The value of an ownership interest in a business may be worth a lot by the time an owner dies. For heirs, whether this interest is diminished by estate taxes depends on the situation…how valuable that interest is and when the owner dies. For planning purposes, things are very confusing. Let’s try to sort them out.
Federal estate tax rules
When the value of an estate is below a threshold amount (called an exemption), there is no federal estate tax. The exemption amount for an owner dying in 2019 is $11.4 million. A married couple can effectively double the exemption amount (there’s “portability” to allow a surviving spouse to use the unused portion of the exemption from the other spouse). If the value of the estate exceeds the exemption amount, it is taxed at 40%.
But the exemption amount is scheduled to drop after 2025 to the former level of $5 million (adjusted for inflation). What’s more, if there is a change in Congress and the Administration before then, the former level could be reinstated even sooner. There have already been bills proposed in Congress to do just that.
State death taxes
The majority of the states have no estate or inheritance tax. But some states impose an estate tax similar to the federal tax, although they have their own thresholds for their estate tax. For example, Connecticut’s exemption for 2019 is $3.6 million ($5.1 million in 2020). Minnesota’s exemption for 2019 is $2.7 million and $3 million thereafter. And Oregon’s threshold is only $1 million. And a handful of other states impose an inheritance tax on heirs.
You can see the rules in your state in this chart from the American College of Trust and Estate Counsel. The rules applicable to you depend on where you’re domiciled (essentially meaning the state you call home).
For owners of growing companies, estate taxes may pose a potential problem for their families and their businesses. Estate taxes are due nine months after the date of death and must be paid in cash. In extreme situations, families may be forced to liquidate the company or sell it at a fire sale just to raise the funds needed for taxes. But planning ahead can help to ease the burden on families. Here are some general strategies to consider:
- Buy outs by co-owners. With pre-planning surviving owners can buy out the interest of a deceased owner, providing the family with funds for estate taxes. Buy-sell agreements for this purpose should address how to structure the buy out and how to pay for it.
- Life insurance. Where there are no co-owners, one way to be sure there is sufficient cash on hand for estate taxes is to have a life insurance policy on the owner. This requires some foresight. The sooner the policy is obtained, the less costly it will be. Properly arranging the ownership of the policy (e.g., through an irrevocable life insurance trust) is important to keep the proceeds from being included in the owner’s estate.
- Give away property. An owner may transfer during his or her lifetime a portion of the ownership interest to children or others, subject to gift tax rules. Making lifetime gifts can reduce or avoid any estate tax upon death by bringing the value of the estate below the exemption amount. According to proposed regulations, individuals planning to make large gifts between now and 2025 can do so without concern that they will lose the tax benefit of the higher exclusion level once it decreases after 2025.
Owners may think in terms of succession planning…who will run the business when I’m gone? But owners should also consider federal and state tax implications for the business upon their death. Work with a knowledgeable estate tax attorney for guidance and any documents that may be required to implement plans.