An all-time high federal gift and estate tax exemption, low interest rates, and (in many cases) decreased values of family businesses resulting from the COVID-19 pandemic have created an ideal opportunity for business owners who are ready to put highly effective succession plans into action. A one-time gift or an annual gifting program may be the family business succession planning strategy that works best for you.
Using a One-Time Gift – Use it or Lose It:
In late 2017, Congress increased the federal gift and estate tax exemption – the so called “lifetime exemption” – from $5 million per person to $10 million per person and indexed the exemption for inflation. For 2020, the federal gift and estate tax exemption is $11.58 million per person. Unless Congress passes further legislation, the tax reforms which provide the increased federal gift and estate tax exemption will “sunset” on December 31, 2025 and the federal gift and estate tax exemption will revert back to $5 million per person, indexed for inflation as of January 1, 2026.
For a period of time after 2017, many tax practitioners had the following concern: If a person made a gift after the tax reforms went into effect in 2017 and before the reforms sunset at the end of 2025 and the value of the gift was greater than the amount of the federal gift and estate tax exemption after the “sunset” ($5 million per person, indexed for inflation) would the excess amount be “clawed” back into the estate of such person if he or she passed away after the reforms sunset and result in liability under the federal gift and estate tax after all? Understandably, this concern caused many tax practitioners to be reluctant to advise their clients to take make gifts having a value in excess of the federal gift and estate tax exemption after the reforms sunset – so called “delta gifts”. But in November of 2018 the IRS issued proposed regulations which indicate that with respect to estates of persons who die after 2017, the IRS will not seek to subject “delta gifts” to the federal gift and estate tax. Therefore, a family business succession planning strategy that incorporates a one-time gift using (before losing) the increased federal gift and estate tax exemption might be a solution that you should consider. So – use it or lose it.
Using an Annual Gifting Program:
In addition to the lifetime exemption, a person may give a certain amount each calendar year to any number of other persons without any federal gift and estate tax liability or reducing the amount of his or her lifetime exemption. This annual amount is commonly referred to as to the “annual exclusion amount,” and it also is indexed for inflation. For 2020, each person may give $15,000 per calendar year to any number of other persons without any federal gift and estate tax liability. Married couples can “split” a gift and give up to $30,000 per calendar year to any number of other persons.
The most successful use of the annual exclusion amount is achieved when it is applied as part of an annual gifting program. To illustrate, suppose a business owner and her spouse desire to adopt an annual gifting program whereby the couple would make gifts each calendar year of ownership interests in the family business entity. Suppose further that for each year during the program the lifetime exemption if $11.58 million per person, the annual exclusion amount is $15,000 per calendar year, and the couple intend to “split” the annual gifts. The couple has two adult children and one adult niece to whom they desire to make gifts as part of the program. After 15 years, the couple has given away $1,350,000.00 worth of the ownership in the family business entity. [$30,000.00 x [15 x 3]]. Additionally, the couple has neither incurred any federal gift and estate tax liability nor has the business owner or her spouse reduced their $11.58 million per person lifetime exemptions.
Federal Income Tax Issues:
A business owner who is considering making either a one-time gift utilizing the federal gift and estate tax exemption or one or more gifts as part of an annual gifting program utilizing the federal annual gift exclusion should be aware of certain federal income tax rules which distinguish between a gift made during the business owner’s life time and a gift made by the business owner upon his or her death. For federal income tax purposes, a family member to whom the gift of an ownership interest in the family business is made takes the tax basis the business owner had in the gifted ownership interest – a so called “carry-over basis”. In contrast, a family member who inherits an ownership interest in the family business from the business owner generally receives a tax basis in the gifted ownership interest equal to its fair market value at the date of the business owner’s death – a “stepped-up basis”. Taking into consideration both federal gift and estate tax consequences as well as federal income tax consequences is a key element to any well thought out plan.
Making a Gift to a Family Member or a Trust:
A business owner may gift ownership in the family business to a family member or to a trust established for the benefit of a family member as a one-time gift using (before losing) the increased federal gift and estate tax exemption, a series of gifts as part of an annual gifting program utilizing the annual gift exclusion, or both. Gifting assets removes not only the value of the assets from the donor’s taxable estate for federal estate tax purposes, but also removes any subsequent income and appreciation related to those assets.
Gifting an ownership interest in the family business to a family member or to an irrevocable trust established for the benefit of a family member removes the value of the ownership interest from the business owner’s estate for federal gift and estate tax purposes. However, there are situations in which making a gift to an irrevocable trust established for the benefit of a family member has additional advantages. For instance, if a business owner would like to make a gift of an ownership interest in the family business to a child but if the child would be a minor at the time or incapacitated, making the gift outright is not a possibility. These are examples of instances in which making a gift to an irrevocable trust established for the benefit of a child is generally required. If the child is in a troubled marriage, has creditor’s claims, or has a substance abuse problem, then making the gift outright is a possibility but seems risky. These are examples of instances in which making a gift to an irrevocable trust established for the benefit of a child and structured so as to shield assets from creditor claims and preclude assets from being subject to claims in a divorce proceeding may be the wiser course of action.
Timing – Sooner is Better than Later:
Making a gift of an ownership interest in a family business is not like making a gift of stock in a publicly traded company. An ownership interest in a family business entity which is to be gifted must be appraised. To do this, first the family business is appraised based upon its enterprise value. Suppose the family business would ordinarily appraise for $11 million but because of the COVID-19 pandemic it has a current enterprise value of $10 million. Then, the ownership interest to be gifted is appraised. If the ownership interest constitutes a minority interest, the ownership interest may be discounted because the holder will have no control over the family business. Further, because the ownership interest is not freely transferable or publicly traded, its value is further discounted. Suppose these two discounts – lack of control and lack of marketability – total 30%. So, although you might expect a 10% ownership interest in a business valued at $10 million to have a value of $1 million, because of the discounts described, the gifted ownership interest might have a value of $700,000.00.
Determining the size of the ownership interest to be gifted, having transfer documents prepared, trusts established, and appraisals conducted all take time. Additionally, if the business owner waits until the end of the year or right before a tax law is to take effect, the ability to secure the services of appraisers, attorneys, and others may be challenging. Accordingly, a business owner who is considering making a gift of an ownership interest in a family business should act sooner and not later.
Please contact the Estate Planning, Probate & Trusts practice group to schedule a time to discuss how a one-time gift or an annual gifting program might be used to assist you in reaching your family business succession planning goals.
Frank L. Leffingwell is a tax attorney in the firm’s Tax Planning & Controversy, Estate Planning, Probate & Trusts, and Real Estate sections.