Blackman on Taxes
New Law Opens New Opportunities for Successful Family-Business Owners
Joe and Mary, both in their early sixties, consider themselves blessed. Joe started his business in 1975. The first dozen years were a struggle, but then revenue and profits began to blossom—more customers and more employees. Now, two key employees are his only kids, Sam and Sid. After college Joe insisted the boys work elsewhere for three years. They did, and now they run the business (Success Co.), with some coaching and help from Joe.
Let’s take a look at Joe’s current wealth. This year’s annual personal financial statement prepared for the bank by Joe’s CPA (Cal) shows a net worth of $18.5 million. Included are two homes, a primary residence in Michigan and a winter home in Florida; the land and building leased to Success Co.; Joe’s 401(k) ($1.1 million); and a stock and bond portfolio ($1.6 million). The prime asset, of course, is Success Co., which Cal values at $11.7 million.
How did Joe feel about taxes? Income taxes are okay, “the price of doing business in America,” he says. But estate taxes, he says, are “a double tax on success.”
Let’s talk about Joe’s estate taxes. When the president signed the new tax law on January 2, 2013, to avoid the fiscal cliff, he initiated two significant changes affecting estate taxes: he lowered the top estate-tax rate from 55 percent to 40 percent, starting in 2013; and he continued forever the $5 million (tied to inflation) that is free of the gift or estate tax, starting on January 1, 2013. Because of inflation, the free amount rose to $5.125 million in 2012 and is now $5.25 million for 2013. And if you are married, that figure doubles to $10.5 million for 2013.
As soon as Joe heard the estate-tax news he called a meeting with Cal and his attorney Lenny, who specializes in estate planning. Joe had questions. First, he asked: “What would my estate tax be on my current net worth?” Everyone had a copy of Joe’s latest personal financial statement. “In the $3.2 million range,” answered Lenny.
“But my wealth grows almost every year, particularly the value of Success Co.,” said Joe “What happens to the estate-tax cost as my wealth rises?”
“Well,” responded Lenny, “for every $1 million in increased wealth, your estate-tax bill climbs $400,000.”
After a bit of give-and-take discussion, all agreed on Joe’s problem:
Joe’s wealth already places him in the highest estate-tax bracket—40 percent. Since the value of Success Co. continues to grow, it should be removed from his estate (by a transfer to Sam and Sid) as soon as possible. Joe must retain control of Success Co. for as long as he lives, and Joe and Mary must have a flow of income to maintain their lifestyle when Joe retires in three years.
A long discussion followed concerning the fate of Success Co. Should Joe sell the company to Sam and Sid, give it to them, or have the company redeem Joe’s stock. Try as they would, they could not agree on a viable solution. That’s when Joe called me.
Many family-business owners have been down the same frustrating path as Joe. A sale kicks up current capital-gains tax. A gift means no more income to Joe and Mary. Variations suffer one or both disadvantages. And inflation, for either a sale or gift, remains an unknown fear factor for Joe when he retires.
What to do? Enter a concept called Spousal Access Trusts (SATs), an irrevocable solution to every issue raised by Joe’s problem.
The first step in creating SATs for Joe and Mary is to divide the Success Co. stock so that Joe and Mary each own 50 percent of the nonvoting stock. Note: If you do not have voting/nonvoting stock, you can create them using a simple tax-free transaction. Typically, Joe will keep the voting stock (say 100 shares) and control of Success Co., and the nonvoting stock (say 10,000 shares) is gifted to the SATs—5000 shares transfers to Mary’s trust and 5000 shares transfers to Joe’s trust.
Now Joe and Mary can each use all or a portion of their $5.25 million gift-tax free exemption when gifting the nonvoting stock to the trusts. An important tax note: nonvoting stock is entitled to various discounts of about 40 percent, making the 10,000 shares gifted to the SATs worth only about $7 million for tax purposes.
Joe’s trust, in simple terms, gives Mary a right to the trust income for life, and at her death the trust assets go to Sam and Sid. Mary’s trust does the same for Joe. It is critical that the trusts be drafted in such a as to be different in order to avoid the so-called “reciprocal trust doctrine,” which would pull the gifts made back into the grantor’s estate. So, make sure you work only with an advisor experienced in drafting and working with SATs.
The second and final step is the year-to-year operation of the SATs. Joe and Mary can only work with their spouse’s trust to get the income they need from time to time. Any income that they do not take stays in the trust and will eventually go to their heirs—kids and grandkids—estate-tax-free.
The results of the SATs for Joe and Mary:
• Success Co. is out of Joe’s estate, but he keeps control.
• Future income earned by Success Co. will be available to Joe and Mary as needed.• When Joe and Mary have gone to the big business in the sky, Success Co. and all of the nonused income accumulated over the years in the SATs goes Sam and Sid, free of the estate tax. MF
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