As we approach the end of 2021, there are important questions business owners should consider before the year is over. One such question is whether now is the time to transfer business ownership by gift, sale, or a combination of both.
Due to recent changes in our country’s political landscape, there has been a lot of buzz about potential upcoming changes to the tax code. For example, there could be increases for income taxes, gift taxes, and estate taxes in the near future. It is possible that tax changes could still occur in 2021, although most practitioners suspect the earliest tax changes will occur is Jan. 1, 2022. This means that the remainder of 2021 could present a unique opportunity to sell or gift a business, before tax changes occur.
Of course, when it comes to selling or gifting a business, common sense says “don’t let the tail wag the dog.” Or, maybe we should say, “don’t let the tax tail wag the dog.” In other words, if a business owner already wants to transfer a business for non-tax reasons (for succession planning or retirement), then it makes sense to take advantage of tax efficient times to do so.
However, transferring a business only for tax reasons may lead to seller’s remorse down the road.
There is much more to business planning than just tax considerations, so keep a broad perspective in mind when evaluating options.
Overview of Current Gift and Estate Tax Laws
To evaluate potential changes in gift and estate tax laws, we need to start with an understanding of current gift and estate tax laws. This article focuses on federal gift and estate taxes, because Wisconsin does not currently have a gift or estate tax (although some other states do).
Under the Internal Revenue Code, both gifts during life and transfers at death are taxed at a 40% rate under a unified system, unless an exclusion or exemption applies to shelter the transfer from taxation. For 2021, the gift tax “annual exclusion” allows all U.S. citizens to make gifts of up to $15,000 per recipient without the imposition of federal gift taxes. This amount is adjusted periodically for inflation.
In addition to the annual exclusion, all U.S. citizens are entitled to a lifetime federal gift tax exemption that shelters lifetime gifts in excess of the annual exclusion from the federal gift tax. The gift tax exemption is also indexed for inflation. For 2021, the exemption amount will shelter up to $11.7 million of gifts per donor ($23.4 million for a couple) that exceed the annual exclusion from the federal gift tax.
All U.S. citizens are also entitled to a federal estate tax exemption. For persons dying in 2021, the amount of bequests that can be sheltered from federal estate taxes at death is also $11.7 million per decedent (unless the bequest otherwise qualifies for a deduction or credit, such as a charitable bequest). The estate tax exemption is also indexed for inflation.
For couples, if less than all of the federal estate tax exemption of the first spouse to die is needed to avoid the imposition of federal estate taxes, the unused portion of the deceased spouse’s federal estate tax exemption may be added to the survivor’s federal estate tax exemption amount.
This transfer of exemption from a deceased spouse to the surviving spouse is known as “portability.” As a result, in 2021 a married couple can potentially transfer up to $23.4 million at the surviving spouse’s death without incurring an estate tax if they had not used any of their exemption during life. Every dollar of gift tax exemption used during life dollar for dollar reduces the amount of estate tax exemption available at death.
Use It or Lose It?
The federal gift tax exemption and estate tax exemption amounts are currently scheduled to drop to approximately $6.3 million per person ($12.6 million per couple) beginning in 2026, unless the law changes before then.
Tax laws could change much sooner than 2026 and exemption amounts could drop much lower than $6.3 million per person. Gift and estate tax rates could also increase higher than 40 percent.
Although exemption amounts could drop at any time, many practitioners doubt changes will occur sooner than Jan. 1, 2022. This may present a “use it or lose it” opportunity before the end of the year to make large gifts using the current exemption amount before it drops.
For example, if a couple owns a $20 million business, and has not yet used any of their exemption amounts, they could give that business to their children right now (or to trusts for their children) free of gift tax, because they would have enough gift tax exemption to cover the gift.
In contrast, if the couple waits to make the gift, and the exemption drops to $5 million per person ($10 million for a couple), then a $20 million gift at that time would result in a $4 million gift tax ($20 million gift – the $10 million exemption = $10 million x 40% gift tax rate = $4 million gift tax).
Or, if they never made the gift and held on to the business until death, they would owe $4 million of estate tax on the business upon the death of both spouses if the business was still worth $20 million at that time, and assuming the last spouse to die had $10 million of exemption available to apply to the business at that time ($20 million business owned at death – $10 million exemption = $10 million x 40% estate tax rate = $4 million estate tax). In addition, the taxpayer’s other assets would be subject to estate tax at death too.
Gifting or selling a business before it appreciates too much is another important consideration. A business that is worth $20 million today could be worth much more in the future.
For example, a $20 million business today could be worth $30 million when the owners die. If the last spouse to die had $10 million of exemption to apply at death, it would trigger an $8 million estate tax ($30 million business – $10 million exemption = $20 million x 40% estate tax rate = $8 million).
Therefore, a gift today doesn’t just save taxes on today’s values, but it actually saves taxes on whatever the future value of the asset might be. This is known as an “estate freeze” technique.
Income Tax Considerations
Besides gift tax and estate tax planning, some business owners want to complete a sale of their business before the end of 2021 for income tax reasons, so the gain is taxed at 2021 capital gain rates. This applies to taxable interfamily sales and traditional sales to a third-party buyer.
Currently, 2021 long-term capital gains are taxed between 0% and 20%, depending on the
taxpayer’s tax bracket. However, President Biden’s tax proposals include
a potential near-doubling of long-term capital gain tax rates, to as much as 39.6% for taxpayers with more than $1 million of adjusted gross income (in addition to net investment income tax and state income tax, as applicable).
If a capital gain tax rate increase occurs effective Jan. 1, 2022, business owners may be wise to close pending sales of businesses before the end of 2021 if possible. However, keep in mind that it is not impossible for an increase in capital gain tax rates to be made retroactively.
If a business owner wants to sell or gift their business, 2021 might present a unique opportunity to do so on a tax efficient basis. It is understandably frustrating that we don’t know when new tax legislation will pass, or whether new legislation will be retroactive. However, many planners believe that the benefits of proactive planning far outweigh the risks of waiting.
This article was originally published on the State Bar of Wisconsin’s
Business Law Blog. Visit the State Bar
sections or the
Business Law Section webpages to learn more about the benefits of section membership.