Wealth Transfer Strategies for Business Owners: Minimizing Taxes, Maximizing Legacy

Wealth Transfer Strategies for Business Owners: Large Legacy, Small Taxes

• Passing a business on to the next generation requires attention to detail and knowledge of myriad techniques
• Cashing out involves its own set of strategies that maximize value to you and not the IRS
• Estate planning, insurance, and an eye on the future are critical aspects of executing a comprehensive wealth transfer plan

Last year, we opined on the importance of legacy planning, primarily from the emotional and sentimental perspectives. This time, it’s time to get down to the brass tacks of, well, taxes. Legacy planning is one thing, but maximizing the after-tax value of your business is what many of my we’ll call them “more seasoned” clients focus on.

I decided to dedicate a more strategic blog to this topic because there are so many options to effectively transfer your business or other assets to the next generation without Uncle Sam reaching too far into your pocket. All the techniques require significant due diligence—not just from a legal standpoint, but concerning your goals and wishes. It’s all part of the wealth transfer and legacy planning process. Of course, constructing a strategy that includes business continuity while providing cash to your loved ones is another common objective.

Without a tailored plan, disputes, tax burdens, and operational disruptions can plague you, your family, and the business. We’ll cover legal, financial, and some emotional considerations to help you navigate the process. Let’s dive into this important topic.

Start with Estate Planning

Minimizing taxes in the wealth transfer process begins with the end in mind. You need to have the basics covered, namely key estate planning documents:

• Last Will and Testament: Who gets what? Anyone with substantial assets should have this.
• Living Trust: A revocable trust keeps you in control and smoothly transfers assets upon your passing.
• Power of Attorney: A POA assigns individuals to make financial and healthcare decisions if you are incapacitated (a Healthcare Proxy is another good document to complete).
• Succession Plan: Outlines who will control the business upon your passing.
• Family Limited Partnership (FLP): This structure allows you to transfer business ownership to family members at a discounted value, which can help reduce estate taxes later.
• Generation-Skipping Transfer (GST) Tax Planning: Passing assets to grandchildren has its own potential tax benefits, and a GST is designed to keep taxes low on wealth transfers that skip a generation.

These are some of the table stakes to constructing and executing tax-efficient wealth transfer strategies. Now, let’s zoom in.

Direct Gifting During Your Lifetime

Among the simpler techniques for passing assets is to gift ownership interests while you’re alive. When done right, this approach can reduce your taxable estate while allowing you to see the benefits of your legacy in action. As they say, “Tis better to give with a warm hand than a cold one.”

Strategic gifting removes the gifted portion and its future appreciation from your taxable estate, thereby bringing down the potential taxable value of what you bequeath. This matters for individuals with an estate valued at more than $13,990,000 at death. Another tool is the federal gift tax exemption, which stands at $19,000 annually—you can give up to this amount to any person for any reason without tax implications. Combining annual gifting with the strategic use of the lifetime exemption can maximize wealth transfer efficiency.

Gifting small amounts is a simple process, but if you want to maximize its value, you should consider the help of a tax professional, particularly if you are unsure of the value of a business asset being transferred.

Using Trusts for Tax Efficiency and Control

Turning to a more complex set of tools, trusts are common but often intricate vehicles for moving assets to the next generation. They are versatile and customizable, but you also must know what you want. Here are some of the most common types of trusts for small business owners:

• Revocable Living Trusts: As mentioned earlier, you retain control of your assets during your lifetime. Upon death, the trust bypasses probate so that the transfer is smooth.
• Irrevocable Trusts: Removing the business from your estate can be accomplished with an irrevocable trust, but once executed, it cannot be changed. So, there’s a tradeoff between lower tax impact and the loss of control.
• Grantor Retained Annuity Trusts (GRATs): This trust type can be ideal for entrepreneurs with growing businesses as a GRAT is designed to pass on future appreciation with minimal tax liability. It works like a term annuity, and when the term is up, the remaining assets (including appreciation) can pass to beneficiaries tax-free.

Trusts are a popular and effective estate-planning tool to transfer wealth (including a business), keep taxes as low as possible, and protect your wishes and privacy.

Selling the Business to Family Members

Some small business owners just want to move ownership into the hands of their kids or other family members upon their retirement. Doing so means you as the owner can receive fair value for the asset (a full or partial cash-out) while keeping the venture within the family.

One method is to structure the sale using a promissory note, which works like a bond once you retire, providing you with an income stream. There are planning implications as the note received freezes the value of the business in the owner’s estate. Making this option appealing but also tricky is that though retirement income is ideal, the buyer must be able to make the purchase; external financing may be required. What’s more, drama and despair can occur if the heir defaults.

A buy-sell agreement is another option. Rather than going through the process of writing a promissory note, a buy-sell legal document outlines how ownership interests will transfer upon your death, disability, or retirement. Many agreements are funded via life insurance policies between partners—e.g., if one partner passes away, the policy’s proceeds are used to buy out the deceased’s share from their estate. This can be a simple process that delivers financial security to the family.

Life Insurance as a Wealth Transfer Tool

Life insurance can be harnessed on its own to facilitate a tax-savvy ownership transition. The primary benefit is to your heirs upon your death, as a life insurance policy provides them cash to cover estate tax and other expenses without having to sell off parts or all of the business. Life insurance can also provide income replacement, perhaps to a spouse or dependents, in the event of your unexpected passing.

For small business owners specifically, “key person insurance” protects the enterprise by providing cash to recruit and train a replacement for an essential team member. This life insurance policy type also protects against financial losses caused by the death of a key person.

Other Considerations: Diversification and Get Started Now

Most small business owners reading this likely have years, maybe decades, to diversify their net worth. The entrepreneurial spirit lives within you, and there’s time left to begin a new adventure or become a mentor to the next set of business leaders. No matter your path, leveraging years and seemingly small techniques over time can make wealth transfer lucrative for you (and less rewarding for the tax man).

The key thing is to communicate your plan with your family and business partners enough so that they have a game plan for when you step away or are called away. As an experienced business manager, you know that keeping good records is key, and bringing in a team of experienced financial and legal experts is often required to get the job done right.

Finally, no plan is a one-and-done deal. That’s especially true for a wealth transfer strategy—you must regularly review and update the plan since your circumstances change and tax laws are always in flux these days.