Estate Planning for the Small Business Owner

Estate Planning for the Small Business Owner

By Jarod A. Cauzza

Benjamin Franklin once said, “Nothing can be said to be certain, except death and taxes.” While proper estate planning may not be able to prevent death, it can be used to prevent, or at least greatly reduce, death taxes. Many Americans when asked about estate planning would most likely pan the notion they would ever need to hire an attorney, accountant, or financial planner to assist them in managing their assets. Many still believe estate planning is a luxury for the wealthy, for multi-millionaires who have more money than they will likely see in their lifetimes. Nothing could be further for the truth. Estate planning is a tool to be utilized by everyone, regardless of the size of their pocketbook. 

Proper estate planning can prevent your assets from being taxed upon your death, but more importantly proper planning can control how and when your assets are distributed and provide those you love most with the foundation and stability to carry on after you are gone. This is especially true for small and family-owned businesses. How a person’s business is organized has a tremendous impact on how it is treated, taxed, and administered after that person’s death. 
 
For example, the assets of a sole proprietorship are deemed the assets of the owner. As such, when the owner passes, even if all of the business assets are in the name of the business, the Internal Revenue Service lumps the owner’s personal assets and business assets together for federal estate tax purposes. This can be troubling for small-business owners whose businesses own numerous non-liquid assets (real property, automobiles, heavy machinery, etc.). The fair market value of these assets will be included with the owner’s other personal assets (including his/her home) for federal estate tax purposes, resulting in estate taxes being levied on the entire estate.. 
 
Another example is ownership in an S-corporation. Many small businesses and family-owned businesses are organized as S-Corporations because they provide families with corporate creditor protections devices, but are not subject to double-taxation. The IRS has established other eligibility requirements for the establishment of an S-corporation, such as having less than 100 shareholders and having only one class of stock. A qualified estate planner can help you determine whether or not your corporation is a candidate for an S-corporation election under the Internal Revenue Code. 
 
However, owning share in an S-Corporation can result in unfavorable estate tax treatment. For example, say three siblings are the only shareholders within the family-owned and operated S-corporation. If one sibling dies personally holding S-corporation stock, the IRS will include the value of these shares in his taxable estate. The value of the deceased sibling’s shares should receive some valuation discounts because he held shares in a family-owned business, but the value of the asset will be included in his taxable estate. A far greater potential problem exists where only one person holds all of the shares in an S-corporation. The IRS will value the entire business and include its valuation in the departed’s taxable estate for estate tax purposes. Proper estate planning can reduce the IRS’s valuation of the S-Corporation thereby reducing the decedent’s taxable estate. 
 
These are but two examples of family-owned business structures and how the IRS may treat their “value” upon a person’s death. Enter the estate planning/tax attorney and financial adviser. These individuals possess the tools and the knowhow to maximize your assets throughout your lifetime and ensure they are properly cared for and distributed thereafter. There are a number of tools available to small and family-owned business owners to achieve their estate planning goals. Several examples include:
 

Family Limited Partnerships & LLCs

FLPs and LLCs are two distinct types of business structures that have been used by estate planning attorneys to hold title to business/personal assets (most commonly real estate) to reduce the value of a person’s taxable estate. These structures allow parents or business associates (as general partners) the power to retain management and control over the business assets while permitting them to gift the value of these assets to their children. Moreover, because these assets are usually real estate, shares in a small business, and other non-cash equivalents, the general partners are able to able to discount their value, thereby permitting them to transfer more than the annual gift tax exclusion amount for that year. In 2011, the annual gift tax exclusion is $13,000.00.    These structures are extremely beneficial to small businesses and families who own a lot of real estate and want to keep the land in the family for generations to come.
 

Irrevocable Life Insurance Trusts (ILITs)

Many individuals have life insurance policies and designate their spouse, children, or other loved ones as beneficiaries. However, many people do not know that the proceeds of any life insurance policy with be included in your taxable estate upon your death if you retain ownership of the policy. An ILIT is one of several ways to avoid this pitfall, because the ILIT is considered a separate entity for tax purposes. As such, all the proceeds from life insurance policies owned by an ILIT will be allocated to the ILIT and not the person who created the ILIT. 
 

Personal Residence Trusts (PRTs)

The IRS will combine your business assets and personal assets upon your death when determining the value of your taxable estate. This includes the value of your personal residence. Many married couples hold title in their homes in either joint tenancy or in a revocable trust. Both of these methods will prevent the property from being subject to probate administration, but will not preclude the IRS from adding the deceased spouse’s interest in the property to their taxable estate. Personal Residence Trusts permit a person to irrevocably transfer their residence to the Trust while reserving the right to live in the residence (rent free) for a number of years, after which the Trust’s beneficiaries take title to the property. Additionally, there are special tax and mortgage rules related to PRTs so it is highly recommend you speak with a qualified estate planner if you are considering a PRT.
 

Joint Accounts/Ownership 

Some assets can be jointly owned, wherein no administrative procedure is required to transfer title from one joint owner to the other upon one’s death. Moreover, in small and family-owned businesses, it is advantageous to have more than one person authorized on business accounts so the business can continue operating after a family member passes away. 

As with any estate plan, there are numerous factors that must be weighed, and the tools that might be beneficial to one business/family may not necessarily be the right tools for you. In addition to lowering your taxable estate and making lifetime gifts to your children, proper estate planning can also protect your assets from creditors. The easiest way to accomplish these goals is to make sure your business assets are separate from your personal assets. Unfortunately, due to the constant fluctuation of federal and state tax laws this task is not as simple as it appears. Death may be certain, but with proper estate planning death taxes do not have to be.


Jarod A. Cauzza is an associate at Neil Dymott. His areas of practice include estate planning, trust administration and probate. For further information, Mr. Cauzza can be reached at (619) 238-1712 or jcauzza@neildymott.com

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