by Joseph A. Lewis, JD, CPA
Most people know, all states allow surviving spouses to inherit tax-free from their partners, but what happens when a business interest is involved? In contemplating their own estate, business owners must decide whether to sell the business, pass it onto their family, or let it simply expire. Either way, the tax consequence of the decision need to be evaluated.
Where the owner anticipates selling his business, he should maximize its value before his death. A tax strategy commonly used during the owner’s life is to increase compensation to minimize profits thus reducing tax consequence. This strategy should be reversed to increase a business’ value in anticipation of selling the business.
Oregon, like most states, and the IRS, does not hit beneficiaries with an inheritance tax. But, there may be an estate tax paid by the estate. Where the business is valued above the exclusion thresholds ($5,250,000 for federal and $1,000,000 for Oregon), the owner’s death will trigger estate taxes at the business’ value on the date of death. The tax rate is on a sliding scale between 10-16% for Oregon; and 15% to 40% (2013) for federal estate filings.
The law allows you to give up to $14,000 worth of assets per recipient to as many people as you wish each year (married donors giving gifts as a couple are allowed $28,000 per recipient per year in gift tax exclusions). For example, if Owen, a business owner had 2 kids and 5 grandkids, a gift of as much as $196,000 ($28,000 x 7) a year could escape taxes. By transferring control of his business during his lifetime (e.g, give shares of stock), Owen could pass ownership tax free. Note, to pass ownership to his minor grandchildren, the ownership (stock certificates) should generally be transferred into a trust account.
Although estate taxes are generally due 9 months after the date of death, where a small business value is more than 35% of the value of the estate, and other conditions are met, the IRS provides relief for taxpayers to defer payments up to fifteen years. Ask us about qualifying your business for using installment sales as provided by IRC §6166.
We caution business owners who use life insurance to protect their business by evaluating the traditional entity purchase, where the business entity itself takes out a policy on the life of each owner and use the proceeds to purchase the share of a deceased owner; compared to a cross-purchase, where the co-owners each take out insurance on each other and buy a share of the dead partners’ interest. The cross-purchase may provide substantial tax advantage because the entity purchase may be more likely pay enough insurance proceeds to the business to triggers tax consequences where the business’ new value exceeds the Oregon and federal exclusion thresholds.
Taxpayers who wish to transfer business ownership to family members should be wary of the value the IRS places on the business if the IRS determines an arms-length, which is a fair value, transaction was not paid. In such cases, the estate might have to pay taxes on the full value of the business, even though the estate receives much smaller amounts per the buy-sale agreement.
Why is it that 70% of family-owned business fail to make a successful transition into the second generation? We believe part of the problem relates to improper tax planning, and WML is happy to assist you!