By: Andrew Willms, The Milwaukee Company
and Maureen O'Leary, O'Leary-Guth Law Office, S.c.
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 January 1, 2022. This means that the remainder of 2021 could present a unique opportunity to sell or gift a business before tax changes occur.
Overview of Current Gift and Estate Tax Laws
To understand the consequences that potential changes in gift and estate tax laws could have on the transfer, we need to start with an understanding of current gift and estate tax laws. This blog post 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 which 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 $11,700,000 of gifts per donor ($23,400,000 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 $11,700,000 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, and the amount of the estate tax exemption available at death is reduced dollar for dollar by the amount of gift tax exemption used during life.
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 $23,400,000 at the surviving spouse’s death without incurring an estate tax if they had not used any of their exemption during life.
Use It or Lose It?
Under current law, the federal gift tax exemption and estate tax exemption amounts are scheduled to drop to approximately $6,300,000 per person ($12,600,000 per couple) beginning in 2026. President Biden has proposed that these tax laws change much sooner than 2026, and exemption amounts could drop much lower than $6,300,000 per person. Gift and estate tax rates could also increase higher than 40%.
Although exemption amounts could drop at any time, many practitioners doubt changes will occur sooner than January 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 $5,000,000 per person ($10,000,000 for a couple), then a $20,000,000 gift at that time would result in a $4,000,000 gift tax ($20,000,000 gift - $10,000,000 exemption = $10,000,000 x 40% gift tax rate = $4,000,000 gift tax). Or, if they never made the gift and held on to the business until death, they would owe $4,000,000 of estate tax on the business upon the death of both spouses if the business was still worth $20,000,000 at that time and assuming the last spouse to die had $10,000,000 of exemption available to apply to the business at that time ($20,000,000 business owned at death - $10,000,000 exemption = $10,000,000 x 40% estate tax rate = $4,000,000 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 $20,000,000 today could be worth much more in the future. For example, a $20,000,000 business today could be worth $30,000,000 when the owners die. If the last spouse to die had $10,000,000 of exemption to apply to the business at death, it would trigger an $8,000,000 estate tax ($30,000,000 business - $10,000,000 exemption = $20,000,000 x 40% estate tax rate = $8,000,000). Therefore, a gift (or sale) 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 may 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%-20%, depending on the taxpayer’s tax bracket[i]. 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 over $1,000,000 of adjusted gross income.[ii] (In addition to net investment income tax and state income tax, as applicable.)
If a capital gain tax rate increase occurs effective January 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.
Up until now it made good sense to hold off on gifts of business interests when the donor’s estate was less than his or her estate tax exemption. That’s because the basis adjustment rules allowed the tax basis of a business interest to be adjusted to its fair market value at death. In other words, the person who inherited the business could avoid capital gain taxes on all unrealized capital gain as of the date of death.
President Biden has proposed not only repealing the so-called step up in basis rules, but to also treat death as a taxable event. In other words, all built in gain could be taxable to heirs as of the date the business owner dies.
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 wants to transfer a business for non-tax reasons (ex. succession planning or retirement) then it makes sense to take advantage of tax efficient times to do so. However, transferring a business for only 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.
If a business owner wants to sell or gift their business, 2021 might present a unique opportunity to do so on a tax favorable basis. It is understandably frustrating that we don’t know if or 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.