Gifting Strategies for the Family Business

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Every day in America there are stories of families losing their multi-generational business or family farm because they had to liquidate in order to pay estate taxes. Most estate planners strive to reduce the impact of estate taxes as much as possible. Tools and techniques such as irrevocable life insurance trusts, family limited partnerships, gift trusts, and others may be employed to reduce the estate tax. And with some charitable planning, estate taxes can be eliminated altogether.

The Gifting Strategy

One strategy to reduce estate taxes is the use of lifetime gifts. For 2016, you can give away up to $14,000 worth of assets each year to any number of recipients, with no gift tax consequences. If you’re married, you and your spouse can give away up to $28,000 each to any number of recipients.

Therefore, a married couple with three children might give away $84,000 worth of assets, including shares in the family business, to their children each year. Over 10 years, the total amount given away could total $840,000 worth of shares, and more if the annual gift tax exclusion is increased by the government to reflect inflation.

If you assume a 40% tax rate, transferring $840,000 worth of company shares from the senior generation to the next generation saves over $336,000 in estate tax. In addition, any growth in the value of the shares after the gifts are made will not be included in the senior generation’s taxable estate.

If you give away more than $14,000 worth of assets to any recipient in one year, the excess is subject to gift tax. No actual tax payment will be due on amounts given up to the lifetime gift tax exemption amount, currently $5,430,000 for 2016. To the extent that the lifetime gift tax exemption is used, it reduces the estate tax exemption at death, dollar for dollar.

Once the $14,000 annual gift tax exclusion and the lifetime gift tax exemption are exceeded, there would be gift tax payable on those excess gifts. (The gift tax is owed by the giver, not by the recipient.) Paying gift tax might be a good trade-off, however, if your estate eventually avoids estate tax on the gifted assets as well as the future growth of those assets.

Valuation Discounts

When using a gifting strategy, the addition of “valuation discounts” may help you give away even more shares of your company at a modest gift tax cost. (Note: There are potential regulations coming that may limit or eliminate these discounts.)

Gift and estate taxes are based on asset values. If the gift tax rate is 35%, for example, and you make a taxable gift of $1 million after using up your gift and estate tax exemptions, you’ll owe $350,000 in gift tax.

However, some assets are hard to value. Shares of a family business fall into that category. How much is your company worth? If you give 10% of the shares to your daughter, how do you value that gift for tax purposes?

To withstand IRS scrutiny, you’ll need to have your company appraised. The appraisal must be done by a qualified appraiser, as defined by the IRS. Moreover, the appraiser can’t be someone who’s connected to you or your company. If you ask the CPA who has prepared your tax returns for the last 10 years to value your company, the IRS might not accept the result as an unbiased opinion. To find a competent appraiser, ask your advisors.

Once you have hired an appraiser, expect to see a detailed report that sets out several methods of valuing your company. Weighing all these possibilities, the appraiser will come out with an estimated value: the price that a knowledgeable, arm’s-length buyer would pay for your company.

Suppose, for example, the appraiser puts the value of your company at $10 million, based on revenues, profits, assets, and so on. You give your son 14% of the shares. Is the value of that gift $1.4 million?

Not necessarily. Your son would have no control of the company with a 14% interest, if you have the other 86%. Your son might have a difficult time selling his shares because few buyers would be interested in acquiring a small piece of a closely-held family business. (The shareholder’s agreement may also restrict your son’s ability to sell his shares without your consent.)

Because of this lack of control and lack of liquidity, the 14% interest that you gave your son would not be worth $1.4 million, in this hypothetical example. The appraiser you’ve hired might state that a valuation discount should be applied; for such gifts, 30%-40% discounts are common. Assuming a 30% discount, for example, giving away 14% of the shares would actually be a $980,000 gift for tax purposes, not a gift of $1,400,000.

Of course this helps tremendously in terms of tax savings and is certainly worth considering.

If you have questions, click here to have our office call to set up a time to discuss this with you.

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