If you're like most business owners, you're probably looking for some tax planning methods that will reduce your annual taxes. Here's an example that shows how using multiple entities in a business transfer of ownership can lower your tax burden.
Andrew is a third-generation owner of a construction company. His eventual business transfer plan is to pass his company to his children, hopefully in a way that avoids the gift and estate taxes Andrew paid when his father transferred the business to him. Since his children are young and he wants to provide them with the best possible education, he hopes to find a way to have his business pay for his children's education, on a tax-deductible basis.
Andrew's 14-year-old son, John, attends an expensive private school, and his 17-year-old daughter, Janice, attends private high school and intends to pursue several years more of higher education. Andrew's advisors suggest he create multiple business entities in an effort to distribute taxable income to his children in specific amounts at specified times. Here's how Andrew can accomplish income tax planning and estate tax planning through multiple entities.
Since Andrew and his wife own the land used in the construction business, Andrew's attorneys suggest this course of action:
Andrew will transfer that real estate into a limited liability company (LLC) owned by the family.
Andrew will present a minority interest in that LLC to trusts created for the benefit of John and Janice.
The LLC will lease the land to the business, insulating the land from the company's operational risks and providing income to the LLC.
Since the children own part of the LLC, they receive and are taxed on each year's earned income. Andrew presents the ownership interests as gifts to the children, applying standard minority and lack of marketability discounts. This method removes two items from Andrew's estate:
The children's share of the property
Future appreciation of the real estate
Here's another huge benefit: the income earned by the LLC owned by the children's trusts is taxed in the children's tax brackets, since each child is over 14 years old. Each child's ownership interest is calculated to produce approximately $40,000 of taxable income each year. After paying taxes of approximately $5,000 (an effective rate of less than 15%), each child has about $35,000 to pay educational expenses or other expenses that are not considered "support obligations" of the parents. Also, $80,000 of income is removed from Andrew's marginal tax bracket, resulting in tax savings of roughly 45% of $80,000–$36,000!
If we subtract the taxes paid by the children ($10,000) from Andrew's tax savings, the entire family saves about $26,000 per year in taxes. If the children are in school for at least ten more years, Andrew's cumulative tax savings run about $260,000. In addition, his estate no longer includes an asset expected to grow in value, and his taxable income no longer includes an income he doesn't need personally.
To provide for other future expenses, Andrew could purchase second-to-die life insurance coverage on himself and his wife, which would provide a benefit of about $3.5 million tax free for use in paying estate and gift taxes when he transfers the entire estate.
The Final Result
Family tax savings of about $26,000 per year
Estate tax savings
Creditor-protection vehicle (LLC) protects the real estate from business creditors
To see this result, the total cost in ongoing accounting and legal fees is usually less than $1,000 per year. Contact SWBC's business advisors to implement cost-saving strategies like this in your business.
Information furnished by Business Enterprise Institute.