The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, better known collectively as the 2010 Tax Act P.L. 111-312, was signed into law by the President on December 17, 2010. Key changes of the law, which practitioners are well familiar with, are the $5 million unified exemption and the new concept of “portability.” Portability may enable a surviving spouse to benefit from the unused exemption from the first spouse to die, although there are a number of significant issues that may affect this benefit. Many, perhaps most, clients believe they don’t need to plan at all given the new exemptions and portability. For many clients, especially those owning closely held businesses, this will prove to be a costly mistake.
Estate planning for business owners has never been only about federal estate tax, although for wealthy clients, that remains an issue. And, as practitioners know, but many clients seem to have forgotten, in 2013, the exemption drops to $1 million if Congress does not act. What should practitioners be recommending to business clients in light of these massive changes, and why? Consider the following checklist:
Gift Valuable Business Interests
Gift valuable business interests now to take advantage of the new large $5 million gift exemption. This provides for a tremendous opportunity to shift business interests to the next generation now.
If this is not taken advantage of, the opportunity might be lost forever. The Obama administration has already proposed reducing the $5 million to $1 million. With pressing budget problems, no one should assume that this will remain intact for long. If the reduction to $1 million happens, clients owning large businesses will be precluded from simple planning.
Gift Non-Controlling Interests
Gift non-controlling interests in businesses now. Discounts for lack of marketability and lack of control are still permitted.
There have been a host of proposals to restrict or eliminate these discounts. If enacted, the ability to leverage gifts of business interests will be lost. Clients looking to transition business interests to the next generation should not lose this opportunity.
Reallocate Business Interests
Reallocate business interests between non-married partners. The estate tax law has always been biased against non-married partners. The portability provisions of the new law are no exception as this tremendous benefit is not available to non-married partners.
If clients have “personal” partners with whom they would like to share the equity in a business, the new $5 million gift exemption provides an opportunity for all but the wealthiest of partners, to shift assets without a gift tax.
For example, Jane Smith owns a successful marketing firm as well as the building in which it operates. Her partner, Sandy Jones has a modest net worth. Jane wants to make sure Sandy is provided for. She might take advantage of the new large gift exemption and gift Sandy a large percentage of the limited liability company that owns the building leased to the business.
This would assure Sandy a cash flow for life if anything happens to Jane, yet no current gift tax would be due. Even if the exemption is reduced to $1 million at a future date, Jane’s primary goal of assuring Sandy’s financial security would have been met.
Use the New Gift Exemption
Use the new gift exemption to structure asset protection planning. For business owners, passive assets can be segregated and transferred into protective structures to protect them from business claims.
For example, Steve Smith owns Widget Manufacturing Corporation. Corporate assets include raw land adjacent to the factory that was purchased for future expansion plans and is being leased to a local private school for overflow parking in the interim, the factory/plant property and the operating assets.
Widget is divided into three separate entities in a corporate division under Code Section 355: raw leased land, factory property and operating assets. The leased land is sold to a dynasty trust for family members, and the factory property is sold to a different trust for an installment note.
Steve retains control over the operating post-division corporation and makes gifts to the children active in the business. The objective is to isolate the raw land and building into separate structures to insulate them from potential business claims. Given the availability of discounts and the $5 million exemption, this type of planning may be feasible now, but not at a future date.
Review Life Insurance Plans
Most business clients have used some type of life insurance to address liquidity issues and the payment of estate tax. These insurance plans should be reviewed and evaluated in light of the massive estate tax law changes, but the continued estate tax uncertainty.
Some clients have taken a knee-jerk reaction deciding to cancel life insurance — potentially a catastrophic choice. Instead, consider advising clients to consider having new insurance projections done to determine the least amount that they can pay in premiums until perhaps the end of 2013 (in case the estate tax issues aren’t resolved until near year end as in 2010) and maintain their policies in force and in good shape.
This is a safer approach in that the client can minimize payments but retain coverage should tax law changes prove it worthwhile.
Split-Dollar Plans vs. Cash
Some business clients have complex split-dollar insurance arrangements that have been created to fund the liquidity issues of their business interests. Split-dollar was often used when the cost of annual insurance premiums exceeded the available annual gift exclusion amounts and the client wanted the protection and tax benefits of having their life insurance held by an irrevocable trust.
The new $5 million gift exemption may permit many of these clients to simply make a gift of cash to their insurance trusts and then have the insurance trust unwind and repay them. This can be used to unwind the split-dollar arrangement, avoid the need for an exit strategy for the plan, and simplify their insurance planning going forward.
Gift to Grantor Trusts
Clients with valuable business or real estate holdings may have sold some portions of their business interests to grantor trusts for notes.
For example, Jane Smith sold 40% of her real estate firm to a Delaware dynasty trust in exchange for a note. The sale was consummated several years ago to freeze the value included in her estate and have future appreciation in the business interests sold growing outside her estate.
When the equity in the business was sold, the trust gave Jane back a note for about 95% of the purchase price. To support the validity of the transaction, Jane’s insurance trust, which has substantial value in permanent policies, guaranteed the dynasty trusts repayment of 10% of the face value of the note to Jane.
These transactions sometimes involved guarantees, especially for larger dollar transactions. It may be possible for these clients to use some of the increased $5 million gift exemption to gift sufficient assets (perhaps interests in the business previously sold) to their trusts and then unwind the guarantees.
It may be feasible for smaller transactions to gift dollars to the trust that can be used to repay the client/seller/grantor for the loan used in the previous sale of business interests to the trust and eliminate the notes and all financing for the transaction.
Regardless of what should occur in the future with the estate tax, helping clients with valuable business interests capitalize on the current law to simplify existing transactions, safeguard assets, and implement succession plans, will be worthwhile.
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