How to Reduce Estate Tax Exposure for Business Owners
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Estate taxes are an unfortunate reality for beneficiaries lucky enough to qualify for them. You want your family to enjoy the fruits of your labor and possibly carry on the legacy of your business after you are gone. However, sometimes success comes at a cost. While only a small percentage of estates qualify for the federal estate tax, and individual states such as Maryland impose an estate tax for somewhat smaller estates, the reality of the potential tax burden (for example, potentially 50% of the value of the estate in excess of available exemptions in Maryland) can be daunting.
Depending on the type of business you own and the value of assets within your estate, several strategies currently exist to help you potentially reduce estate tax exposure when planning for the future.
Business Valuations in General
During the valuation process, a business may be valued based on several criteria, including:
- Stock Value
- Asset Value
- Income/Cash Flow
Factors that may impact a business’ fair market value include:
- The business delivers lower margins than other competitors in the marketplace.
- The marketplace in question has a low barrier of entry.
- The business does not innovate in its marketplace, nor does it own a propriety technology that would cause it to stand out among its competitors.
- The business employs a small management team and most operations are driven solely by the owner.
Market leaders, as well as businesses that are consistently growing or expanding, will most likely experience higher gross valuations.
Valuation Discounts
A valuation discount is attributed to a business after a professional business evaluator determines that certain factors reduce the fair market value of your interest in your company. The two most common valuation discounts are a discount for lack of marketability and for a minority interest.
Lack of Marketability Discount
Often, the interest in a privately held company will receive a valuation discount because a potential purchaser would be less inclined to pay full value to purchase an interest in a business that does not have a ready market for resale. For example, stock in a company that is sold on a national stock exchange typically has many potential buyers and can be liquidated very quickly. Buying into a privately held company will often have a very limited resale market, thus reducing the amount that a purchaser would be willing to pay.
Minority Interest Discount (Lack of Control)
Minority interests are generally interests constituting less than 50% of a business. The minority interest discount relies on the idea that the sum of the parts is worth less than the whole. In essence, a business owner can transfer minority interests in his or her company via gift to various beneficiaries and if the transfers are of minority interests, these interests will often be discounted because the beneficiary is unable to control the management of the company, including the ability to dictate distributions to owners. Similar to a lack of marketability discount, the idea is that a willing buyer would pay less for such an interest because he or she has no control over the decision-making in the company and no control over distributions.
A savvy business owner may consider spreading that percentage out among several trusted beneficiaries during their lifetime, thereby limiting the estate tax on the business as a whole. Fragmenting a business across multiple owners can also help with the valuation process.
Gifting a financial stake to your beneficiaries may also help prepare them to take majority ownership down the line. While you are still alive, you can help guide your beneficiaries and help them get acclimated to the business, making the most of their minority ownership.
Often, prior to death, the original owner of the business will gift more than 50% of the interest in the business over time, and at death, the owner’s remaining minority interest can then receive a minority interest when it passes to the beneficiaries.
Charitable Giving
Charitable giving can be a fantastic way to reduce your estate while also leaving a positive impact on the world and contributing to a cause you are passionate about.
For business owners, one option is to consider gifting a portion of your business to charity before a sales event. Through various strategies, a business owner may be able to save both in income taxes and estate taxes. In any event, because there is an unlimited charitable deduction against estate taxes, leaving assets to charity at your death, can meaningfully reduce or eliminate your estate tax exposure.
Although statistically, state and federal estate taxes will only affect a fraction of business owners, United States tax law is a constant conversation in Washington. We recommend staying up to date and informed on any and all changes which may impact you and your family’s future.
Before deciding the future of your business, be sure to talk to a professional estate planning attorney to review all of your options.
If you have questions about reducing your tax exposure, please contact us at (443) 589-5600. At Sessa & Dorsey, we consider the bigger picture at hand and advise our clients on the best estate planning tools for their specific needs and desires.
Related blog posts:
Is a Qualified Personal Residence Trust (QPRT) Right for You?
Estate Planning for Owning Real Estate in Multiple States
Understanding the Ins and Outs of Charitable Giving
The Top 5 Benefits of a Trust