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Tax Law Changes on the Horizon
Odds seem increasingly likely that Congress will succeed, using the budget reconciliation process, in passing a tax bill between October 1 and the end of the year.
Income and capital gains tax rate increases are anticipated, along with a reduction in the estate tax exemption amount from the current $11.7 million to possibly $5.0 million or even $3.5 million per person.
If you’re a business owner, current market optimism, coupled with looming tax law changes, present a unique climate of urgency in deciding whether to sell your business.
Fortunately, closing a sale before year-end is still feasible. Good businesses brought to market now may sell more quickly and at higher than normal multiples because of historically low interest rates, readily available debt financing, and high levels of “cash on the sidelines” to invest—all of which are driving buyer interest.
Tax changes alone shouldn’t dictate your decision to sell. That said, specific proposals under President Biden’s American Families Plan are impacting exit planning. Most salient include the proposal to nearly double the top long-term capital gains tax rate to 39.6% (43.4% if you include the net investment income tax), and taxing the appreciated value of unsold assets at the owner’s death. Long-embraced strategies for tax planning efficiencies are being upended by these proposals.
Consider, for example, a business owner planning to make a bequest of family business interests to his or her children at death. The owner could see that bequest treated as if it were a sale for income tax purposes, taxable at the 43.4% capital gains rate (subject to certain exemptions and payment deferrals); in effect, the owner could see a loss of the basis step-up tax benefit for gifts from holding those assets until death. Moreover, this tax would be independent of the gift and estate tax, currently assessed at 40% on amounts gifted or transferred at death in excess of $11.7 million per person. An increased estate tax rate and a lower exemption amount under the Biden plan would exacerbate the tax hit.
Often you as an owner don’t have the luxury of scripting the precise timing and path between formation and exit. If external forces (e.g., market conditions or tax law changes) are driving the sale of your business before year-end, there’s still time for effective estate planning measures.
3 Proactive Steps You Can Take To Mitigate Estate Taxes:
1. Put governing documents in order
Be sure your Operating Agreement, Voting Agreements, Shareholders’ Rights Agreements, Buy-Sell Agreements, and the like are current and complete, and consistent with your overall estate and business succession plan. Consider whether any provisions are stale and in need of an update (such as a valuation formula in a buy-sell agreement). Confirm all necessary signatures are on file and ownership information is up-to-date. Because time kills deals, eliminating potential hiccups in the due diligence phase is even more critical now if you’re seeking to close before year-end and mitigate the impact of higher taxes.
2. Leverage Generational Gifting
If the sale of your business will create a taxable estate, there is powerful leverage pre-sale to gift and sell interests in your business, prior to a market value being set by an outside buyer. You can take advantage of lack of marketability and lack of control discounts for minority, non-voting interests ranging from 25-35% or more, depending on the circumstances.
Ideally, you should complete any gifting of business interests long before signing the Letter of Intent with the buyer. The IRS has taken the unofficial position that the execution of an LOI sets a price.
Pre-LOI, you can maximize lifetime gifting planning by removing business interests from your estate at the discounted value. Any increase in value at the time of sale, along with future appreciation on the business interests, would occur outside of your estate.
If you simply don’t have time to focus on estate planning before signing the LOI, all is not lost. You may still be eligible for discounts “before the deal is done” based on uncertainties inherent in any deal.
Discounts for the time value of money held in escrow, probabilities of hitting earnout targets, and risk arbitrage regarding whether a deal will happen at all provide a basis for taking discounts on pre-sale gifts of business interests, potentially in a range of 12-13%.
3. Leverage Charitable Gifting
If you’re charitably inclined, charitable gifting pre- sale can help you achieve your goals and at the same time yield tax efficient results. For highly appreciated assets, pre-sale is a perfect time to consider a contribution to a charitable remainder trust (CRT). You can gift an interest in your business to a charity and retain an interest in a periodic payment (such as an annuity) for a specified term.
At the end of the term the remaining assets would pass to the charity. Tax benefits are three-fold: [1] there would be no gift tax on the gift to the charity; [2] as a tax-exempt entity the charity would pay no income tax on the sale of the interests (notwithstanding the gain on the appreciation of the company’s assets at the time of sale), and [3] you as the business owner would receive an income tax deduction for the value of the assets given to charity in the year of transfer.
IRS Section 7520 interest rates, used to calculate the annuity amount that is paid to the owner, remain low, making this a good time to consider a CRT.
If your goal is to close on the sale of your business before year-end, it’s not too late to implement certain business succession and estate planning techniques. Acting now could have a meaningful impact.
Maribeth Younger, Counsel, Williams Weese Pepple & Ferguson.