Death & taxes

Congress is considering a repeal of the estate, or “death” tax — again. So what’s a business owner to do?

From the pages of In Business magazine.

One of the most important things a business owner should do, and likely one thing that keeps them up at night, is succession planning, yet statistics show that the majority of business owners fail to do so.

Perhaps entrepreneurs and “oldpreneurs” alike avoid the issue because they fear the expense, or the time it may take, or coming face-to-face with their own mortality. More likely, though, they’re so involved in their day-to-day operations that they simply can’t come up for air.

Whether Congress, under President Trump’s administration, ever gets around to repealing the estate tax — aka “death tax” — is still a mystery with health care and other issues in the forefront, but repeal is in the Trump tax plan; as such, it bears watching.

Through the years, U.S. tax law has become so complicated that even those in the know sometimes spin their heads.

“Tax law has not gotten easier,” notes Karen Prochaska, CPA/manager at Porter & Sack CPAs in Madison. “Every time we hear that a new tax law will simplify things, there’s so much analysis that I don’t think any change will be simple.”

It all boils down to how much is owed the government when the business is either sold, handed down, or a business owner dies.

“If a business owner gifts someone an asset, such as shares of stock, while they’re living, the recipient’s basis when he or she goes to sell that asset will be what the donor’s basis was,” Prochaska explains.

This is called the carryover basis.

If the donor doesn’t gift the asset, but owns the asset on death and it passes to the heirs after death, the heir’s basis is “stepped up” to fair market value. In many situations, she says, an heir can benefit from basis step up when comparing the gift of an appreciated asset to holding the asset until death.

Carryover and step-up bases can also be completely different values and do not dictate the amount a business can be sold for, Prochaska adds, but they can help provide a more fair valuation.

Though most businesses do not have to pay estate tax, they do pay income tax and capital gains. “Right now we have a very nice rate for capital gains versus ordinary income tax rates,” Prochaska states. “That’s the kind of tweaking we look at when we’re looking at succession planning.

“From our standpoint, it isn’t so much about whether the estate tax will be repealed, it’s a question of what the new thresholds will be. There’s talk on both ends, but we haven’t seen enough yet to know which way they’ll go.

“I’ve been doing this for almost 30 years. Over the last five years we haven’t seen a lot of consistency. We wait for the forms to be finalized and sometimes that doesn’t happen until January. If there is a tax law change, are they going to retroactively change things back to an odd date, or will it be January 1, 2018?”

Nate Dosch, vice president and market leader at First Business Trust & Investments, concurs. “In 2010, we had 11-and-a-half months with no estate taxes and then Congress reinstated it and made it retroactive to the first of the year. So we’ve been here before.”

While the estate tax only affects a small percentage of high net-worth individuals, it doesn’t lessen the importance of succession planning for everyone else, especially because of the ever-changing laws.

Case in point: In 2008, a state death tax credit was phased out. In 2010, the federal estate tax disappeared, albeit temporarily. “We have an estate tax currently on the books but it really doesn’t exist because the federal credit fell off,” notes Dosch. “There’s nothing for it to tax at this time. Most states are like that.”

Estate tax defined

The federal estate tax is a tax paid by an estate. Roy Fine, attorney at Murphy Desmond, helps explain: “An individual with a business that’s valued over $5,490,000, or $10,980,000 if you’re married, or a business and other assets that exceed that, has the potential for an estate tax,” he says.

For income tax purposes, the person inheriting a business after the owner’s death takes it at the value they inherited it. “So, if they inherit a $12 million business and decide to sell it the next day for $12 million, there’s no income tax on that sale because the value stepped up to that amount,” he says.

Fine most frequently sees one of two scenarios when working with clients: a succession plan that involves selling to a third party; or one that is a business transfer to long-term employees or family members.

“If the sale is to a third party, then it is largely a function of the tax treatment that the buyer is looking for, and they’re taking a new basis because they’re paying in new money.

“But if it’s a different kind of transaction among relatives, we may take some steps to try to avoid some of the income tax consequences that we’re talking about, and we might begin the process before the business owner dies.”

In those instances, Fine says there are techniques generally referred to as valuation discounts, or methods used to adjust the value of a business so a $12 million dollar business, for tax purposes, is less than that. “Perhaps the discounts get the number under the estate tax threshold, which may reduce the amount of income tax. It depends on which is the worst evil.”

Estate tax law should be of big concern to the affected group, he says, but the uncertainty is an even bigger issue. “It’s not knowing whether it’s an estate tax and they need to have liquidity to pay that tax so they don’t burden their family if it’s an income tax situation.”

The income tax, he explains, could come home to roost for an heir when that heir sells the business and has to recognize the capital gain. But it’s also possible that under the new law, it might have to be recognized when the business owner dies.

There is some chatter, Fine says, about making the owner’s death a recognition event so that the income tax would have to be paid even if there’s not an estate tax. “That could be problematic for a business, especially one that has debt already —
to have to pay income tax and still try to carry the debt. My hope is that Congress doesn’t go in that direction.”

Because of Trump’s campaign promises for tax reform, Fine wouldn’t be surprised if Congress acts as soon as the first of the year. If Congress repeals the estate tax, Fine argues that the best scenario would be to continue the step up in basis. “That way, the estate wouldn’t be taxed and the business would step up to the value on the date of the owner’s death,” he explains. “That would create the least amount of problems.”

The estate tax is not a huge moneymaker for the government, Fine notes, as the total tax collected amounts to just a tiny percentage of the entire federal budget. Still, if repealed, could Uncle Sam decide to replace those dollars with something new? “Good question,” Fine answers. “Often in these situations, the government repeals one tax and another one shows up.”

Dosch agrees. “That’s part of how government works. In the end, its only source of revenue is taxes. Money in, money out. So you either cut services or raise taxes.”

Collecting those estate taxes can also be labor intensive, Dosch adds, because of the dollar amounts involved. At that level, tax bills are often contested and may even end up in court.

Does Dosch believe the current tax will be repealed? “I think the exemption will stay where it is. It’s so high that it doesn’t impact a lot of our population, but I also think it will be difficult to get rid of completely. My fear is that they’ll tweak it like they did in 2010.”



Certain uncertainty

While most business owners do not fall under the estate tax parameters, whether the law is repealed remains pertinent because nobody has that crystal ball. A college athlete can become a multimillionaire overnight if he or she is drafted into the professional ranks. A startup business can be sold for millions after just a few short years.

A business owner could be killed by a bus tomorrow. That happens, too. The unknown is a burden faced by all.

Tax rules are always changing, which makes planning all the more challenging. “There is some discussion about permanent repeals or changes,” Fine says, “but over my 35 years of practice, I haven’t seen one tax rule that is considered permanent or unchangeable. Some don’t change but that doesn’t mean they couldn’t be changed.”

Certainty about the tax law would allow people to make decisions about what to do with their businesses and how to handle their assets. Fine says there is a school of thought that says people don’t need to worry too much about any of these tax provisions unless they’re advanced in age. “Under the Byrd rule, no tax law that has the potential to significantly increase the federal deficit materially can have a lifetime greater than 10 years,” he explains. “So if a business owner is in his or her 40s and healthy, they can probably wait out this line of taxes.”

One thing is certain: While business owners should not use Washington’s indecision as an excuse to delay succession planning, most businesses still operate without a plan.

A 2015 FPA/CNBC Business Owner Succession Planning Survey found that fewer than 30% of business owners actually have a formal succession plan in place.

That doesn’t surprise Dosch or his Madison colleague, Dave Shaw, senior vice president at First Business Trust & Investments, who believe that figure could be even higher.

“As a business bank, we deal with lots of small and medium-sized business owners,” notes Shaw. “We ask that question all the time: What is the end game? Oftentimes they’re so busy running their business that they’re not sure.”

Family planning

The assumption that a family business will continue to the next generation is no longer a given, notes Dosch. “We see fewer second- or third-generation family members engaged in the business, and that really complicates estate planning and the succession planning idea.

“Twenty years ago, it was assumed the next generation might take over a family business, but now they go to college, get a different degree, and don’t come back,” he says.

Succession planning helps with those scenarios, Shaw says. “With family, you may have two or three family members in the business, or maybe just one, and how do you make things equitable?” What if a family member isn’t equipped to handle business ownership? “That opens up another set of questions on transitioning outside the family,” he states.

So is the family-business star fading?

“I think that’s the world we live in now,” admits Dosch. “It seems family businesses are more often being sold rather than moving down the family line. It’s hard to look away from some of the unsolicited offers that people are getting when they can liquidate with little pain. The only pain is the legacy piece. They put their blood, sweat, and tears into a business, or their parents did, so it’s very emotional.”

The healthy economy has spawned scores of private equity or other companies looking to acquire businesses, Dosch says. “There is cash out there and an appetite to buy successful family businesses.”

In fact, many small business owners get calls every year from merger and acquisition advisors or competitors, Shaw explains, and since the majority of their assets are tied to the business, it’s crucial to plan for the best transition possible. Tax implications often determine whether it is better to sell the business in a tax efficient manner or hold it “until death,” which is what their parents may have done.

If the plan is to sell one day, the business owner must make the company shine in every respect. For example, Shaw says, during due diligence, potential buyers will look at the strength of the business’ management team. “If that business owner says, ‘well, that’s pretty much me,’ it could make the company less valuable to the buyer.”

If they’re interested in selling, it goes without saying that owners should always try to operate at peak sale value. “In effect, the pot of money they receive in the end becomes their new employer,” Shaw explains. “That’s where their check will come from.”

“The best course of action is to plan,” Dosch adds, “but don’t put that plan into a drawer and hope for the best, especially when you’re in a dynamic political environment like we are now when the tax law will probably continue to change.”

He suggests owners surround themselves with a competent and trustworthy team of experts consisting of a financial/banking advisor, tax attorney, CPA, insurance advisor, and valuation expert, and revisit their succession plan annually.

Tom Walzer, CEO at SACO Foods in Middleton, has done just that. SACO is a consumer packaged goods company that supplies products to grocery stores such as Walmart, Kroger, and Woodman’s, and its history dates back 100 years. SACO hired Walzer, a former CFO at Spectrum Brands, as part of its succession planning in 2014.

“They brought me in to protect the Sanna family from a financial perspective, but also as a strategy not to partner with a company that could have dissolved the operations,” Walzer states. “It was important to grow the company from within.”

Last year, Walzer brought in Chicago-based Benford Capital to help with SACO’s succession planning and help manage growth. That allowed Walzer to protect and financially reward Ray Sanna, the company’s owner, and “take some risk off the table.”

The partnership also allowed SACO to expand its succession plan, do acquisitions, and grow more quickly utilizing Benford’s capital. As a result, Walzer has since elevated six employees to owner status, rewarding them for their hard work and providing each with a roadmap to financial independence.

“That was my big succession move,” he says proudly, “and the company should be able to continue now for years into the future.”

SACO just broke ground on a new facility.

Walzer, who also owns Ancora Coffee, assembled a strategic “dream team” years ago, including Park Bank, DeWitt Ross & Stevens, and Baker Tilly. “It’s a comfortable relationship,” he says. “At SACO, we always want the business to be bigger than any one person and leave the experts to do what they do best.”



Just git ’er done!

The worst thing a company of any size can do is nothing when it comes to succession planning. “Regardless of whether the estate tax level is $5 million or $1 million or goes away entirely, the vast majority of businesses need an estate plan,” insists Dosch, to plan for the business’ future.

Some transition options include:

(1) Sale to an owner or partner/shareholder where one party buys out the other;

(2) Sale to top manager(s);

(3) Sale to a competitor, consolidator, or private equity group;

(4) Sale to all employees through an employee stock ownership plan (ESOP)

ESOPs give a portion or all of the company back to the employees and allows a company to continue when the current owner leaves. “That’s a great option,” Dosch states, “rather than selling the company to an equity group that consolidates and suddenly they’re all out of jobs.”

A systematic gifting program can also be implemented as part of a plan, which is not only tax efficient but also eases up on the company’s cash flow. “You can still give money every year to sons and daughters from a tax-free perspective,”
he reminds.

Shaw advises starting early — in fact, the earlier, the better. “It could be as long as a 5-year process to get things in place,” he cautions. “There’s always a chance for a crisis, a death, or losing key employees, so having a plan for all those aspects is really important.”

Prochaska usually begins the planning process by asking business owners to complete a checklist beginning with the most basic of questions: Do they have a will? What about health insurance? How will the assets be passed? Who will inherit the business? Is the plan to sell the business or pass it along?

“Business owners cannot make income or estate tax decisions until they know where the assets will go,” she explains, “and you don’t want to do anything drastic unless we’re looking at something more than an income-tax decision.

“These are important conversations to have right now, but to do anything in anticipation of a possible change is premature. Until we see something, we’re shooting from the hip.”

Click here to sign up for the free IB ezine — your twice-weekly resource for local business news, analysis, voices, and the names you need to know. If you are not already a subscriber to In Business magazine, be sure to sign up for our monthly print edition here.