By: Jason P. Livingston, Esq. and David P. Shaffer, Esq.
Are you a business owner considering passing your company to the next generation? There may be no better time to act than the present. The old adage tells us that nothing is certain but death and taxes, however the amount of taxes (or more importantly the exemptions) has been fluctuating greatly in recent years.
In December 2010, Congress passed the Tax Relief Act which considerably increased the federal gift and estate tax exemptions. However, these increases are only temporary and set to expire at the end of 2012. The current exemption amount, coupled with other valuation factors, offers an opportunity to transfer additional wealth and shift subsequent appreciation out of a taxable estate. These resulting benefits are especially obvious in transitioning business interests during lifetime. This article will address some business planning options and the gift and estate tax consequences.
First, it is important to understand the basic taxable events under current New York and federal law. New York has no state gift tax, and the federal annual gift tax exclusion allows an individual to gift up to $13,000 per recipient per year and avoid the IRS reporting requirement (this amount doubles for spouses gifting together). Transferring assets in excess of this annual exclusion requires IRS reporting, although no tax is paid unless an individual has used up his or her lifetime gift tax exemption. This lifetime gift tax exemption has been the focus of opportunity in business succession planning.
Prior to the Tax Relief Act of 2010, the lifetime gift tax exemption remained relatively stable at $1,000,000. The Tax Relief Act, passed in the final weeks of 2010, increased the lifetime exemption to $5,000,000, adjusted for inflation. As a result, the 2011 exemption was $5,000,000 and the inflation adjustment increased the 2012 exemption to $5,120,000. Individuals are currently permitted to gift assets, tax free, in excess of their annual exclusion up to $5,120,000.
With current federal estate tax legislation set to expire on December 31, 2012, various scenarios may play out. Some commentators have speculated that Congress will take action at the end of this year to extend the current $5,000,000 exemption amounts (plus inflation) into 2013 and beyond. Other commentators think Congress will reintroduce the $3,500,000 estate tax exemption and $1,000,000 gift tax exemption amounts that were in place in 2009. However, the certainty is that if Congress fails to take action, both the estate and gift tax exemptions will fall to $1,000,000, and the tax rates will jump from their current 35% rate to 55%.
If the exemption amounts decrease beginning in 2013, 2012 will prove to be a critical year for gifting. In that scenario, “tax free” gifts made in 2013 will generally be limited to the amount of the then available exemption (whether that be $1,000,000; $3,500,000; or some other amount).
For estate tax purposes, these taxable gifts will be included in the transferor’s estate. However, clients in a position to transfer assets during lifetime can still recognize considerable benefits and estate tax savings. It is important to remember that the amount of the exemption applied against a lifetime gift is valued at the time of the gift. As such, gifting appreciable assets (such as business interests), coupled with other valuation practices, can greatly enhance the benefits of lifetime gifting, particularly at a time when market conditions are depressed.
For example, if a family business owner transfers $1,000,000 of company stock or other assets to his or her children, and the stock subsequently appreciates to $2,000,000 after the transfer is completed, only $1,000,000 (less the annual exclusion amount) will be counted against the owner for gift tax purposes. The appreciation will pass estate tax free to the donees. Moreover, with low interest rates, transferring assets to certain types of trusts for the benefit of children also allows business owners to “leverage” the exemption to transfer wealth to future generations in a tax-efficient way.
Finally, recapitalizing a business into voting and non-voting interests provides another planning opportunity for business owners. Here is how it works: A business owner transfers a portion of the non-voting interests to his or her children, while maintaining control of the company by retaining the voting interests. The transfer of non-voting interests is advantageous from a gift tax standpoint because the value of the non-voting interests is “discounted” from a fair market value perspective. The discount is attributed to the “lack of control” associated with the non-voting interests. A separate discount for “lack of marketability” can also be obtained if the children’s ability to transfer the interest is restricted pursuant to, for example, a shareholders’ agreement. Most commentators believe that a 20% to 40% discount is appropriate for gift tax reporting purposes but these discounts should be supported by a qualified appraisal. Therefore, in many cases, a business owner who transfers $5,000,000 worth in non-voting interests to his or her children will only be considered to have transferred $3,000,000 to $4,000,000 as a result of these discounts.
2012 provides a year of relative certainty in the estate and gift tax realm. This certainty allows family business owners to take control over the future of their business and begin transferring wealth in a tax-efficient way. Therefore, individuals in the position to begin transferring assets to lower generations during lifetime will realize considerable tax benefits.
Jason P. Livingston and David P. Shaffer are associates in the Family Wealth Planning practice group at Woods Oviatt Gilman LLP. Jason can be reached at 585-987-2866 David can be reached at 585-987-2878.