Family-owned businesses have a long-standing tradition of becoming generational businesses that are handed down from founder to children to grandchildren and great-grandchildren. But what the Internal Revenue Service has in store for many family-owned companies is more than just a passing of the office door keys, but also a larger take of the company’s profits through the ‘gift tax.’ Learn the ins and outs of the Estate and Gift Tax rules and how you can hand down your small business to a family member.
Changes in the American Taxpayer Relief Act of 2012 brought about a change to existing ‘gifting rules’ as they relate to businesses and their transfer to family members. In mid to late 2012, there was the threat that the existing rules would revert back to pre-2002 Bush-era tax exemptions of $1 million. The Estate and Gift Tax is a unifed tax, meaning that assets transferred as gifts during a person’s lifetime are combined with those transferred at death. These ‘gifts’ are subject to a single rate schedule. The associated gift tax was slated to rise from 35 percent to 55 percent. However, Congress did act and under the ATRA of 2012, the new tax exemption amount was changed to $5.12 million per person ($10.24 for married couples) for 2013. Additionally, the gift tax rate was increased from its original 35 percent to 40 percent. The amount for deaths in 2013 was raised to $5.25 million.
The inside track is that all gifts made to a spouse are tax-free as long as he or she is a U.S. citizen. Other family members must abide by the 2013 rules. Report all gifts on Form 709 regardless of whether a tax is owed. This is so the IRS can track what percentage of the $5.12 million has been used. As part of this reporting requirement, taxpayers must also report how the gift will be used; classified as ‘a present of interest’, meaning that the recipient can use the gift immediately. Any time a gift is made that is not a ‘present of interest’ it must be reported, no exceptions.
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Should you give the business to an individual child, split it equally among all children or create a family trust in which the business will reside?
One popular method of ‘gifting’ is to establish a 529 college savings plan, creating an individual account for every applicable family member. Gifts can be made to the accounts for as much as five times the annual exclusion in a lump sum. The catch is that while you can elect to spread this gift out over five years, during that five year period, you cannot make any additional contributions/gifts to the beneficiary of the 529 plan. The ‘gift’ also falls under the Estate Tax rules in the event that you pass away during the five year period, reverting the remaining years of your five-year gift to be treated as part of your estate tax.
· Separately, gifts can be made to individuals to a maximum of $14,000 per year in 2013, and are not counted as part of the annual exclusion maximum of $5.25 million mentioned above. Spouses can join you in this gift to double the amount.
· You can transfer property or money to a spouse for a combined exemption of $10 million. Additionally, any other estate tax deductions, such as those for contributions are also retained and a spouse can inherit any unused exemptions. For example, if a husband dies and leaves an estate of $2.5 million, the remainder of his $5.25 million exemption can then be used by his wife, increasing her exemption by the remaining $3.25 million.
· Establishing a trust can provide increased asset protection from creditors and potential divorce.
· The Generation Skipping Transfer Tax Exemption addresses estate tax avoidance through gifts and bequests to a later generation. When generation-skipping transfers are made to a trust, “the estate tax exemption applicable to them also exempts the associated earnings during the trust lifetime[i].” Historically, trusts have been limited to a twenty-one year life but most of these rules have been eliminated.
· Grantor trusts establish an individual as the owner for income tax purposes. With regard to the Estate and Gift Tax, these two entities are treated as separate individuals.
Estate and Gifting rules are very complicated and decisions shouldn’t be made with regard to tax and legal implications without seeking the advice of the tax or legal professional.
David Bradsher, CPA