When it comes time for a business owner to transition or sell their business, taxes tend to be one of the most important considerations. Over the past several years, income tax reductions in the form of credits and deductions as well as reduced tax rates included in legislation have increased the value of businesses. However, with the sunsetting of that legislation and the addition of tax provisions included in the recently passed Inflation Reduction Act, it has become more important than ever to ensure proper tax planning.
The lifetime gift and estate tax exemption is scheduled for reduction, from $12.92 million per taxpayer in 2023 to approximately half that amount on January 1, 2026. Interest rates are expected to increase, and the values of many businesses are depressed in the current economic environment. Against the backdrop of these combined developments, now may be the optimal time for business owners to implement tax-efficient strategies, so they can protect the value of their legacy.
Throughout the cycle of building, operating and ultimately transitioning a business, a variety of strategies are available to help protect the value of a business from state and federal income tax as well as lifetime gift and inheritance taxes.
Going into the sale of a business, many questions may arise regarding how to manage income tax associated with the sale. These income tax concerns exist regardless of the year of the sale, and as the favorable current tax legislation sunsets, planning needs to begin.
If a sale will occur five years from now, there continues to be income tax considerations but there are also estate tax complications. Assuming the business continues to grow during this five-year period, advanced planning can help shift appreciation so it is captured outside of the taxable estate. The three pillars of advanced planning focus on:
Many income tax mitigation strategies are available to business owners. The following four strategies have been gaining popularity among clients:
Incomplete gift non-grantor (ING) trust: This trust structure allows a business owner to shift tax exposure from a high-tax state, such as California or New Jersey, to a state with no state income tax, such as Delaware or Nevada. If created sufficiently in advance of a sale of the business (usually at least two years), an additional benefit is the elimination of state capital gains tax on the sale. Sophisticated planners have realized this type of jurisdictional planning can help wealthy families mitigate home-state tax, though some states (such as New York) have passed legislation restricting this technique.
Investment in a Qualified Opportunity Zone (QOZ): A QOZ is a real estate development program to encourage long-term private investment in underserved communities. Investing capital gain proceeds from the sale of a business into a QOZ fund within 180 days of the sale allows an owner to defer the tax due on the gain until December 31, 2026. If the owner retains the capital gain proceeds in the QOZ fund for ten years, the appreciation on the invested proceeds does not incur capital gains tax.
Charitable remainder unitrusts (CRUT): A CRUT allows a business owner to transfer shares to a trust that pays an annual payment to a non-charitable beneficiary, with the remainder (which must be at least 10% of the funding value) transferred at the end of the trust term to a charitable organization. The owner can limit the annual payments to the income earned by the trust (called a Net Income with Make-Up CRUT, or NIMCRUT). If the business is sold, the owner mitigates capital gains on the shares the owner transferred to the trust sufficiently in advance of the sale. A CRUT provides a quadruple benefit: an immediate charitable income tax deduction, capital gains tax mitigation, substantial annual payments to the owner or another non-charitable beneficiary, and a significant contribution to charity.
An interest charge domestic international sales corporation (IC-DISC). An IC-DISC is an entity created to enable exporters to convert ordinary income from sales to foreign unrelated parties into qualified dividend income (up to 50% of combined domestic and international income). This strategy allows international companies to convert ordinary income tax into capital gains tax, reducing their federal tax obligation each year and increasing the value of the business that a buyer would be willing to pay.
Rollovers and exclusions do not require business owners to execute a transaction or create a separate legal entity. The tax code explains that rollovers and exclusions may be utilized as long as certain criteria are satisfied. Three of the most relevant tax code sections for business owners are:
Section 1202 capital gains exclusion: Section 1202 allows small business owners to exclude at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) held for five years or longer. This gain is limited to the greater of $10 million or ten times their basis in the stock. For more on this, consult our paper, The Tax Benefits of Investing in Small Businesses.
Section 1045 rollover: Section 1045 allows the seller of a business to rollover the taxable gain of QSBS into another QSBS within 60 days of the sale, thus deferring the recognition of the capital gain due until the disposition of the stock in the newly acquired business. This technique can be combined with section 1202 so that some of the proceeds of a qualified sale can be retained as cash, and the remainder can be reinvested in another venture. This technique may be particularly useful for “serial entrepreneurs.”
Section 1042 “Tax-Free” rollover from the sale of a business to an employee stock ownership plan (ESOP): Section 1042 allows a business owner to sell company stock to an employee stock ownership plan (ESOP) and defer, and potentially extinguish, federal (and often state) tax on the transaction by rolling over the proceeds into qualified replacement property (QRP), such as domestic operating company stock or bonds.
Perhaps the most thoughtful way to consider passing a highly appreciating asset like a business to children, while minimizing the tax impact of the transaction, is to “freeze” the value of the business at its current valuation, transfer the asset to a child and then sell it in the future after it has appreciated in value, thus mitigating gift or inheritance taxes on the future appreciation.
Six of the most common strategies for accomplishing this tactic include:
Annual gifting: Individuals may transfer up to $17,000 ($34,000 for married couples) of stock in their company to each child, every year. While likely insufficient to fully transfer a business, this technique can be useful.
An installment sale to an intentionally defective grantor trust: This strategy involves a sale of all or part of the business to an irrevocable trust for the benefit of the seller’s children in exchange for a note, typically several years in advance of a sale. When the business is ultimately sold, the trust receives the proceeds from the transaction and repays the note to the seller. Any growth in the value of the business during the interim period between the transfer and the sale will remain in trust for the seller’s children, having transferred out of the estate free of gift or estate taxes. During this interim period, profits from the business that are distributed to the trust can be used to cover the interest payments on the note due back to the seller.
Private annuities: A strategy similar to the installment sale described above involves a private annuity. The annuity can be structured whereby a business owner sells the business to his or her children in return for an unsecured promise to pay back the annuity to the business owner for life. This technique may be riskier if the business owner intends to rely on the annuity payments to cover ordinary living expenses and does not have complete confidence in his or her children’s ability to manage the business.
Grantor retained annuity trust (GRAT): A GRAT is a well-established wealth transfer strategy that involves transferring shares of a business to a trust in return for an annuity typically equal to the value of the shares transferred. Any subsequent appreciation in the value of the business after it is transferred to the GRAT passes to the trust beneficiaries free of gift and estate taxes. Earnings and appreciation on the business must exceed the aggregate annual annuity payments for this technique to succeed. This is a popular technique in a low interest rate environment, because annuity payments are based on interest rates and will be low as a result.
Charitable lead annuity trust (CLAT): A CLAT is a charitable alternative to a GRAT where shares of a business are transferred to a trust that pays an annual annuity to a charitable organization. At the end of the annuity term, whatever value is left in the trust (the remainder interest) passes to the trust’s non-charitable beneficiaries, such as the grantor’s children. This technique can be structured to provide an immediate charitable income tax deduction, yet — if the shares are highly appreciable — also allows for the appreciation of the remainder interest to remain in the family free of gift and estate taxes.
Family limited partnership (FLP) and recapitalization: This technique involves recapitalizing shares of a business into voting stock held by the business owner and non- voting stock held by the business owner’s children or trusts for their benefit. This strategy enables the business owner to retain voting control of the business while transferring almost all economic value of the business (i.e., the non-voting stock) and any future appreciation out of his or her estate free of gift and estate taxes. The value of the non-voting shares may be transferred at a discount to fair market value due to the shares’ lack of marketability and lack of voting control, thereby allowing additional wealth transfer free of gift and estate taxes.
Thoughtful tax, trust and estate planning, as well as business succession strategies, provide the greatest opportunity to maximize legacy economic wealth for business owners. With an estimated $30 to $65 trillion in financial and non-financial assets in North America expected to transfer from the hands of baby boomers to their heirs over the next 40 years, reducing the tax impact of wealth transfer remains an essential component of building personal wealth and preserving multigenerational longevity.
Familiarizing yourself with these strategies is only the first step. It is imperative you have a collaborative team of advisors, including attorneys, accountants, wealth managers and planners, who can incorporate your vision for your business and your plans for succession into a well-defined, tax-efficient structure.
This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
The Bank of New York Mellon, DIFC Branch (the “Authorized Firm”) is communicating these materials on behalf of The Bank of New York Mellon. The Bank of New York Mellon is a wholly owned subsidiary of The Bank of New York Mellon Corporation. This material is intended for Professional Clients only and no other person should act upon it. The Authorized Firm is regulated by the Dubai Financial Services Authority and is located at Dubai International Financial Centre, The Exchange Building 5 North, Level 6, Room 601, P.O. Box 506723, Dubai, UAE. The Bank of New York Mellon is supervised and regulated by the New York State Department of Financial Services and the Federal Reserve and authorized by the Prudential Regulation Authority. The Bank of New York Mellon London Branch is subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential Regulation Authority. Details about the extent of our regulation by the Prudential Regulation Authority are available from us on request. The Bank of New York Mellon is incorporated with limited liability in the State of New York, USA. Head Office: 240 Greenwich Street, New York, NY, 10286, USA. In the U.K. a number of the services associated with BNY Mellon Wealth Management’s Family Office Services– International are provided through The Bank of New York Mellon, London Branch, One Canada Square, London, E14 5AL. The London Branch is registered in England and Wales with FC No. 005522 and BR000818. Investment management services are offered through BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, One Canada Square, London E14 5AL, which is registered in England No. 1118580 and is authorized and regulated by the Financial Conduct Authority. Offshore trust and administration services are through BNY Mellon Trust Company (Cayman) Ltd. This document is issued in the U.K. by The Bank of New York Mellon. In the United States the information provided within this document is for use by professional investors. This material is a financial promotion in the UK and EMEA. This material, and the statements contained herein, are not an offer or solicitation to buy or sell any products (including financial products) or services or to participate in any particular strategy mentioned and should not be construed as such. BNY Mellon Fund Services (Ireland) Limited is regulated by the Central Bank of Ireland BNY Mellon Investment Servicing (International) Limited is regulated by the Central Bank of Ireland.
Trademarks and logos belong to their respective owners.
BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.
The information in this paper is as of January 2023 and is based on sources believed to be reliable but content accuracy is not guaranteed.
© 2023 The Bank of New York Mellon Corporation. All rights reserved. WM-304883