Current Economic Conditions Present Wealth Transfer Opportunities for Business and Property Owners
The primary objective of wealth transfer planning is typically to minimize the estate and gift tax impact of the transfer.[1] Before getting into why the current economic conditions present a wealth transfer opportunity, let’s recall how our estate and gift tax system works. When we die, our personal representative is responsible for determining whether an estate tax return must be filed and, if so, reporting everything we owned and how much it is worth, including the benefit amount of life insurance policies we own on our own life.[2] After subtracting debts and certain miscellaneous items, the estate tax is imposed on the amount by which our taxable estate exceeds the Unified Credit amount. In other words, the Unified Credit is a sort of “standard deduction” for purposes of the estate tax. In 2001, Congress passed a law that gradually phased out the estate tax resulting in no federal estate tax in 2010. Then they revived the tax through 2013 but increased the Unified Credit to $5 million. Unless Congress passes another law making the new estate tax rules permanent, the $5 million credit expires in 2013 and goes back down to $1 million. The amount by which the taxable estate exceeds the Unified Credit will be taxed on a progressive scale quickly approaching 55%.
Most estate tax planning strategies involve somehow reducing the amount of the projected taxable estate. Some strategies rely on complex legal distinctions to reorganize the ownership structure of existing assets such that they should not be considered as being owned by you for estate tax purposes. Other strategies involve growing and acquiring assets in structures that similarly are not considered part of the taxable estate. The timing and amount of charitable contributions can also be planned in ways that maximize both the income and estate tax benefit of their donations. The tactics used by estate tax planners are virtually limitless and are constantly changing as the law and IRS practices evolve. Perhaps the most effective estate tax minimization strategy for the business and real property owner, especially under current economic conditions, is to gift partial interests at today’s lower valuation that would otherwise be included in their taxable estate at tomorrow’s higher valuation. These gifts often consist of a percentage interest in the business valued at up to the $1 million lifetime credit provided for gift tax purposes, because most gifts beyond that credit are taxed at rates that approximate the estate tax to prevent taxpayers from avoiding the estate tax by making gifts prior to death. Traditionally, this strategy was reserved for assets expected to appreciate substantially. Most property and businesses appraised in this economy, however, will almost certainly be appraised higher after a recovery.
Here’s an example of partial interest discount planning and an illustration of how a lower valuation permits a larger tax free transfer[3]:
Transfer of Future Appreciation
Smith Enterprises, LLC is owned 50/50 by Mr. and Mrs. Smith and is estimated to be worth approximately $10 million. Mr. Smith dies in 2011 leaving his 50% to Mrs. Smith; no estate tax is due as a result of the unlimited marital deduction for transfers between U.S. citizen spouses. Mrs. Smith dies in 2014 when the business is worth $15 million (50% appreciation). The tax due on Mrs. Smith’s estate is calculated on a base of $14 million ($15 – 1 million credit).
Assuming the same facts above, but instead if Mr. and Mrs. Smith each gifted a portion of their LLC interest worth a combined $2 million to their daughter in 2011, they would file a gift tax return and both apply $1 million of their lifetime gift tax credits to eliminate any gift tax liability. Using the same $10 million company valuation, the combined $2 million tax free gift would represent 20% of the company ($2 / 10 million x 100%). The gift would reduce their taxable estate to $8 million ($10 – 2 million). When Mrs. Smith passes away in 2014, her 80% interest in the company would only be worth $12 million ($8 million + 50% appreciation) and the other 20% interest now worth $3 million is already in their daughter’s hands tax free. The tax due on Mrs. Smith’s estate is now calculated on a base of only $12 million instead of $15 million, resulting in over $1.5 million in tax savings.
Partial Interest Discounts
Using a properly structured and implemented Family Limited Liability Company, the Smith’s can also discount the value of the interest they gave their daughter because, for example, her vote is insufficient to have any control over the company and also because she is restricted from selling the stock to anyone outside the company. If these negative factors mean the interest is really only worth half as much to a hypothetical buyer, then the Smith’s can give their daughter twice as much of a share of the company without exceeding their combined $2 million lifetime gift tax credit. Thus, the Smith’s can use their combined $2 million lifetime gift tax credits to give their daughter 40% of the company in 2010 tax free ($10 million x 40% = $4 million x 50% discount = $2 million). The gift would reduce their taxable estate to $6 million ($10 – $4 million) and consequently in 2014 Mrs. Smith’s interest in the company would only be worth $9 million ($6 million + 50% appreciation) with the other $6 million already in their daughter’s hands tax free. The taxable value of Mrs. Smith’s estate when she dies in 2014 would now be only $9 million instead of $15 million, resulting in over $3 million of tax savings!
Depressed Valuation Environment
By now the current wealth transfer opportunity becomes obvious. In addition to the discounts mentioned above, most valuation methods applied to the Smith’s business under the current economic conditions would support a lower than normal appraisal thereby permitting an even higher percentage to be transferred tax free. For example, the company’s competitors may be trading at lower multiples, or recent sales of comparable companies are unusually low due to them being distressed, or simply an excess of supply over demand. Even though the Smiths are fortunate enough to not have to sell their company into this kind of market, they can still transfer part of their wealth using today’s weak valuations. Just because the Smith’s daughter might be able to sell the business or property for $15 million in 2014 doesn’t mean a partial interest couldn’t be valued for much less in 2011, thereby permitting the Smith’s tax free transfer of a substantial amount of equity to her tax free without losing control of the business. If they miss the opportunity in 2011 and still hold 100% of the business in 2014, the estate tax bill may be so high that their daughter may be forced to sell the business or incur substantial debt just to pay the taxes.
The IRS has challenged the applicability of these discounts to partial interests on legal grounds with mixed results and therefore this type of planning must be done very carefully with realistic expectations. On the other hand, valuations of the business as a whole are a matter of fact and many cases are settled with favorable results for the taxpayer. The tax attorney, CPA and valuation professional must work closely together to design, calculate and document a transfer that can withstand IRS scrutiny taking into account recent court decisions and IRS pronouncements. Moreover, any transfer should be based on an objective and verifiable appraisal using IRS guidelines and performed by an established expert in the field. Regardless of the valuation discount the IRS may accept, now is still the best time in recent history to make these transfers due to the low valuations and rising tax rates.
Finally, it’s important to remember estate tax planning does not occur in a vacuum. Even though transfers like these present opportunities to review and update internal documentation such as shareholder, partnership and operating agreements, special care must be taken to ensure these documents are drafted properly so that the transferor retains control over the property and can prevent the interest from falling into the hands of the transferee’s creditor or spouse, for example.
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[1] Other considerations include asset protecting the business or property from personal lawsuits against the owner; asset protecting company assets (tangible and intangible) from lawsuits against the company; protecting trade secrets and other proprietary information from competitors and former employees; reviewing key contracts and agreements for “change of control” triggers (e.g. loan agreements, leases, etc.) and transfer restrictions (shareholder/partnership/operating agreements); limiting the owners’ personal liability for lawsuits against the business or relating to the property; exit strategy; pre/post nuptial planning; business management succession; etc.
[2] However, a carefully drafted and maintained Irrevocable Life Insurance Trust (ILIT) can keep the value of life insurance proceeds outside of a decedent’s taxable estate.
[3] This example is simplified for illustration purposes. Taxes can be further reduced using other planning techniques.
