For many people, a family-owned business is their primary source of wealth, so it’s critical to plan carefully for the transition of ownership from one generation to the next, and one of the biggest consideration is tax.
The best approach depends on your particular circumstances. If your net worth is well within the estate tax exemption ($11.18 million for 2018), for example, you might focus on reducing income taxes. But if you expect your estate to be significantly larger than the exemption amount, estate tax reduction may be a bigger concern.
Here is one technique to transfer a family business:
An intentionally defective grantor trust (IDGT) can be a highly effective tool for transferring business interests to the younger generation at a minimal gift and estate tax cost if your estate exceeds the gift and estate tax exemption.
An IDGT is designed so that contributions to it are completed gifts, removing all future appreciation on the trust assets from your taxable estate. At the same time, it’s disregarded (i.e., “defective”) for income tax purposes; that is, it’s treated as a “grantor trust” whose income is taxable to you. This allows trust assets to grow without being eroded by income taxes, thus leaving a greater amount of wealth for your children or other beneficiaries.
The downside of an IDGT is that, when your beneficiaries inherit the business, they’ll also inherit your tax basis, which may trigger a substantial capital gains tax liability if they sell the business. This result may be acceptable if the estate tax savings outweigh the income tax cost, or if there’s no intention to sell the business.
Determining the right strategy to implement when transferring ownership of a business to heirs depends on the value of your business and other assets and the relative impact of estate and income taxes. Also keep in mind that the gift and estate tax exemption is scheduled to drop to an inflation-adjusted $5 million in 2026. Even if you believe you don’t have an estate worth more than $5 million, if there’s a change in Congress (before or after 2025), the future estate tax exemption could well be significantly less than $5 million and you may need to plan accordingly. If you’d like to learn more, please feel free to contact our estate planning team.