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After years of running a successful business, you may be ready to expand the
business dramatically, start yet another company, or even retire. But,
if you're like many entrepreneurs, making any of these moves is complicated
by the fact that much of your personal wealth is tied up in the business.
And, unless it's done just right, extricating your money or yourself from
the business could endanger what you've built.
At Commerce Trust, our staff of professional business valuation specialists,
tax attorneys and trust experts can guide you through these important
transitions.
At considerably lower cost than national accounting and consulting firms,
Commerce Trust can conduct a business valuation that is as in-depth and
professional as the major companies provide. Our valuations are performed
by associates with advanced degrees who are also members of the Association
of Investment Management and Research and the American Society of Appraisers.
Taking into account all the factors that contribute to your company's
value, we provide a thorough, accurate report that can facilitate:
Giving Within the Family
Passing a closely held business between generations can be smooth, as long as someone competent is available to take over management. Passing the business with minimum tax impact
is another matter. Careful planning is essential to preserve your assets.
Lifetime gifts to other family members are a proven way to pass business assets and save estate taxes
as well. With proper structuring of the gifts, total gift and estate taxes
can be minimized or even eliminated in some cases. A lifetime gift works
well because it removes from the giver's estate (and estate tax liability)
any appreciation in the gift assets that occurs after the gift is made.
A sizable annual exclusion from both gift and estate taxes (up to $10,000
per recipient, $20,000 if both spouses give) simplifies transferring assets
over a multi-year period. (The annual exclusion amount is adjusted for
inflation.)
Here's an example of how it can work: You are the sole owner of City-Wide Widgets, which today
is worth $900,000. You are looking toward becoming less active in the
business and want to start transferring ownership. Joined by your spouse,
you give your two sons and daughter $20,000 worth of stock each annually
without any gift-tax liability. After just six years, your tax free transfers
will total $360,000. You'll reduce your estate by the entire $360,000
because both the $360,000 value and any subsequent appreciation in stock
value are excludable from the estate. If you are in today's top estate-tax
bracket, your potential tax savings will be $198,000!
Save More With a Minority Discount
Are those $20,000 gifts in the example really worth the entire $20,000? Not when you consider that
yours is a closely held corporation, and no minority shareholder can influence
management or liquidate the company. So, in general, minority shares in
closely held companies are valued at a discount from their proportional
share of the company's full value. That can let you give away more shares
each year within the gift-tax annual exclusion limit.
For years, a minority interest discount was a problem with the IRS if the gift was to a person within
a family that owns all, or the majority, of the corporation's stock. The
IRS formerly ruled that no minority discount would apply because the family
unit continues to control the corporation.
Now the IRS position has changed. As long as a corporation has a single class of stock, other family owned shares no longer have to be lumped with the transferred shares in determining eligibility for a minority discount.
Continuing the above example, the value of the stock you give your sons and daughter would be discounted because it represents minority interests in your company. So you would be able to give each child more shares each year without exceeding your gift-tax annual exclusion limit.
The possibility of capital gains taxes can't be ignored in considering a gift strategy. What if children sell the stock they receive as gifts? The giver's tax basis carries over to the children. With the same tax basis as the original owner, the children may be liable for a substantial capital gains tax.
It works like this: Say you paid $200 a share for the transferred stock. When you make your gift, the value is $500. At the time your child sells, the value has risen to $700 each. The taxable capital gain will be $500 a share ($700 sale price, less your $200 basis).
What if instead you leave your stock to your children at your death? The capital gains situation
will be much better. The stock's tax basis will "step up" to its value at your time of death. Your estate would contain the stock and, therefore, owe estate taxes on it. But your children would pay a lower capital gains tax when they sell.
For example, your children inherit the stock from you. The stock is taxable in your estate, and at your death it's worth $760 a share. If a child later sells the shares for $800 each, the applicable capital gain would only be $40 a share.
It takes a very careful analysis of your particular situation to find the asset transfer approach that will be best. Frequently, that approach is to make lifetime gifts. Your tax professional can help you analyze your circumstances and plan for tax-wise transfer of your assets.
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Loans From Your Company—Dividends in Disguise?
Taking a personal loan from your closely held corporation may be a appropriate financing strategy, provided you take into consideration how the IRS would look at such a transaction. You'll want to take steps to make sure the IRS will not reclassify the loan as a taxable dividend.
In general, a distribution to a shareholder is considered a bona fide loan if, at the time of the disbursement, both the corporation and the shareholder intend that the distribution will be repaid. Here are some rules to keep in mind:
- Loans should bear interest and specify a maturity date (if not payable on demand). Merely classifying a disbursement as a loan on the corporate books and financial statements is not sufficient documentation.
- All loans to shareholders should be documented by means of promissory notes.
- Making repayments of principal and interest according to a predetermined schedule will help bolster a shareholder's case that a distribution is indeed a loan.
- If a corporation doesn't charge adequate interest on loans over $10,000 to its shareholders,
interest must be imputed (the IRS publishes acceptable interest rates monthly).
While you may be tempted to treat withdrawals of corporate funds by owners casually, the unfavorable results of many Tax Court cases show that this may not be wise. Many corporate owners have been required to pay income taxes on loans that they could not properly substantiate. Moreover, since these loans were considered dividends, the corporation could not deduct the payments as compensation. Result: a double tax on the payments.
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How Closely Held Stock Can Help Pay Estate Taxes
As the owner of a privately held business, you may be worth enough to incur a large federal estate-tax liability on their death. (While federal estate tax is scheduled for repeal in 2010, estate taxes are a threat until then, and there's no guarantee of whether the tax regulations will remain the same after 2010.) Yet, your estate may contain comparatively little of the cash needed for the taxes and administrative expenses at death. Fortunately, your estate plan can incorporate a strategy that will generate the necessary cash without a distress sale of your assets.
A Company Buyback
One strategy can work well if you own closely held stock. You can arrange for your company to buy back your stock at a tax advantage on your death. Section 303 of the federal income tax law makes this advantageous stock redemption possible. A Section 303 stock redemption will let your family receive tax-free cash to take care of your estate taxes, funeral expenses, and estate administrative expenses. Ordinarily, a company's payment in exchange for stock is considered a taxable dividend (taxed at ordinary income rates), but Section 303 can convert that distribution into a tax-favored sale of inherited stock.
Selling inherited stock is typically income tax free because the tax law steps up the stock's basis for income tax purposes to the value on the date of its owner's death or the alternate valuation date. If your company redeems the stock before it appreciates after your death, any capital gain during your life avoids income tax.
Qualifying For Section 303's Tax Advantage
Your estate
must meet several requirements to gain the benefit of Section 303:
- Your gross estate must include the stock's value for estate tax purposes. That can happen even if you don't own the stock when you die. Stock held in a trust that you have a life interest in would qualify, for example. So would any redeemed stock that your estate has distributed to a beneficiary. The other Section 303 requirements must still be met.)
- The redeemed stock must be more than 35% of the adjusted gross estate. This is the gross estate minus the taxes, losses, debts, and administrative expenses. What if your estate will be too large to qualify? Additional planning may be able to adjust your estate's size to meet the Section 303 requirement.
- The redemption amount cannot be more than the death taxes, funeral expenses, and administrative
costs combined.
- Generally, the redemption has to be made after your death but within three years and 90 days after the filing of your federal estate-tax return.
Will Your Company Have the Cash?
A Section 303 redemption won't be practical unless your company can fund the buy back from your estate or heirs. The techniques available to assure enough liquidity include insuring your life through your company in an amount that is enough to pay for the stock redemption.
We're Ready to Help
Making certain estate expenses will be covered is far from simple. A professional's advice is essential to determine whether a Section 303 redemption would be a desirable strategy under your business, financial and family circumstances, and a professional's help is needed to put the strategy in place. Do you want to know more about this and other estate planning strategies? Please call on us.
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Placing an Accurate Value on a Closely Held Business
The business you own may make up most of your net worth. When you consider the future disposal of your interest in the business, wholly or partially, it will be essential to determine an accurate value for the business for several reasons.
- An accurate valuation lets you negotiate realistically with buyers. Misunderstandings can
be avoided and time saved.
- If you someday dispose of your business through a gift or it is transferred at your death, determination of a realistic and accurate value will ease the calculation of gift and estate taxes. If your death is unexpected, a valuation can be even more important. Control of many a family business has been lost because of forced asset sales to satisfy estate tax obligations. With accurate advance knowledge of the worth of your business, you may be able to use insurance or other strategies to assure that your estate will have sufficient liquidity to handle estate taxes.
No standard method exists to determine value because each business is different. But valuation professionals and the IRS typically use a group of factors when they fix the value of an operating business. These factors include the company's:
- Nature and history
- Economic outlook
- Annual budget, sales history, and sales projections
- Financial condition and stock book value
- Capacity for earnings
- Ability to pay dividends
- Previous stock sales and block size being valued
The general economic outlook may also be a consideration, as well as the prices of stocks of
similar publicly held companies.
Usually valuation professionals examine a combination of the above factors to determine an appropriate value. A factor that may control the valuation of any size corporation may not be nearly as important when valuing another corporation whose type of business is different. When determining valuation, each closely held corporation is unique.
Any valuation report you receive should be both well documented and comprehensive, with confidential treatment for any company information. You should be able to rely on your valuation professionals for their full support if any question is raised about the valuations of your business. Their support should extend to reporting to your Board of Directors and defending their work in court or to the IRS.
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