BUSINESS OWNER ESTATE PLANNING CONCERNS AND STRATEGIES Gregory S. - PDF document

BUSINESS OWNER ESTATE PLANNING CONCERNS AND STRATEGIES Gregory S. Williams and Keith A. Wood Carruthers & Roth, P.A.

BUSINESS OWNER ESTATE PLANNING CONCERNS AND STRATEGIES Gregory S. Williams and Keith A. Wood Carruthers & Roth, P.A. 1. Introduction and Overview. Business owners are almost always faced with a complicated mix of critical estate planning issues, including the estate tax, succession planning, family dynamics and income tax issues. Unfortunately, oftentimes the issues are not complementary, and they can never be addressed with canned solutions. Addressing these issues with an analytic and deliberate approach is necessary to obtain a favorable outcome with a business owner's planning. This paper is focused primarily on the estate tax aspect of such planning, but addresses income tax and non-tax succession planning issues when appropriate. The stakes have never been higher for American business owners. Their businesses are under pressure not only to survive, but to create jobs, provide benefits and fund the economic recovery. Unprecedented health care obligations, stiffer global competition and weaker consumer loyalty make these burdens even tougher. A spiraling national debt and ever burgeoning government make increased income and estate tax pressures all the more likely. In fact, at the end of this year, American business owners may possibly be faced with increased tax rates and the first ever drop in the estate tax exemption amount. The election result and the pace of economic recovery will surely affect the burdens placed on business owners. But in the meantime, 2012 will be remembered as a year that many business owners (and wealthy families in general) engaged in estate planning strategies to take advantage of expiring tax breaks. This paper provides an outline of many of such strategies. 2. Estate and Gift Tax -- Key Concepts. The federal estate tax system imposes a transfer tax on the value of assets passing to family members at death. In order to assure taxpayers do not avoid estate taxes by making lifetime transfers, the federal transfer tax system also imposes a gift tax when assets are transferred to family members during the donor's lifetime. a. Tax Rates. Under current law, whenever the transfer of an asset is subject to federal transfer taxes, the transfer tax rate is 35% on any transfers which are not sheltered by available exemptions from taxation. (Note that absent Congressional action before 1/1/2013, the maximum rate will rise to 55%.) b. Unified Credit. Under the federal transfer tax system, each taxpayer may pass up to $5,120,000 (in 2012) of property away during lifetime, or at death, free of federal estate and gift tax. This number is scheduled to plummet to $1,000,000 per taxpayer on 1/1/2013 without Congressional action.

A credit of the "applicable credit amount" is allowed in computing the estate tax (IRC § 2010(a)) or gift tax (IRC § 2505(a)(1)) of a U.S. citizen or resident. The "applicable credit amount" is the amount of the tentative tax that corresponds to the applicable credit amount. In 2012, that amount is $1,772,800. c. Unlimited Marital Deduction. Under the federal transfer tax system, an individual may pass an unlimited amount of property to a spouse, completely free of estate or gift taxes. Unlimited Charitable Deduction. Under the federal transfer tax system, an d. individual may pass an unlimited amount of property to a qualified charity, completely free of estate or gift taxes. Gift Tax Annual Exclusion. Each individual taxpayer may give up to $13,000 e. ($26,000 for a married couple) of property to an unlimited number of donees each year completely free of gift taxes. f. Gift Splitting. For federal transfer tax purposes, spouses can elect to treat gifts by one spouse as having been made one-half by each. This means that, regardless of which spouse actually makes the gift, the donor-spouse can use both spouses' annual exclusions and applicable exclusion tax-free amounts to shelter the gift from gift tax. However, the better practice is for the spouses to make separate gifts. Step-Up in Basis to Fair Market Value. Under Section 1014 of the Internal g. Revenue Code, the basis of property inherited by a beneficiary from a decedent is equal to the value of the property as of the date of death of the decedent. Generation Skipping Transfer Tax System. The generation skipping transfer h. tax is imposed at a flat rate equal to the maximum estate tax rate (currently 35%) and is in addition to the estate or gift tax. Thus, the GST tax can have a punitive and confiscatory effect. The GST tax is imposed on transfers, distributions and the vesting of present interests, either directly or in trust, to or for the benefit of "skip persons." A "skip person" is (i) a "natural person" assigned to a generation two or more generations below the transferor or (ii) a trust in which all interests are held by skip persons or (iii) a trust in which no person holds an interest in the trust and in which no future transfers may be made to a non-skip person. Section 2613. A grandchild of the transferor is assigned to the generation immediately below the transferor (and thus is not a skip person) if the transferor's child who is the parent of the grandchild is deceased. A similar rule applies to descendants below the grandchild, apparently in cases where all lineal descendants between the transferor and the transferee are deceased. Section 2612(c)(2). Estate Taxes Due Within 9 Months of Death. Federal estate taxes are due and i. payable nine months after the decedent's death. In some cases, the estate may be able to defer the payment of these death taxes over a period of years. 2

3. Outright Gift. Making an outright gift is perhaps the simplest estate planning strategy that an individual can use to take full advantage of his or her unified credit and reduce the size of his or her taxable estate. a. Structure . A donor can make an outright gift by merely transferring cash or other property to the donee. Many family business owners, however, do not have the liquidity to make transfers of cash to fully use their unified credit amount ($5.12 million in 2012) because their wealth is often tied up in the business. Thus, family business owners are often limited to transferring business interests when making outright gifts. The drawback to transferring business interests is the valuation of such interests. Specifically, the Internal Revenue Service may challenge the value of the business interest subject to a gift, potentially resulting in unintended gift tax liability. For example, suppose that a business owner transfers 100 shares of family business stock purportedly worth $5.12 million in 2012, thereby fully using the transferor's unified credit amount. If on audit the value of the transferred shares is found to be $6 million, the transferor will have unintended gift tax liability because the gift exceeded the transferor's available unified credit amount. To mitigate the risk of unintended gift tax liability, practitioners occasionally include special provisions known as defined value formula clauses in business interest gifting instruments. A defined value formula clause references a fixed dollar amount rather than a fixed quantity of property, and is especially useful when the transferred property is difficult to value. The Internal Revenue Service has been successful in challenging such clauses for public policy reasons, claiming that such clauses retroactively adjust the value of the transfer, causing the excess value to pass to some other donee (typically a charity that would result in the excess transfer being eligible for the gift tax charitable deduction). Recently, however, the Tax Court upheld a stated dollar defined value formula clause in which no charity was involved in the formula allocation. Wandry v. Commissioner, T.C. Memo 2012-88. The defined formula clause used in Wandry was specifically worded to make it clear that if the Internal Revenue Service challenged the taxpayer's valuation, the quantity of business interest units being transferred were to be adjusted accordingly, in the same manner a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination. The impact of Wandry, however, is uncertain, as the case is currently on appeal before the Tenth Circuit as of the writing of this manuscript. b. Advantages and Disadvantages. i. Advantages. A. Simplicity . Outright gifts are perhaps the simplest estate planning strategy that an individual can use to take full advantage of his or her unified credit and reduce the size of his or her taxable estate. 3