Tools to Help Business Owners Understand and Survive the Financial Crisis

Proposed Changes to Estate and Gift Tax - A Wakup Call for Business Owners

Posted on July 29, 2009

Congress and the President appear dead set on creating lasting damage to independent business through ill conceived tax policies. The latest reports show that Congress is planning to solve our health care crisis at the expense of the “rich” with family incomes over $350,000 by imposing a new surtax of as much as 8-9% in addition to other tax increases already in the Obama budget. According to a 2007 Treasury study reported by the Wall St. Journal, fifty percent (50%) of the incomes affected by the new taxes will be generated by the sole proprietorships and Sub-S corporations which are responsible for creating 70+% of the new jobs in the United States.

If anything like the proposed new taxes comes to pass, it may be time for business owners to shift some wealth back to their tax planners and to dust off C-Corporations and tax shelters as areas of strong interest. When considering their options, business owners should take into account the negative (double taxation) impact of tying up their wealth in taxable C-Corps. In our M&A practice, we find that structuring private businesses as C corporations is one of the major impediments to successful exit transactions. Planned increases in the capital gains taxes are certain to make things even worse. For many business owners the best answer may well be to sell now before these overreaching tax law changes make it infinitely harder to realize fair value from their many years of hard work.

Less well publicized are various tax proposals aimed at “reforming” the estate tax laws. In addition to the planned return of the wealth transfer tax following the expiration of the Bush tax cuts, the administration has several surprises in store which could have a major detrimental impact on the ability of business owners to pass ownership of their companies to subsequent generations. Our friend Denis Brown of Pace Capital Resources, a business ownership transition firm based in Atlanta, has shared with us several goodies, including the elimination of marketability and minority interest discounts in the valuation of privately owned companies. This would have the effect of increasing valuations for estate tax and other purposes by as much as 25-30%. We’ve reprinted Denis’s article on the subject below:

The following is reproduced with permission from Denis Brown of Pace Capital Resources in Atlanta, GA.

As a norm a business owner will spend considerable time planning and working in the business.  But unfortunately, will spend little time developing a plan to exit the business and incorporating appropriate estate and gift planning strategies in the process.  Given that the biggest asset is the business, the proposed changes to estate and gift tax by the Obama administration may change the urgency on the part of business owners.  The proposed changes will have a significant negative impact on the ability to transfer wealth.  However, there is a limited window of opportunity to preserve wealth for those who act now.

The administration’s proposed changes would freeze the unified credit exclusion amount at $3.5 million ($7.0 million for couples) and the tax rate at 45%.  The proposal also includes a portabililty provision that allows a surviving spouse with an estate that exceeds the applicable estate tax exemption to apply any unused portion of the deceased spouse’s exemption.  That is the good news.  The bad news is the proposed minimum term for Grantor Retained Annuity Trust (“GRAT’) is 10 years and the elimination of minority and marketability valuation discounts on closely held entities.

A GRAT allows the grantor of a trust to pass on appreciating assets free of gift and estate taxes.  The annuity paid back to the grantor over the life of the trust equals the initial value of the asset plus a rate established by the IRS.  The annuity is not taxed since it is a flow back to the creator of the trust.  If the assets in the GRAT outperform the IRS set rate of return the remainder is out of the estate and transferred to the beneficiaries without incurring a gift tax.  A GRAT is an attractive strategy to pass ownership interest in a family business and appreciating assets.  There is, however, a mortality risk; if the grantor passes before the term of the trust then the asset reverts back to the estate.  Current strategy incorporates a series of short term GRAT’s to minimize mortality risk and downturns in the economy.  Under the proposed 10 year term minimum owners must weigh the risk they won’t survive the 10 year period.

A potentially more detrimental impact is the elimination of discounts on closely held entities.  Often times the combined minority and marketability discounts are significant typically ranging from 25% to 40%.  Thus, greatly reducing both gift and estate taxation for estates that otherwise likely would be over the applicable exclusion amount.  For example an owner’s business is worth $20 million and devises 25% to each of his four children.  At death each transfer would qualify for a minority and marketability discounts equal to 30% (will vary dependent upon several factors) and each child’s share would be valued at $3.5 million, $14 million in aggregate (the sum of the parts is less than the whole).  The difference is $6 million which equates to an estate tax savings of $1.125 million ($6 million less $3.5 million exclusion times a 45% tax rate).  This is a simple example of the negative impact of the proposed change and the need for planning by business owners when the estate is much greater than the exclusion.  In the real world transferring the business in equal parts to siblings, some of which may or may not be active in the business or capable, is typically a formula for disaster unless the owner intends to exit by selling to a third party.

On a positive note there is a window of opportunity and current conditions are highly advantageous with capital assets at a historic low and interest rates that would be required on a note by the IRS under a transfer is also at a historic low (approximately 2%, changes monthly).  In essence, a business owner with an estate exceeding the exclusion amount and subject to the 45% estate taxation rate should consider taking advantage of current conditions and transfer a minority interest in family owned entities under current regulations.  Contact your tax advisor and estate planning professional to determine how these changes will affect you and remember every business owner will eventually leave the business, voluntarily or otherwise.  Proper Exit Strategy Planning enables an owner to leave under their time frame, maximizing after tax value, ensuring continuity in case of an unexpected event and assuring financial security for the family.