Many taxpayers and their advisors have put estate planning decisions on hold while awaiting the outcome of the arcane deliberations going on in Washington over the federal budget. Family business owners and lobbying groups were hoping that some form of estate tax relief might emerge from the budget tug-of-war, even though the President in December vetoed the first budget bill passed by Congress—and, with it, the American Family Owned Business Act.
To be sure, the bill produced by a House-Senate conference committee was a breakthrough in that Congress recognized for the first time that many smaller family businesses are sold or liquidated after an owner dies because the family cannot pay the estate tax bill. Some type of relief for family businesses may be enacted, if not this year, in future sessions of Congress. However, waiting until then to take action on reducing your estate tax would be an expensive mistake for many reasons.
First of all, the legislation worked out in the Congressional conference committee would have applied to only a limited number of firms that could meet its stringent tests for eligibility (see, “Big guns in Congress back estate tax reform,” Autumn ’95). Just as important, the bill didn’t do much to help larger family companies which pay the highest estate tax rates (up to 55 percent). Under the conference agreement, each taxpayer could exclude up to $1 million in qualified family business interests from the estate of a deceased owner. For family business interests worth more than that, each taxpayer could exclude 50 percent of the amount between $1 million and $2.5 million. The maximum amount that could thus be excluded under the bill was $1.75 million per taxpayer—a boon to many families but a disappointment to others.
Second, many family businesses are in need of estate tax relief simply because their owners procrastinate. Though aware of techniques that are effective in reducing or eliminating the estate tax burden, they just never get around to pursuing them. Now may therefore be an appropriate time to review some of the available options.
Many of the techniques use gifting or other types of asset transfers during the owner’s lifetime. The sooner these transfers take place, the greater the potential for removing the future appreciation in value from the owner’s estate. Even if the American Family Owned Business Act is eventually enacted into law, planning will still be essential to protecting non-business assets such as publicly traded securities and non-business real estate, and to reducing estate tax on family business interests over $1 million.
A significant component of any estate plan should be a gifting program to fully utilize the annual gift tax exclusion of $10,000 per taxpayer. This $10,000 exclusion ($20,000 for a married couple) is not renewable; if you don’t use it in a given year, you lose it. In addition to this $10,000, there is no limit on the amount that can be excluded from gift tax for money paid to a health care provider for a family member’s medical expenses or paid to an educational institution for a child or grandchild’s tuition. Business owners who use these exclusions systematically each year can easily achieve significant reductions in estate tax. The estate can be shrunk further by choosing assets for these annual gifts that are expected to appreciate in value.
Another popular technique is the Family Limited Partnership. This strategy can help overcome one of the main objections to estate planning: the owner’s fear of losing control of the business. FLPs allow a family to shift wealth among the various partners while keeping control in the hands of one or more partners. In a typical FLP, parents (or a corporate entity that they control) are the general partners and retain operational control of the company even if their economic interest is only a small fraction of total ownership.
Generally, after creating the FLP, the parents gift limited partnership interests to the children. By using discounts for lack of marketability of shares in a privately held company and for a minority interest, the parents can leverage the amount of the gift that is free of gift or estate tax. Various assets can be contributed to an FLP, including securities, real estate, or shares in a business. Nowadays, the most frequently used asset is real estate, because much of it has declined in value around the country. If you feel the value of the real estate you own will recover, you may want to make a gift of the property now, at today’s values, in order to keep the future appreciation out of your estate.
Congress and the President have been arm-wrestling for weeks over reduction in the capital gains tax. If you want to avoid the capital gains tax entirely, and save on estate taxes as well, consider a Charitable Remainder Trust. This technique is used by many taxpayers who wish to establish a charitable legacy while achieving tax savings. The grantor contributes an asset (usually highly appreciated) to an irrevocable trust that has split interests. One beneficiary, who is not a charity, receives interest income from the trust for a designated period (say, the lifetimes of the taxpayer and spouse), and at the end of this period, the remainder interest (the value of the remaining assets) passes to a charitable organization.
Another valuable tool for transferring income-producing property to family members at a lower tax cost is the Grantor Retained Interest Trust (GRIT). Grantors in this case transfer an asset to an irrevocable trust, from which they receive an income for a pre-determined period. As with a CRT, the payments can be either a fixed annuity (Grantor Retained Annuity Trust) or a variable payment (Grantor Retained Unitrust). In the case of GRATs and GRUTs, however, the property passes to family members at the end of the specified term. The value of such a gift for tax purposes is the actuarily computed present value of the remainder that will pass to your family at the end of the trust term. The higher the income payout, the lower the gift tax valuation.
Since a grantor trust does not pay tax itself, grantors will pay income tax on all of the income received by the trust and not just the amount distributed to them. The income taxes paid on trust income over the term of a GRAT or GRUT has the effect of further reducing the grantor’s estate. It is also important to point out, however, that the trust assets will be included in the taxpayer’s estate if he or she does not survive the term of the trust. The trust term should be determined with this in mind.
Besides considering estate planning techniques, owners of closely held businesses must try to anticipate problems of liquidity that may be faced by heirs.
If most of the family’s assets are tied up in the company, heirs may have difficulty paying estate tax—even if the estate value has been reduced. Subject to certain restrictions, the law allows heirs to pay off estate tax on an installment basis over a 14-year period. The solution chosen by numerous business owners, however, is to purchase life insurance to cover the taxes.
If life insurance is needed, it is often wise to put the policy into an Irrevocable Life Insurance Trust (ILIT). The proceeds of a policy purchased for an ILIT will not be included in your estate if the trust is properly structured. Without such a trust, you may need to purchase roughly twice as much insurance, because the proceeds will be part of your estate and therefore taxed. Generally in an ILIT, the trust purchases a new policy. But sometimes a taxpayer will transfer ownership of an existing policy to the trust. In such a case, the proceeds will be included in the estate if he or she does not survive for three years after the transfer. The proceeds of a policy may also be included in an estate if the taxpayer retains certain rights, such as the ability to borrow against the policy.
There are many nuances to consider when designing the various techniques that have been described, and it is therefore wise to thoroughly discuss your circumstances with an estate tax professional before taking action. Our purpose here is to remind owners of the opportunities that are currently available and should not be overlooked because of what is happening (or, more accurately, not happening) in Washington.
Like income tax planning, estate tax planning is a dynamic process that is subject to many political and legal uncertainties. The rules are continually changing, and those who sit on the sidelines waiting for the game to be decided will lose the most. The old saying has never been more appropriate: “Failing to plan, is planning to fail.”
Stephen P. Kunkel is the director of taxes for Duitch, Franklin & Co., a Los Angeles-based accounting firm that specializes in tax consulting for closely held and family owned businesses.