Tax PreparationAs his manufacturing business prospered, Roger Valentine realized he needed to protect his assets in case something happened to him.
“I could potentially leave my family with enormous messes that they would not be able to straighten out,” says Valentine, president of Rochester Manufacturing Corp. in Wellington. “A lot of businesses fail when something happens to the owner, and the debt is such that a business may be put up for auction, and your family may end up with nothing. I didn’t want that to happen.”
Valentine set up his estate plan 15 years ago. But because the economic downturn is lowering the value of businesses and their assets, entrepreneurs such as Valentine may want to consider updating their estate plans to realize the hidden benefits in a business slowdown.
Professional estate planners say business owners can take advantage of today’s low interest rates and tight credit markets by placing assets in some estate-planning tools such as grantor-retained annuity trusts, recapitalized stock or family loans. An owner can transfer some of his wealth to the next generation tax-free and reduce the size of his estate, which also helps to lower estate taxes after he dies. By transferring currently depressed assets, a business owner could benefit his heirs as those values increase in better economic times.
“There are some good opportunities in estate planning that are just not available in a strong growth market,” says Marcia J. Wexberg, partner at Calfee, Halter and Griswold in Cleveland, who chairs the firm’s estate and succession planning group. “So that’s why we’re encouraging business owners to think about what they can do now that will help their businesses and their next generation over the long run.”
In addition, there are simpler estate-planning options available, such as life insurance, AB trusts and buy-sell agreements that can protect your business assets and your family. These options also can help you avoid probate court and lower federal and state taxes after your death.
Although estate planning is not at the top of most business owners’ to-do list, a national survey of estate-planning attorneys found that the vast majority — 93 percent — believe there will be a greater demand for estate-planning services because of the aging baby boomer generation. The survey, conducted by WealthCounsel, a Madison, Wis.-based organization of estate-planning attorneys, found more clients are seeking estate-planning services for three reasons: to bypass probate court, prevent loss of estate value due to taxes and avoid creating a chaotic experience for surviving family members.
Developing Trust
With help from an experienced professional, establishing a grantor-retained annuity trust (or GRAT) can be an effective estate-planning tool during a slow economy. This trust can transfer your wealth to the next generation free of gift or estate taxes.
For example: You can put a $500,000 investment into a GRAT, which then pays you an annuity of $100,000 annually for five years plus interest based on an IRS-prescribed rate. That rate in December was 3.4 percent. If the value of your GRAT increases by 8 percent per year during the five-year term (income and capital growth), the excess (about $86,000, in this example) is a tax-free gift to your children.
“Whatever is leftover at the end of five years is a tax-free gift to your children,” says Wexberg. “You may make a little money or you may make a lot of money, but it depends on how deep the economic recession is and how quickly we recover from it.”
What’s more, the only tax you pay is on the interest you made on the annuity. However, if you die before the five-year term expires, the assets in your GRAT return to your estate, and you are in the same position as if you had not created the GRAT.
All in the family
Lending to family members can be another way to transfer wealth in these tight times. Uncle Sam allows you to make loans to members of your family at the applicable federal rate.
During an economic downturn, the rate is very low, usually even lower than what banks typically peddle. The federal rate in December was between 1.36 and 4.36 percent, depending on the loan terms and the payment frequency, and could go lower in 2009. This also can help you bypass today’s tight credit markets and the strict credit requirements set forth by banks to get a loan.
“If the senior generation loans money to the junior generation, the interest that has to be paid back is very low,” Wexberg says. “If the junior generation takes that loan and makes an investment that produces a higher rate of return, then your son or daughter will benefit from it.”
Let’s say you lend your daughter $200,000 at the federal interest rate to expand her business into a new niche with fast growth opportunity. As long as the business yields a higher return than the loan’s low interest rate, your daughter will come out ahead.
In addition, you can help your daughter jump-start the business, because the federal government allows you and your spouse to each give her $13,000 annually tax-free. Any amount over that is subject to estate tax.
Take some stock
You can also transfer some of your wealth tax-free to the new generation by creating nonvoting stocks for your company. “Most of the time, the senior generation will want to maintain control of the business, but they also want to allow the junior generation to have an economic interest in the company,” explains Wexberg.
One way to do that is to recapitalize 100 company shares into 1,000 shares. The 900 nonvoting shares would give the next generation an economic interest in the company, but no decision-making authority. The 100 voting shares would be held by the senior generation to retain control over the company.
Over time, you can gift the 900 nonvoting shares — up to $13,000 or $26,000 worth of stock annually — to the next generation tax-free. Because of the slow economy, your depressed stock values could eventually benefit the new generation as the value of your stock increases when the economy recovers.
Get a life ... insurance
Life insurance is a simple way to protect your business assets. It can help you pay off most, if not all, of the estate tax, when the value of your estate exceeds the federal or state exemptions. Life insurance is also a good tool to pay off debts.
Remember, however, that if you buy insurance, it could be added to your estate after your death. The simple way to get around this is by giving your children money to pay the premiums on your life insurance. When you die, the life insurance won’t be considered part of your estate, and the proceeds will be paid to your children’s estate tax-free.
“My life insurance will pay off all of my company debts,” says Valentine. “It makes my business whole in the sense that my survivors don’t have to worry about creditors breathing down their necks. It gives them time to make good decisions as to how to keep operating the business, liquidate it or sell it.”
Valentine also carries a personal life insurance policy that benefits his wife and two children.
In his experience, Valentine says, it’s more cost effective to buy $1 million or more in life insurance.
“You can buy $1 million worth of life insurance almost as cheaply as you can buy $225,000,” says Valentine. “So when you get a bigger policy, you get a better deal on the cost of insurance. It costs a little more money but not as much as you think. You have to do some shopping to determine the best life insurance that fits your needs because there are many options.”
Establishing a life insurance trust also may be a good option. Because the trust owns the life insurance policy, it won’t be part of your estate, and the proceeds go to your beneficiaries tax-free.
Federal restrictions, however, require the life insurance trust to notify beneficiaries annually of their right to their share of the principal. The trust also needs to be set up at least three years before death.
You can avoid the three-year look-back period if the trust is set up properly, says Chardon-based estate-planning attorney Kelly A. Slattery of Thrasher, Dinsmore & Dolan LPA.
If you miss just one annual notification to beneficiaries, or if some other mistake is made in the management of the trust, Slattery says, you can run into problems. The best way to avoid this is to make sure you have an experienced estate professional who knows how to set up this trust — or any trust for that matter.
Simple as AB
The AB trust, sometimes called a credit shelter trust, is a way to bypass the expense and public exposure of probate court. Additionally, an AB trust also can reduce or avoid the federal estate tax.
The federal government allows you and your spouse to pass on $3.5 million each or $7 million total to your heirs free of federal estate tax. If you and your spouse own a combined estate worth $7 million and you die, the spouse inherits the estate tax-free. But when the surviving spouse dies, then $3.5 million of that $7 million estate is exempted, meaning it can be passed on to your children or other beneficiaries without tax. The other half — $3.5 million — your spouse inherited, however, is taxed at a hefty 45 percent rate.
“The advantage of an AB trust is that you can make full use of the exemption amount of both spouses as opposed to just one,” says Slattery.
Here’s how an AB trust works: When you die, your half of the estate — $3.5 million — is funneled into an A trust. (Anything more than that amount would go into the B trust.) The funds never become part of your spouse’s estate. However, your surviving spouse receives distributions of interest and may take distributions of principle for health, education, general support and maintenance.
By creating an AB trust for your spouse as well, her half of the estate — $3.5 million — undergoes the same process. Taxes are only paid when the second spouse dies and only apply to funds in the B portion of each trust.
Make an agreement
If you have one or more business partners, make sure you hammer out a buy-sell agreement, which will spell out exactly what happens to the business if you or one of your partners dies, becomes disabled or leaves the company.
If a partner dies, then the partner’s spouse inherits the shares of the
business.
A buy-sell agreement can give you the right to buy the spouse’s shares. The partners should also carry life insurance on each other to cover the costs of buyouts.
“Buy-sell agreements are very important, because they can avoid a lot of disagreements, misunderstandings and legal disputes,” says Howard S. Rabb, administrative partner at Dworken & Bernstein Co. in Painesville. “A good buy-sell agreement requires a commitment by all partners. It’s not always easy ... but it’s a very important part of your business’ estate plan.”