Many people plan to grow their businesses so they can sell them, collect a tidy sum, and retire comfortably. But with family businesses, which represent 80 percent of all businesses in the U.S., the goal for many owners is to pass on a successful operation to the next generation. Gifting is a good strategy if you have sufficient funds to meet your retirement needs and want to nail down your succession plans now. The time is right to act on transferring business interests now.
1. Federal gift tax rules are favorable
There’s no income tax when you receive property as a gift, but the person giving the assets away (called “the donor”) may owe a gift tax, which is a separate tax from the income tax. Legislation passed late last year created very favorable federal gift tax rules for 2011 and 2012.
Every person can transfer up to $5 million in a lifetime. While using this exemption from gift tax reduces what you can pass tax free at death, there is probably little reason to wait. Delaying a transfer with the expectation of leaving your business to family members at death may prove costly if you don’t die by the end of next year and the estate tax exemption amount declines after 2012.
No one knows what will happen after 2012 to the estate or gift tax exemption. The exemption amount could return to the former limit of $1 million, or to something less than the current $5 million amount.
2. Business values are low
Bad economic times, which have caused low business values, have a tax advantage. Lower values mean that a greater interest can be transferred without tax cost than when values are high.
Say you want to transfer 10 percent of your interest in a privately-owned business to your three adult children, each of whom is married. Your interest is worth $2 million. The gift is only $200,000.
In figuring what portion, if any, of the gift is taxable, you can apply what is referred to as “valuation discounts” for lack of marketability and minority interests. Because the interests you’re giving cannot be readily sold (it’s not like publicly held stock) and the children will have only a minority ownership interest, the true value of their gift is less than $200,000. There is no set formula for the amount of the discounts—they can range in total from 10 percent to 40 percent. Assuming a 25 percent discount, the value of the gift is only $150,000.
Caution: Prior to the legislation last year, there had been considerable talk in Congress of eliminating valuation discounts—as yet they are still permitted, but could be changed after 2012.
In addition to the lifetime exemption, each person has an annual gift tax exclusion. The exclusion for 2011 is $13,000. This applies to each gift you make to another person. If you’re married and your spouse joins in the gift, you can double the tax-free gift without even resorting to the exemption. Thus, you can give each child and each child’s spouse (a total of six) a gift this year and one next year. All of these transfers will be made tax free by the annual gift tax exclusion (each gift this year and next year is valued at $12,500, which is less than the annual exclusion). The transfer of 10 percent of your business doesn’t cost you any tax.
Note: If you are in Connecticut or Tennessee, there’s a gift tax at the state level.
3. Waiting invites trouble
Unfortunately, many senior family members don’t make succession plans. When they die, this can:
- Create chaos for heirs. Say all your children inherit equally, but only one is working in the business. How will this affect the child in the business when it comes to decision-making?
- Cost estate taxes that could have been avoided. While the exemption for federal estate tax is $5 million through 2012, it is considerably lower—$1 million—in a number of states, including Massachusetts, New Jersey, and New York. Planning ahead can minimize the tax cost.
- Devastate the business. If you die wealthy (don’t forget that your estate includes not only your interest in the business, but also your home, your 401(k)s and IRAs, and other property), your estate may owe estate tax nine months after your death. Unless there are liquid assets, some or all of the business may have to be sold, probably at fire-sale prices, in order to raise cash for the tax bill.
Get started on your plans if you have not yet done so. It can take time to develop a plan that works best for you, your business, and your family. It’s a good idea to meet with an estate planning advisor who can help you craft a succession plan that fits neatly within your financial and estate plans. And you’ll probably need to obtain a business appraisal to accurately value the business interests that are being given away.