If you currently own a business, estate planning is probably not one of your highest priorities. You are certainly more concerned about where your income is coming from, how to beat the competition, and how you can better develop your product and service.
However, you should definitely keep estate planning in mind, especially as your business gets more successful. In addition to the dozens of ideas we have discussed, planning your exit strategy from your business opens up a number of new cans of worms. This is especially true if you want your enterprise to continue beyond your “usefulness.” Today, we’ll cover some gifting fundamentals, review some federal estate and gift tax laws, and demonstrate how gifting discounted shares of your business could potentially save your estate a great deal of taxes.
Gifting as an Estate Reduction Strategy To state perhaps an obvious point, a key way to reduce estate taxes is to lower the value of assets in your estate. The lower the value of your estate, the less there is to tax. There are several ways to gift to your children outright, and all serve to reduce the amount of your estate:
Annual gift tax exclusions. Currently, you can gift property valued at up to $13,000 per year per donee (person to whom you give the gift) without any gift tax consequence.
Other gift tax exclusions. Gifts for the purposes of the donee’s health or education are also excluded from gift tax calculations (this is why your parents could pay seemingly unlimited amounts for your doctor appointments and, for some lucky ones, your schooling expenses).
Lifetime gift tax exemptions. In 2012, you can give lifetime gifts totaling up to $5.12 million before any estate, gift, or generation-skipping taxes are charged. However, none of these strategies will necessarily provide your business with any direct benefit.
Gifting Discounted Shares of Your Business Not surprisingly, gifting shares of your business to your children can also provide you with a lowered estate. However, by controlling your business through a “family limited partnership” (FLP) or a “family limited liability company” (FLLC), you can get the added benefit of gifting your shares at considerable discounts.
Let’s explain how through an example. You privately own 100% of a business that is worth $1 million, and decide to create and transfer your business into an FLP. You then decide to give 10% of your FLP shares to each of your three children. Basic mathematics would tell you that the amount of your gift to your three children is $300,000 (30% of $1,000,000.)
However, the IRS allows certain discounts on the value of that gift:
Lack of marketability discount. FLPs are frequently designed to protect assets by keeping them in the family and protected from individual creditors. In exchange for these benefits, FLP agreements usually disallow the sale of any shares outside the family without majority approval. Because your kids would have a great deal of trouble selling their 30% of the FLP, the IRS concedes that the shares are probably worth a bit less than $300,000.
Minority interest discount. Additionally, a discount is allowed where the holder owns a minority share of the FLP. In our example, because you own 70% of the FLP, the children have virtually no control of the business. Under the theory that no outside investor would pay full value for shares of a closely-held business over which she would have no control, the IRS permits a discount for this as well.
If an expert appraiser deems that these two discounts total 40% of the value of the children’s shares, the value of the gift is reduced to $180,000. In other words, you have taken $300,000 out of your estate, at the cost of gift tax on only $180,000.
By the way, in real life, you also subtract the $13,000 annual exclusion three times (one for each of the children), so your gift would be valued at $141,000. Additionally, you most likely would not have to write any check to the IRS; the value of your gift is merely subtracted from your remaining lifetime exemption.
One Caveat While all of this may fascinate, consider what would happen if the current $5.12 million lifetime estate and gift tax exemption amounts are made permanent. Gifting for the purposes of reducing assets to lower one’s estate tax bill would be a useless strategy for most people because their assets will not approach such an amount. For others, however, this is not true and the time to gift is NOW.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
Randall A. Denha, Esq. of Denha & Associates, PLLC is licensed to practice law throughout the state of Michigan and his offices are also licensed to practice in the state of Florida. The Denha & Associates, PLLC Law Firm practices in the areas of estate planning, business succession planning, asset protection planning, probate, business and tax law. For further information, visit www.denhalaw.com or call (248) 265-4100.