Political and economic factors suggest a higher tax environment is possible. Understand your options for income, corporate and estate tax planning.
Democratic U.S. Senate candidates swept the Georgia run-offs in early January, resulting in Democratic control of both Congressional houses in addition to the White House. Among other new political realities, this result increases the odds that elements of President Elect Biden’s tax proposals could be implemented. Additionally, key provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) remain scheduled to expire, suggesting a higher tax environment could be on the horizon.
We emphasize that it is far better to plan than predict and that the best strategies focus on long-term goals and flexibility. That said, given the above dynamics, heightened awareness of your options is appropriate. Note that the following strategies for business owners merit consideration regardless of the political landscape.
INCOME AND CORPORATE TAX PLANNING
Sell all or a portion of your business
If you are thinking about (or in the process of) selling all or a portion of your business — particularly if shares of the business have appreciated significantly — consider the potential benefits of accelerating the sale process. This could have advantages in the event that capital gains taxes are raised. The decision to sell, however, must weigh a number of factors, including (i) the advantages of running a longer sale process with a broader list of potential buyers, (ii) the possibility of continued upside in the business, and (iii) the tax implications of various transaction structures (e.g., asset sale vs. stock sale).
Elect installment sale treatment on sale of shares
If you are considering selling shares of your business and are concerned about if (and when) legislation could be passed increasing the capital gains rate, electing installment sale treatment for the sale of these shares could provide some optionality. For instance, you might sell shares of your business (either to a third-party buyer or to a trust for the benefit of your heirs) in exchange for a promissory note. If you elect to treat the transaction as an installment sale, capital gains tax on the shares sold would be paid over the course of the promissory note as principal payments are received. Installment method treatment may also be available for business transactions that are structured as an asset sale, which is generally the transaction structure preferred by buyers.
We have recently fielded numerous questions from business owners on the possibility of retroactive tax legislation. While we believe the probability is low, it is possible. In this scenario, if capital gains tax legislation were to be adopted effective retroactively as of January 1, 2021, the installment sale treatment allows you to defer the capital gains tax into future years. If, however, capital gains tax legislation is adopted effective as of a future date, you may “elect out” of installment sale treatment and trigger the entire gain at the time of the sale at the current lower rate. An election out of the installment method must be made on or before the due date (including extensions) for filing the seller’s income tax return for the year in which the transaction occurs. As such, this “election” out could occur as late as October 15, 2021.
Consider a “dividend recapitalization”
If you want to generate liquidity but are not prepared to sell or issue additional shares of your business, consider the benefits of a “dividend recapitalization.” In a dividend recapitalization, the business takes a loan and uses the proceeds to pay a one-time dividend to shareholders. Paying a dividend now may help reduce the tax burden on shareholders in the event that the tax rate on qualified dividends is increased prospectively. The current low interest-rate environment also makes this strategy potentially attractive for business owners.
Revisit the entity structure of your business
The potential for an increase in the corporate tax rate signals a good time for you to revisit your business’ entity structure from a tax perspective. Continuing business operations as a pass-through entity such as an LLC or partnership instead of converting to a C corporation could be advisable to guard against a potentially higher rate. Alternatively, if your entity is a C corporation, electing S corporation status could be advisable, depending on your broader goals.
ESTATE TAX PLANNING
Transfer shares of the business to your heirs
Consider utilizing your remaining lifetime exemption to transfer shares of your business out of your estate so that any increase in the value of these shares will pass to your heirs free of estate and gift tax. Doing so now will help reduce tax liability in the event that estate taxes increase in the future and/or the larger lifetime exemption amount under the TCJA expires sooner. For business owners who have received a paycheck protection program (PPP) loan, note that certain transfers of ownership may require advanced notice and/or approval by the PPP lender as well as the Small Business Administration.
Consider creative solutions to address possible retroactivity
We have fielded numerous questions from business owners who are concerned that, if they utilize their lifetime exemption to transfer shares of their business out of their estate in 2021 — and legislation reducing the lifetime exemption amount is enacted and effective retroactively as of January 1, 2021 — the amount transferred over the reduced exemption amount would be subject to gift tax.
In the event that such legislation were to be proposed, there are various creative estate planning techniques to unwind the transfer. Some of these strategies have traditionally been used to accommodate fluctuations in the estate tax exemption amounts, but are largely untested for gift planning purposes. One is the use of disclaimer trusts. With a disclaimer trust, you would gift shares of your business into the trust, and the trust instrument would include language indicating that, if the beneficiaries of the trust “disclaim” the gift within a specified time period, the shares would be returned to you. This strategy could allow you to “unwind” the gift of shares in the event of retroactive estate tax legislation, although the window to disclaim is relatively brief (nine months).
Utilize business valuation discounts
From an estate-planning perspective, business owners have historically applied “valuation discounts” for lack of marketability and lack of control when transferring business interests to their heirs. Applying these discounts allows owners to transfer shares of their business out of their estate at a lower valuation, thereby using less of their lifetime exemption.
The Obama administration was unsuccessful in its proposal to restrict the use of these valuation discounts for transfers of interests in family-controlled entities, but there is a possibility such proposals could be revived. Consider revisiting your ownership structure for holding business interests and other family assets, including family limited partnerships, and utilize valuation discounts where appropriate.
Create optionality by setting up GRATs now for later use
Grantor retained annuity trusts (GRATs) are a common estate planning technique that, when structured properly, allow individuals to transfer assets into a trust for their beneficiaries while paying little to no gift or estate tax. The Obama administration proposed curtailing the use of GRATs; however, no legislation was enacted. To plan for the possibility that these proposals could be revisited, consider setting up GRATs now to be used later. For instance, you might create a GRAT with a term of five years and fund the GRAT with a certain amount of cash. The GRAT would pay you an annuity during the five-year term. If legislation is later adopted that curtails or eliminates GRATs, presumably the GRAT that you set up would be grandfathered, allowing you to swap assets carrying valuation discounts (for example, shares of your company) for the cash inside the GRAT.