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How to Transfer Business Ownership Interest to Reduce Estate Tax Exposure

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By: Marcia Urban at BMO Wealth Management

BMO Wealth ManagementThere comes a time in every business owner’s life when they start thinking about what comes next. They have their eye on retiring, and they want to make sure the business is left in good hands and good financial health. Maybe that’s selling to a worthy competitor, selling internally to employees or passing it down to the next generation of family members to run. The CFO has an important role to play no matter the succession goal.

Even if a business owner isn’t planning to transfer ownership interest in the near term, CFOs should help business owners plan – years in advance – for a smooth transition and personal wealth planning. By the time a letter of intent is in place, it’s too late to make important changes.

Plan Now to Reduce the Estate Tax Burden

Pre-transition planning helps business owners avoid a larger than expected estate tax burden. In 2023, the Estate Tax Exemption is $12.92 million per person (over $24 million per married couple), and is expected to increase to over $13 million ($26+ million per married couple) next year. However, the federal law that set these exemption amounts will be sunset in 2026, and the allowed exemption is expected to drop to approximately $6.5 million per person unless Congress acts. If no congressional action is taken, business owners could see their estate tax exposure increase significantly if they don’t start planning now for what may come.

Here are some actions CFOs and business owners can take now to reduce their estate tax exposure.

Make Lifetime Gifts

Under current federal law, the estate tax is taxed at 40% above the allowed exemption. That means if a business owner’s estate is worth $112.92 million and they pass away unexpectedly, the estate will owe $40 million in taxes on the remaining $100 million. Many business owners want to avoid that tax burden.

Making lifetime gifts is an effective way to move future appreciation out of the estate. These gifts can be made to any number of people and in 2023, in addition to one’s lifetime exemption amount, the annual exclusion is $17,000 per person without paying estate taxes on the gift. Gifting can move a tremendous amount of money out of the estate each year, and savvy business owners do this to reduce their estate tax exposure.

Leverage Valuation Discounts

A business owner can leverage valuation discounts if they’re not ready to relinquish control of the company but want to reduce estate tax exposure. Where the business owner gives a minority stake in the company—anywhere from 10% to 45%, valuation discounts are typically applied in cases of minority interest and lack of marketability.

To substantiate valuation discount, an enterprise appraisal of the business will be required, along with a second appraisal for valuing ownership interests transferred or sold. This is a smart strategy to supercharge tax exemptions if a business owner plans to pass the company down to the next generation in the family. When ready, give them a controlling stake now, leverage the valuation discount and reduce estate tax exposure. Transfer of ownership interests should occur well before any subsequent sale of the business to take advantage of valuation discounts.

Transfer Equity to Non-Voting Ownership Interest

Where a business owner isn’t ready to have only a minority interest in the company, they can recapitalize the company into voting interest and non-voting interest for transfer to various parties (typically family members the owner intends to pass the business down to). For example, the owner can retain management control of the company by retaining a 10% voting interest and transferring 90% of non-voting interest and receive the enhanced discounts.

Non-voting interest are widely used for gifting purposes because it transfers a portion of the equity in the business now, shifting the future appreciation, earnings and potential sales proceeds away from the estate tax—and the IRS’ 40% stake, while maintaining control of the business.

The Importance of Pre-Transition Planning

Think of the IRS as a silent business partner. They have no role other than to collect taxes on a transfer of your business. Any business that pays the full 40% freight in estate taxes has made a conscious decision to pay in full. However, with pre-transition planning and taking the IRS’ 40% interest stake into account early, more value is retained by the ultimate estate heirs.

CFOs and business owners can lay the groundwork for a smooth business interest transition and reduced estate tax burden by working with their attorneys, accountant and personal financial advisors to coordinate and ensure the structure of a company can be easily transitioned and any sale or gift is in the best interest of the business and the business owner’s long-term financial health. Pre-transition planning with your financial advisor, whose focus is on making sure the business owner is financially secure throughout their life, provides the peace of mind owners need to move forward toward business succession while retaining more of the fruit of their life’s work.

Marcia Urban, Senior Wealth Planning Strategist, BMO Wealth Management

Urban has 35 years of taxation and wealth management planning experience, helping business owners and their CFOs navigate complex tax requirements and prepare for a post-sale transition. She also serves as an adjunct professor at the University of Minnesota’s Carlson School of Management, teaching fiduciary income tax in the Master of Business Taxation Program

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