For a business owner considering the sale of their business, there are two competing goals: maximizing the proceeds from the sale and minimizing the estate and gift taxes that will be due on the owner’s enhanced estate.
If the size of your estate exceeds the estate tax exemption, an estate planning attorney, working with your accountant and other professionals, can help you accomplish both goals through gift and estate tax strategies that will allow you to:
- Transfer more wealth to the next generation through payment of fewer transfer taxes.
- Determine a plan for managing wealth and taxes after the sale.
- Implement a charitable strategy to meet personal goals and manage taxes.
It is important to realize that the earlier you start planning for a potential sale, the better the end results will likely be. Several tax planning and gifting strategies can be implemented up until the time you sign a letter of intent, but they offer greater financial benefits if they are started much earlier. Additionally, some strategies won’t provide any benefits when they are completed too close to a company sale.
Of course, every business is different, as are each owner’s circumstances, family dynamics, expected sale timeline and desired retirement lifestyle. Depending on your situation, your attorney may suggest some of these planning options that can provide tax efficiency when completed in advance of a business sale:
- Gift early and often to your family. Utilizing the gift tax annual exclusion amount allows you to shelter gifts of company stock from gift taxes. Each year you are permitted to give assets valued up to $17,000 to an unlimited number of recipients without being subject to gift tax or reporting requirements for the IRS. In addition, the lifetime gift and estate tax exemption allows you to shelter gifts in excess of the annual exclusion amount and is currently at an all-time high of $12,920,000 per person in 2023.
- Make lifetime gifts of company stock to the next generation (ideally in trust for added benefits) at today’s values. Completing gifts early allows you to transfer not just the value of the gifted stock, but also the appreciation on the stock over the years. You should also consider obtaining a professional valuation of the stock to be gifted that includes lack of marketability and control discounts (if applicable) to transfer the stock at a reduced value, thereby using up less exemption.
- Make additional gifts above your federal exemption amount and pay the gift tax now. While it may go against traditional thinking to pay taxes now instead of later, gifting company stock now allows the appreciation on the gifted shares to escape transfer taxes. And paying gift tax now is “cheaper” than paying estate tax later since the gift tax paid now, along with the appreciation on the shares, comes out of the business owner’s overall estate, reducing the assets that are taxable in the future (possibly at a higher tax rate than is applicable now).
- “Freeze” the value of the company for estate tax purposes using partial freeze techniques, such as:
- Grantor retained annuity trusts (GRATs) – When utilizing a GRAT, an owner transfers shares of company stock to the trust while retaining an annuity to be paid by the GRAT over a certain number of years. When the payments end and the GRAT terminates, any appreciation on the stock above the IRS Section 7520 interest rate is passed to the beneficiaries of the GRAT transfer tax free. In addition, throughout the term of the GRAT the owner pays income tax generated by the stock owned by the GRAT, essentially making tax-free gifts to the GRAT beneficiaries.
- Sales to intentionally defective grantor trusts (IDGTs) – An owner can transfer shares of company stock to a trust created for the benefit of their family in exchange for a promissory note bearing interest at the IRS applicable federal rate. Here all appreciation over the applicable federal rate is transferred to the beneficiaries transfer tax free. And, similar to a GRAT, as the owner pays income tax generated by the stock owned by the IDGT, they are essentially making tax-free gifts to the IDGT beneficiaries.
- Preferred stock recapitalizations – By separating the ownership of the business into “common” and “preferred” of stock classes and gifting most of the common stock to heirs, the owner can essentially “freeze” the value of the company for future estate tax purposes and shift appreciation in the company’s common stock to heirs while still retaining control of the company.
- Gift shares to private foundations, donor-advised funds, charitable trusts or charities. While giving shares of company stock to a charitable entity can lead to a charitable deduction and the avoidance of capital gains taxes upon a sale, the timing of this charitable giving is important. If the gift is made too close to a business sale, capital gains taxes could still be owed for the shares owned by the charity. This is complex planning because restrictions and tax liabilities exist depending on your business structure, the basis of the donated shares and the type of charitable vehicle receiving the shares.
These strategies need to be executed months, if not years, before you offer your business for sale, so engaging with an estate planning attorney early in your planning provides the most significant benefits, including better after-sale proceeds and improved tax efficiency. As a bonus, these planning strategies can also provide tax efficiency if you later decide to pass your business to the next generation instead of selling it.
If you are ready to start planning for the future sale or generational transition of your family business, contact your Warner estate planning attorney or Beth O’Laughlin at bolaughlin@wnj.com or 616.396.3118.
