Read these important estate planning tips if you have a small business you want to protect.
If you’ve got a successful small business, you’re probably pretty busy keeping up with the day-to-day hustle. You might be thinking about tax planning for next year or even what your five-year goals are, but you might not be thinking about long term estate planning yet. If you’re in that boat, you might be interested to learn that most small businesses don’t survive past the first generation. It’s not because these businesses aren’t financially sound – rather, these failures are usually due to poor communication and lack of proper estate planning.
Can you imagine embarking on a long trip and leaving your kids, your pet, or even your plants alone for an extended period without a well-thought out plan? You’d never do that, but when it comes to your business, you may not have a great plan in place for extended (or permanent) absences.
If a business owner passes away without a plan in place, it’s the survivors who are left hanging. Your business might be rocking right now, but will it survive if you’re not around? Even if you don’t anticipate your business lasting after your death, estate planning is important so that you don’t leave your heirs in a bad spot. Communication, planning, and documentation are key steps to leaving your business and your assets in good shape.
Minimize Taxes—Pass on More of What You Earned
Even if you don’t expect your small business to outlive you, there’s at least one big reason to invest the time to come up with a solid estate plan. Strategic tax planning is one of the most important things you can do to make sure that the government doesn’t get an outsized portion of the assets you leave behind. You put in the work to create and grow your business—you don’t want to give away everything you’ve worked for unnecessarily! Estate taxes can take up to 50% of your business’s value, so planning now is of critical importance.
Most small businesses don’t have a lot of liquid assets, so paying the estate taxes that normally come due within nine months of the owner’s demise can often necessitate selling the business. With a short window to meet the tax burden, the business sale is often executed at fire sale prices, meaning your heirs don’t get the full value they should. The good news is, thoughtful estate planning can help prevent this outcome to ensure that your family gets to keep more of what you worked hard to earn.
IRS Estate Tax Breaks for Small Business Owners
- Section 303 Stock Redemption: When a closely held business (most small businesses that are not publicly traded qualify as a “closely held business”) purchases its own stock at a shareholder’s death, that qualifies as a Section 303 stock redemption, which is subject to capital gains tax treatment under Section 303 of the Internal Revenue Code. Congress enacted Section 303 specifically to help ease the liquidity problem we discussed above. When an estate is made up almost entirely of an interest in a closely held corporation, it may be hard for that estate to come up with the liquidity to pay off estate taxes.
Your tax advisor can help you understand how Section 303 can help you specifically, but here’s a broad example: Your spouse is an owner of stock in a closely held corporation at the time of their death. As the executor of your spouse’s estate, you sell their interest back to the corporation and receive cash for that sale. The amount of cash you receive that is less than or equal to the funeral and administrative costs (including federal and state death taxes) is eligible for capital gains tax treatment. Since the shares held by your spouse’s estate will normally have a basis equal to the fair market value, this means that there will be little or no capital gain upon the sale, and little or no tax due.
- Section 6166 Estate Tax Deferral: Section 6166 permits an estate to defer payment of estate tax for up to 14 years at favorable interest rates if the value of the the interest in a closely-held business exceeds 35% of the adjusted gross estate. This allows the business owner’s estate time to decide how to handle the business and its possible sale, without feeling rushed to sell it quickly to pay estate taxes.
Buy-Sell Agreements Help Set Expectations for Partnerships and Small Corporations
When shareholders or partners set up a plan for the business in the event of incapacitation or death, this can be called a buy-sell agreement. The main component of a buy-sell agreement is the establishment of a sale price for the business and your share of the business. In this agreement, you can document your expectations and wishes in a legally enforceable way. If for example, you want your heirs to sell your portion, the terms and price are already set to avoid confusion during a difficult time.
Special Considerations for Sole Proprietors
If you’re a successful sole proprietor, you know that in many ways, you are your business…and vice versa. With this type of business, it’s critically important that you have a clear plan for what should take place after you’re gone. How should your heirs handle any business debts? Do you intend to pass on the business? If so, who will succeed you? If you expect the business to be sold, consider doing some preliminary research on your heirs’ behalf to make that sale easier. What you own personally can be used to cover business debts. Delegate and prepare your successor if you want to pass on the business. If you want to sell the business, do the research that will make selling it easy and inexpensive for your heirs.
There are many questions to think about and eventualities to plan for. The most important thing is to communicate early and often, and document everything. Working with a great estate planner to set up the documentation can be incredibly helpful. (Need someone good? Prime is here to help!)
The Life Insurance Liquidity Solution
Life insurance policies can play an important role in managing partnerships in the event of a partner death, particularly if the partners would like the surviving partners to buy out their interest in the business from their estate. Insurance payouts can provide the liquidity necessary to achieve that type of buyout, which is why many businesses will have each partner take out life insurance policies that name the other owners as beneficiaries. Proper use of this strategy ensures that the surviving owners will have tax-free proceeds to purchase the deceased’s portion of the business from his or her estate.
Family-Run Businesses: Special Considerations for Heirs
If you have a family-run business, you may have some heirs who are involved in the business and others who are not. In cases like this, it can be difficult to decide how to divide your business assets. One option is to distribute assets based on an heir’s contribution level, while another option is to allocate everything evenly. It’s important to think about these types of decisions before your death and document the plans to avoid extra heartache at an already difficult time.
Whenever someone passes away, powerful emotions and turbulent life changes can complicate business decisions. Whenever possible, spending some time with a tax and estate planning specialist to strategize and document your wishes can result in a smoother transition, more successful business outcomes, and a larger portion of your estate’s proceeds staying in the hands of the ones you love. If you’d like help setting up a financial plan for your family, reach out to set up a consultation any time—Prime experts are here to help.