Tax Advisor 2020

While the economy today is unpredictable and recovery from the COVID-19 pandemic is unknown, the current environment has presented a great opportunity for business owners to think about the succession and continuity of their businesses. The current economic downturn, historically low interest rates, and prospect of future tax rate increases provide an opportune environment to effectively transfer wealth to future generations. This article highlights some strategies to consider.  

Gifting Your Business

Gifting an interest in your business, partial or whole, allows you to remove the value of the business as well as any resulting gift taxes from your estate. In 2020, you can give up to $15,000 per year, per recipient, without incurring gift tax. You also might consider making a gift up to your remaining applicable lifetime exclusion amount ($11,580,000 for individuals and $26,130,000 for married couples in 2020) during your lifetime instead of waiting until your death. When you make a gift of some or all of your business interest, the fair market value of the gift, as well as the future appreciation, is removed from your estate. The increased lifetime exclusion is set to expire on January 1, 2026, absent further legislation. In addition, election years always create uncertainty, which could create a change sooner than expected.

Family Limited Partnerships

A family limited partnership (FLP) is a holding company owned by two or more family members created to retain a family’s business interests or other assets contributed by its members. A FLP is formed generally by a senior generation that contributes its business interests to a FLP in exchange for general and limited partnership interests. The senior generation retains the general partnership interests and, over time, gifts limited partnership interests to younger generations. For example, Bob and Mary own a business worth $4 million, and they want to pass it on to their children one day. They set up a FLP as general partners and, over time, gift limited partnership interests to their adult children. Bob and Mary are able to maintain control of the business operations and cash flow while the children can collect dividends, interest, and profits. Since a willing buyer typically will pay less for an interest if they won’t control investments or distributions, or have the ability to readily sell the interest, the value is discounted for gift and estate tax purposes at the time the limited partnership interest is transferred as a result of the restrictions the FLP creates.

Use of Trusts

Two of the most common trusts to consider in an economic downturn are the intentionally defective grantor trust (IDGT) and the grantor retained annuity trust (GRAT). 

The IDGT can allow an individual “settlor” to use a combination of both gift and sale of assets to the IDGT in exchange for an installment note. The installment note will provide for interest to be paid at no less than the current applicable federal rate. The appreciation of the assets beyond the interest rate on the installment note will pass to beneficiaries free of estate and gift tax. The gain on the sale of the assets to the IDGT is disregarded, as the sale is not respected for income tax purposes while still complete for transfer tax purposes. In addition, the tax on the income earned in the trust is paid by the settlor and is not considered an additional gift for gift tax purposes. 

The second type of trust is the GRAT, which is created when a settlor makes a gift of low-value assets or depreciated assets, in which appreciation in the future is expected, in exchange for an annuity paid to the settlor for a set term. The value of the gift is the fair market value less the present value of the annuity payments back to the settlor. The GRAT uses the current Section 7520 rate (0.4 percent in September 2020) to determine the annuity payable to the settlor. Like the IDGT, the appreciation on the assets remains in the trust and will pass to beneficiaries free of estate and gift tax.

Self-Canceling Installment Notes

A self-canceling installment note (SCIN) allows a business owner to sell business interests in exchange for a promissory note. The note calls for principal payments and interest. Interest is paid at the applicable federal rate, which is currently at a historic low (long-term 1 percent as of September 2020). If the seller dies during the term of the note, the remaining payments will be canceled. Because of the cancellation feature, it is important that some risk premium be used with a SCIN, whether it is a higher sales price or increased interest rate. The use of SCINs provides the seller control of the business and an income stream during his/her lifetime and avoids gift tax.  

With the federal lifetime exemption currently allowing married couples to transfer more than $23 million without incurring a transfer tax, most families will not owe federal estate tax and may not be concerned with tax strategies to reduce their federal taxable estate. Still, now is a good time to revisit previously implemented wealth transfer strategies and take stock of the assets in your estate to better avail you and your family of the “step up” in basis upon your death.

It is important to note that there are both advantages and disadvantages to the wealth transfer strategies described above, and it is strongly recommended that you consult your tax, estate, and investment advisors prior to implementing any of these strategies. That said, the common theme to note is it is an ideal time to consider your business and personal wealth transfer strategies, and those contemplating transfers should discuss and consider executing these plans before the end of the year.

For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.

FORVIS Private Client services may include investment advisory services provided by FORVIS Wealth Advisors, LLC, an SEC-registered investment adviser, and/or accounting, tax, and related solutions provided by FORVIS, LLP. The information in this presentation should not be considered investment advice to you, nor an offer to buy or sell any securities or financial instruments. The services, or investment strategies, mentioned in this presentation may not be available to, or suitable, for you. Consult a financial advisor or tax professional before implementing any investment, tax, or other strategy mentioned herein. The information herein is believed to be accurate as of the time it is presented and it may become inaccurate or outdated with the passage of time. Past performance does not guarantee future performance. All investments may lose money.

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