With the government printing money like they actually had some, most people expect the tax rates in the future to go in the upward direction to cover all of the current spending. Nancy Haney Scott (www.haneyscottlaw.com), an Attorney we recommend to clients needing business “exit strategies,” mergers or acquisitions, wrote a very helpful article advising how business owners can overcome the decline in their business value and utilize the bad economy to set some things in motion and save their family money in the future.
Gifts of Equity in Privately Held Businesses – The Silver Lining of the Recession
By: Nancy Haney Scott
With all the gloom and doom we sometimes forget that “Every Dark Cloud has a Silver Lining.” One silver lining is that lower valuations help privately held businesses take advantage of important planning opportunities. Now is a great time to reorganize your business for more efficient operations, business succession and preparing the company for future exit strategies. It’s also the time to consider cost savings for estate and gift planning.
For example: Mr. Smith owns 80% of Devalued, Inc., while his two sons who work in the business own 10% each. Devalued, Inc. was worth $3,000,000 in 2007. By the end of 2008, it was worth $2,500,000. After exploring the tax strategies and planning opportunities with his counsel he decides to gift 20% of his shares, worth $500,000, to each of his sons leaving him with a 40% stock interest.
The estate and gift tax advantages (assuming current tax law) are as follows:
- The stock gifted to each son was previously worth $600,000. The current market value of such stock to each son is now only $500,000. If Devalued, Inc. goes back to its prior value once the economy recovers, then the $200,000 increase in the value of the shares now belongs to the sons ($100,000 each) without Mr. Smith having to make an additional taxable transfer. At a current estate and gift tax rate of 45%, Mr. Smith’s family can save $90,000 (45% * $200,000).
- The gifts to each son are gifts of a minority interest in Devalued, Inc. Gifts of shares in privately held business lack marketability due to the limited market for such shares. Estate and gift tax rules allow discounts for these factors that reduce the value of assets transferred. A conservative discount rate for minority interests and lack of marketability can be 25%. With such discounts, the value of each gift for tax purposes is reduced by $125,000. At a current estate and gift tax rate of 45%, Mr. Smith’s family can save another $112,500 (45% * $125,000 * 2 sons).
- Mr. Smith’s gifts of stock are eligible for the annual donee exclusion of $13,000. In addition, Mr. Smith’s wife, Mrs. Smith will join in this gift, which will allow for a second $13,000 exclusion. So the taxable value of the gift to each son is now reduced again by an additional $26,000 (Mr. and Mrs. Smith’s $13,000 each = $26,000). The family saves an additional $23,400 (45% * 26,000 * 2 sons).
- If Mr. Smith makes no further gifts and dies with his reduced ownership interest of 40%, his estate can claim the minority interest and lack of marketability discounts against his remaining shares. If Mr. Smith dies in 2014, when Devalued, Inc. is worth $4,000,000, a conservative discount rate of 25% will save his family another $180,000 (45% * $400,000 discount).
- The bottom line is that Mr. Smith can take advantage of the under-performing economy, discounts for lack of marketability and minority interest and the annual gift tax exclusions (with his wife) to save his family a considerable amount of future estate and gift tax. In the example above, Mr. and Mrs. Smith will need to file a gift tax return in the year the gifts are made.
This is just one example where a lower valuation can be helpful. Now may also be the time to consider your business succession plan. The same principles apply. Each situation is very unique and very fact specific. Remember this planning depends on the particular factual setting of each client. One difference in the type of entity or the facts can completely change the outcome. If you are interested in more information about this concept and other potential advantages to acting now, please contact me at www.haneyscottlaw.com.
Tax opinion disclaimer
This article contains tax advice. Please note that additional tax issues may exist that could affect the tax treatment of the tax advice or shelter addressed in the advice. The advice does not consider or reach a conclusion with respect to those additional issues. Further, the advice was not written and cannot be used by the recipient for the purpose of avoiding penalties under code section 6662(d) with respect to those issues outside the scope of the advice.