If you are a small- to mid-sized business owner, you have probably said the following: “I am getting crushed by taxes!” With 70,000 pages in the Internal Revenue code, looking at some of the main taxes most business owners don’t think about is a wise first step.
Beginning with income taxes, there is the sales tax and the estate tax. Estate taxes can penalize families and their succession plans. Then there are the “stealth taxes.” These are the gift taxes and generation-skipping transfer taxes. Each of these has their own unique set of rules.
Here’s a fact: The US tax code can potentially subject a business and its owners to a tax rate upwards of 90 percent when considering payment of the taxes listed above. At the same time, the tax code is loaded with opportunities to defer taxation on income earned. The traditional advice for businesses is to set up tax postponed accounts now, with the hope of being in a lower tax bracket when (and if) one retires later. Funds that are left in these accounts and not distributed correctly can add to the taxation total of an estate. Beneficiaries often take distributions, exposing their funds to excessive income tax/penalties, and then realize that they made a tactical error the following year come tax season.
Next, let’s say the business prospers and grows to $20 million or $30 million in valuation. This would be well over the $5.45-million threshold for estate taxes of which the owner is allowed.
Let’s suggest that it was the owner’s intent to leave the business to a family member or business partner. How do they transfer these types of sizable assets to someone else? Well, not without paying the government its fair share. This is where gifting thresholds come into play. Every American is allowed to gift up to $14,000 a year to any person or entity they wish, without counting against each tax payer’s overall limit. The IRS combines the estate tax limit and gift limit into one item, called the unified credit allowance. It is equal to the same amount listed above; $5.45 million. Anything over this amount is taxed at the highest tax rate of about 40 percent. A married couple could potentially give away up to $10.9 million combined! Business owners can easily hit these thresholds with business valuations and life insurance proceeds.
Finally, there is the Generation Skipping Transfer Tax (GSTT), which is the government’s defense against an end run around estate and gift taxes. It imposes a flat tax on gifts and bequests above the estate/lifetime gift exclusion that avoids the gift or estate tax by skipping one or more generations.
With the potential of an additional 40 percent tax liability to an estate, working with a tax attorney or CPA to mitigate the tax burden is the appropriate step to take.
About the Author: Christopher J. Lester, ChFC®, CCPS, is president of Somerset-based Professional Planning Services. The firm was founded more than 20 years ago to help small businesses and families plan for retirement.