Seize the opportunity: Transferring business interest to save estate taxes

When planning for the future transition of your business you have many options to consider, including taking advantage of estate planning strategies designed to transfer ownership interests to your family in a tax efficient manner. But this valuable planning opportunity is too often lost by owners not acting well in advance of a business sale, or before their death if the business is staying in the family.

Why is estate tax planning so important for business owners

Depending upon your net worth you may have a silent partner in your business—the IRS for a 40% percent interest and at no risk! That’s because the current federal estate tax rate is 40% with the estate tax payment due nine months after a business owner’s death (or for married couples upon the last to die of the business owner and their spouse). And for business owners who live in a state that has its own estate tax, that rate can jump up significantly. For example, the Illinois estate tax rate can be as high as 16%. 

This estate tax account payable can be a huge contingent liability that if not strategically planned for can negatively impact the future viability of your business. And if you plan on selling your business, not moving ownership interests to the next generation well  inadvance of a sale will allow the IRS to share in a portion of the sales proceeds if those dollars are eventually taxed in your estate.

Taking advantage of the exemption amount

The federal estate and gift tax exemption amount has never been higher ($13.61 million per person or $27.22 million for a married couple). But absent future action by Congress, the current exemption amount is scheduled to be cut in half after 2025. So there is a potential use it or lose it opportunity right now to make use of the “extra” exemption before it possibly goes away.

Unfortunately, you cannot choose to apply the exemption amount from the “top” first. Essentially what this means is that to get the benefit of the extra exemption you must make gifts that in total exceed what the exemption amount will revert back to in 2026. For example, if the estate tax exemption ends up being $7 million in 2026 you would need to make gifts in excess of that amount prior to the end of 2025 to receive any benefit from the current extra exemption.

For business owners who have a substantial estate tax exposure making large gifts to use up the full amount of their extra exemption can easily result in millions of dollars in future estate tax savings. But even business owners looking at a more moderate estate tax liability should consider the benefit of using at least some of their exemption for lifetime gifting to shift future appreciation out of their taxable estate. 

With the constantly changing political climate and ever-increasing federal budget deficits it’s also always possible that the exemption amount could be further reduced in the future. So for many business owners, gifting early and often will be the right strategy to save on estate taxes.

Leverage valuation discounts

A compelling reason to make lifetime transfers of interests in your business is to take advantage of valuation discounts that will otherwise not apply if you sell your business or wait until death to transfer ownership to your family. Minority interest and lack of marketability discounts can substantially reduce the gift tax value for such transfers getting you more bang for your buck from your exemption amount. Transferring nonvoting interests may enhance the discount while also allowing you to retain complete management control of your business until you have put a leadership succession plan in place.

To take advantage of valuation discounts, it is important that any transfers of ownership interests occur well before a subsequent saleof  the business to minimize the risk of an IRS challenge that the transfers were made in contemplation of sale. The valuation provisions in the shareholder agreement for the business should also be reviewed to ensure they are consistent with the application of a discount on the transferred ownership interests. For gift tax reporting purposes, a business valuation will be required along with a qualified appraisal of the ownership interests being transferred.

The benefits of a trust for transfers of business interests

Many business owners utilize trusts for transfers of ownership interests to allow for multi-generational sheltering from the estate tax. Holding a transferred business interest in trust can also provide family members with a measure of creditor and divorce protection. If professional oversight of trust distributions and management of liquid investments (including any future business sales proceeds) is desired, then naming a corporate trustee for such duties can provide that additional layer of protection for your family while still allowing you to designate one or more individuals to serve as the trustee(s) responsible for making all decisions concerning the business interests held by the trust.

If you are married, a Spousal Lifetime Access Trust (SLAT) is a special type of trust you may want to consider for transfers of business interests, because your spouse can be included as a beneficiary along with your other family members without causing estate tax inclusion. Trust distributions can be made from the SLAT to your spouse if needed to help maintain your accustomed manner of living and if properly structured your spouse can even act as the trustee to oversee trust distributions and investments.Setting up a SLAT for your spouse may be an attractive strategy to make a large gift and take full advantage of your estate tax exemption amount. Depending on your situation and with proper planning to avoid the trusts being considered reciprocal, you and your spouse could also consider establishing SLATs for the benefit of each other.

The advantages of an IDGT

A way to “supercharge” your planning is to structure your trust as an intentionally defective grantor trust (IDGT). An IDGT is designed so that the contributions you make to it are completed gifts removing all future appreciation on the trust assets from your taxable estate. At the same time, the trust includes special provisions allowing for it to be disregarded (i.e., “defective”) for income tax purposes and treated as a ”grantor trust” whose income remains taxable to you. Transactions between you and the IDGT, including your sale of appreciated business interests to the trust, are treated as nontaxable events for income tax purposes so no capital gains are realized.

Why would you want to continue to be responsible for paying ongoing income taxes on the business interest you have transferred to the IDGT? Well, your payment of the income taxes for the trust essentially amounts to a tax-free gift to the trust beneficiaries allowing a greater amount of wealth to be transferred to the next generation and out of your taxable estate.To provide flexibility the IDGT can be structured so that the grantor trust status can be turned off with the trust becoming responsible for paying its own income taxes.

Selling business interests to an IDGT for an estate freeze

From a pure estate tax reduction standpoint, the easiest and most tax effective transfer method generally would be for you to simply make gifts of interests in your business to your desired beneficiaries either outright or ideally to an IDGT. But if you have concerns about ensuring your own financial security or giving away too much, you may be more comfortable selling the business interest to an IDGT in return for an installment note. Conversely, a sale to an IDGT may be the right strategy if you want to make a transfer that exceeds your gift tax exemption amount. 

This estate freeze strategy transfers all of the future appreciation on the transferred business interest out of your estate while paying you back over time the discounted value of such interest plus a modest interest component. A SLAT is considered an IDGT for income tax purposes so it can be an ideal vehicle for this strategy.

The installment sale to an IDGT strategy is designed for businesses that are structured as pass-thru entities for income tax purposes, like S corporations and LLCs. Because you will still be treated as the owner of the transferred business interest for income tax purposes, the IDGT can use tax distributions to make note payments to you. Any shortfall will need to be paid with additional distributions from the business or, if the business is eventually sold, from the IDGT’s share of the sales proceeds. Consequently, a very important condition of implementing this strategy is that a financial analysis be done first to confirm that sufficient cash flow will be generated by the business to support the IDGT’s debt service obligations.

Here’s a look at how the transaction would work in an illustrative case:

• You would first make a gift to the IDGT equal to at least 10% of the value of the business interest being sold. This is referred to as a “seed gift” which is used to support that the later transaction is a bona fide business deal and that the IDGT is a creditworthy borrower with other available resources.
• The IDGT will then purchase the business interest from you with an installment note equal to the fair market value of the business interest being sold (taking into consideration applicable discounts).
• You can set the payment terms of the note to amortize or be interest only with a balloon payment. Interest is typically set at the IRS Applicable Federal Rate and will not be taxable to you.
• The IDGT will use tax distributions from the business to make payments to you on the installment note. If the business is sold, the IDGT can use its share of the sales proceeds to pay off the note.
• Your sale of the business interest to the IDGT will not be a taxable event and no capital gains tax will be due. The transaction will be treated as a sale and not a gift because the IDGT has purchased the interest for fair market value. 

After the note is paid off or if distributions from the business to the IDGT exceed what is needed for servicing the debt, such excess cash flow can be invested or perhaps used to acquire life insurance on your life to provide your family with tax-free proceeds for additional liquidity upon your death.

Have a coordinated plan

The strategic planning for your business and your estate planning should go hand-in-hand. BMO Wealth Management Business Owner Strategists can help you develop an integrated game plan that considers your family dynamics, ownership goals and leadership succession objectives in aligning the strategy for your business with your estate plan.