really won't help very much. As seen in 2010, Congress may or may not extend, modify, or otherwise alter these new laws. If nothing is done, we will revert to the rules that would have been applicable in 2011 without the act, i.e., a $1 million federal estate tax exclusion and a maximum estate tax rate of 55 percent.

The act's biggest benefit to business owners, however, is a 500 percent increase in the federal lifetime gift tax exclusion. Since 2001 the lifetime gift tax exclusion has remained at $1 million. Under the terms of the act, the gift tax exception increases dramatically to $5 million and the gift tax rate is reduced to 35 percent. Like the estate tax exclusion, the gift tax exclusion is an exclusion from federal transfer taxes for assets transferred to other persons except that it relates to transfers made while you are alive. The federal gift and estate tax exclusions are unified such that any lifetime gifts which use a portion of your gift tax exclusion will also reduce dollar for dollar the amount of your estate tax exclusion available upon your death.

What does all of this mean for business owners? During this brief, two-year window you have an unprecedented opportunity to pass up to $5 million (or up to $10 million for a married couple) in business interests or other assets to the next generation or generations. The combination of this previously undreamed-of gift-tax exclusion, depressed asset and real property values, and rock-bottom interest rates has created a once-in-a-lifetime opportunity to transfer very large blocks of your business interests wealth to your children and beyond free of any gift and estate taxes. There has not been a better time to make gifts in several decades.

Importantly, the act does not disturb some very advantageous estate planning tools such as the grantor retained annuity trust (GRAT). Valuation discounts for minority interests and illiquid assets (such as closely-held business interests) are also still available and are often used with various estate planning techniques to leverage a person's gift and estate tax exclusions to make tax-free transfers of substantially more assets than would otherwise be possible. For example, assume Father and Mother own a business worth $10 million. Father and Mother would like to transfer the business to their three children who all participate in the business. By gifting equal 33 percent interests in the business to the three children, Father and Mother can take valuation discounts due to the lack of control and lack of marketability associated with those 33 percent interests. After the transfers, none of the children will have a controlling interest in the company and there is no ready market or stock exchange available for them to quickly convert the business interests to cash. Therefore, Father and Mother may be able to discount the value of the gifted business interests as much as 30 percent to 40 percent.

Assuming a 30 percent discount in our example, Father and Mother would utilize $7 million of their combined $10 million gift tax exclusions. The remaining $3 million in gift tax exclusions could be utilized to transfer other assets to their children or others. Not only would Father and Mother avoid taxation resulting from the transfer of their business, but also they would maximize the amount of assets transferred by discounting the asset values. The transfer also allows any future appreciation in the value of the business to inure directly to the children outside of Father's and Mother's estates.

Some of you have already exhausted your $1 million lifetime gift-tax exclusion. The act provides a limited time period to make additional gifts. You have another $4 million to gift for the next two years. Alternatively, you may have sold business interests to irrevocable trusts for your children, in return for a low interest promissory note payable (which is still a very useful planning method). Generally, the purpose of these transactions is to take advantage of valuation discounts and to "freeze" the value of the business interest in your estate by replacing the business interest with a very low interest promissory note. If you want to be free of the hassle of the ongoing note payments, then the additional lifetime gift tax exclusion presents an opportunity to forgive the promissory note and thereby conclude the transaction.

In terms of planning beyond the act's two-year horizon, we feel that the only prudent thing to do at this time is to assume that the act will expire and take prompt action.

Don L. Ross and Jason C. Morris are attorneys practicing in the areas of estate planning, taxation and probate at Woodburn and Wedge.

Contact them at 688-3000 or dlross@woodburnandwedge.com and jmorris@woodburnandwedge.com.