The purpose of this post, part three of our “Estate Planning for the Business Owner” series, is to provide a sample using real numbers showing the impact and benefit of using closely held business interests in lifetime gifting. Assume a new business-owner client comes in and says that he or she has never had his or her business valued, but based on the earnings and the industry he or she is in, he or she is confident that a third party would buy 100 percent of the business for $100 million. Let’s further assume that the effective income tax rate on the sale of the business is 30 percent, and the client has $13 million of gift/estate tax exemption available.

Option 1: No planning

Assuming the client is able to sell the business for $100 million, and keeps the net sale proceeds at a constant value until death.

Option 2: Gifting via Valuation, Followed by Subsequent Sale

Assume the client listens to the estate planner and decides to gift 20 percent of the business in equal shares to the client’s two children. This gift occurs before any formal offers are received for the sale of business. The estate planner engages a valuation expert, who provides a valuation report that meets the adequate disclosure requirements. The valuation expert conducts its due diligence and decides that 100 percent of the business should be valued at $85 million. The valuation expert further opines that the 20 percent interests gifted should have a 25 percent discount for lack of control and lack of marketability, resulting in a gift of $12,750,000 ($85M x 20% x 75%). The company later sells for the anticipated $100 million.

As a result of the valuation report, both as to the value of 100 percent of the business as well as the use of the valuation discounts, $47,700,000 is able to be passed to heirs, or an additional $500,000.

Option 3: Gifting via Valuation to Grantor Trust, Followed by Subsequent Sale

Assume the same facts as Option 2 except that the client really listens to the estate planner, and instead of gifting the 20 percent interest directly to his children, he instead gifts the 20 percent interest to an irrevocable trust for their benefit, which is a grantor trust for income tax purposes. A grantor trust is any trust in which the grantor (generally, the individual who created and funded the trust) is still considered the “owner” of the trust assets for income tax purposes, and therefore is personally responsible for the payment of the income tax liability of the trust. This payment is not considered an additional gift to the trust (i.e., the payments of the income tax liabilities are essentially tax free gifts to the trust), making it incredibly useful for estate planning purposes.

As a result of the valuation report, both as to the value of 100 percent of the business as well as the use of the valuation discounts, $50,100,000 is able to be passed to heirs. The use of the grantor trust makes the income tax payment come from assets that would otherwise be subject to the 40 percent estate tax, resulting in a more optimized tax result.

Option 4: Spouses Gifting via Valuation to Grantor Trust, Followed by Subsequent Sale

Assume the same facts as Option 3 except that the client is married and both the client and the client’s spouse have $13 million of exemption. Assume further that the spouses want to gift 40 percent rather than 20 percent to utilize their combined lifetime gift tax exemptions.

The use of both spouse’s exemptions allows for more value to be transferred to the grantor trust and outside of the client’s taxable estate, resulting in $58,200,000 passing to heirs after all taxes.

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The above examples are simplified and do not take into consideration the value of the net proceeds in the grantor trust being invested and growing over time, nor do they take into consideration any changes in the federal gift/estate tax exemption between the date of the gift and the donor’s subsequent death. The transfers of the business interests could also occur when the value of the business is much lower compared to the ultimate sale price. These differences amplify the importance of time to truly see the benefit of estate planning. We will look at how to document gift transfers in the next part of the series.

^[1] Assumes $13,000,000 of exemption and a flat 40 percent tax on anything above that amount. If the client is domiciled in a state that imposes a state-level estate tax (currently, Connecticut, the District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington) or an inheritance tax (Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania), additional state-level death taxes may also be due upon his or her death.

^[2] Assumes $250,000 of exemption remaining and a flat 40 percent tax on anything above that amount. Again, if the client is domiciled in a state that imposes a state-level estate or inheritance tax, additional state-level death taxes may also be due upon his or her death.

^[3] Assumes $250,000 of exemption remaining and a flat 40 percent tax on anything above that amount. Again, if the client is domiciled in a state that imposes a state-level estate or inheritance tax, additional state-level death taxes may also be due upon his or her death.

^[4] Assumes $250,000 of exemption remaining for each spouse and a flat 40 percent tax on anything above that amount. Again, if the client and his or her spouse is domiciled in a state that imposes a state-level estate or inheritance tax, additional state-level death taxes may also be due.

Read Part 1

Read Part 2