Estate planning is something that people generally begin to think about when they're old. But what about young entrepreneurs? When should they start thinking about estate planning?
If the younger business owner can take just a few minutes to focus on estate planning as the process of building the business perhaps toward an IPO moves forward, there is an important opportunity for tax savings, providing for children and also for the community through a family foundation.
First, you'll need a little tax background to understand the reason why estate planning is important. Aside from paying income tax, everyone is taxed on the assets they own when they die. The tax rate rises quickly to 55 percent and in some cases can be as high as 60 percent. There are four exemptions from this tax:
- Applicable Exclusion Amount. Unless your assets are worth more than $675,000 this year, you aren't subject to the estate tax. That exemption grows over time, to reach $1 million by 2006.
- Marital Deduction. Anything you leave to your spouse avoids estate tax until your spouse dies. In essence, the estate tax is only imposed when assets pass from parents to children (or other, non-spouse heirs).
- Charitable Deduction. Anything left to charity is exempt from the estate tax. However, children are often left asking, "where's my inheritance?"
- Family Owned Business Deduction. Avoids tax this year on up to $625,000 of "qualified family owned business." This exemption probably doesn't apply to young business owners.
There is also a gift tax, which was enacted to put "teeth" into the estate tax. The gift tax taxes gifts based on the value of the asset given, in virtually the same manner as the estate tax would tax what you own when you die.
One additional exemption to the gift tax is the annual gift tax exclusion. This exemption allows everyone to give up to $10,000 per year to their children (or anyone else for that matter) without a gift tax consequence. What happens if you make a gift of more than that amount? As long as there is applicable exclusion amount left over, no gift tax is paid. Instead, the applicable exclusion amount is reduced. For example, if I give my child $15,000 in 2000, $10,000 of that amount escapes the gift tax completely. The excess $5,000 reduces my applicable exclusion amount from $675,000 to $670,000.
With this tax background in mind, consider this important question: when is the best time to give an asset away? The answer is when it is not worth a lot so that when it becomes worth a lot, that increase in value happens in the hands of the children and therefore avoids the estate and gift tax.When time is right
Let's say that you are a business owner and your shares are worth $1 today. You own 1,000,000 shares of your company. You also expect those shares to appreciate to $50 in value, after an IPO and later run-up in market value. You are in a perfect position to do estate tax planning, even though it's hard for you, as a young business owner, to think about estate planning, especially if you don't have children. However, with some foresight and planning, unborn children and alternate beneficiaries' assets can be put into trust and tax saving vehicles put into place.
You should consider establishing a trust for your children, and gifting shares to that trust now. The value of the gift for gift tax purposes is $1 per share given. Later, when the trust owns shares worth $50 per share, you've effectively transferred the appreciation $49 per share without incurring the 55 percent tax.Control over trust
Although you can't be the trustee of the trust, you can hold the power to fire the trustee and replace him or her. If you choose a close friend to act as trustee and retain this power to remove and replace the trustee, effectively you retain control of the transferred interest. This, along with other planning mechanisms can be used to insure that control of the company remains in your hands.
If you're married, you and your spouse can gift $1,370,000 of shares to a trust for a child without incurring gift tax ($20,000 is your combined annual gift tax exclusions and $1,350,000 is your combined applicable exclusion amounts). If you have 1,000,000 shares and they are worth $1 per share, you could gift them all without tax.
Let's assume you and your spouse want to give a quarter of your shares, or 250,000. Your gift of these shares to a trust for a child would be a gift of $250,000. The first $20,000 is gift tax free, and the other $230,000 uses up $115,000 of each of your applicable exclusion amounts (reducing them from $675,000 to $560,000). When the shares increase to $50, the trust owns $12.5 million worth of stock. You've saved gift taxes on $12.5 million minus the amount of applicable exclusion used ($230,000). If the tax rate is 55 percent, the tax savings is $6,748,000.
If you own more shares, and you want to transfer more than your applicable exclusion amount, there are two techniques you may consider. One is called a "gift through a grantor retained annuity trust," and the other is called a "sale to an intentionally defective irrevocable trust." Using these techniques, the appreciation can be transferred without using any applicable exclusion amount.
After transferring significant sums to a trust for children, the business owner's estate plan becomes simple. He or she can leave everything for his or her spouse, with the assets remaining at the survivor's death to pass to a family foundation managed by the children. The children can do good charitable deeds with the assets of the foundation, and no estate tax is ever paid.
Andrew Katzenstein is a partner in the Los Angeles office of Katten Muchin Zavis, where he focuses his practice on estate planning, probate and trust administration and charitable tax planning. He can be reached at email@example.com.
Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California. Contact James Klein at (213) 743-1759 with feedback and topic suggestions.
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