Estate planning allows for your assets to be distributed the way you want them to be after you are gone. As a business owner, estate planning takes on even greater importance, as a significant portion of your wealth (and your family’s source of income after you are gone) is likely tied up in your business. Failing to put measures into place for your business can leave your business legacy by the wayside. It’s important to start estate planning early and communicate and reassess with your advisors, business partners and family. With a strategy in place, you can feel confident that your business and your loved ones will be taken care of, no matter what.
When creating an estate planning strategy, you should consider the following:
- Assessing your needs
- Wills and living trusts
- Minimizing taxes
- Succession planning strategies
- Best practices
You may be a sole proprietor with an owner-dependent business who does not intend to keep your business open after your death. You may have multiple business partners who you’d like to set up a buy-sell agreement with. You may have a family-run business and be faced with the difficult decision of choosing a successor from amongst your children. The bottom line is that each business has different estate planning needs, and without assessing those needs, it’s impossible to put a strategy into place.
Before designing an estate planning strategy, you should consider the following questions:
- Will your estate be subject to estate taxes?
- Do you have an accurate will?
- Do you want your business to continue after you are gone?
- Do you want to sell your business to a new owner or pick a successor from within your company or family?
- Do you want your family to have an active role in the business?
- Do you want to retire from your business or wait until your death to pass on ownership?
Determining the answers to these questions will help identify the direction of your estate planning strategy.
Wills and living trusts
A will is the most basic aspect of an estate planning strategy. If you don’t have one, the court will decide how your assets are divided instead of you or your family. Many think that designating how assets should be distributed in a will is enough, but for business owners in particular, other measures should be put in place to ensure the proper transfer of assets.
Wills are subject to probate, the process where a court examines a will, deals with any conflicts and approves or carries out its requests. Probate prohibits the immediate transfer of your assets and depending on the complexity of the will can last for months or even years. Probate is a public process, so anyone will be able to see what you owned and what you owe. Creating a living trust, on the other hand, sets up a separate entity that legally holds ownership of your assets so that, unlike a will, their distribution cannot be contested in court. Living trusts bypass probate, which offers you increased privacy and decreased legal fees. It also allows the transfer of your assets to happen immediately and ensures that your business assets will be transferred in exactly the way that you want—they are not subject to the decisions of a judge. Trusts also allow more control over assets, as they allow the creator to put specific restrictions or amendments on its distribution.
While establishing a living trust is beneficial for business owners, you will still need a will. A will allows you to name guardians for your children or forgive debts, which a living trust cannot. Also, you usually don’t transfer all of your assets to a living trust—even if you try, it’s likely that you’ll miss something or you may acquire an asset shortly before your death. A will takes care of those assets not owned directly by a living trust. Fortunately, if you have a living trust, you should only need a simple will that states who should inherit the remainder of your property.
Federal estate taxes apply to estates of $11.58 million (2020 indexed for inflation) or above and will be assessed on the value of the estate on your date of death. Estate taxes are due nine months after the date of death and can be assessed up to 40 percent, so without a strategy in place to minimize or fund these taxes, some businesses have to be sold below market value so that the estate beneficiaries can raise the funds in time. If your estate will be subject to estate taxes, there are several strategies to consider to reduce the amount of taxes your family will have to pay.
Grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs) are effective options for those who will be passing on a rapidly growing business and want to avoid rapidly growing estate taxes. These types of trusts allow you to “freeze” the value of the trust, so if you transfer your business assets into a GRAT or GRUT and they grow within the trust, the appreciation will not be subject to estate taxes. In addition, you retain the right to receive distribution payments from the trust, so you can continue to have a source of income even if you no longer own the business assets.
One option to provide family with a source of funds for possible estate taxes is an irrevocable life insurance trust (ILIT). An ILIT is a trust designed to hold your life insurance policy, which allows the trust to avoid probate and gives your family immediate access to income. Once an ILIT has existed for three years, it is considered outside of your estate, so creating an ILIT also helps to lower estate taxes.
If you own a family-run business, you can consider creating a family limited partnership (FLP) or family limited liability company to hold business assets. Family members can buy in to be given limited partnership interests, which then eliminates this interest from your taxable estate. It also allows you to gift shares to your family members and take advantage of gift tax exemptions. However, the tax advantages of these structures have caused the IRS to heavily monitor their creation. The IRS closely scrutinizes most family limited partnerships to make sure their valuation is correct and to stop families from creating “death bed” partnerships, or partnerships created solely to obtain estate valuation discounts. If the IRS finds that you have created an FLP solely for avoiding taxes, they can bring the assets back into your estate. Make sure you consult your lawyer before establishing an FLP, as the IRS repercussions can be severe.
The simplest of tax minimization strategies would be to use your $15,000 (2020, indexed for inflation) per year tax exclusion to gift your business interests to your successor. This can allow you to transfer a large part of your business tax-free. It’s important to keep in mind that this strategy can take a significant amount of time, depending on the size of your business. However, lifetime gifts allow you to have significant control over transfer amount and timing, so you can transfer your business in the way that you are most comfortable.
Succession planning strategies
Beyond protecting the financial assets of your business, it’s important to have a strategy in place to protect the integrity of your business. A business succession strategy should address how you will transfer management and ownership of your business. It will usually involve details such as how you will develop and train successors, how and in what timeframe you will delegate responsibility and authority to successors, and what employees or practices you see as vital to the company. You will also have to choose how you want to pass on your share of the business.
Whether you choose to sell to an external party, name an internal successor or liquidate your business, the way you pass on your business will affect your finances and, in turn, your estate plan. For example, if you choose to sell the business, you’ll likely receive a lump sum that can help ease the burden of any estate taxes you may incur. If you choose to name an internal successor within your company, you will have to decide whether to sell your share of the company or leave it for your family to inherit. As with all other aspects of estate planning, this decision will require a lot of consideration. You’ll have to find a balance between protecting the business you helped build and ensuring that your family will be well cared for. You should think about factors such as how involved your family is in the business, how successful the business is and how much you could profit from selling the business. While there are many business succession options available, only you can decide what is best for both your business and your family.
Whichever methods you use to set up your strategy, keep the following business-estate planning practices in mind:
Determine how your debts will be paid once you are gone: This is especially important if you are a sole proprietor and business debts will be solely in your name. If this is the case, it’s important to name in your will how you want your debts to be paid out of your personal assets and to have a strategy set up to address this, so that your family isn’t left with business debt and no way to pay for it.
Coordinate all business documents: All too often, carefully laid estate plans are upset by one erroneous name on one single document. You should make sure that all of your business agreements, real estate deeds and estate plan documents agree. For example, if the real estate deed for the building housing the business has you and your spouse’s name on it, but your will states that you are leaving your business to an internal successor, that internal successor may be forced to buy out the real estate from your spouse. The language in the deed will most likely trump the language in the will, so you can’t rely on your will to be foolproof. It’s important to be meticulous and make sure all of your legal documents are in agreement to avoid confusion after your death.
- Have your business valued: Bringing in an outside appraiser to value your business can help you determine what kind of taxes you can expect and set a reasonable price if you are considering selling the business.
- Start early, communicate often: You never know what the future holds, so it’s important to start preparing early. By discussing the future of your business with your family, business partners and employees early on and continuing this discussion as your business develops, you can help make sure that your estate and succession strategies will run smoothly.
- Set up a durable power of attorney: This is especially important if you are the sole decision-maker for your business, but is valuable for any business owner. Setting up a durable power of attorney allows your business to continue running in the event that you become incapacitated.
- Review your strategy: Estate planning never truly “ends.” It should be an ongoing discussion that develops along with your business and lifestyle changes. Check in with your Prudential financial professional regularly to make sure all your documents are up to date and your estate plan strategy is still functional.