Estate taxes can become a large problem for those looking to pass their business down to the next generation. Here are the solutions to that problem.
If you don’t properly plan for the estate taxes that will be assessed on your business when it transfers between generations, you can run into catastrophe.
First, let’s assume your company is a manufacturing company, your children work there, and you want it to stay in the family when you retire. Let’s also say your company is worth $20 million.
One of the great things about your company is that it will grow in value; you have a great product, access to great markets, and within 10 years, your business will be worth $40 million due to growth opportunities.
If you want your business to end up in the hands of your kids, it will be subject to estate taxes—40% on the federal level and 1% on the state level—on anything above the amount the IRS allows you to pass onto the next generation and/or that you get an exemption for. If you’re single, that limit is $11.4 million, and if you’re married, it’s $22.8 million.
Now let’s assume that you’re married and you have a $22.8-million exemption on your estate. That means if you and your spouse pass away and transfer the business to your children, $17.2 million will be subject to federal estate taxes. And it will take almost $7 million to satisfy the IRS.
Tax liabilities can become a huge issue for transferring companies between generations.
So how are you going to do that? Will you sell the business just to pay the $7-million estate tax? If you go to the bank and borrow that much while you’re trying to run a fast-growing company, it will be a huge problem for your company; you’ll be paying principal and interest over maybe 10 years to cover the debt service on that $7 million.
There are ways to keep this from getting out of control:
First, you can move stock into the hands of your children right now, when the company is worth $20 million, and let a portion of the growth end up in the hands of your children. Both you and your spouse can give $11.4 million this way.
You could also sell the stock now in exchange for a note back. Let’s say your company will be worth $60 million instead of $40 million and that your kids are going to end up having the business anyway. If you sell the stock to your kids in exchange for a note back, then the growth rate on your personal financial statement is just the interest rate on the note. All the growth in the value of the stock will be in your kids’ estates instead of your (the parents’) estate. That way, you keep this tax liability from becoming a huge issue for your own estate.
Thirdly, you can get life insurance on either you or your spouse for an amount that ensures the family has the liquidity to pay off the IRS. With this strategy, no stock has to be sold and the business can be kept in the hands of the family.
So what do you do if your taxes are still too high? Now let’s discuss why it makes sense to get life insurance to pay estate taxes.
Nine months after the date of your death, an IRS auditor will show up to your family demanding that they pay a tax bill to the tune of 40% of your estate that isn’t exempt. If you don’t properly plan for this, you’ll end up throwing away 40% of your estate just to satisfy the IRS.
But there is an alternative: you could send a little bit of your estate to an insurance trust each year. That insurance trust then sends money to a life insurance company, which then either insures you as the business owner or both you and your spouse. Joint policies are less expensive.
If you use this strategy before you pass away, the insurance company then pays the IRS the amount they demand, and your family gets to keep the estate for future generations.
We don’t represent any particular insurance company, so when it comes time to look at policies, we gather their medical files and give them to our underwriting team to consider each individual. They’ll then bid the insurance out to multiple companies so that we can get offers before we submit a formal application. This lets us know the upfront costs and ensure accuracy for clients. If you don’t follow this strategy and are declined, your information can be posted in the Medical Information Bureau, where it becomes available to all insurance companies, even those you haven’t submitted applications to.
If you have any questions or would like to implement any of the strategies we use to help families avoid estate taxes and protect their companies, don’t hesitate to reach out to the Nabity Business Advisors. Let’s see if we can’t solve some of these problems for you!