Part IV – Taming the Planning B.E.A.S.T. Part IV – Succession Planning
In this, the final installment of the “Taming the B.E.A.S.T.” series, we at last hit on the topic that is on the mind of all entrepreneurs – Tax Minimization. The “T” in our planning BEAST has two components: estate tax and income tax minimization. Each is critical to consider and will be surveyed below.
I. Estate Tax Minimization
Few object more to estate taxes than the entrepreneur. When one has accumulated wealth through taking on great risk and responsibility in a private business, and paid income taxes all along the way, it is hard to give up approximately half that wealth at the time of death in the form of state and federal estate taxes. So, while each entrepreneur strives to build the value of the business over a lifetime, they often fail to realize that they are building it in part for the benefit of the government.
When confronted with a taxable estate, an individual generally has 3 options in planning for the corresponding estate taxes: 1) pay them; 2) reduce them; and 3) avoid them. The optimal strategy will depend on the nature of the assets, as well as the objectives of the client.
Paying the Estate Tax
As difficult or undesirable as it may be to conceive, some people actually have to plan in a manner that simply provides for the full payment of estate taxes at death. This is a common strategy for those with highly illiquid estates that are to be retained, those with no available or intended heirs, or those who are simply unwilling to part with assets prior to death. Given that the typical entrepreneur has a fairly illiquid business, this is a key discussion point for planning.
The two methods to pay the estate tax are either a) use one’s own assets or b) use insurance. For those entrepreneurs who have been able to harvest profits and invest away from the business in cash and marketable securities, paying the estate tax associated with the business and other illiquid assets (i.e., real estate) with one’s own assets is a viable option given their liquidity. However, in the case where the entrepreneur constantly plows profits back into the business, or invests in other illiquid assets, then another source of liquidity at the time of death must be found. The answer – insurance.
Life insurance is the most common solution, as the death proceeds provide the instant liquidity needed to pay any applicable taxes. In general, the entrepreneur simply needs to maintain insurance with death benefit at least equal to 50% of the value of the business and other illiquid assets in the estate. And of critical importance: the insurance should not be owned by the entrepreneur themself; rather, it should be owned by an irrevocable insurance trust (or family limited liability company) in order to keep the proceeds out of the estate as well.
Reduce the Estate Tax
Most entrepreneurs object to paying any estate tax, let alone using a solution to pay all possible estate taxes. Therefore, the next strategy to explore is estate tax reduction. Logically, in order to reduce estate taxes, one must reduce the value of the estate. Such reduction in value is achieved through a) the gifting of assets to the next generation; b) application of valuation discounts; or c) preventing future growth by the creation of asset freezes.
First, the direct gifting of assets can take many forms and is very effective. Essentially, one is reducing the size of the estate by giving assets away to others. The benefit to gifting during one’s lifetime is that not only is the asset value removed from the estate, but so too is all the appreciation that occurs after the date of gift. This allows a taxpayer to ultimately give away more than the available estate and gift tax exemption amount (currently $5.25M per taxpayer and $5,340,000 for 2014.
The direct gifting of assets is generally achieved through one of the following methods:
- Formalized Gifting Programs – Using the annual and/or lifetime exclusions.
- Qualified Tuition Expenses – Paying tuition directly to an institution for others.
- Qualified Medical Expenses – Paying medical bills directly to an institution for others.
- 529 College Saving Plans – 5-year front-loading = $70,000 tax-free, currently.
- UGMAs/UTMAs – Making contributions to a minor’s custodial account.
- Crummey Trusts/2503(c) Gift Trusts – Using gift trusts to receive the gifts for others.
In each of the foregoing strategies, the donor is parting with the assets and giving up control. Oftentimes, to maintain control and make a more indirect gift, we utilize family limited liability companies; the assets are owned by the LLC, and it is only the ownership interests in the LLC that are gifted. The donor typically retains some form of control and access to the assets as a manager of the LLC. In either case, the economic value of the wealth is being transferred, thereby reducing the size of the estate.
Valuation Discounts & Asset Freezes
The estate tax one pays is tied directly to the value of the assets reported on the tax return. Therefore, the lower the value of the assets, the lower the estate tax. Many people overlook that the assets they are valuing can be reduced significantly just by applying certain allowable valuation discounts.
Whether dealing with the entrepreneur’s business or properly structured family LLC, the interests in these types of entities can generally benefit from two types of discounts: a) lack of marketability; and b) lack of control. While other types of discounts may apply, these are the most common and most effective. And although the facts will vary in any given case, the range of acceptable discounts is usually 20-40% depending on the nature of the assets. For example, a 30% discount would reduce a $2M asset to a reported value of $1.4M, thereby reducing the size of the gift by $600K.
Valuation discounts apply equally during lifetime as at death. That is, gifts of the business or family LLC interests during one’s lifetime, or the same gifts provided in a will or trust at death, are entitled to the same reduction in value. In either case, a formal appraisal by a valuation expert must be obtained and submitted to the IRS.
Another strategy for reducing one’s estate is to cap the value of the estate by transferring all future appreciation to the next generation. Such structures are known as “freeze” techniques in which the assets are frozen at the current value, so the estate exposure is known. All increases in value after the date of the freeze are outside the estate.
The most common asset freeze techniques are:
- Straight Sale – An asset is sold directly to next generation. The amount of the proceeds is the frozen amount.
- Grantor Retained Annuity Trust – An asset is gifted to a trust in which the grantor generally receives an annuity interest equal to the value of the gifted asset.
- Sale to Defective Trust – An asset is “sold” to a trust, which provides installment payments back to the seller. The trust is structured to be taxable to the seller for income tax purposes, so no capital gains tax is owed.
- Qualified Personal Residence Trust – A residence or vacation home is gifted to a trust for the benefit of the next generation, and the senior generation retains the right to live in the house for a prescribed period of time rent-free.
In each of the above techniques, consider a combination approach in which the asset values are first squeezed down through valuation discounts and then transferred via the freeze technique. This combined approach is a “squeeze and freeze.”
Perhaps the best way to avoid inclusion of an asset in one’s estate is to never actually own the asset. Diverting original acquisition opportunities of business interests, real estate, competitive enterprises, and speculative securities to the next generation in the first place will remove the asset and all future appreciation from the estate. At some point, those with taxable estates need to realize enough is enough, and start building bigger estates for those downstream.
II. Income Tax Minimization
Of course, each year the entrepreneur is reminded of high income tax rates and the annual loss of wealth that results. Income taxes can be minimized, but the entrepreneur and his or her advisors need to be proactive in doing so. General strategies for income tax minimization include:
Maximizing Business Deductions – As a business owner, each entrepreneur benefits from a whole set of business expenses that he or she is entitled to deduct. Most leave dollars on the table by failing to maximizing the business deductions permitted under Section 162 of the Code. Some business expenses can indeed provide personal benefit as well – and you’d rather pay for such items with pre-tax rather than post-tax dollars. Maximizing business deductions, of course, results in lower taxable income on the individual return. Entrepreneurs should consult a tax adviser each year to review expenses, to ensure material items are not being overlooked.
Maximizing Personal Deductions – Each individual taxpayer is also entitled to certain annual deductions or exemptions under the Code. So, in addition to the corporate deductions, entrepreneurs should maximize individual deductions such as personal and dependent exemptions, charitable contributions and tax-deductible investments (e.g., oil & gas, agribusiness, tax credits, etc.).
Shifting Income to Lower Tax Brackets – Once the entrepreneur understands that the wealth proposition is more of a family wealth proposition as opposed to an individual one, then that focus should turn toward income tax planning as well. The goal is to minimize the overall family income tax burden. One simple way to do so is to allocate income – through salary, profits or certain benefits – to those family members in lower tax brackets. Although passive income may be subject to the “kiddie” tax, and taxed at the parent’s rate where applicable, earned income is not. Careful analysis of all family tax rates should be considered to ensure the greatest efficiency.
Establish a Tax-Free Earnings Environment – Instead of trying to find deductions and juggle multiple tax rates, it is sometimes easier to simply establish a tax-free earnings environment altogether. Retirement assets, portfolio investments and even businesses can be often be placed in a tax-free vehicle so that there is no ongoing tax drag on the annual income. Examples include ERISA plans for retirement, high cash value insurance policies for portfolios and corporations owned by Employee Stock Ownership Plans.
There are variations and combinations of the foregoing to consider as well. For example, a captive insurance company is an insurance company established by the entrepreneur to principally insure risks of his or her entity(ies). While the goal is to increase profit through positive underwriting, a properly formed captive can also provide significant tax benefits. First, the premiums written from the entity(ies) are deductible, reducing the taxable income. Second, with a specific 831(b) captive, the first $1.2M of premium to the captive can be received tax-free. Third, distributions from the entity are currently taxed at lower qualified dividend rates as opposed to ordinary income. And fourth, if the entity is established with a family trust as the owner, the entity can be set up completely outside the entrepreneur’s estate.
Combining various tax strategies has to be carefully pursued with experienced counsel, but the results can be compelling if done correctly. Obviously, entrepreneurs should seek experienced counsel when engaging in tax minimization planning as faulty planning can have disastrous results.
Taming the Planning B.E.A.S.T. Part IV – Succession Planning