Year End Planning for The Year That Never Ends
The results of this year’s presidential election could have a drastic effect on estate planning techniques in the coming months, and even in the coming years.
Potential Changes to The Estate/Gift Tax Exemption in 2021
Because of President Trump’s Tax Cuts and Jobs Act(“TCJA”), the lifetime estate/gift tax exemption and GST exemption (“Exemptions”) are currently $11.58 million per person. As written, these Exemptions are sunset provisions that will automatically be reduced back to $5 million per person (adjusted for inflation) at the end of 2025. However, if presidential candidate Joe Biden wins the election in November, and if we have a Democratic Congress, the Exemptions will likely be reduced much sooner than that.
Although Biden has not laid out his full tax plan, it is probable that he will make it a priority to repeal the TCJA and the $11.58 million Exemptions per person that came with it. At the very least, this means that the Exemptions amount will return to $5 million per person (adjusted for inflation). If the Senate also flips and the Democrats are in control, the Exemptions could be reduced even further, with some estimates hovering around $3.5 million per person. With the current top rate of 40%, the estate/gift taxes forfeited for failing to make a completed gift before changes are made to the tax law could be at least $2.4 million per person. That’s $2.4 million that can instead be gifted to a family member or loved one of your choosing, if the proper estate plan is in place.
Don’t Procrastinate: Why you need to start planning now
If Biden wins the election, and if we have a Democratic Congress, any changes he may make to the tax policy could be deemed retroactive to January 1, 2021, which is why it is imperative to make important estate planning decisions before the end of the year.
How to Use the Exemption Before It’s Too Late: Gifts and SLATs
There are various ways to effectively use the Exemptions before the end of 2020. One easy way is by making outright gifts or gifts in trust for your descendants; however, clients are often concerned about access to the funds in the event that their other assets are not sufficient to support their accustomed manner of living.
One popular technique designed to save estate taxes without losing all access to the gifted funds is the transferring of assets to a Spousal Lifetime Access Trust (“SLAT”). Through an irrevocable lifetime transfer, the grantor can use some or all of his or her available exemption, while still having some indirect access to benefits from the trust. The SLAT is structured for the benefit of the grantor’s spouse and descendants, and both spouses can create SLATs for each other, as long as they are non-reciprocal. This means that through optimal SLAT planning, married couples can “lock in” $23.16 million, estate/gift tax free, for the benefit of themselves and their descendants, before any changes in the tax law.
We recommend that married clients work with their financial advisors to model their income needs under varying circumstances to see if they are comfortable using one or both spouse’s Exemptions, and ensure the surviving spouse’s needs will be met if her or she loses access to one SLAT upon the first to die. If you and your spouse would like to take advantage of the non-reciprocal SLAT planning, it is imperative that you begin immediately. Transfers between spouses, if necessary, will require time and planning.
There are, however, a few drawbacks to be noted about SLATs. There is no step-up in basis at the grantor’s death for assets gifted to the trust, and the surviving spouse will lose indirect access he or she had to the income and principal in the trust the survivor set up with the deceased spouse as beneficiary. On the other hand, an advantage to SLAT planning is the ability to set up the trusts, make a loan, and forgive the loan after the election if you would like to wait and see what the results will be in November.
Additional Planning to Consider While Interest Rates are Low: GRATs and Loans
If you have already used most or all of your Exemptions, a Grantor Retained Annuity Trust (GRAT) may be a good option for you. If the value of the assets increases by more than the IRC §7520 hurdle, which is at a historical low of 0.4% for November 2020, the GRAT will be an effective wealth transfer technique. This economic success can be magnified if you use a volatile asset that is successful.
Another wealth transfer strategy to utilize while interest rates are low is intra-family loans. You can lend money directly to family members or trusts for their benefit as long as the interest rate is greater than or equal to the adjusted federal rate (“AFR”). The short-term adjusted AFR for notes less than three years is 0.13% as of November 2020. If you have any outstanding intra-family loans, now would be a good time to consider refinancing to take advantage of the current low interest rate climate.
Additionally, if you take advantage of grantor trust planning, interest payments on the intra-family loans can avoid income tax consequences if the loan is made to a grantor trust. Grantors also have the ability to pay the taxes for the trust (which is an additional tax-free gift to the trust), allowing the trust to grow estate tax free. Further, if the grantor permits the substitution of assets, higher basis assets can be “swapped” for lower basis assets, which would then get a step-up in basis at the grantor’s death.
2020 has been a particularly volatile year in many ways. Now is the time to stop and think about your family’s estate plan and make any important changes while you still have the opportunity. Pending the election results, the $11.58 million in Exemptions may only be safe until December 31st, and if you don’t use it, you lose it.
PPP Loans and Estate Planning
Many businesses participated in the Payroll Protection Program authorized by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and modified by the Paycheck Protection Program Flexibility Act of 2020. The essence of the PPP program is that businesses impacted by the COVID-19 pandemic could apply for a forgivable loan that could potentially be forgiven if the borrower spends the loan proceeds on payroll and certain authorized non-payroll expenses.
On October 2, 2020, the Small Business Administration (SBA) issued an SBA Procedural Notice (5000-20057) that contains procedures for changes of ownership of an entity that received PPP funds. Many estate planning techniques involve gifting or selling closely held business interests to family members or trusts organized for the benefit of family members. Thus, it is very important to consider the impact of the procedural notice on estate planning transactions that result in a change of ownership of a PPP borrower.
The procedural notice provides that a change of ownership will be considered to have occurred when (1) at least 20 percent of the common stock or other ownership interest of a PPP borrower (including a publicly traded entity) is sold or otherwise transferred, whether in one or more transactions, including to an affiliate or an existing owner of the entity, (2) the PPP borrower sells or otherwise transfers at least 50 percent of its assets (measured by fair market value), whether in one or more transactions, or (3) a PPP borrower is merged with or into another entity.
Prior to the closing of any change of ownership transaction, the PPP borrower must notify the PPP Lender in writing of the contemplated transaction and provide the PPP Lender with a copy of the proposed agreements or other documents that would effectuate the proposed transaction.
There are different procedures depending on the circumstances of the change of ownership. There is no restriction on a change of ownership if, prior to the closing the sale or transfer, the PPP borrower has: (1) repaid the PPP note in full; or (2) completed a loan forgiveness application and (a) the SBA has remitted funds to the PPP lender in full satisfaction of the PPP note, or (b) the PPP borrower has repaid any remaining balance on the PPP loan.
If the PPP note is not fully satisfied, then there are alternate procedures. These procedures all require lender approval and may also require SBA approval, depending on the circumstances.
Thus, for example, if an estate planning transaction contemplates the transfer of 20 percent or more of ownership interest of a PPP borrower entity, the borrower must seek the approval of the lender and potentially the SBA. This can significantly slow down the closing of the transaction. In addition, it has been reported that lenders are not readily granting approval of these assignments.
If you are planning to make a gift or transfer of an ownership interest or sell assets of a business that borrowed money under the PPP program, then you should first contact your lender to make sure that the planning transaction will not conflict with your PPP loan.
The How and When to Sell Your Business During a Pandemic
The COVID-19 pandemic has introduced significant uncertainty into what had been a sellers' market for closely-held businesses. It is difficult to know how quickly the mergers and acquisitions (M&A) market will rebound from this crisis.
However, regardless of whether the M&A market rebounds in a matter of months or years, a business owner who is thinking of selling the family business at some point in the future should always be prepared for when the right opportunity presents itself. It is never too soon to consult legal counsel and your tax advisor. Significant value can be added up front.
Estate and tax planning, years ahead of a transaction, will result in more wealth staying with the family and will reduce what Uncle Sam ultimately takes from the sale proceeds. Among other things, a charitable gift of a portion of company equity prior to sale can reduce capital gains while helping to fulfill your philanthropic goals.
Prior to any sale, it is important to ensure that employees have entered into appropriate restrictive covenant agreements and that key employees—whose efforts are vital to completing a sale transaction—have entered into stay bonus agreements that will motivate them to stick around until the deal closes.
Interviewing and selecting an investment banker is critical to most sale transactions. The right investment banker can help identify potential buyers and, in turn, maximize your company’s value. The investment banker not only needs to intimately know your business, warts and all, but must also have a clear understanding of where your business sits in the marketplace. They also need to understand your timeline and goals. Once you have selected the appropriate investment banker, it is important to negotiate the investment banker’s engagement terms. All too often, business owners engage investment bankers without understanding all of the options available to them. This can lead to disappointment at closing when expectations are not met because the investment banker’s engagement terms were not negotiated up front.
Once an investment banker has been engaged, it is necessary to prepare Confidential Information Memoranda (CIMs) and other marketing materials to be presented to targeted potential buyers. As misstatements in these materials can lead to liability, your counsel should review these materials. As potential suitors can and likely will be competitors, non-disclosure agreements are essential to protect the business from those that do not end up being the buyer.
If your investment banker will conduct an auction process, laying out bidding procedures will help ensure apples to apples bidding. Requiring bidders to submit sufficiently detailed proposed deal terms will help facilitate your, your counsel’s and your other advisors’ review of each bid. In an auction process, the seller often proposes a form of purchase agreement. The agreement is, of course, pro-seller but subject to negotiation by bidders.
The letter of intent is a negotiated outline of the deal. All too often, clients bring in tax advisors and counsel after letters of intent are signed. Although the letter of intent is not the purchase agreement, it lays out the critical terms that will provide the foundation for the purchase agreement. While this is not the appropriate time to hash out every detail of a deal, agreeing to certain key deal terms at this point can help reduce back and forth later in the process and ensure that there is a meeting of the minds. If the letter of intent contains sufficient detail, then it will be less likely that the deal will fall through. Moreover, as sellers often have maximum leverage at the letter of intent stage, it is critical to work with counsel and your other advisors to ensure that the letter of intent includes the most seller-favorable legal and business terms possible.
Negotiating the purchase agreement and other transaction documents is necessary to get the deal closed. Counsel is significantly involved in this stage.
Among the most critical deal points are the seller’s and key senior employees’ roles after the sale. If one or more of them is going to be employed (or engaged pursuant to a consulting agreement) post-closing, the negotiation of their employment or consulting agreements cannot be left to post-closing. Rather, the terms of the rollover and incentive equity that sellers of businesses—and senior management of these businesses—receive will be critical to the success of the deal.
The success of a sale will be directly related to the talent of the seller’s team, which includes seller’s counsel, accountant and investment banker. Legal issues to be addressed include tax, employee benefits, employment, environmental and real estate.
In short, while the COVID-19 pandemic may have put a damper on the M&A market for the time being, owners of closely-held businesses should continue to prepare for future opportunities. We would be happy to further discuss the many ways in which Gunster adds significant value for our clients before, during and after the sale process.
All references to available/allowable estate tax exemptions and credits relate only to persons who are U.S. citizens; references to gift tax exemptions/exclusions generally apply to U.S. citizens and U.S. Lawful Permanent Residents (i.e., “green card” holders). While most transfer tax savings techniques discussed can be fine-tuned to benefit non-U.S. citizens, the results will differ and must be addressed on a case-by-case basis.
The 2020 Annual Exclusion is an aggregate of $15,000 per donee, from each donor; or $30,000 per couple, if a husband and wife file a “split gift” Gift Tax Return on gifts made from either of their assets this year. Medical/Tuition [“ed/med”] Exclusion Gifts allow a donor to pay an unlimited amount for anyone’s medical or tuition expenses (including health insurance premiums), if paid directly to the service provider, without incurring any gift tax or use of their unified credit; and, if properly structured, ed/med gifts should not reduce the $15,000 amount available to be given to the same person by a donor each year.
This publication is for general information only. It is not legal advice, and legal counsel should be contacted before any action is taken that might be influenced by this publication. Tax Advice Disclosure: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.
