4 Estate and Tax Considerations When Succession Planning
Succession planning helps business owners ensure their company will continue running like a well-oiled machine, even after a transfer of ownership. For privately-held business owners, tax, retirement, and estate planning are closely tied to succession planning. Some owners choose to sell the company before retirement and often rely on the proceeds to support their post-retirement living expenses. Others transfer assets directly to family members, whether by selling or gifting. No matter how you plan to exit your business, you need a solid plan that considers the tax implications.
Estimating Income Based on Tax Rates & Entity Structure
Before you transfer ownership, you need to know the value of your business. If you are selling the business, you need to know the value will cover your expenses after you retire. Accurate estimates are critical to this process. Business owners need to consider tax rates and available tax benefits when estimating future income and working to increase the value of the company.
Currently, the federal corporate income tax rate is 21%, and it affects income for C corporations. Sole proprietorships, LLCs, partnerships, and S corporations are pass-through entities, meaning income is taxed at the individual level. For individuals, income is taxed based on current tax brackets. Depending on your level of income, you could pay taxes at income tax rates ranging anywhere from 10% to 37%.
Leveraging Available Tax Benefits
Some businesses are eligible to make an election to be taxed differently. Depending on your circumstances, filing an election may help you lower income taxes or help you meet your succession planning goals.
The QBI deduction allows qualifying pass-through entities to deduct 20% of qualified business income, subject to phase-out limits based on income. This deduction often leads to significant tax savings, so it is an essential consideration in both general tax planning and succession planning. Business owners may be able to leverage retirement plans to qualify for the deduction. For example, if you have a SEP or a 401(k), you can make a contribution up to the plan’s limit, which can help you lower your income. If you have a defined benefit plan, you can also take advantage of tax deferment.
Keeping Up With Legislative Changes
In its original form, the Build Back Better Act (BBBA) proposed provisions that would increase the federal corporate income tax rate and change the qualified business income (QBI) deduction. The BBBA also proposed provisions that would increase the tax rates for individual ordinary income, capital gains, and dividends and change gift and estate taxation. However, these changes did not survive the negotiation process in Congress, and the Act ultimately stalled.
The Inflation Reduction Act, a significantly smaller piece of legislation, passed this month; however, it does not include the tax rate increases or changes mentioned above. The Act does make a few other tax-related changes for corporations. Effective after December 31, 2022, the Act also imposes a 15% Corporate Minimum Tax on adjusted financial statement income for corporations with profit in excess of $1 billion. The Act also imposes a 1% excise tax on stock buybacks. The legislation includes a number of tax credits related to climate change. Depending on your industry, the credit may be helpful in providing tax savings that can help you reach your business’s succession goals.
Incorporating Gift & Estate Planning
Business owners need to keep in mind that they may have to pay capital gains tax on the sale of their company. As you plan for retirement, another expense to consider is federal estate tax. Some states impose estate tax as well. Because the federal lifetime estate and gift tax exemption are unified, the amount you gift affects your estate tax exclusion.
If you gift limited partnership or limited liability interests while you are living, they are eligible for the annual gift tax exclusion. For 2022, the gift tax exclusion is $16,000 ($26,000 for married couples). Under the Tax Cuts and Jobs Act (TCJA), the lifetime unified estate and gift tax exemption is temporarily at an increased limit. For 2022, the exemption is $12.06 million ($24.12 million for married couples). The increase is set to sunset on December 31, 2025, at which time it will revert to the base exemption ($5 million, adjusted annually for inflation).
By gifting assets during your lifetime, you also reduce the value of your gross estate, which can lower your estate tax liability. However, careful planning is required. Suppose a retired business owner gifts assets throughout his lifetime equal to $6 million before he passes away in 2026. Let’s say his last gift was made in 2025 (when the lifetime exemption was increased). By 2026, the TCJA’s increase had expired, and the exemption was only $6 million. In this case, he did not exceed the base exemption, so the “bonus” exemption never came into play. There is no estate tax exclusion left to apply to his estate tax liability.
If you gift company shares to your spouse, they will not be liable for capital gains tax. However, when shares are gifted to other heirs, they will be liable for capital gains tax on the amount the shares increased in value while you possessed them. Suppose a business owner purchased 10,000 shares for $0.10 each, and they were valued at $1.00 each at the time she gifts the shares to her daughter. Her daughter will owe capital gains tax on $9,000 (acquisition value minus base price) at a rate based on her annual income. In some cases, business owners can utilize grantor retained annuity trusts to transfer business assets to their children and keep their business tax liability in check.
Contact Livingston & Haynes
L&H’s business tax team provides succession planning services that help privately-held business owners manage financial risk, minimize tax consequences, and reach their personal and business goals. Contact me today to discuss your business’s succession planning strategy and other accounting, tax, bookkeeping, or business advisory needs.
Steven Haynes, MBA, is an administrative partner at Livingston & Haynes. Steve’s firm, laurie@alisonsimons.com (EBPI), became an affiliate of L&H in 2007. Steve specializes in bookkeeping, payroll, and business advisory services, including tax, M&A, and funding and equity transactions, for technology, entrepreneurial, and emerging growth firms.