The problem is not new: How does a successful, married business owner nearing retirement remove assets from his taxable estate while retaining access to them to support himself and his spouse until his death?
To avert the fiscal cliff, President Obama signed new tax legislation on January 2 that included two significant changes related to estate taxes: It lowered the top estate tax rate from 55 percent to 40 percent for 2013, and it continued the gift-tax exemption of up to $5 million per person, adjusted for inflation. This exemption was due to expire at the end of 2012 and revert to $1 million, but the new legislation extended it instead. Indexed for inflation, the exemption has increased to $5.25 million for 2013.
Joe, a successful business owner in his early 60s who plans to retire in three years, considers estate taxes “a double tax on success.” He started Success Co. in 1975, and his two sons, Sam and Sid, now run the business. Joe’s current net worth is $18.5 million, which includes a primary residence in Michigan and a winter home in Florida, the land and building leased to Success Co., $1.1 million in a 401k, a stock and bond portfolio worth $1.6 million, and Success Co. itself, valued at $11.7 million. At this net worth, Joe’s estate tax at his death would be about $3.2 million. But as his wealth rises, his taxes will, too. For every $1 million in increased wealth, his estate tax bill will increase about $400,000.
Joe is looking for a way to lessen the tax blow on his estate and at the same time maintain an income for himself and his wife, Mary, until his death.
Joe’s wealth is already in the highest tax bracket of 40 percent, but the value of Success Co. continues to grow. To soften the tax impact at his death, he should remove it from his estate by transferring it to Sam and Sid as soon as possible, although he can retain control of the company for as long as he lives.
So what is the best way to transfer the company to his children? Sell it to them? Give it to them as a gift? Have the company redeem Joe’s stock? Use a variation or combination of these options?
Joe’s problem is not unique. Many family business owners have been down the same frustrating path and encountered similar obstacles. Selling the company to Sam and Sid kicks up a capital gains tax. Gifting the company to them would mean no income for Joe and Mary, and they will need a source of income to maintain their lifestyle when Joe retires in three years. Variations of these options have one or both disadvantages, and Joe also is concerned about inflation’s impact on either a sale or gift when he retires.
A strategy called an irrevocable spousal access trust (SAT) can enable Joe to transfer the company to his children and take advantage of the $5.25 million gift-tax exemptions ($10.5 million for Joe and Mary combined) without relinquishing access to his assets.
The first step in funding SATs for both Joe and Mary is to divide Success Co.’s non-voting stock so that each person owns 50 percent of it. Once that is done, they can use all or a portion of their $5.25 million gift-tax exemptions to gift the non-voting stock to the trusts.
Creating voting and non-voting stock is a simple, tax-free transaction. In this case, Joe will keep the 100 shares of voting stock and control of Success Co., and 10,000 shares of non-voting stock will be gifted to Joe and Mary’s SATs (5,000 shares to each). In addition, non-voting stock is entitled to various tax discounts of about 40 percent, making those 10,000 shares worth only about $7 million for tax purposes.
In simple terms, Joe’s trust will provide Mary with income for the rest of her life and Mary’s trust will do the same for Joe. After both are deceased, the trust assets go to Sam and Sid. It is critical, however, that each of the trusts be drafted to be different from each other to avoid the so-called “reciprocal trust doctrine,” which would pull the gifts back into the grantor’s estate.
On a year-to-year basis, Joe and Mary are limited to working only with their spouse’s trust to get the income they need. Any funds they do not take stay in the trusts and eventually will go to their heirs’ estates, tax-free.
Using this SAT strategy enables Joe and Mary to achieve three goals: Joe gets Success Co. out of his estate but retains control of the company; Joe and Mary will continue to have access to Success Co. income as needed; and after their deaths, the unused funds accumulated over the years in the SATs will go to Sam and Sid free of the estate tax.
So if you are a successful business owner trying to figure out how to pass along your operation with the least tax impact and still support your family until your death, you too should consider the benefits of SATs.