Investor's Business Daily, May 2nd, 2007
According to the U.S. Small Business Administration, we have nearly 26 million small businesses. Most are owned by individuals or families. Eventually, one of two things often happens to these firms: They're sold or passed on to the next generation.
Either way, major tax issues exist.
A sale usually results in a capital gain. That means a tax bill for the seller. That's often a big number if the business has been in the family for generations. Its cost basis is likely to be relatively small.
The other option is to transfer shares of stock to the kids. That can also involve a big tax.
Instead of a capital gains tax, you could trigger a gift or estate tax. In 2007, estates with values over $2 million are federally taxed as high as 46%. Many states also levy a separate estate tax.
Gifts are taxed, too, but only when the gift exceeds $12,000 to any individual per year. The tax threshold is $24,000 when combined gifts come from a married couple. For example, if mom and dad have three kids, they could give $72,000 away each year to the kids, tax-free.
Avoidance Planning
You can avoid some taxes with proper planning.
If the business is eventually going to the kids, it makes sense to make gifts now rather than waiting until death. That's because the value of a business is likely to increase over time. That could just make any eventual estate tax bigger.
But gifts can be tax-free. If they're big enough to trigger tax, the levy is at a lower rate than the estate tax.
When you make gifts of your business, you don't sign over the inventory to your son or daughter. Instead, you give away shares of stock in the firm. The beauty of giving shares is that the value of those shares can be discounted because they represent minority interests.
Say you have a business worth $1 million. And there are 100 shares outstanding. Each share represents $10,000 when kept in one owner's hands. If the shares are given to kids, the value is typically less than $10,000. A value as low as $6,000 would not be unusual, says Steve Naito, a Portland, Ore., attorney.
The kids' shares are often worth less because they would not have voting control. They also usually can't easily sell the shares. Few people are interested in buying a minority stake in a private company.
Because these minority shares have a lower value, more of them can be given tax-free. In the above example, mom and dad could give three shares to each kid per year without paying a gift tax. Before discounting, each gift would be worth $30,000, which is over the limit of $24,000. After discounting, the three shares might be worth $18,000, well below the threshold.
If you make systematic gifts every year, you could very well transfer your entire business to the next generation tax-free.
"You're able to pass along your wealth to your kids in a very tax-advantaged way," said Dan Gilbert, a certified public accountant who values shares of private companies.
The degree of discount for minority shareholders depends on many factors. One stems from the fact that other shareholders usually have a right to veto any transfers.
Typically, a business appraisal written by a qualified professional must accompany the gift tax return.
If your company has shares of stock outstanding because it's a corporation, you can give shares that you own.
If it is a sole proprietorship or a partnership, you may need to engage an attorney to create shares. A popular way to do that is by creating a limited liability company.
An LLC insulates owners from personal liability.
"The advantage of an LLC is that the LLC's creditors can't come after the owners' personal assets," Naito said.
LLCs can also be used to transfer interests in real estate. Let's say you bought an apartment building 10 years ago for $300,000. Today it is worth $2 million. And it generates $150,000 in annual cash flow after expenses.
You can use the LLC to gradually transfer the property to your heirs.
Partners' Prerogatives
The LLC consists of shares or membership units. Each represents fractional ownership in the LLC. In turn, the LLC holds the real estate, family business or other property. The LLC usually has an operating agreement. That typically spells out issues such as limitations on the transfer of shares.
How much can it cost to create an LLC and have the shares valued by a qualified business appraiser?
"Between getting a valuation and the attorney fees, you're probably looking at $7,000 to $10,000," Gilbert said. "Given that combined federal and state gift tax rates can be more than 50%, and discounts can range from 30% to 50%, it doesn't take much of a business to more than offset these costs."
