Thursday, September 21, 2023

How to pass on business assets while paying as little tax as possible

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Shreya Christina
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Jim Farmer is Managing Partner of Group of financial strategiesa leader in the insurance industry that offers customers practical solutions.

When it comes to your financial estate, business owners and executives who accumulate a significant portion of their net worth in their company’s stock rely on current tax laws that state that the basis of wealth bequeathed to heirs is “raised” upon death, to the fair market value at the date of death. For example, if you had stock that was worth $500,000 when you received it and is now worth $3 million, your heirs would not pay capital gains tax if they sold the stock for its current value. Last year, a proposal to abolish the step-up in basic narrowly escaped (subscription required) and was included in President Biden’s The American Families Plan. Then, earlier this year, as part of the president’s budget proposal for 2023, another attempt was made finish the step up in the base for those with capital gains over $5 million ($10 million for couples).

While these efforts have so far been unsuccessful, for many entrepreneurs and others who have built illiquid wealth, surviving the step-up does not mean that all of their assets will get a step-up. Notably, assets held in an irrevocable trust fund cannot enjoy an increase in base for generations.

Benefits of Irrevocable Grantor Trusts

One of the first steps you will likely take in an estate plan is to donate assets so that they are no longer part of your estate. Donating assets that are expected to increase over time, such as company stock and real estate, to an irrevocable trust fund and valuing those assets outside of your estate can help reduce your exposure to estate taxes. The amount you can gift is not unlimited and is limited to you and your spouse’s combined lifetime federal estate and gift exemption (which is $25,840,000 in 2023).

As the donor of the irrevocable donor, you are taxed on all income in the trust, even though you receive none of it. The good news is that paying taxes from your estate reduces the value of your estate proportionally. This also means that the assets in the trust can grow tax-free.

A disadvantage of donating appreciative assets to a trust fund is that the assets retain the tax base that you, as the donor, had before you donated the assets. This means that since the assets are no longer part of your estate when you pass away, the assets you have transferred to the donor’s trust will not receive an upgrade based on what their value is at that time. Capital gains tax occurs when the trustee or beneficiary sells the valued asset. State-level capital gains taxes vary from 0% to 13.3%while the federal rate ranges from 0% to 20% (with an additional 3.8% tax for the highest earners).

Strategies to Avoid Capital Gains Tax

Assuming one of your goals for setting up the trust is to pay as little tax as possible, there are a few ways to avoid capital gains tax within a trust fund.

As a donor, you retain the power to take back trust assets by purchasing them with cash or replacing them with other assets – low valuations are ideal. For example, if you receive a large portion of your employer’s publicly traded stock, you can trade those stocks for other publicly traded securities of equal value that have appreciated in value. Since the assets traded must be equal in value, there should be no change in the value of your estate used for calculating estate taxes. After the trade, you own the highly valued shares, but there is no taxable gain if you die, as you receive a step up based on that.

Similarly, for donor trusts containing valued real estate, an IRC §1031 exchange allows capital gains taxes to be deferred when exchanging one investment property for another.

Another strategy to reduce or eliminate capital gains tax within a trust fund is to set up a charitable rest trust (CRT). The grantor can sell investments without being subject to capital gains tax, receive income for the life of a beneficiary of the trust, and obtain a partial tax deduction. Here’s how this would work.

• Grantor, an executive of a public company, donates $1,000,000 in his employer’s stock to a CRT.

• Trustee sells the shares tax-free and reinvests the proceeds.

• Grantor receives a current income tax deduction and an income stream of at least 5% of the fair market value of the proceeds in the CRT.

• Upon the beneficiary’s death, the remaining portion of the CRT’s proceeds will go to a charity, private foundation, or donor-advised fund.

If the donor wants to replace the value of the donation to charity, a life insurance policy can be used to provide a tax-free death benefit for their heirs that acts as a stepping stone.

What about when a donor has trust assets that are not highly prized, as is often the case when the trust is established upon the death of the donor? By investing in a low-cost variable life insurance contract with no lump sum, future capital gains taxes can be eliminated. These contracts offer many high-quality underlying fund options that can be traded in and out tax-free. Either the donor or a beneficiary can be the insured. The trustee can distribute contract income tax-free, and when the insured dies, the trust receives the death benefit tax-free, similar to an increase in the base.

The cost of life insurance is about 1% of your income, much less than the capital gains tax rate.

Final thoughts

These are just some of the options available to you to help achieve the goal of passing on wealth with as little strain as possible. Each situation is unique and a financial advisor should be consulted to discuss the right strategy for you.

The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation. Business Council is the leading growth and networking organization for entrepreneurs and leaders. Am I eligible?


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