Federal estate taxes are due nine months after a business owner’s death. If the heirs do not have enough cash to pay these taxes, selling the business may be the only way to satisfy the tax bill. Family business owners can take steps to avoid this nightmare scenario through proper succession and estate planning.
A trust is the most common tool used to help reduce inheritance taxes on a family business. One type of trust especially effective in limiting estate taxes is the credit shelter or bypass trust. Using this vehicle, a couple can take advantage of the estate tax credit and transfer millions of dollars in assets to children or other heirs free of estate tax.
Another is a qualified terminable interest property trust, or QTIP. This type of trust can provide a steady stream of lifetime income for a surviving spouse. Life insurance trusts are also widely used in family business estate planning. More flexible forms of irrevocable trusts, such as the survivorship standby trust or the spousal support trust (also known as the spousal access trust), have become increasingly popular in recent years.
Forming a family limited partnership, or FLP, is another way to reduce inheritance taxes on a family business. An FLP is a limited partnership that exists among members of a family. Typically, founding generation family members will transfer assets (including shares in a family business) to the partnership. Limited partnership shares can then be given to children and grandchildren, while the founders retain the controlling general partnership shares. The result is that founders are still able to manage the business while reducing estate taxes at the same time; in other words, they are able to transfer equity in the business but not control.
Be aware that the Internal Revenue Service has worked hard in recent years to curb what it considers the misuse of FLPs as a tax-saving device. In this environment, the formation of an FLP strictly as a tax-saving vehicle generally is not recommended. If you can’t substantiate a nontax or business reason for the FLP, you probably shouldn’t establish one.
An alternate strategy is to give the business away to heirs by instituting an annual gifting program. This will reduce the value of the business upon your death and thus the amount of estate taxes due to the federal government.
Here’s how it might work: The tax code gives each individual a $1 million lifetime gift-tax exemption, so you can give partnership interests up to this amount to your heirs tax-free during your lifetime. In addition, the tax code allows annual gift exclusions of up to $13,000 per individual. So if you and your spouse have three children, you could give away up to $78,000 a year in nonvoting shares of the business, or more than $1.5 million over 20 years, and still maintain control of the business until you are ready to step aside.
If some amount of inheritance tax is still due upon death despite estate planning efforts, there are options to help ease the payment burden. IRC Section 6166 extends the amount of time in which an estate can pay the tax attributable to an interest in a closely held business to 14 years. To qualify, the deceased’s interest in the closely held business must exceed 35 percent of the adjusted gross estate.
And under IRC Section 303, company stock can be redeemed to pay estate taxes, generation-skipping transfer taxes, and funeral and administration expenses. To qualify, the value of the corporate stock must exceed 35 percent of the adjusted gross estate. Filing for Section 6166 or 303 elections must be done by the due date of the estate tax return.
Be sure to consult with a tax advisor or estate planning professional for details on your particular situation.
Don Sadler is a freelance writer and editor specializing in business and finance.