Estate planning offers itself as the type of long-term, strategic thinking that can help owners grow-and protect-their businesses. However, not enough company founders and owners see it that way.
At first glance, estate planning seems distracting, taking valuable time away from the day-to-day responsibilities of managing one’s business. It’s also difficult, forcing owners to hunt down reliable executors and trustees, selecting possible heirs, and even consider giving up some control of the business. These are tough decisions for any owner to make.
Still, the advantages of savvy estate planning outweigh the hassles. That’s because estate taxes-currently pegged at up to 45 percent of a business’ appraised value at its owner’s death-are nothing short of treacherous. After all, how many businesses valued at $10 million would have enough cash flow to cover a $3.6 million tax bill from Uncle Sam? Even if the heirs could spread payments (plus all the accruing interest charges) our over 10 years, that amount is an incredible tax bill for any business. (The extension, known as a Section 6166, applies only to estates in which the closely held business is worth more than 35 percent of the gross estate. )
Most legal experts recommend that company owners set up full-fledged estate plans-including wills, executors, tax-avoidance plans, management-succession strategies, insurance policies, trust funds, and more-regardless of the other constraints on their time. The risks of going without are simply too great.
A practical approach for business-minded estate planning involves the three cycles of a business:
Here's how it works:
When a fledging business owner has a child, its often time to consider estate planning. For starters, you should have a will written, no matter how large or small your business is. Typically, your goal will be to leave the assets of your business to your spouse. And it's wise to sign up for plenty of life insurance-this helps ensure your family is taken care of in the event of your untimely demise.
Next, consider setting up a family partnership. One approach is to combine a standard family partnership with a sale-lease-back strategy, an arrangement still possible under today's tax laws. This allows the corporation to basically own its working capital and the family partnership owning everything else through lease-back.
Make sure to structure the family partnership with estate planning in mind. Each year you can make tax-fee contributions under your children's names to the partnership-starting out at the Internal Revenue Service's limit and eventually reaching the current cap. Through the regular addition of leasing fees, you can pass on more revenues to your children than would have been possible had you been locked into the tax-free gift limits.
By setting yourselves up a general partners, you can control the use of the partnership's growing funds. This means you can spend the money how you like-machinery, equipment, property, or whatever is in the interests of the company. This is a safer strategy than simply giving money to the kids, who might spend it unwisely if they are unsupervised. There's also another advantage to this type of family partnership/leasing strategy; income earned by the partnership, mainly in the form of leasing fess, is taxed at low personal rather than corporate tax rates, since it is treated by the IRS as income to each individual partner.
The family partnership/leasing plan works well for families that share ownership in their businesses, whether with venture capitalists, employees, or other partners. All that's required is agreement about which assets need to be owned by the corporation and which can be leased just as easily from the partnership or another third party.
As the company matures, your estate planning should evolve as well. Ideally, an estate plan at this stage of a business's development should focus on:
- Reducing future estate
- Planning for future ownership of the company
- Contingency arrangements for the management succession
During this stage, company owners can make use of the so-called GRIT (grantor retained income trust). It's another way of minimizing taxes while passing along stock to the second generation. GRITs work like this: a business owner transfers shares in his or her company to an irrevocable trust, set up for maximum of 10 years. The gift is then taxed at a maximum rate of 46 percent, which at first glance sounds just as terrible as the estate tax rate. But here's the advantage. The GRIT gift is first discounted to only 37 percent of its face value, so the tax on a $10 million gift would be only $2.9 million, compared with $3.6 million if it passed at the owner's death.
During the lifetime of the GRIT, the owner can receive income from its shares in the form of dividends. Owners who have never declared dividends before must set up a formal structure-a simple matter for accountants-since funds transferred to a GRIT must produce income. Afterward those shares pass on the children free of all estate and gift taxes-no matter how big the business has grown. There are just a couple of problems. If the grantor dies during the 10-year term, the trust is voided and the assets revert to the estate. The heirs get a credit for the gift tax paid, but they have to make up the balance. Also, most people are only comfortable putting up to 49 percent of their company's stock into a GRIT, since they don't want to give up control of the business. For business owners too young-or uncomfortable with the logistics-to consider GRIT's, the best alternative is insurance and lots of it. Buy enough to pay off whatever estate taxes are expected, above the $4 million exemption permitted to each married couple ($2 million for singles).
For the transitionary stage- when owners want to find successors and enjoy the fruits of the labor in retirement or protect their business after their deaths-its critical to find worthy successors. Typically, owners will promote from within, someone whom they trust. Their role will be either to ensure a smooth succession to new family management or, if none of the children wants to stay involved, to sell the company. Also, it is possible to set up a plan whereby if only one of your children wants to stay in the company, he or she must buy out the other family members at market cost.
Finally, if you're still in doubt about the merits of estate planning, ask yourself this question: why work so hard to grow a business only to lose its value one day? We work not only because we want to raise our own standard of living, but also want to leave something behind for our family, especially our children. Understandably, it doesn't make sense to give away a big chunk of that money to the government through probate costs and taxes.