Tax and Financial News for October 2002

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Tax Tips for Transferring the Family Business
Transferring control and ownership from one generation to another is one of the most daunting challenges facing family-owned businesses. In addition to the emotional issues involved, there's the critical need of minimizing the cost of the transfer. Many business owners worry about the estate tax, and whether they'll be able to transfer ownership without raiding the business's cash reserves to pay those hefty taxes.

There are ways to control the tax burden, but you likely will need expert help. Here's a brief overview of some of the options facing a business owner seeking to transfer a business to another family member.

Transferring to a spouse.

Assets, including the value of a business, can pass tax-free from one spouse to another. So a spouse inheriting a business will incur no estate-tax liability.

The estate tax itself starts at 18%, for estates with up to $10,000 in taxable assets (See your CPA to define “taxable assets”). It scales up to a marginal rate of 50% for estates with taxable assets of more than $2.5 million.

But the tax doesn't kick in until the value of the estate exceeds $1 million for 2002 (This changes annually). So if all the value of your estate is in the business and the business is worth $1,010,000, you would pay less than $4,000 in estate tax on only that last $10,000.

Of course, that's a gross simplification. Most people who have built businesses of significant value have a variety of options for passing on the business to other family members while further minimizing estate-tax considerations. These options include:

  • Setting up a bypass trust. With a properly structured bypass trust, a couple can eventually pass on an estate or business worth as much as $2 million to heirs tax-free.

  • Making tax-free gifts to relatives. You can give up to $11,000 in 2002 (This also changes annually) to an unlimited number of individuals without having to worry about any gift tax. If you're married, your spouse can also give $11,000 to anyone.

But gifts of this size can add up pretty fast. If you have a child who is married, the gift-tax rules mean that you and your spouse could transfer up to $44,000 in cash and other assets to your child and their spouse each year, free of the gift tax.

The value of the business can be transferred in the same way. You should work with a team of experts — perhaps an attorney, business appraiser, and especially your tax professional who are all well-versed in small-business issues — to determine the value of your business and the value of any transfer or gifting of minority shares in the business.

Warning: Because valuations of closely held businesses are somewhat subjective, they are prominent on the Internal Revenue Service's radar screen. Neither you nor your heirs should cut corners on expert advice in this area.

Making taxable gifts.
It may make sense to give away part of the value of your company as a gift, even if the gift is subject to the gift tax. Why?

Even if the gift is in excess of your $11,000-per-person limit, it might not result in a tax in the current tax year. That's because beyond the $11,000-per-person limit, you have a $1 million exemption from current gift taxes on taxable gifts. People don't generally get taxed when they give a taxable gift; the value is just applied against the $1 million exemption amount. If you use up the credit, you then pay a tax just as if it was an inheritance.

So, theoretically, you could make a gift of a business worth $1 million to a relative (or anyone else) without incurring any gift tax. Of course, if you'd made taxable gifts previously, thus reducing the $1 million exemption, you'd be subject to a tax on at least part of the value of the transfer.

Remember, the law keeps changing.

Congress and the White House created an estate-planning monster with the tax bill approved in 2001. Among other features, while the special additional exemptions for some family-owned businesses phase out in 2004, the estate-tax exemption increases three times between now and 2009 before the estate tax is scheduled to be eliminated in 2010.

Congress amazingly (or cynically) decided to minimize the apparent long-term cost of estate-tax reduction by saying that the exclusion would go back to the current $1 million exemption in 2011.

But making long-terms plans based on current rules probably isn't prudent — not one tax or estate-planning pro expects the estate-tax law to remain unchanged for the rest of the decade. For now, the estate-tax-free transfer options for small businesses are getting broader — but the need for experienced and savvy professional guidance probably has never been greater.


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