Passing down a successful business from generation to generation is the goal of many business owners, as discussed in our previous piece.
With advanced planning involving an insured Section 303 stock redemption plan, many obstacles that occur at the owner’s death can be avoided. Some obstacles that a Section 303 helps to avoid are:
- Estate liquidity
- Need for income
- Equalizing inheritances
- Impact on the family business
Facts, Features, and Funding a Section 303
Funding a corporate Section 303 stock redemption plan can occur in three different ways:
- Cash method
- Loan method
- Insured method
Of the three different ways, the insured method is the only one that guarantees that the cash needed to redeem the stock at the owner’s death will be available.
The features of a Section 303 stock redemption plan can help a business owner accomplish the following:
- Funds necessary to pay estate settlement costs are available so that there is no need to liquidate any business assets.
- Controlling interest is retained by the family.
- Other estate assets are protected.
- Even if there is enough cash in the estate to pay settlement the proceeds from a Section 303 redemption can be used as a source of continued income for the surviving spouse or to create equal inheritances for all children.
- Payment is immediate since the funds are not tied up in probate.
Some important facts to remember when constructing a Section 303 stock redemption plan include:
- Premium payments are not tax deductible for life insurance in order to fund a Section 303 stock redemption plan by the corporation.
- Although, at the owner’s death, the life insurance proceeds received by the corporation are usually not subject to federal income tax. However, they may be subject to the corporate alternative minimum tax.
- The partial redemption of the stock, if all Section 303 requirements are met, is treated as a capital transaction and subject to capital gains tax. This keeps the transactions from being considered as a dividend where they would be subject to ordinary income tax.
- The dollar amount received from a Section 303 partial redemption is subject to little or no capital gains tax, since the stock is stepped-up to its fair market value when the owner dies.
- Any redemption more than what is allowed under Section 303 is treated as dividend income and subject to ordinary income tax. Redemption amount limits are taken from the estate’s federal and state death taxes, funeral costs, and estate administration expenses.
- In a family owned corporation, a Section 303 partial stock redemption causes attribution problems.
Taking all of the above into consideration, any current and future estate tax provisions should be taken planned for when the retention of shares occurs in a closely-held corporation at a shareholder’s death.
Estate Planning Considerations
The federal estate tax is a progressive tax which increases from 18% up to as much as 40% based on the taxable value of an estate. This tax is essentially a transfer tax levied on the privilege of transferring property at the death of the owner.
If a property is transferred while the owner is still living, a federal gift tax is imposed on the transfer. The tax is not a tax on the asset itself, but rather on the right to transfer the asset. However, the determined amount of tax payable is measured by the value of the transferred asset.
Next, once the federal estate or gift tax is determined, the amount is reduced by a gift and estate tax unified credit. For taxable estates with a value less than or equal to the unified credit, federal estate taxes will not be due. A cumulative lifetime taxable gift also falls under the same rules, but the gift amount is added back to the value of the owner’s estate to determine federal estate taxes.
In 2018, the unified credit equivalent, as adjusted for inflation, is $11,200,000. This means that an individual may transfer, as a gift or after death, an amount over $11,000,000 without incurring any tax liability.
Additionally, a spouse may also take advantage of any unused portion of the estate tax unified credit ($11,200,000), not used by the other spouse. With careful estate planning, a married couple can essentially shield over $22 million from the federal estate and gift tax.
The estate tax deferral allows the payment of this estate tax that is attributable to the value of the closely-held business included in the estate to be deferred for a time period of up to five years.
Generation-skipping Transfer Tax
The generation-skipping transfer tax (GSTT) involves skipping a generation when transferring property. Since the federal government collects taxes on property transfers from one generation to the next immediate generation, such as father to son, the GSTT allows an estate owner to skip the children and transfer property to a family member who is two or more generations removed, such as grandfather to grandson. By doing this, the government is deprived of any estate taxes that might have been collected on the property by children of the property owner.
A generation-skipping transfer more than the available exemptions is subject to the maximum federal estate and gift tax rate of 40% for 2018. The GSTT is an additional tax due and payable by the estate, transferor, or the trustee of the trust set up in a generation-skipping transfer.
There are many different legal ways to avoid paying the government more than it is trying to take. A Section 303 stock redemption plan funded by life insurance is one very advantageous way to set up a series of events at the owner’s death that will leave the surviving family members and the family business in secure financial shape.
As with any complex business and estate plan, talk with a qualified financial advisor. Plan with flexibility in order to adjust to an uncertain tax future. Protect your family and your legacy today by talking with a financial advisor.