Occasionally, we like to share some of our personal stories and experiences and how they’ve helped shape how we serve our clients. In today’s blog post, I’ll share a personal story of lessons learned as the third generation of a family manufacturing business.
The Importance of Business Valuation, Life Insurance, Succession Planning and Estate Tax Strategy when Sudden Illness and Death Occurs.
40 years ago, and roughly a year before I was born, my grandfather died after an unexpected and short battle with cancer. He was a dynamic businessman. The son of an immigrant blacksmith, he worked and innovated his way into a successful and profitable metal stamping and manufacturing business. He kept his product line simple but well-constructed and, at its height, the company employed 300 people.
Due to growth, production constraints emerged that could be solved only by a newer, larger, and more efficient manufacturing plant. With this need in mind, my grandfather compiled a large cash pool for the purchase of land and construction of a plant. Suddenly, and unexpectedly, he became ill and passed away.
The North Star that guided our family was quickly lost with no direction left behind. My grandmother was an incredible homemaker and lovely woman but not in the position to take over a thriving business. That responsibility was left to my mother and her three siblings, only in their late twenties. Not only was the entire family emotionally devastated, but when the estate taxes came due, there was nowhere to turn for funds aside from the manufacturing plant reserve setup by my grandfather inside the company. What took years to accumulate was suddenly gone. Over the business’s subsequent 40-year life, the cash pool was never re-established nor was a larger production facility ever purchased.
Estate Taxes & Life Insurance
In hindsight it is easy to see that failure to plan for a possible estate tax can destroy a company’s viability and sustainability. No one enjoys paying for, or thinking about, life insurance. However, once serious illness occurs, it becomes difficult, if not impossible, to obtain proper coverage. This taught me to be realistic about mortality and to be intentional about succession planning and business continuance. We should all take the time to work with trusted advisors to assess potential estate tax implications of our decisions.
Importance of Business Valuation
There is another concept that should not be overlooked: how do you properly value a business? Business valuation is complex with various methodologies yielding different results. For gift & estate tax purposes, a lower valuation is advantageous to decrease the associated tax due.
When my grandfather died, initial counsel valued the business extremely high. It was immediately clear the family needed the assistance of better-qualified professionals who understood the full implications of the work being performed. Upon hiring a qualified appraiser with a background in tax, alternative methodologies were considered with appropriate discounts and a lower valuation was eventually determined. The appraiser considered discounts for lack of marketability and lack of control, which are powerful tools that can help reduce the value included in the decedent’s taxable estate. This illustrates how important it is to work with a highly skilled tax professional and qualified appraiser.
In addition, an alternate valuation must always be considered. The alternate valuation is the value of an estate’s assets six months after the date of death. If the estate’s value decreases during this time period, the lower values should be used. It’s important to remember that if an asset is distributed out of the estate, sold, exchanged or otherwise disposed of during the six-month period, the alternate valuation would not apply.
Other Options to Pay Estate Tax
Today, under Internal Revenue Code (IRC) Section 6166, the estate would have an option to extend the time for payment of the federal estate tax. Under IRC Section 6166, if an interest in a closely held business makes up more than 35% of the adjusted gross estate, the executor may elect to defer the tax into two or more, but not to exceed 10, equal installments. The amount of tax that can be deferred is based upon the proportion of value of the closely held business to the total adjusted gross estate. This proportion is then applied to the total federal estate tax net of any credits.
A simple example may be helpful. A decedent has an adjusted gross estate of $50,000,000. Included in the adjusted gross estate is a closely held business valued at $40,000,000. Here, the closely held business makes up more than 35% of the estate ($40,000,000 / $50,000,000 = 80%) making the election under IRC Section 6166 available. If the total estate tax, after credits, was $20,000,000, $16,000,000 would be eligible for the election (80% * $20,000,000 = $16,000,000).
If elected, the first principal installment must be paid by the beginning of the 5th year following the original federal estate tax due date. Subsequent principal installments begin one year from the initial payment date. This election allows the estate to pay the tax over a maximum 14-year period. If this seems like a loan from the federal government to pay a portion of the estate tax, you’re correct.
Only interest is due over the first five years and in any subsequent years of deferment. Interest is to be paid annually beginning with the one-year anniversary from the original federal estate tax due date. There are two buckets of interest charged on the deferred amount. The first derives from a 2% interest rate charged on the first $1,570,000 of taxable value of the closely held business. This $1,570,000 is the value for 2020, indexed for inflation annually from the original $1,000,000 figure set in 1998. The second bucket is imposed on the remainder of the taxable value of the closely held business and is set at 45% of the current rate applicable to the underpayment of tax.
The story of my family business has helped me to become a better advisor because I can relate to many family business challenges. At Drucker & Scaccetti, we have several CPAs and attorneys whose families have successful businesses. This perspective, coupled with our knowledge of tax law, makes us uniquely qualified to help you plan for your business’s future. Call on us to discuss how we can help with your family business succession plan and other tax strategies.