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Crash Course in Family Succession – Part 2

The Anatomy of a Deal Newsletter

Smart Summary

  • While family transitions can bring onerous estate and gift taxes (though for only a small percentage of the population), sophisticated tax planning can help owners avoid these taxes entirely.
  • Annual gifting can be a very effective, albeit sometimes slow and risky (if not done strategically), way to pass a company’s value on to the next generation.
  • A strategy involving annual gifting plus some targeted and properly structured larger gifts can provide the right mix to move value to the next generation without creating additional headaches or problems.

Last month, we addressed some of the reasons why family transitions are so hard. This month, I promise to be more optimistic (but also more boring—hey, it’s not my fault the subject matter is so dry) as we talk about how to actually make the transition work once we’ve laid the proper groundwork to ensure a successful hand-off to the next generation.

As we said last month, transfers within the family raise a whole host of unique issues, and that’s also true of the actual nuts-and-bolts processes by which we accomplish the transfer. So let’s dive right in.

Death + Taxes

We all know Ben Franklin’s old saying about death and taxes. That saying has never held more truth than when talking about a transfer within the family. And that’s because we don’t have to worry just about income taxes (which do still apply in family transitions), we also have to worry about estate and gift taxes. Whoopee!

For as long as I’ve been practicing law, there has been some proposal or another to eliminate the federal estate tax. Yet, unless you died in 2010 (in which case, let me thank you for being a loyal reader of Anatomy of a Deal from the afterlife!), you’ve lived in a world where federal estate taxes still exist, with no signs of that changing anytime soon given the current political landscape.

At the same time, however, estate taxes are becoming less onerous and affect fewer people. In 1975, the estate tax exemption per person (i.e., the amount of net worth an individual has at death that is exempt from estate tax) was $60,000 and the top estate tax rate was 77%. Ouch!

Today, the exemption is $11.7 million and the top estate tax rate is 40%--at least for the next few years when the law is next scheduled to change. As a result, a married business owner today—with some proper planning—could avoid federal estate taxes entirely if the owner’s total net worth (including the business) at the time of death is $23.4 million or less.

So despite the estate tax being a political hot button for many years, the truth is that it only affects a very small percentage of the general public and represents just a tiny fraction of the federal government’s revenue. However, of those whom it affects, a disproportionate number are owners of privately held businesses. And despite the fact that they are wealthy on paper, the reality is that most of those business owners’ net worth is tied up almost entirely in the business itself. If the IRS came knocking on the door for its 40% share, many business owners’ estates would be forced to sell off the company to generate the cash needed to pay the government. A disagreeable result for business owners who dream of passing the business on within the family.

Fine. “Why don’t I just give the business to my kids before I die? My estate tax problem goes away, right?” Good thought, but Congress already saw that coming and enacted a gift tax, which complements the estate tax. So, if you make gifts in excess of those same exemptions as noted above (though, at some points in history, there have actually been lower gift tax exemptions than estate tax exemptions), you still pay the tax. There’s no simple fix to the problem.

And it’s important to point out that the estate and gift tax exemptions are “unified,” meaning that gifts you make during lifetime against the gift exemption also reduce the estate exemption remaining at your death on a dollar-for-dollar basis. So you don’t get both a gift exemption and an estate exemption.

Also, be aware that some states levy their own estate taxes. Ohio abolished its estate tax, but in other states, the state estate tax can be onerous.

Are you still there? Oh, good. I thought I’d lost you. So now that we know the problem, what can we do?

Sometimes you’ll hear it said that estate and gift taxes are a “voluntary” tax. While not literally true, the reason is that if—and that’s a very big IF for many business owners—you’re willing to do some sophisticated tax planning and you’re willing to do it early enough, you can avoid paying these taxes entirely. So let’s introduce some of the ways we can do that…depending on the specific situation.

The Gift That Keeps on Giving

The simplest (but slowest) way to transition ownership from one generation to the next is through annual gifting. In addition to your estate and gift tax exemption as noted above, the government also gives you an “annual exclusion” whereby you can gift up to a certain amount per recipient, per year. As long as each qualifying gift stays under the annual exclusion limit (currently $15,000/recipient/year, but can change annually based on inflation) that amount doesn’t count as a gift for tax purposes and it doesn’t even count against your estate/gift tax exemption.


Maybe an example will help. Let’s say business owner and spouse each give the full $15,000 to each of their four children every year. That’s a total gift of $120,000 per year. And because the children are all married, they can each give another $15,000 per year to their children’s spouses. There’s another $120,000. So that’s almost a quarter of a million bucks in value that can be transferred, per year, with no tax complications. Add in grandchildren, and you could increase these amounts even further. And the best part is that these gifts don’t reduce the business owner’s or spouse’s estate/gift tax exemption; the entire (current) $11.7 million remains available to shield further gift or estate taxes at a later date, or at death.

And the gift doesn’t need to be cash. It can be any property, so long as you’re able to establish the value is less than the annual exclusion limit. One of the great benefits of using private company stock for gifts or any of the other types of transfers described below is that there are often discounts that apply based on the fact that the stock is non-marketable and non-controlling. That gives you more gifting bang for your buck. Discounting is a much bigger topic for another day, but suffice to say that you want to be sure you’re getting the help of experienced advisors whenever you’re transferring private stock.

The downside of the annual gifting strategy, of course, is that it takes a long time to move really big values. If the business owner owns a business worth $20 million, he or she will need to start annual gifting very early to make any meaningful dent. And because the real power of annual gifting comes from having multiple gift recipients, the business owner has to “spread the wealth” among a bigger universe of people to get the greatest effect. Is the business owner comfortable transferring ownership to sons- or daughters-in-law? What about grandchildren?

Some of those concerns can be mitigated by recapitalizing the company to provide for voting and non-voting stock, so that only the non-voting stock is being gifted. And trusts with so-called Crummey powers (Crummey is the name of the court case that endorsed this strategy—not a commentary on the quality of the trust, as I originally thought when I first started practicing law) can be used to ensure that the assets are “locked up” in some fashion and to protect those assets from creditors, divorce, spend-happy beneficiaries, etc. But there is still some risk whenever you broaden the universe of people who directly or indirectly own a part of the company.

While annual gifting is great, at some point it may make sense to make bigger gifts and start using up some of that lifetime estate/gift tax exemption. This is particularly true when the exemption amount is scheduled to be reduced, as was supposed to happen at the end of 2012 and 2020 (but didn’t) and is next scheduled to occur at the end of 2025, unless it happens before then. Or it doesn’t happen at all. Or it goes up. The incessant political uncertainty over the estate tax makes planning for business owners exceptionally difficult.

Even once you exhaust your exemption and have crossed the threshold into paying gift tax, there are strategies that can limit the gift tax exposure (such as so-called “net gifts”). And, while few business owners like the idea of paying taxes today, there are sometimes good reasons to do it now.

First, making the gift now ensures that future appreciation in the value of the stock grows outside of the owner’s taxable estate. We avoid magnifying the problem by transferring the stock before it has even more value. Second, it’s actually mathematically true that paying gift taxes today is cheaper than waiting and paying estate taxes at death, all else being equal—which, unfortunately, is often hard to gauge given the ever-changing political dynamics. That’s because paying the gift taxes during lifetime will remove the gift taxes already paid from your taxable estate at death.

For many business owners, a strategy involving annual gifting plus some targeted and properly structured larger gifts provides just the right mix to move value to the next generation without creating additional headaches or problems. Trusts can provide some flexibility and control over how the stock is handled post-gift. But, for clients where gifting alone isn’t sufficient—or where the idea of giving the business to children outright rather than selling is inconsistent with their personal planning or values—other options are available.

Next month, we’ll continue with Part 3 of this deep dive into business legacy planning by covering related strategies for transitioning value during an owner’s lifetime: strategic trusts. 

Next Month: Crash Course in Family Succession Strategies – Part 3

Read last month’s piece: Crash Course in Family Succession Strategies – Part 1

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