Small Business owners work long and hard to build, develop, and maintain a successful business, but how does a successful business owner “cash-out” and/or ensure their family is fairly compensated following the owner’s death? How do you transition the business to the next generation? What happens to my business if I become disabled or die? While there are a myriad of moving parts at play-from the type of business and nature of the business, ownership interests in the business, business and family dynamics, death tax, income tax, and valuation, among others- this article will briefly highlight some issues for small business owners to consider in formulating a succession plan as part of a well thought out estate/post mortem plan.
Benjamin Franklin is credited with saying, “If you fail to plan, you are planning to fail,” and that is true with many things in life, and the orderly transfer of business interests is no exception. According to the Small Business Administration, the United States has approximately 30.2 million small businesses (less than 500 employees). While numerous, each small business is unique as is each business owner and that owner’s individual family dynamics and situation. I hope the following raises general awareness of business succession planning as part of an estate plan and prompts small business owners to consider and implement a business succession plan, with the ultimate goal of limiting expense and aggravation.
If your business has more than one owner, you should consider a Buy-Sell Agreement (generally as part of a shareholder(s) agreement for a corporation, a partnership agreement for a general or limited partnership, or operating agreement for a multi-member limited liability company) with specific terms outlining the automatic and orderly sale/purchase of business interests should an owner become disabled/incapacitated or die. This would include terms on how the disabled/incapacitated or deceased owner’s interests are valued and the terms of payment to that owner or that owner’s estate. A properly structured Buy-Sell Agreement ensures continuity of management and ownership, ensures the owner’s family is fairly compensated, and avoids/limits issues between the remaining owners and the family or estate of the disabled or deceased owner.
Death -Business Interests are part of your Estate
Generally, your business is an asset of your estate following your death. Whether you operate your business as a sole proprietorship, a partnership, a limited liability company, or a corporation (whether Subchapter C or Subchapter S corporation), your interests in your business are typically part of your estate and following your death must be administered as part of your estate.
Small business owners should have a Will to set forth that owner’s intent and wishes on how his/her business (as well as other property) should be distributed following death. A trust may be an alternate vehicle to transfer your business interests. Small business owners should also have a comprehensive durable financial Power of Attorney to allow business decisions to be made in the event of a disability.
A major component of most business estate planning involves consideration of taxes, particularly death taxes. Death taxes have a federal and state component.
A. Federal Estate Tax.
The federal government/IRS will not tax your estate (including your business interests) if your estate is valued under the estate tax exemption amount. For the tax year 2020, the federal estate tax exemption is $11.58 million per person and $23.16 million per couple. So, if a business owner happened to die in 2020 and that owner’s assets, including the business, were worth less than $11.58 million dollars, that business owner’s estate will not owe any federal estate tax.
B. Pennsylvania Inheritance Tax.
Separate and apart from the Federal Estate Tax, however, Pennsylvania imposes an inheritance tax, which does not have an exemption like federal estate tax. Essentially, it starts at dollar one of an estate. Inheritance tax, unless otherwise provided in a Will or Trust, requires the individual who inherits the assets (“beneficiary”) to pay tax on the value of those assets. More specifically, the tax rates on beneficiaries are, generally, as follows:
0% for a spouse.
4.5% for a child/grandchild/descendant or parent/grandparent/ancestor;
12% for a sibling;
15% for all other family members or individuals.
Possible Options to Minimize Death Taxes or avoid probate
So how can small business owners avoid or limit death taxes on business interests following death? Unfortunately, there are few, if any, good options to eliminate the death tax, but limiting tax exposure is still possible. One option may be a Grantor Retained Annuity Trust or GRAT, which, if properly structured, allows the owner to transfer appreciated business interests and assets to the family and retain a stream of income for himself/herself. Proper use of these trust vehicles may protect the appreciated value of business assets otherwise subject to gift or death taxes. Another option may be to form a Family Limited Partnership (“FLP”) to hold business assets, which allows for the lifetime transfer of portions or units of that business to the owner’s successors or family at discounted values. While not specific to limiting taxes on the transfer of business interests following death, one more direct way to ensure the family has money while the business interests are being transferred is to set up an Irrevocable Life Insurance Trust or ILIT to promptly pay proceeds and provide liquidity to the owner’s family. Generally, those insurance proceeds are not subject to income tax, Pennsylvania Inheritance Tax, or Federal Estate Tax, provided the benefits are not payable to the estate and/or the deceased owner is not both the owner and insured under the life insurance policy. Please note, GRATs, FLPs, and ILITs are subject to complex rules and may not be appropriate depending on one’s goals, wishes, and particular set of facts. Accordingly, the author strongly recommends consultation and review with a knowledgeable tax and estate-planning professional.
As mentioned, each small business and each owner’s situation is unique and requires careful and specific planning to accomplish that owner’s goals and avoid unnecessary time, expense, and aggravation. I hope this article provides readers with some food for thought.
This article is intended as general legal information and not as legal advice. Should you have any questions regarding the subject matter of this article or wish to discuss your particular circumstance or situation, please contact the author.