The choice is clear if you plan to leave a legacy.
Even with best intentions, training and teaching, children grow up to be adults with interests and talents of their own. When that doesn’t align with your empire (or, let’s just call it a business), it still requires the kind of foresight that Mr. Arnault gave to his own family and fortunes.
Even though you won’t be passing the business itself on to your heirs, if you want to leave a legacy, albeit different than you first imagined, you have some serious planning to do while you still own the business.
Let me share this scenario:
Joe and Mary have a business worth $10 million. They plan to retire in five years, but their children don’t want the business. They’d like to give some to charity, but for the most part, their legacy is aimed at their heirs. Selling the business and leaving the proceeds to their children would reduce their inheritance dramatically because of capital gains. So how do they meet all their goals, create a healthy retirement for themselves, leave some to charity, and have the business they created ultimately benefit their children as first intended?
A successful outcome doesn’t just happen. It must be planned while you’re still in ownership of the business, and able to employ tax planning strategies to minimize, defer or eliminate the taxes.
Without planning, a $10 million business may lose $4 million in a sale to capital gains taxes. That’s a big number.
There are better options:
Options include a Deferred Sales Trust (DST) and investing in Qualified Opportunity Zones (QOZ). (There are more, but for this example, we’ll dive into DSTs and QOZs).
These options would allow your heirs to receive a passive income without doing the work of running the business, especially when proceeds exceed $5 million. Because there will be different needs for that money (some may be needed immediately and other funds can be delayed), and diversification is key to mitigating risk, both strategies may have a place among your options, no matter the size of the business.
Qualified Opportunity Zone:
Let’s dig into the QOZ as an option. Its benefits include the gains of being in the real estate business, without the headaches. The downside is that income from this strategy requires patience.
QOZs are zones identified by federal and local governments as regions in need of economic development. Any individual or corporation (who qualifies with sufficient net worth) can defer taxes on capital gain income by using those capital gains to invest in real estate or businesses within these regions. The investment must be done within 180 days of realizing the capital gain to qualify, with exceptions.
Let’s imagine that, via the QOZ, your investment is put into a development on the Miami waterfront. The condominiums are under construction, however, and will take three years before they see a profit. Therefore, that investment, while deferring capital gains tax, will not realize any recurring income for your heirs until those three years have passed.
Through the condominiums’ QOZ, you are buying an investment that will generate income – later. Your heirs will not have to take the time and resources to run the business you created and, likewise, do not have to manage the QOZ. Their investment is similar to buying stock in a company. They get the benefits of investing in a company, as they would with stock, but without having anything to do with the company itself.
Delaware Statutory Trust:
With a DST, income may be realized almost immediately. Upon establishing the Trust, the business is sold directly to the Trust, in exchange for an installment note.
The Trust then sells the asset directly to a third-party buyer and collects sale proceeds. No capital gains tax liability is incurred as part of that transaction because the property is sold for the same price it’s purchased for, resulting in no actual capital gains to be taxed.
The tax-deferred proceeds are held by the Trust in assets, such as stocks, bonds or other business investments, allowing for tax-deferred growth until the funds are distributed to the Trust’s beneficiaries.
Some additional considerations include:
The standard installment agreement is for 10 years. At the end of the installment period, the remaining value in the Trust is transferred to the beneficiary and taxed or the beneficiary can elect to renew the DST for another 10-year installment note and continued tax deferral.
The asset must be transferred to the Trust prior to sale so that the beneficiary does not take direct receipt of any funds.
Legal fees to register the Trust will range somewhere from $20k-$25k. An annual trustee fee is also assessed.
Under current federal tax law, the capital gain rate may be 0%, 15% or 20% depending on an individual’s annual taxable income. Proper tax planning used in conjunction with a DST has the potential to shift a large capital gain taxed at 20% to the lower brackets of 0% and 15%.
While there are a myriad of considerations, every tool holds its benefits, cautionary notes, and varied outcomes. A well-planned transition, however, will allow a business owner to fund their retirement years, provide the flexibility of controlling their marginal tax rate, and provide for their heirs.
The many moving parts of your estate – business, heirs, real estate, philanthropy, investments – need to be orchestrated in concert to maximize your legacy and reduce your loss to estate taxes. This requires significant inter-disciplinary expertise to realize the benefits and avoid the pitfalls. Planning Network Partners is dedicated to examining this and other opportunities as part of a larger picture of your whole financial health.
Contact Us today for expert assistance.