Estate Planning Considerations for Business Owners

Passing on the business from one generation to the next is often a fundamental concern for the owner of a business due to the substantial investment one makes in their business. By properly positioning the owner's assets and income, any estate tax due upon the owner's death can be minimized and the amount of assets passing to the heirs can be maximized. Therefore, some degree of estate planning is appropriate to ensure the orderly transfer of the business and the owner's other assets. Certain basic estate and gift tax factors will need to be considered in formulating an estate plan that will provide the business owner with the maximum tax advantage.

Long Range Gift Program

One of the most common estate planning strategies for an owner of a business is the gifting of the owner’s interest or share in the business. Each year, an individual can give away up to $12,000, tax-free, to each of an unlimited number of persons. Given this gift exclusion for present interest transfers, a long-range gift program can be an effective estate planning tool. If the donor is married, both spouses can consent to the gift of the business interest which would total a value of $24,000 per donee, per year at no transfer tax cost. The gifted interest will no longer be present in the estate of the business owner. Over time, the owner can gift away some or all of his business interest to a family member or key employee. This effect should result in no valuation problems associated with those assets at the time of death as the value of the gift was established and documented at the time of transfer.

The advantages to a business owner of an established gift program are that the income that passes to the younger generation may be taxed at a lower marginal rate; the future appreciation on interest or stock will be shifted to the younger generation, thereby reducing estate taxes; over a period of time, control and ownership can be passed to the younger generation without any adverse tax costs; and through transfers, it is possible to avoid the inconvenience of probate and related costs of transferring a business interest at death. The amount of the gift is the fair market value of the interest or stock at the date of the gift.

Business Valuation

The valuation of a business interest is essential since the IRS can challenge a value utilized for a gift of a business interest in an estate even though the gift may have taken place many years earlier and even though the gift tax statute of limitations may have appeared to have lapsed. Having knowledge of the value of the business is important to the business owner for the following reasons: to evaluate the fairness of an offer to sell, acquire or merge a business, to take full advantage of a strategy of lifetime gifting of a business interest, and to determine the amounts of deductions for contributions of a business interest to charity, just to name a few.

There are various valuation methods employed in determining the value of a business. For a corporation, one method is to compare the corporation with a comparable publicly held corporation whose stock is traded on the open market to indicate evidence of the stock's worth. Another method is the asset valuation method which is based on a determination of how much the business could get for its assets if they were sold incident to a liquidation. A formula approach may also be used to support the valuation of a business and includes determining the book value or value of the business's net assets and applying the weighted average formula which assigns a weight to the various valuation methods which are averaged to arrive at the fair market value.

Of course, once the market value of the business is established, discounts must be allowed for other factors affecting the fair market value such as a discount for the lack of marketability, a minority interest discount, or a discount for the loss of a key person. Arriving at the market value can take considerable time and calculation; however, it is an invaluable procedure to the business owner's estate planning and should be done in conjunction with a certified business evaluator.

Reduction of Estate Value

A business owner must be concerned about the impact of estate taxes as a lifetime of work represented by the business may have to be broken up to pay such taxes. The reduction of the estate value during the owner’s lifetime can help solve this problem. Techniques, such as the “estate freeze” is where the taxpayer transfers the appreciation in their business interest from their estate to their heirs by "freezing" the value of the estate. This freezing technique, although not new, can often face legal challenges with regard to the valuation of the gift component of the estate freeze. Thus, the IRS added "special valuation rules" to impose stricter rules on valuing the interests retained by the older generation. The purpose of the new rule is to impose a gift tax at the time the "estate freeze" transaction occurs rather than wait until the taxpayer dies.

Another technique for passing on the business at reduced tax cost is the private annuity. A typical private annuity involves the transfer of a business interest to a son or daughter in exchange for the child's promise to make periodic payments for the remainder of the owner's life. Alternatively, and in the case of a corporation, the corporation may redeem the shareholder's stock in exchange for a private annuity. The private annuity reduces or avoids estate tax by removing the business from the estate. At the same time, it offers an opportunity to defer income taxes resulting from the transfer. Further, the annuity payments provide the shareholder/owner with a continuing cash flow and any future appreciation in the value of the business accrues to the person to whom the interest was transferred. Should the owner die prematurely, the unpaid portion of the annuity is not an asset in the estate.

Some of the advantages of a private annuity are that when properly structured, the private annuity allows for a transfer of a business interest free of gift tax. From an income tax standpoint, the transfer does not produce an immediate tax. The private annuity can also serve as an additional source of retirement income for the owner yielding more favorable tax consequences than consulting fees which may be subject to self-employment tax and challenged as unreasonable compensation or as an increased dividend.

Some of the disadvantages are that a private annuity may trigger a gift tax in the event that the value of the interest and the present value of the annuity are not equal. Also, the financial burden that is placed on the person obligated to make the annuity payments can be very high especially where the value is great and the owner's life expectancy in short.

As illustrated, both the corporate freeze and private annuity serve as a means of passing the owner's interest in the business on to the next-in-charge with little or no tax consequences. Reager & Adler, PC, can assist you with such intricate business and estate planning, guide you through the process and help create an estate planning team of accountants and business evaluators to accomplish your intended goals.

Susan H. Confair, who is part of Reager & Adler’s Transaction Group contributed this article. She holds a B.S. in Business Administration from West Virginia University and a J.D. from West Virginia University College of Law. Susan’s practice focuses on all aspects of real estate law, estate planning and elder law. She may be reached by calling (717) 763-1383 or via email at

  • Facebook
  • Twitter
  • DZone It!
  • Digg It!
  • StumbleUpon
  • Technorati
  • NewsVine
  • Reddit
  • Blinklist
  • Add diigo bookmark
Harrisburg Magazine Readers' Choice 2011